The biggest economic policy mistake of the last decade, and it had nothing to do with academic economists

"The biggest policy mistake of the last decade" is the title of an article by Ryan Cooper, and the mistake is of course austerity. (It is a very US focused piece, so Brexit is not on the map.) Cooper goes through all the academics who gave reasons why austerity was necessary and how their analysis later fell to bits. (How much they fell to bits is still a matter of dispute as far as these authors are concerned.)

Here is his concluding paragraph:

“As we have seen, the evidence for the Keynesian position is overwhelming. And that means the decade of pointless austerity has severely harmed the American economy — leaving us perhaps $3 trillion below the previous growth trend. Through a combination of bad faith, motivated reasoning, and sheer incompetence, austerians have directly created the problem their entire program was supposed to avoid. Good riddance.”

There is a lot I could say about the details of the article, but this conclusion is essentially correct, and it applies at least as much to the UK and to the Eurozone countries. With Trump’s large tax cuts for the rich paid for in large part by borrowing, the Republicans can no longer credibly tell everyone austerity is essential. In contrast the political right’s enthusiasm for austerity in Europe remains strong.

Reading the article brought back memories of my first year or two writing this blog, where I became part of a mainly US blog scene of mainstream academics opposed to austerity, lead by Paul Krugman and Brad DeLong. We were trying to take down the academic arguments for austerity, and we succeeded. As Cooper’s article suggests it was not a very difficult task. Sometimes very senior economists who should have known better made simple mistakes of the kind I discussed here. On other occasions, like the predictions of massive inflation from Quantitative Easing that Cooper discussed, events quickly proved the Keynesians correct. Only in the case of the studies from the two pairs of Alesina and Ardagna and Reinhart and Rogoff was additional research required to challenge their conclusions.

As far as us Keynesians were concerned, the intellectual battles were won by the end of 2012 if not before. In particular Paul De Grauwe’s influential analysis of why Eurozone countries were experiencing a debt crisis, pointing to the lack of a sovereign lender of last resort, put an end to the academic credibility of ‘we are going to become like Greece’ stories. When the ECB introduced OMT in September 2012 and the Eurozone debt crisis came to an end De Grauwe was proved right. In 2013 Krugman wrote of austerity:

“Its predictions have proved utterly wrong; its founding academic documents haven’t just lost their canonized status, they’ve become the objects of much ridicule.”

What we didn’t know for sure then was the lasting damage that austerity would bring, and which Cooper notes.

I want to add two important points that Cooper’s article does not cover. The first is that although by 2013 most academics had become convinced about the austerity mistake (it was always a minority view anyway), economic journalists in the non-partisan media could not recognise that because the politicians were continuing to implement the policy. Here is Robert Peston in 2015:

“And before I am savaged (as I always am) by the Krugman crew of Keynesian economists for even allowing George Osborne’s argument an airing, I am not saying that the net negative impact on our national income and living standards of cutting the deficit faster is less than their alternative route of slower so called fiscal consolidation. I am simply pointing out that there is a debate here (though Krugman, Wren-Lewis and Portes are utterly persuaded they’ve won this match – and take the somewhat patronising view that voters who think differently are ignorant sheep led astray by a malign or blinkered media).”

We now know that voters were indeed being led astray by a malign or blinkered media, or at least a media that did not have the courage to call the result of the academic debate.

The second point is that this academic debate had zero impact on politicians. In that sense Cooper’s article is of purely academic concern. Austerity was not begun because politicians chose the wrong academic macroeconomists to take advice from, and the fact that the Keynesians won the debate therefore had no impact on what they did. The academic debate was in this sense a complete sideshow. I think many Keynesian academics understood that: it was a fight we had to win but we were under no illusions it would change anything. I wrote in 2012 that if all academics were united we might have an impact on public opinion, but that illusion did not last very long and Brexit showed it was indeed an illusion.

