Very Serious People and the deficit

I'm glad Paul Krugman liked my General Theory of Austerity paper. But he wonders whether I might be missing something, in not explaining why Very Serious People (VSPs) in the US, or mediamacro in the UK, presume that deficit reduction is always a good thing. The constant call for deficit reduction seems to transcends party politics, and furthermore should be something that the wise always promote.

I do talk about the influence of the City/Wall Street and central banks, but perhaps there is something in addition which I talked about in a recent post: deficit bias. Keynes talked about 'practical men' who tended to absorb some of the wisdom of 'academic scribblers' of 'a few years back'. The wisdom in this case was deficit bias: the tendency that many economists discussed before the financial crisis for deficits and debt to tend to rise over time, across cycles.  Perhaps VSPs and mediamacro have absorbed this particular area of academic analysis?

I think you can tell a similar story about academic scribbling of years past when it comes to the roles of monetary and fiscal policy. In the UK George Osborne argued explicitly that the economic consensus was now that monetary policy should deal with stabilising output and inflation, while fiscal policy makers should look after their own deficit. I have called this the consensus assignment. If he, or his advisors, absorbed this piece of conventional wisdom, so may VSPs and mediamacro.

So the headline academic scribbling was governments should control deficits, not the economy, and they are bad at it. Some of the theories put forward to explain deficit bias involve politicians knowingly deceiving voters by pretending tax cuts or spending designed to capture votes were 'affordable', and relying on general lack of understanding of the government finances to not be found out. That gives VSPs and the media more generally a clear role in providing a public service to help counteract the wickedness of politicians. VSPs might even think it was their public duty to constantly advocate deficit reduction to counter deficit bias.

As they say, a little knowledge can be a dangerous thing. Those of us working on the front line of monetary and fiscal interaction, or who had studied economic history or looked at the lost decade in Japan, knew the conventional assignment broke down when interest rates hit their lower bound. We knew that a liquidity trap was absolutely not the time to worry about deficits, and if you did so you would cause tremendous damage. And we were right.

So if you believe this story, the lesson for VSPs and mediamacro is you really need to talk to economists in the front line more often.

In the long run ... our children are adults

One of the annoying aspects of the Brexit debate is that every piece of macroeconomic news, every survey or data point, is interpreted as evidence one way or another about the economic costs of Brexit. The problem with this is partly that Brexit has not happened yet, but more fundamentally the important costs of Brexit were always long term. The Treasury’s analysis of the permanent costs of Brexit looked 15 years ahead, because that is the kind of time period over which the full impacts will be felt.

That has another annoying implication, which is that it will be very difficult to ever know what the actual costs of Brexit will have been. GDP being 6% lower after 15 years (the Treasury’s central estimate based on a bilateral trade agreement) will have a noticeable impact on economic growth, but who knows what the counterfactual is? As I have noted many times, the trend growth in UK GDP per capita was a remarkably steady 2.25% until the financial crisis, but since then productivity growth has collapsed, so who knows what it might have been without Brexit.

It is true that with rational expectations the future will have an impact on the present. That is why the exchange rate fell sharply on news of the vote. As I keep pointing out, unless those in the markets change their minds, that depreciation makes every UK resident poorer, perhaps forever. Equally if everyone anticipated that their future income will be lower they should reduce consumption now. But one reason the vote went the way it did is that many people did not believe that Brexit will have a long run negative impact on their standard of living.

We can make the same point in a more concrete way by thinking about the problem facing the OBR as it makes its forecast before the Autumn Statement in November. Those expecting to see something dramatic in these forecasts may be disappointed, partly because Brexit is likely to actually occur in the middle of the OBR’s 5 year forecasting period. Where the OBR will have to come clean about their view on the long term impact of Brexit will not be until next summer, when it does its 50 year ahead projections.

While these long term costs were always what really mattered, I have the impression (see also Paul Krugman) that the campaign spent much more time talking about short run impacts. As I have argued, these could be significant but are much more uncertain because they are more complicated. (How much will the depreciation boost net exports, for example?) So why was there so much focus on the short term in the campaign, and why did some (mainly politicians) start talking about Brexit creating a short term crisis?

