A self-fulfilling expectations led recession?

The only two lectures on Oxford’s core undergraduate macro course that I still teach, and which I have just taught, are the last two on fiscal policy. I use the privilege of the last lecture to end on a reflective note. I acknowledge that macro rightly got a lot of stick by largely ignoring the role of finance, but I also point out that the poor recovery has involved a vindication of the core macro model: austerity is a bad idea at the ZLB, QE was not inflationary and interest rates on government debt did not rise but fell.

So far so familiar. But I end by showing them my this chart.

And I say that we really have no idea why there has been no recovery from the Great Recession, so there are plenty of mysteries left in macro. The puzzle is sharpest in the UK because the pre-crisis trend is so stable, but something similar has happened in most places. I think it is a suitable note of humility (and perhaps inspiration) on which to end the course. 

A mechanical way to explain what has happened is to bend the trend: to suggest that technical progress has been slowing down for some time. This inevitably means that the pre-crisis period is transformed into a boom. I have been highly skeptical about that story, but I have to admit part of my skepticism comes in part from traditional ideas about what inflation would do in a boom.

However another explanation that I have always wondered about and which others are beginning to explore is that perhaps we remain in an extended period of demand deficiency. Keynesian theory is very suggestive that such a possibility could occur. Suppose that firms and consumers came to believe that the output gap was currently zero when it is not, and that they erroneously believed that the recession caused a step change both in potential GDP but also possibly its growth rate. Suppose also that unemployed workers priced themselves into jobs by cutting their (real) wage or disappearing by no longer looking for work. The former could happen because firms could choose more labour intensive production techniques: scrapping the car wash machine for workers with hoses.

In that situation, how do we know that we are suffering from demand deficiency? The traditional answer in macroeconomics is nominal deflation: falling wages and prices. But because workers have already priced themselves into jobs, nothing more will come from the wages route. So why would firms cut prices?

If the pre-crisis trend still applies, it means that there are a large number of innovations waiting to be embodied in new investment. With this new more efficient capital in place, firms would either increase their profits on selling to their existing market or try to expand their market by undercutting competitors. We would get an investment led recovery, accompanied by rising productivity and perhaps falling prices.

But suppose the innovations are just not profitable enough to generate an increase in profits that would justify undertaking the investment, even though borrowing costs are low. Maybe a far more dependable motivator for embodied technical progress to take place is the need to satisfy an expanding market. The firm needs to install new capacity to satisfy growing demand for its product, and then it is obvious to investment in equipment that embodies new innovations. The accelerator remains a very successful empirical model of investment. (On both points, see this discussion by Caballero.) But if beliefs are such that the market is not going to expand that much, because firms believe the economy is ‘at trend’ and trend growth has now become pretty small, then the need to invest to meet an expanding market largely goes away.

This idea goes right back to Keynes and animal spirits of course. Others have more recently reformulated similar ideas, such as Roger Farmer. This is a little different from the idea of adding endogenous growth to a Keynesian model, as in this paper by Benigno and Fornaro for example. I’m assuming in this discussion that potential output has not been lost, because innovation has not slowed, but it is simply not being utilised.

It is this possibility which is the reason that I have always argued central banks and governments should have been much more ambitious about demand stimulation after the Great Recession. As I and others have pointed out, you do not have to attach a very high probability to the scenario that demand will create supply before it justifies a policy of ‘testing the water’ by letting the economy run hot. Every time I look at the data above, I ask whether we have brought this on ourselves by a combination of destructive austerity and timidity.

Disaster

William Keegan, while discussing my NIER article on the UK government’s macro record, writes:

After the collapse of output of some 6-7% engendered by the financial crisis, output per capita grew by “just under 2%” from 2010 to 2013, whereas in 1981-84 and 1992-95 growth was over 8%. Wren-Lewis comments: “In short, the performance of the coalition government has been a disaster.” “Disaster” is a strong word from such a rigorous academic as Wren-Lewis, but I fully agree with him.