I think this lack of influence that academic economics can have is not understood by many. It often suits some heterodox economists to pretend otherwise. Economists can be influential, but only when politicians want to listen, or the media is prepared to confront them with academic knowledge. For example politicians have not done nearly enough to ensure another financial crisis does not happen, but that isn’t because economists have told them not to or have not shown them how to do so. It is because politics prevents it happening.

The reason why economists like Alesina or Rogoff featured so much in the early discussion of austerity is not because they were influential, but because they were useful to provide some intellectual credibility to the policy that politicians of the right wanted to pursue. The influence of their work did not last long among academics, who now largely accept that there is no such thing as expansionary austerity or some danger point for debt. In contrast, the damage done by austerity does not seem to have done the politicians who promoted it much harm, in part because most of the media will keep insisting that maybe these politicians were right, but mainly because they are still in power.  

Could the US become a democratic dictatorship?

China calls itself a democratic dictatorship, so it looks like the title’s question is a very odd one to ask. You can find various indices that measure countries on a line with dictatorship at one end and democracy at the other. So how can a country actually be (rather than call itself) a democratic dictatorship?

Consider Hungary. Its Prime Minister Viktor Orbán has pledged to create an illiberal state like Russia or China. Perhaps as a result, European Commission President Jean-Claude Juncker at a 2015 EU summit dispensed with diplomatic protocol to greet Orbán with a "Hello, dictator." To further this aim he has gone about controlling the media and courts either directly or through placement of allies, with complete success. Yet he and his party remain popular in part because of the lethal combination of extreme nationalism, scaremongering about migrants and antagonism against Muslims and Jews. In addition NGOs have been attacked, which has led to legal proceedings by the European Commission. A host of public bodies like its fiscal council, the central bank, and the national elections commission, have been abolished or their independence limited.

Yet Hungary is still a democracy in the sense of having reasonably genuine elections. As the opposition is fragmented there is little need to resort to the kind of tactics used in other democracies, such as Turkey. When occasionally the opposition does win a local election, Orbán unleashes the full might of his nationalist, enemies at the door, enemies within narrative at them. With almost total control of the media and civil institutions, he can make life very difficult for the opposition. He won his last election with ease. It is an effective model that could survive for many years.

So would it be reasonable to call Hungary a democratic dictatorship [1], or is that just a contradiction in terms? Hungary is no longer a pluralist democracy, by which I mean there are no independent centres of power. But there are still elections, which are not a complete fiction. But you cannot call elections where one side completely controls the media fair. The acid test would be if a unified opposition under a credible leader ever did appear whether he would ever be allowed to win.

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“American media should study Hungary’s record,” Newt Gingrich declared after a visit to Hungary. He was talking about the 13ft-high razor-wire border fence that Orban erected against the influx of “foreigners”, but few can doubt that Trump would like to emulate Orbán in other ways. He already has what is effectively a state TV station, the widely watched Fox News. His attacks on the independent press are relentless. He does not yet control the media in the same way as Orbán does, but he gets his apologists on CNN and other stations as these stations try and keep ‘balanced’.

Having Fox on his side is crucial in his ability to control the Republicans in Congress. Speak out and you risk losing your seat in a primary election against a Trump loyalist. The few who do speak out tend to be retiring from politics. The democratic norms of politics that have stood for decades in the US have gone out of the window. He breaks the norms because he knows no one will stop him. Other countries that are able to have long recognised that the way to get foreign policy favours is to grant some business perk to him or his family. (We see similar corruption in Hungary.)

He may not control the courts to the extent that Orban does, but he is not miles away. Soon he, or at least his party, will get a majority on the supreme court. He has pardoned whoever he likes at his whim. The Republican party have retained a majority in the House in part because of gerrymandering, and the supreme court allows this to continue. Orbán fights a long but successful battle to close down a university in Budapest, while Trump’s climate change denying appointees try to close down scientific research in the US. (On the latter, see this excellent essay from Carl Zimmer HT Tim Harford.)