I suspect (and this is just a guess) that one reason is that talk about long run costs had little impact in the media and on voters. (This is what the polls suggest: voters seemed more prepared to agree that there might be short run costs to Brexit.) To an economist that seems odd, because the economics behind the long term impact is much more solid than what might happen in the short run. Of course Keynes had a famous phrase about all being dead in the long run, but as Simon Taylor points out he made that comment to counteract a tendency for some to dismiss problems like unemployment caused by recessions as unimportant because it will disappear in the long run.

One suggestion I have seen links the lack of traction over long run costs to the fact that Leave voters tended to be older, and therefore that they did not care too much about the long run. I think this is unfair: most of those older voters also have children who they care about.

I suspect the problem came from a basic misunderstanding that was deliberately encouraged by the Leave campaign, which is to see all economic analysis as an unconditional macroeconomic forecast. The retort ‘who knows what will happen in 15 years time’ resonates if that is what you are familiar with. Too many people who should have known better, or perhaps chose not to know better, failed to make the distinction between conditional and unconditional forecasts. We had the ridiculous charge that the Chancellor should not have said people will be worse off in 15 years time, because with normal growth in absolute terms they probably will not be.

To see how nonsensical this framing is, think about the advice any doctor will give you that by smoking you will be worse off. Society does not collectively shrug that off by saying who knows what will happen in 10 or more years time. Except of course some teenagers do say this and come to regret it. Nor, by the way, do people tell medics that they failed for decades to predict that smoking would kill people so why should we take any notice now. We are completely familiar with doctors giving us conditional forecasts, but for some reason some in the media kept trying to view any analysis of long term Brexit costs as another unconditional macroeconomic forecast. [1]

One implication of this is that the consequences of Brexit may never become obvious, particularly to those who voted to Leave. Of course economists will do the best they can with the data, but I doubt very much that their analysis will get through to most people. One of the many sad aspects of the Brexit decision is that those who helped make it possible will never be held responsible for their actions.

[1] Note also that these long term Brexit costs essentially came from empirical studies with fairly common sense theoretical content well grounded in evidence. 

A General Theory of Austerity

“If we cannot puncture some of the mythology around austerity … then we are doomed to keep on making more and more mistakes”

Barack Obama, New York Times, April 2016

I have just completed a working paper based on my talk to the Royal Irish Academy at the end of last year. (Yes, I know, that was six months ago - it’s all the media training I have to do :-)) It has the title of this post: in part an allusion to Keynes who had been here before, but also because its scope is ambitious. The first part of the paper tries to explain why austerity is nearly always unnecessary, and the second part tries to understand why the austerity mistake happened.

I start by making a distinction which helps a great deal. It is between fiscal consolidation, which is a policy decision, and austerity, which is an outcome where that fiscal consolidation leads to an increase in aggregate unemployment. If you understand why monetary policy can normally stop fiscal consolidation leading to austerity, but cannot when interest rates are stuck near zero, then you are a long way to understanding why austerity was a mistake. Fiscal consolidation in 2010 was around 3 years too early. A section of the paper is devoted to showing that the idea that markets prevented such a delay in consolidation is a complete myth.

I say that austerity is nearly always unnecessary because (given the title) I also cover the case of an individual monetary union member that has an unusually (relative to the rest of the union) large government debt problem. Here some austerity is required, but not for the reason you might think. It has nothing to do with markets: the Eurozone crisis from 2010 to 2012 was a result of mistakes by the ECB. If a union member’s government debt is not sustainable, there needs to be some form of default (Greece). If it is sustainable, then the central bank should back that government, as the ECB ended up doing with OMT in 2012. The reason some austerity is necessary is that to support financing this unusually high debt, the union member needs a real depreciation, and in a monetary union that has to occur via lower wages and prices relative to other union members.