I like the idea - which is probably true - that rigorous academics generally refrain from calling things a disaster in print. Does that mean I’m not as rigorous as Keegan believes? I thought I’d try and justify my departure from this norm with some more data. It comes from a newly released dataset put together by the Bank of England. I’ve used it to calculate GDP per head over a much longer time horizon than I’ve shown before. Here it is.

It is a story of two trends: one from 1820 to WWI, and another from the end of WWII until the financial crisis. Now whether this really is a good way to describe how the economy evolved over the last two centuries I will leave to others, but it is remarkable how well this simple idea of deviations around a constant trend seems to work for the UK economy. To see this more clearly, here is 1820 to 1913 with the trend drawn in.

 The trend growth rate is just under 0.9% per annum. Here is the equivalent graph since 1950.

The trend growth rate, estimated from 1950 to 2010, is more than double that of the 1800s, at about 2.25%. Quite when and why the growth rate increased so much between the two world wars is a huge question, but my concern here is with deviations from these trends. Apart perhaps from two booms - the 1870s and the 1970s - large deviations from trend are short lived, with correction back towards the trend occurring pretty quickly.

The big exception, of course, is what has happened since the Great Recession. The deviation from trend just kept on getting bigger, and even with a fairly generous estimate for 2014 the best that can be said is that we might have started growing at trend again, so the gap has stopped getting any bigger. Even after the slump of 1919-21, GDP growth for the next four years was well above trend. What has happened since the financial crisis is unprecedented. This below average growth in GDP per head is one reason why real wages have been falling steadily over this period, which is also unprecedented.

It could of course be that what we are seeing is part of an adjustment to a new lower trend growth rate that was going on behind the scenes before 2010. That is what the methods used by the OECD and IMF (but not the OBR) assume. However they imply that 2007 was a huge boom in the UK, whereas all the other evidence says any boom was decidedly modest. It could be that these trends can suddenly shift after traumatic events. What is abundantly clear is that the last few years are no success story, and the constant drum beat in macromedia that the economy is doing well is completely inappropriate. A much better way of describing the last four years is to say it has been a disaster.

The size of the recent macro policy failure

In my Vox piece, I did a simple exercise to show how important fiscal austerity has been in the US, UK and Eurozone. If government consumption and investment had grown by 2% from 2010 onwards, and assuming a multiplier of 1.5, GDP could be around 4% higher in all three ‘countries’. [1]

It cannot be emphasised enough what a huge waste of resources this represents. If 1% growth was lost each year, then by 2013 that gives a cumulative loss of 10% of GDP. That approximation works well for the US. It also roughly fits with Eurozone estimates based on simulations of the NIGEM and QUEST models described here, but the Rannenberg et al study that I have discussed generates cumulative GDP losses up to twice as large. The UK is different from the US because austerity was concentrated in the early years. Using the same methodology (i.e. a multiplier of 1.5) you get a cumulated loss of around 14% of GDP.

For the UK I’ve often quoted a smaller figure of a 5% loss, but based on an analysis which I have always been careful to describe as conservative. It takes OBR estimates of the impact of austerity, which uses lower multipliers (although it does include the impact of higher taxes, which I ignore), and then assumes that all this lost GDP was recouped in 2013. Both differences are equally important in going from 14% to 5%.

Why, for the UK, do I tend to quote the conservative estimate? Four reasons. First, the government is fond of using OBR analysis when it suits them, because their work has some authority. Second, the OBR analysis is more detailed and comprehensive, and it implicitly allows for some monetary policy offset, which may be reasonable given how high inflation was in 2011. (I discuss this issue in much more detail here.) Third, I thought there was some poetic justice in assuming that all of the GDP growth in 2013 was simply a bounce back from earlier austerity, given that many people argue that 2013 growth vindicated this policy. [2] Fourth, losing 5% of GDP is bad enough, so there seemed no gain in using a higher figure, particularly when most of mediamacro act as if the number is zero. But if you asked me what my best guess is, it is nearer 14% than 5%. [3]

As I show in the Vox piece, if US GDP was 4% higher in 2013 it would be above the CBO’s current estimate of potential. The same is true for OECD estimates of potential for the UK and the Eurozone. But all three estimates assume that ‘trend’ or ‘potential’ GDP, or whatever you want to call it, has slowed substantially following the Great Recession. In a subsequent post I want to consider how reasonable it is to assume potential GDP is independent of actual GDP, and why even my 10% (14% for the UK) figure could be an underestimate.