Trump makes no secret of his admiration for dictators. In a way it does not really matter if Putin has ‘something on him’ in the form of a tape of whatever, as Trump admires Putin anyway as a strong man leading his nation. His natural enemy is Europe: hence his attack on Merkel and his constant and incorrect references to rising crime as a cost of immigration in Europe.

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Another way of looking at this is to consider human rights and their suppression. Hungary has just passed a law making it illegal to provide legal help to undocumented immigrants seeking asylum, as part of a set of bills incredibly called ‘Stop Soros’. George Soros has become Orbán’s bogeyman. Trump separates the children of illegal immigrants from their families. As Fintan O’Toole says, this has not been a ‘mistake’ by Trump, but a trial run

“to undermine moral boundaries, inure people to the acceptance of acts of extreme cruelty. Like hounds, people have to be blooded. They have to be given the taste for savagery. Fascism does this by building up the sense of threat from a despised out-group”

Or to deal with an infestation of immigrants, as Trump said recently. And O’Toole thinks the experiment was a success: the base were happy, and Fox news talked about child actors pretending to cry. Italy’s new interior minister calls for a “mass cleansing” of migrants from “entire parts” of the country, street by street.

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Arguments that democracy is still safe in the US seem rather naive. A Washington Post piece from just a year ago says there are four barriers to the US becoming a ‘populist’ state. The four are the independence of congress and the judiciary, being restrained by the Republican party, limited patronage powers, and the absence of any crisis. The first two have not done too well and the last two do not seem to matter. Tyler Cowan thinks the US government is just too large and complex for one man or group to take control. He is correct insofar as Mueller has been allowed to continue. But there is little chance of Trump being impeached by this Republican party. Whether Mueller is allowed to continue depends a lot on whether he goes after Trump family members, and Mueller probably understands that. The important point is that Trump does not need to control every part of government to control what happens.

Trump certainly acts like a dictator would act. The barriers to Trump becoming an Orbán type figure are that his supporters do not control most of the media, and he faces a single and organised opposition party. These are the two threads by which this pluralist democracy hangs. You might think it an exaggeration to call these two only threads, and I hope we will see that it is in the midterms, but there are worrying signs in the US and elsewhere that popular support for democracy is falling, as documented by Yascha Mounk in a book reviewed here. The fact that Trump could be elected and then supported in the first place by one of the two main political parties in the US is a clear sign that all is not well with US democracy. Those, like Paul Krugman, who have for a long time appeared ‘shrill’ about what was happening to the Republican party have been fully justified in their fears.

The rise of the far right and democratic dictatorships in the West have happen before, of course. It is no coincidence that in the 1930s and now economies were scarred by deep recessions followed by bad policy. That may be important in part because it fosters intolerance of ‘outsiders’, particularly immigrants, which parties of both the far right and unfortunately the centre right have exploited. (In the UK, and also in Hungary and Poland, the EU has also become an outsider.) Since perhaps Nixon, the Republicans have exploited race: more explicitly and vigorously as time has gone on. Parties of the right do this in part because their backers want to avoid redistribution being used as a way of mitigating the impact of bad economic times, and focusing on social conservatism can capture voters who would otherwise vote left on economic issues. I have described both the bad policies (austerity and fears about immigration) as forms of deceit (using debt as a cover for reducing the state and setting targets for immigration without intending to meet them), and collectively as neoliberal overreach.

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If the demonisation of immigrants is the common thread in these moves towards democratic dictatorships, then it becomes important to resist the early stages of this process. One lesson of the experience across countries is that popular concern is not primarily about numbers. It is not the reaction of citizens worried about being overwhelmed by immigrants. Less than 5% of the population in Hungary are immigrants: 3% if you count only immigrants from outside the EU. Nor is it true that attitudes to immigration are always going to be hostile. This year for the first time in a decade more people in the US think legal immigration should be increased rather than decreased.