None of this theory is at all new: hence the allusion to Keynes in the title. That makes the question of why policy makers made the mistake all the more pertinent. One set of arguments point to an unfortunate conjunction of events: austerity as an accident if you like. Basically Greece happened at a time when German orthodoxy was dominant. I argue that this explanation cannot play more than a minor role: mainly because it does not explain what happened in the US and UK, but also because it requires us to believe that macroeconomics in Germany is very special and that it had the power to completely dominate policy makers not only in Germany but the rest of the Eurozone.

The set of arguments that I think have more force, and which make up the general theory of the title, reflect political opportunism on the political right which is dominated by a ‘small state’ ideology. It is opportunism because it chose to ignore the (long understood) macroeconomics, and instead appeal to arguments based on equating governments to households, at a time when many households were in the process of reducing debt or saving more. But this explanation raises another question in turn: how was the economics known since Keynes lost to simplistic household analogies.

This question can be put another way. Why was this opportunism so evident in this recession, but not in earlier economic downturns? There are a number of reasons for this, which I also discuss here, but one that I think is important in Europe is the spread of central bank independence, coupled with a phobia that European central bank governors have about fiscal dominance. In the UK, for example, the Bank of England played a key role in 2010 in convincing policymakers and the media that we needed immediate and aggressive fiscal consolidation. Keynesian demand management has been entrusted to institutions whose leaders (but not those who work for them) threw away the manual. But as Ben Bernanke showed, it does not have to be this way. [1]

If my analysis is right, it means that we cannot be complacent that when the next liquidity trap recession hits the austerity mistake will not be made again. Indeed it may be even more likely to happen, as austerity has in many cases been successful in reducing the size of the state. My paper does not explore how to avoid future austerity, but it hopefully lays the groundwork for that discussion.

[1] Here is Bernanke is October 2010 saying “indeed, premature fiscal tightening could put the recovery at risk”, although no doubt he could have said it louder.

Understanding Anti-Keynesians

Paul Krugman says Keynes is slowly winning. Tyler Cowen says no, there is lots of evidence Keynes is still losing. If this strikes you as slightly juvenile, I don’t blame you. Squabbling over the relevance of some guy who died nearly 70 years ago does make the academic discipline of macroeconomics seem rather pathetic.

Now, as you probably know, I’m not a neutral bystander in this debate. However I have always thought it important to try and understand where the other side is coming from. Leaving aside the debating points, what deep down is the core of the other side’s beliefs? But before addressing that, we need to be clear what we are arguing about. Let me single out three Keynesian propositions.

1)    Aggregate demand matters, at least in the short term and in some circumstances (see 2) maybe longer.

2)    There is such a thing as a liquidity trap, or equivalently the fact that there is a zero lower bound to nominal interest rates matters

3)    At least some forms of fiscal policy changes will impact on aggregate demand, and therefore (given 1), on output and employment. Because the liquidity trap matters, when interest rates are at their zero lower bound we should use fiscal policy as a stimulus tool, and we should not embark on fiscal austerity unless we have no other choice.

If propositions (1) and (2) strike you as self evidently correct, you might accuse me of drawing the lines in this debate in a biased way. I would of course agree that they are correct, but I would also note that there are large numbers of academic macroeconomists (don’t ask me how many) who dispute one or both of these ideas. Tyler Cowen in the post cited above talks about a ‘so-called’ liquidity trap in the context of the UK.

Many macroeconomists - particularly those involved in analysing monetary policy - did think as recently as ten years ago that there was a broad academic consensus behind both (1) and (2). I was one of them. There was talk of the new neoclassical synthesis (pdf). This idea that there was such a consensus fell apart when a number of prominent academics objected to governments using fiscal stimulus in 2009.

This suggests (3) is at the heart of the dispute. However my reason for including (1) and (2) is that if you accept these two points, point (3) follows pretty automatically. I was careful in formulating (3) not to claim that fiscal policy should become the only or main stimulus tool: exactly what role it should play alongside Quantitative Easing or other forms of ‘unconventional’ monetary policy - including those analysed by Keynesian macroeconomists - remains unclear and can be reasonably debated. As I have noted before, the two sides are not symmetrical on this point: while most Keynesians are happy for central banks to undertake various forms of unconventional monetary policy, the aversion on the other side to using fiscal policy seems more absolute.