Whether it is 5% of GDP, or 10%, or more, it is numbers like this that I had in mind when I wrote these two posts. They illustrate all too clearly the asymmetric risks that I talked about there. If these numbers are right, but monetary policy makers are nevertheless broadly content with their performance over the last five years, they either have a completely distorted view of the costs of inflation [4], or they have become fooled by a belief in the divine coincidence: that they only need to look at inflation to judge performance. (They could believe that they did not have the tools for the job, or that they had the wrong target, but if that is what they thought that is what they should have said.)

Going from the past to the present, Paul Krugman recently talked about the difference between insiders and outsiders on policy. This also reflects my own experience in the UK. How do we outsiders change this? I think the best place to start is by getting the insiders to think about the costs of fiscal austerity. Once you do that, you realise how large the recent failure of macro policy (but not macro theory) has been, and therefore how important it is not to carry on making the same mistake.  

[1] I write could, because any extra demand growth might - or might not - have been offset by a tighter monetary policy. If it had been offset, in this counterfactual world I would then be writing posts about the foolishness of monetary policy.

[2] We would then have a perfect example of my ‘closing a part of the economy down to boost future growth’ repost, which I used when people wanted to describe 2013 UK growth as vindicating austerity. Paul Krugman prefers being hit by a baseball bat.

[3] So rather than my conservative estimate that austerity lost every adult and child in the UK £1500, my best guess is nearer £4,000. (That is £10,000 per average UK household.) The equivalent number for the US (10% of GDP per capita) is just over $5,000, and for the Eurozone  E3,000.

 

[4] A weak recovery probably shaved the odd percentage point off inflation between 2011 and 2014, but if you ask most people how much they would have been prepared to pay for this, I doubt if the answer would be in the thousands of dollars, euros or pounds.

To all UK journalists

who plan to talk about the economy over the next 100 days. Here is a very simple fact. [3] GDP per head (a much better guide to average prosperity than GDP itself) grew at an average rate of less than 1% in the four years from 2010 to 2014. [1] In the previous 13 years (1997 to 2010), growth averaged over 1.5%. So growth in GDP per head was more than 50% higher under Labour than under the Conservatives, even though the biggest recession since the 1930s is included in the Labour period!

You have all read, and perhaps written, that the Conservatives will focus on the economy, because they think that is their strong point. Compared to their performance on other issues, maybe it is their strong point. But relative to the previous administration, this simple fact suggests otherwise.

George Osborne says: “Britain has had the fastest growing major economy in the world in 2014.” However GDP per head in the UK in 2014 remains below 2007 levels, but it had exceeded those levels in the US and Japan by 2013. The UK is not bottom of the league in these terms only because the Eurozone’s performance has been so poor. That GDP per head growth under 1.9% in 2014 can be trumpeted as a great success when it is no more than average growth between 1971 and 2010, and when we should be recovering from a huge recession, and when there are signs that this growth may not be sustainable, shows how diminished our expectations have become.  

In terms of a historical comparison between the record of this government and the previous administration Labour has no case to answer, because its performance is miles better. I am sure a supporter of the current government would say at this point that they had to clear up the mess that Labour created. But just think what such an excuse implies:

(1)  The Great Recession was in 2009, so it is included in the Labour government’s growth average, not that of the current government. You can see the impact of the recession on the average (the red line) in the chart below. [2] Are they really saying that the mess Labour left was worse than the impact of the global financial crisis!?