But this idea is difficult to get across. In the UK for example it is true that rising concern about immigration follows rising numbers, but it follows increased newspaper coverage even more closely, and which newspapers people read is the best explainer of immigration concern. [2] With a few important exceptions the concern is generally about immigration ‘in the country’ rather than locally. In the UK stoking fear about immigration may not as yet have created the conditions for a democratic dictatorship, but it has spawned a ‘hostile environment’ policy that led people to be locked up and deported illegally, and of course it was critical in forcing the country make one of its biggest policy errors for a generation.

I have heard people say that we have to have Brexit because otherwise half the country will feel betrayed (as opposed to the other half already feeling that). But in reality the opposite is true. Xenophobia becomes strong when economic conditions are bad, and Brexit will make them worse. Brexiters are going to feel betrayed anyway when they realised they have been sold snake oil. If we are to avoid a self reinforcing cycle of economic and political decline, we must give priority to the economy and stop scapegoating immigrants for each policy failure.

[1] Whether the term dictatorship is more accurate than one party state or the term plutocracy that I have used before is interesting, but not I think critical for the discussion here.

[2] Let me try and be clear what I mean by immigration concern not being about numbers. Of course large numbers of immigrants make it easier for newspapers to talk about ‘floods’ and ‘being overwhelmed’. The mistake is to think that if only the numbers could be reduced somewhat, the concern would disappear. It will not because it is not in the interests of those whipping up concern for that to happen. Any attempt to appease the concern by, for example, vetting patients in A&E only gives credibility to the idea that immigrants are responsible for reduced access to the NHS: in reality the opposite is true.

Brexiter nonsense and policy entrepreneurs

Brexiters typically sound convincing if you know little about what they are talking about. Ian Dunt takes a typical example from Rees-Mogg (still favourite to be next Conservative leader). Rees-Mogg asserts, with absolute certainty, that a House of Lords committee have missed a crucial aspect of trade law related to WTO rules. Trade experts spend some time scratching their heads wondering what on earth he is talking about. They finally work out where the idea comes from, and why it has next to zero applicability to Brexit. (See also Jim Cornelius here.)

As Dunt points out, nonsense of this kind is effective. Because broadcasters often fail to match Brexiters with trade experts, they get away with their nonsense. By the time the nonsense is revealed as such, and enough people know why it is nonsense. the discussion has moved on and new nonsense appears. The fantasy that is Brexit remains intact at the level of public discourse.

Politicians like Rees-Mogg are not able to generate this nonsense themselves. How could they when they seem to spend most of their lives going from one broadcast studio to the next. Because this nonsense normally has some tenuous connection to reality, it has to come from someone with some knowledge of international trade and trade agreements. Welcome to the policy entrepreneur.

The term policy entrepreneur comes I believe from Paul Krugman’s first book from 1995, Peddling Prosperity, which unfortunately remains as relevant as ever. The book begins with the Laffer curve and the economists - including Laffer - who promoted the idea that cutting taxes would raise revenue. It is a typical piece of nonsense. It takes the reality that if taxes were 100% lots of people would stop working, and mutates this into the idea that taxes are already so high that cutting them would encourage more growth such that tax revenue will rise. It is typical political bullshit: giving an imagined respectable gloss on something that too many Republicans just wish were true.

But in the latter part of Peddling Prosperity things got personal, as Krugman describes how different policy entrepreneurs took some of Krugman’s own research and used it in a way Krugman would not to lobby President Clinton for trade protection. Economic theory suggests that if a profitable opportunity arises and there are no barriers to entry people will exploit that opportunity. I think the policy entrepreneur is a good example of that happening. Some politicians want to pursue a policy but want some kind of rationalisation for it, and the policy entrepreneur steps up with some nonsense erroneously derived from economics or some other discipline to provide that veneer of respectability.