It is here that I have a difficulty. It seems to me in a mature, ideology free science we would be discussing - when in a liquidity trap - the relative merits of alternative forms of monetary and fiscal stimulus. It would also be generally agreed that, given the uncertainties involved with all forms of unconventional monetary policy, now was not the time to undertake austerity. But that is not the discussion we are having. Why not?

An easy answer is that it is all political or ideological. Just as politicians can use fears about debt as a means of reducing the size of the state, so antagonism against fiscal stimulus comes from the same source, or an ideological aversion to state intervention. That in my view would be a sad conclusion to draw, but it may be naive to pretend otherwise. As Mark Thoma often says, the problem is with macroeconomists rather than macroeconomics.

I can think of two alternative explanations that might at least apply to some anti-Keynesians. The first comes from thinking about the importance of money to macroeconomics. Money is very important, and indeed you could reasonably argue that the existence of money is critical to point (1) above. The mistake - in my view - is to therefore feel that monetary policy has to be the right way to stabilise the economy. It makes you want to believe that (2) is not true. This seems to me to have nothing to do with ideology.

The second is historical. I suspect we would not even think of questioning the central role of Keynesian ideas for macroeconomics today if it had not been for the New Classical revolution in the 1970/80s. This revolution was successful in the sense that it did change the way academic macroeconomics was done (microfoundations and DSGE models). Most academic macroeconomists - for better or worse - are deeply committed to that change. But the revolution was opposed by many in the Keynesian consensus of that time, and so Keynesian economics became associated with the old fashioned way of doing things. This association was encouraged by many of the key revolutionaries themselves. We now know, as a result of the development of New Keynesian economics, that there is no necessary incompatibility between the microfoundations approach and Keynesian ideas. However I suspect that, at least for some, the association of fiscal policy with old-fashioned Keynesian ideas set down deep roots. It certainly seems that some notable academics were surprised that New Keynesian models actually provided strong support for the use of countercyclical fiscal policy in a liquidity trap.

I should really stop there, but having started with Tyler Cowen’s post, I really should say something about his comments on the UK. The basic facts are very simple. We had significant fiscal contraction in financial years 2010/11 and 2011/12, which then stopped or at least slowed significantly. The UK recovery was erratic from 2010 to 2012, and only reached a steady pace in 2013. That is entirely consistent with the importance of fiscal policy in a liquidity trap. (The OBR calculate that austerity reduced GDP growth by 1% in 2010/11, and by 1% in 2011/12, with little impact thereafter.) Quite why the obvious fact that other things besides fiscal policy are important in explaining growth in any year is thought to be an anti-Keynesian point I cannot see. And if the case against Keynesian ideas rests on the incorrect forecast once made by a prominent Keynesian then this is really scraping the barrel. 

Disagreements between nations

My recent posts on the Eurozone and German attitudes have attracted a lot of hostile comments, and generated a lively debate. Sometimes I feel the debate is skating on the thin ice of national stereotypes, and occasionally the ice breaks. Some people just plunge straight in! For more debate on the desirability or otherwise of fiscal union, which I hope does not fall into that trap, there is an interesting discussion of various proposals by Yanis Varoufakis and James Galbraith at OpenDemocracy, plus two responses from myself and Frances Coppola.

Another clash between nations is described in Ed Conway’s account of the Bretton Woods summit that created the IMF, World Bank and the post-war international macroeconomic framework that lasted until 1971. I must admit my preconceptions about the impossibility of making macroeconomics fun to read about have been thoroughly shattered over the last year. First there was Tim Harford’s guide to macroeconomics that I talked about here, and now a book about a three week conference discussing macroeconomic institutions and exchange rate regimes that manages to be a great read. Admittedly this particular conference had as it central characters two intriguing individuals: Keynes I knew about of course (although I felt I learnt a lot more here), but Harry Dexter White, the maybe spy, I did not. If you think I’m biased because I’m a macroeconomist, read Peter Preston’s review here.