(2)  This excuse implies that bringing the government deficit down rapidly (austerity) meant that GDP growth is bound to be lower. This is something that the government’s critics have long argued, and which the OBR agrees with [4], but the government has always denied. Are they now admitting that austerity was (really) bad for growth?

(3)  If a government was elected just after a major recession, you would normally expect the exact opposite from these figures to be true. The new government would benefit from the recovery from the recession, while their predecessors average would be weighed down by the recession itself. So in any normal world, you would expect GDP per head to have grown much more rapidly over the last four years than any long run average. The fact that it has grown by considerably less means that the government should have a lot of explaining to do.

Growth under Labour, including the Great Recession, was 50% better than under the Coalition. So please, if you want to make your reporting on the economy over the next 100 days objective, use this fact. If the Conservatives win this election because enough people believe that they are more competent than the previous government at handling the economy, it will be a devastating verdict - on the UK media and its journalists.  

Quarter on previous year's quarter growth in UK GDP per head, 1997Q2 to 2014Q3

[1] The ONS data can easily be found here. The fourth quarter data is not out yet, so I have taken the ONS data updated on 21st January, and assumed growth of 0.5% in the final quarter, which is the first estimate of GDP growth in that quarter. That is obviously an overestimate, as it assumes no population growth in that quarter.

[2] The chart uses quarter on previous year’s quarter growth rates for the actual data (no estimates), and the average shown there is simply the average of these growth rates.

[3] A tweet from Ann Pettifor inspired this post, but of course responsibility for it is entirely mine.

[4] The OBR estimate, somewhat conservatively, that austerity reduced GDP growth by 1% in both FY 2010-11 and 2011-12. That alone would raise the average growth in GDP per head over the four years from 0.9% to 1.4%. Research by Jorda and Taylor suggests austerity had larger and more prolonged effects. 

How good has the UK recovery been?

In the next five months we will hear a lot about the strength of the UK recovery since 2013. Forget 2011 and 2012, certain people will say, it is finally coming good. To assess the validity of these claims, we can look at the latest ONS data for output per capita. It is important when comparing this recovery to previous experience to use GDP per capita rather than GDP, because population growth has been much more rapid in the last decade compared to the previous three. GDP per capita rather than GDP is a more relevant measure of average living standards. Here is the annual growth in UK GDP per head since 1980 (source: ONS).

The recession of 1980/81 was followed by years of over 2% growth. The ‘ERM recession’ likewise. In contrast, after the 2008/9 recession we have had a very weak recovery. Even growth in 2013 is well below the 1971-2007 average of around 2.2%. Only in 2014 do we seem to have got back to trend. Here are recently quarterly growth rates.

The trend quarterly growth rate is about 0.55%, so only in the last two quarters is there even a hint of exceeding that trend. So the best that can be claimed about growth so far is that we have in the last two years managed to return to trend growth. We have made no progress in getting back the ground that we lost in 2010-12, let alone recoup the ground lost in the recession.

Isn’t this true elsewhere? Only if we look at the Eurozone, which in 2013 also had levels of GDP per capita well below 2007 levels. In the US and Japan GDP per capita exceeded 2007 levels (just). So the UK has matched Eurozone performance, but without having to contend with an existential funding crisis.

Now maybe it might still be worth talking up the recovery if it included the promise of better times ahead. This could be the case, for example, if it had occurred despite a large rise in consumer savings, or because of a strong increase in net exports. Unfortunately in both cases the opposite is true: the current savings ratio appears pretty low, and our trade performance has been poor despite the depreciation during the crisis. This change in the terms of trade has also made consumers poorer than the GDP numbers would suggest.

So even if we exclude the years 2011 and 2012, this looks like a below par recovery by most standards. Economists who suggest otherwise are looking at their prejudices rather than the data. To what extent this is down to the government or something else is another issue. What it does suggest is that the government should be explaining why they have been unlucky, rather than boasting of their success.