Policy entrepreneurs can be academics: in the UK the most obvious example many would point to is Patrick Minford. But they can just be good lobbyists, who put themselves in the right place at the right time. In the case of Brexit, the policy entrepreneurs from whom the Brexiters get most of their information are in the Legatum Institute. BuzzFeed has a very good profile of their until recently director of economic policy, Shanker Singham. It is worth quoting from it.

“BuzzFeed News spoke to multiple economists, policy wonks, Conservative advisers, politicians, and journalists who said they’re baffled that he’s become so prominent in the Brexit debate. They say his standing in the trade world has been overblown. They don’t dispute that he knows the subject, but most hadn’t heard of him before he emerged at Legatum. They find it exasperating that he’s been portrayed in the UK as a vastly experienced trade negotiator, as if he were one of the decision-makers in the room when the world’s biggest trade agreements were hammered out. He wasn’t that close to the action, they say.”

But of course someone with more experience or more knowledge could not take Singham’s place, because they would not be the true believer that Brexiters require. When you have faith as the Brexiters have, you do not seek real knowledge, but just enough facts to sound good and thereby promote the cause.

Policy entrepreneurs, whether they are seeing a profit opportunity or really are true believers, are a symptom that what I call the knowledge transmission mechanism has broken down. As Krugman’s book indicates, Brexit is not the first time that policy entrepreneurs have helped politicians enact destructive policies. Here I argue that that the knowledge transmission also broke down when it came to austerity. (Paper here.) It is possible for policymakers to use intermediaries like civil servants to find the best research and use it - it has happened in the past - but today it seems like the exception rather than the rule.

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.

Economists versus bankers

Nearly a year and a half ago I wrote a post about encouraging dialogue between economists and other social scientists. I concluded with the following three paragraphs:

“Let me take a real world economic problem: the response to the financial crisis. Some have suggested that banks have become too large and need to be broken up, or that the activities of high street banking need to be separated from the activities of the casino. Your economic analysis tells you that networks of many small entities can be as subject to crises as networks involving a few large banks. You are also able to devise a system of Chinese walls that mean that the activities of the casino can be separated from those of the high street even within the same company, and your political masters seem to prefer this approach. You recognise that different assets differ in their liquidity, and so you devise complex weighting algorithms for computing capital ratios. Your suggestions form the basis of negotiations between officials and bankers, and a set of rules and regulations are agreed.

Over the next few years you watch in dismay as your complex system begins to unravel. The CEOs of the large banks seem to constantly have the ear of politicians, who in turn gradually compromise your elaborate controls to render them less and less effective. Those in charge of administering the rules find it much more lucrative to work for the banks, and so regulators gradually lose expertise and resolve.

And you realise that right from the start you made the wrong choice. You decided to focus on what you knew, which was how to design systems that worked well as long as those systems remained unchanged, but which were not robust to intervention by self-interested parties. In short, they were too open to rent-seeking. You realise that actually the best thing to have done was to break up the banks so that their political power was forever diminished. And you recall a conversation with your social science colleague when this all started, who might have been trying to tell you this if only you had understood the words he was using.”

I was afterwards asked whether I had one particular UK economist, John Vickers, in mind when I wrote this. He chaired, at the government’s request, a commission on banking reform. He has become increasingly vocal about how his original commission’s proposals (pdf) are being watered down and how the Bank of England appears to be putting public money at risk once again. (For his detailed assessment, see this paper. And here is what another commission member, Martin Wolf, thinks about the financial sector. Adam Barber details how the attitude of the UK government has changed. In the US this very issue became an important point of difference between Clinton and Sanders.)

The honest answer is that I did not have him in mind. It was a fictional account designed to make a point, and so I took elements from different debates which together apply to no one country or individual. The point is that in finance good reforms are those that can best resist political or economic manipulation by banks, and perhaps economists in general have been slower to see that than some of their colleagues in other social sciences..