There are numerous little surprises. I had not realised how, perhaps because of the war, economists were often central in international negotiations. James Meade writes at one point: “Ten years ago at Oxford I should never have dreamed that an economist could live in such a heaven of practical application of real economic analysis!”. Though the detail is fascinating, I was left wondering just how important the conference really was. Although it created both the IMF and World Bank, neither was actually that important in the decade that followed the war, and their eventual roles were rather different from that intended by the Bretton Woods agreement. I also wonder just how much the prosperity and stability of the Bretton Woods era was caused by that agreement.

What I think will surprise many is just how inconceivable an era of floating exchange rates was to those taking part in that conference, Keynes included. Of course the debate over fixed versus floating will never end: some might argue that the demise of Bretton Woods in the early 1970s sowed the seeds of subsequent financial instability, but the current troubles of the Eurozone also remind us of the dangers of fixing exchange rates. One clear impression I got from the book is that when exchange rates are fixed, the creditor nation (or nations) call the shots. This was evident in the asymmetric influence of White versus Keynes in their various negotiations, and it helped me understand more clearly just why the influence of Germany is so strong within the Eurozone right now.

Keynes and the Macmillan committee

This book, by Peter Temin and David Vines, has just been published. As you can see from the endorsements, I liked the book. In this post I just want to focus on a particular chapter, which was Keynes’s role as part of the Macmillan committee, an episode I did not know about before. Just as the book does so well, I want to draw parallels between the past and current events.

It is the end of 1929: UK unemployment was already high as a result of going back on to the gold standard five years earlier, and Wall Street had just crashed. The new Labour government was overwhelmed, so in the British tradition it set up a committee to recommend what to do, and Keynes was a member. As Temin and Vines note, although Keynes was at the centre of economic discussion at the time, he was also outside the establishment, as a result of publishing his attack on the Versailles treaty in the Economic Consequences of the Peace.

Keynes diagnosis of why British unemployment was so high linked returning to the gold standard at an uncompetitive level and the problems of downward nominal wage adjustment. The book’s description of how the then governor of the Bank of England, Montagu Norman, failed to see the problem is amusing - from a distance of nearly a century - but of course as the book points out this is exactly the ‘conversation’ that Germany is currently having with the rest of the Eurozone.

The obvious solution was therefore devaluation, and the book seems a little ambivalent about whether that was not much discussed because it was ‘off the table’ for political reasons, or whether Keynes and others thought that, having joined (which Keynes had opposed), Britain should stay the course. (Eurozone parallels again. Ironically Britain did devalue three months after the report was published, although as I note here, this was forced rather than a choice.) What Keynes argued for was instead increased government spending, but he failed to convince the committee that its impact on unemployment would not be crowded out. Here Temin and Vines attribute this failure not to the ability of the others to see the obvious, but to the fact that Keynes arguments did not fit with the model he was using, which was the model of the Treatise. They write: “the Macmillan Committee is of interest to us because Keynes’ presentations to it didn’t add up to a coherent view. Rather, they show Keynes thinking on his feet at a time when his ideas were in flux.” Those ideas ended up, of course, with the General Theory.

Finally, one thought of my own. When I was younger, I drew the wrong inference about the Great Depression. If only the General Theory had been written 10 years earlier, I reasoned, much of the agony of the Great Depression could have been avoided. Instead I should have focused on the gold standard. Not because this was more important as a cause of the world wide Great Depression - it well might have been - but because of what it tells you about the influences on macroeconomic policy.

Montagu Norman said to the committee “I have never been able to see myself why for the last few years it should have been impossible for industry, starting from within, to have readjusted its own position”. This was a few years after the General Strike of 1926! This was not someone lacking a coherent theory, but someone blind to the evidence and human nature, and enthralled to the ideology of the gold standard. No doubt being a central banker rather than a worker, or even an industrialist, helped this blindness. The lesson I should have drawn from the Great Depression is that a powerful ideology, in the hands of people remote from those adversely affected by it, can overcome common sense and evidence.