It would probably be fair to say that before the financial crisis economists got on pretty well with the financial sector. There was a common interest in monetary policy (although the motivation for that interest might have been different) and the sector was a useful source of funds for conferences and (for a few) consultancy. Most economists did not look too hard at what the financial sector was actually doing, although those that did often raised serious questions. Behind this nice piece by Ben Chu is an army of academic research which suggests that fees paid to manage funds are a waste of money.

The situation changed after the financial crisis, for obvious reasons. Since then economists have increasingly questioned whether the whole business model behind banking is sound. In particular they have questioned why banks should be so different from other companies in terms of the amount of equity capital they hold in relation to their assets. These economists include the previous governor of the Bank of England, Mervyn King. They have also questioned whether one of the side effects of current regulation is to maintain the monopoly power of big banks.

If all that was not bad enough, we have the influence that the financial sector has on monetary policy. Mainstream macro has put a lot of emphasis on the importance of day to day monetary policy being independent of politicians, and far too little on it being independent of the influence of finance and bankers. Paul Krugman has talked about the links between interest rates and bank profits and how that might ‘guide’ the views of bankers. If you want to see a clear case of that, read this FT op-ed by David Folkerts-Landau, chief economist at Deutsche Bank.

The article could not be more wrong. The reason the Eurozone has performed so badly compared to the US, Japan and even the UK is not because of lack of structural reform, but because of the relative reluctance of the ECB to stimulate the economy. Rates were raised in 2011, and Quantitative Easing delayed until 2015. The article is full of hopeless lapses in logic. If there is any sense here at all, it is that high unemployment is required as a political incentive to undertake structural reform. So the ECB “has become the number one threat to the eurozone” because it has allowed politicians to put that reform off.

Here I can do no better than quote Adair Turner. “Vague references to “structural reform” should ideally be banned, with everyone forced to specify which particular reforms they are talking about and the timetable for any benefits that are achieved. If the core problem is inadequate global demand, only monetary or fiscal policy can solve it.” In the Eurozone the core problem is lack of aggregate demand, as below target inflation shows.

Why this hostility from German bankers to low or negative rates? What the author does not tell you is that the profits of German banks, and the viability of other parts of the German financial system, are particularly (IMF pdf, box 1.3) vulnerable to low rates. (For those that can access it, Wolfgang Münchau in the FT provides an excellent summary.) And also that the profitability of Deutsche Bank is not great right now, as Frances Coppola notes. In the UK or US if this kind of nonsense from bankers appears in the press it gets a lot of kick back from economists - in Germany perhaps less so.

So who cares if economists have crossed swords with bankers? It matters because finance gets away with so much partly through a process of mystification. Mystification is how banks can perpetrate widespread fraud on consumers and businesses. When bankers say that being forced to ‘put aside’ more capital keeps money out of the economy it sounds plausible to many, even though it is completely false. (Admati and Hellwig (pdf) list 30 other similar false claims.) There is also a belief that because bankers are involved in financial markets, they must know something about how the macroeconomy works, a belief which the FT op-ed shows is clearly false. In all these cases, economists can provide demystification.

If we are ever to cut finance down to size (metaphorically, and perhaps also literally), economists are going to be vital in the battle to do so.

The Eurozone recovery

Which posted the strongest growth at the beginning of 2016: the US, UK or the Eurozone? The answer is the Eurozone. Growth at 0.6% for the quarter (about 2.5% at an annual rate) is nothing to write home about, but it is not the stuff of doom and gloom either. Reasonable growth like that should come as no surprise. The economy is receiving as much monetary stimulus as the ECB can currently muster, and fiscal contraction has come to a halt.

Inflation is still well below target, but the reason for that is straightforward enough (as Martin Sandbu points out): there is still a lot of spare capacity. Inflation will only stabilise at around the 2% target when that spare capacity has disappeared. Policy should be doing everything (more public investment!) to ensure that happens through strong growth rather than, as seems to have happened in the UK, a gradual contraction in supply. On inflation the ECB should make their target 2%, rather than the current ‘below but close to’ 2%, to avoid the Japan problem that Narayana Kocherlakota discusses here.

I went further when I wrote two weeks ago (the GDP figures came out a week ago) that “I also think we may see rapid Eurozone growth before [2020]”. By rapid growth I mean something in excess of 2.5%. I said that because I was adding one other factor into the mix of fiscal neutrality and monetary expansion, which is that the Euro has been pretty competitive for well over a year. As Martin points out, that has so far not contributed anything to recent Eurozone growth.

I have read in a few places recently people saying that the impact of international competitiveness is not what it was. I agree with Paul Krugman that this pessimism is unlikely to be warranted. I have spent a significant part of my working life estimating and applying trade elasticities (the impact of international competitiveness on trade and hence demand), and this experience has taught me that this effect is a bit like Milton Friedman’s description of how monetary policy works: there can be long and variable lags. So I expect that the Eurozone’s competitiveness gain over the last year and a half will begin to impact on Eurozone GDP at some point in the next year or two, and that might just provide more rapid growth than we saw at the beginning of 2016.

Explaining the last ten years

The Great Recession was larger than any previous post WWII recession. But that is not what it will be mainly remembered for. Unlike previous recessions, it appears to have led to, or coincided with, a permanent reduction in the productive potential [1] of the economy relative to previous trends. As unemployment today in the US and UK is not very different from pre-recession levels, then another way of saying the same thing is that growth in labour productivity and real wages over the last seven years has been much lower than pre-recession trends. (As employment has not yet recovered in Europe, I will focus on the US and UK here.)

I have posted charts showing this for the UK many times, so here is something similar for the US. It plots the log of real GDP (green) against the CBO’s (Congressional Budget Office) estimate of potential output (yellow). Unlike the UK, potential growth in the US does not appear constant from 1955, but the CBO has potential output growth between 3 to 3.5% in most years between 1970 and the early 2000s. The break created by the Great Recession is clear: potential growth fell to as low as 1% immediately after the recession, is currently running at 1.5%, and the CBO hopes it will recover to 2% by 2020.

US Actual (green) and Potential (yellow, source CBO) Output, logged. Source: FRED.

There seem to be two ways of thinking about this decline in potential output growth. One is that the slowdown in productivity growth was happening anyway, and has nothing to do with the global financial crisis and recession. This seems unlikely to be the major story. For the UK we have to rewrite the immediate pre-recession years as boom periods (a large positive output gap), even though most indicators suggests they were not. A global synchronised slowdown in productivity growth seems improbable, as some countries are at the technological frontier and others are catching up. As Ball notes, “in the countries hit hardest by the recession, the growth rate of potential output is much lower today than it was before 2008.” However the coincidence story is the one that both the OECD and IMF assume when they calculate output gaps or cyclically adjusted budget deficits. The CBO numbers for the US shown above adopt the coincidence theory to some extent, reducing potential growth from 3.5% in 2002 to 2.0% by the end of 2007.

If we stick to the more plausible idea that this is all somehow the result of the financial crisis and recession, we can again split explanations into two types: those that focus on the financial crisis and argue that crises of this type (rather than other types of recession) impact on potential output, and those that look at the impact of the recession itself. The distinction is important in understanding the impact of austerity. If the length and depth of the recession has permanently hit potential output, as Fatas and Summers suggest, then the cost of austerity is much greater than we could have imagined.

Looking at previous financial crises in individual countries, as Nick Oulton has done for example, does suggest a permanent hit to potential, but I have noted before that this result leans heavily on experience in Latin American countries, and Sweden’s recovery from its 1990 crisis suggests a more optimistic story. Estimates based on OECD countries alone suggest more modest impacts on potential output, of around only 2%.

What about the impact of the recession itself? Here it is helpful to go through the textbook story of how a large negative demand shock should impact the global economy. Lower demand lowers output and employment. Workers cut wages, and firms follow with price cuts. The fall in inflation leads the central bank to cut real interest rates, which restores demand, employment and output to its pre-recession trend.

We know why this time was different: monetary policy hit the zero lower bound (ZLB) and fiscal policy in 2010 went in the wrong direction. Yet employment has recovered to a considerable extent (although less so in the US than the UK). A recovery in employment but not output (relative to pre-recession trends) means by definition a decline in labour productivity growth. How could this happen?

The table below shows the rate of growth of real and nominal wages in the UK and US in pre and post recession periods.

US	2002-7	2008-15
Annual wage growth (1)	3.8%	2.1%
Annual price growth (2)	2.5%	1.5%
Difference	1.3%	0.6%
UK
Annual wage growth	4.5%	1.7%
Annual price growth	2.8%	2.1%
Difference	1.7%	-0.4%

1. Compensation per employee, source OECD Economic Outlook
2. GDP deflator, source OECD Economic Outlook

Nominal wage growth followed the textbook story. But price inflation did not fall to match, implying steadily falling real wages, particularly in the UK. This could just reflect the decline in productivity, which occurred either coincidentally or as a result of the financial crisis and recession.

The financial crisis could have reduced productivity growth if a ‘broken’ financial sector had stopped financing high productivity investment projects, or kept inefficient firms going through ‘pretend and extend’ lending. The recession could have reduced productivity growth by reducing investment, and therefore embodied [2] technical progress. Perhaps this loss of embodied technical progress occurs in all recessions, but we do not notice it because recoveries are quick and complete.

However the causality could be the other way around. Falling real wages led firms to switch production techniques such that they employed more labour per unit of capital. Workers priced themselves into jobs. The big question then becomes why did firms let this happen? Why did firms not take advantage of lower wage increases to reduce their own prices, and choose instead to raise their profit margins?

One story involves a secular increase in firms’ profit margins (Paul Krugman’s robber barons idea), either because of a reduction in goods market competition (profit margins are sometimes called the degree of monopoly), or a rise in rent seeking as Bob Solow suggests (HT DeLong). [3] However it is not obvious why this should be connected to the recession. If it is not, it is like the coincident and exogenous productivity decline. We will not get back to the earlier productivity growth path without reversing whatever caused this secular rise in profit margins.

Another, in some ways more optimistic, story involves different degrees of nominal rigidity: nominal wages are less sticky than nominal prices. As a result nominal wages led prices in reacting to the recession, but now prices are ‘catching up’ and profit margins will fall back. That would fit nicely with inflation continuing below target for some time, and real wages and productivity recovering. It is an optimistic story, because an additional demand stimulus would increase wage but not price inflation, and we would see rapid growth in labour productivity as firms reversed their earlier labour for capital substitution.

Unfortunately recent data suggests this is not happening. Instead core inflation is now above target in the US and rising to target in the UK.    

So is there some other way that a large recession in itself can cause a large reduction in potential output? Macroeconomists group such explanations under a general heading called ‘hysteresis mechanisms’: mechanisms whereby recent history can have permanent effects. Ball summarises the three main types of mechanism that economists have identified: “it appears that recessions sharply reduce capital accumulation, have long-term effects on employment (largely through lower labour force participation), and may slow the growth of total factor productivity.” If technical progress is embodied, we can link the first and last. That will be the subject of a later post.  

[1] For those not familiar with the term, a traditional way of thinking about potential output is that it is what output and incomes could have been if we had avoided booms and recessions, or equivalently if we had avoided domestically induced variations in inflation. Potential output can increase either because the labour force increases, or because labour productivity increases due to either technical progress and investment.

[2] Embodied technical progress is greater labour productivity brought about through new machinery i.e. it needs investment for it to happen.

[3] Postscript (just): Here is Martin Sandbu on the same issue