How the lessons from austerity have not been learned

The UK and the Eurozone are both vulnerable to the next recession, but both politicians and central bankers think each other should deal with it.

I don’t want to talk about the likelihood of a recession in the UK, US or Eurozone. Forecasting is a (necessary) mug’s game, where there are just too many variables to make anything like an accurate prediction. It is worth outlining the risk factors, and Grace Blakeley does an excellent job here. Instead my concern is the vulnerability in both the UK and the Eurozone to the impact of a recession if it happens. This vulnerability was clearly illustrated by the mistakes made after the Global Financial Crisis, yet in many ways the lessons of that failure have not been learnt.

Most people know the story of austerity after the Global Financial Crisis (GFC). In the UK the negative impact of the GFC was so severe that even cutting interest rates from around 5% to 0.5% was not sufficient to counteract its impact. As a result the Labour government in 2009 undertook various fiscal stimulus measures. They, together with lower interest rates, succeeded in stopping the fall in output, but by 2010 the signs of a recovery were still fragile. The new Coalition (Conservative and Liberal Democrat) government decided to focus on the rising budget deficit rather than the recovery, and undertook a large fiscal contraction in what became known as austerity.

The consequence of UK austerity was the slowest recovery from a recession in centuries. Here is a nice chart from a recent report by James Smith of the Resolution Foundation, which clearly illustrates the extent of the weak recovery.

Employment eventually recovered, but at the cost of an unprecedented fall in real wages. James Smith gives some evidence to suggest that the reason employment got off comparatively lightly but wages suffered by much more than we might expect was the 2008 sharp depreciation in sterling. This allowed firms to respond to the recession by keeping wages low, whereas in recessions in which sterling did not fall firms resisted nominal wage cuts and so had to resort to cutting jobs.

The idea that austerity was essential to reduce the deficit is simply wrong. It undoubtedly was a large factor in the weakness of the UK recovery. The tightening of fiscal policy has continued until today, with the consequence that interest rates have had to stay low to offset this fiscal tightening. The net result is that instead of rates being near 5% as they were before the GFC, they are below 1%. As James Smith points out, interest rate cuts in previous recessions have ranged from three to ten percent. This means that conventional monetary policy has almost no room to counteract a new economic downturn if one came.

The Eurozone is in an even worse position. Their history is of two recessions since the GFC, the second of which was largely caused by fiscal tightening as a result of the Eurozone crisis of 2010-12. The last time core inflation in the Eurozone touched 2% was in 2008, and it is currently around 1%. (More details from Frances Coppola here.) Interest rates set by the European Central Bank (ECB) remain at their lower bound. If a new recession happened, caused for example by a disruption in trade due to Donald Trump, conventional monetary policy would be unable to do anything about it.

Of course central banks in the UK and Eurozone still have various unconventional monetary policy tools. But the clue to their reliability at ending a recession is in their name. They are unconventional because they have only been used since the GFC, so we have limited evidence on their impact. It is like having an accelerator on a car where how far you have to push your foot down varies from second to second. You will end up driving slowly, which in economic terms means a prolonged recession.

All this is now largely understood by central bankers. All have said in one place or another that they will be relying on fiscal stimulus to help counteract the next recession. The ECB needs fiscal stimulus right now to get out of the last one. Yet fiscal stimulus is in the hands of politicians and not central bankers, and many of the politicians and political parties that were crucial in implementing the austerity that hit the post-GFC recovery are still in power.

There is therefore a danger that the policy of fighting the next recession will fall between two stools. Central bankers will say, in their own quiet and politically sensitive way, that they are not equipped for the task, but politicians may be deaf to these messages and will once again start worrying about deficits that inevitably rise in an economic downturn. To say more, we need to differentiate between the UK and the Eurozone.

In the UK some may think that with a new Prime Minister the problem of austerity has disappeared. In order to get elected both candidates have promised all kinds of tax cuts or spending increases. But as I have argued recently, what we are seeing here is what economists call deficit bias: the tendency to borrow just for political gain. Worse still, if the borrowing is mainly for tax cuts (including tax cuts for the rich), there is a danger that it is part of a strategy called ‘starve the beast’, which involves increasing the deficit with tax cuts and then demanding spending cuts to bring the deficit under control.

The upshot is that a Tory leader wanting to spend and cut taxes to please party members provides no guarantee that they will undertake effective fiscal expansion in any future recession. Neither of the Coalition partners has apologised for the mistake of austerity, and we have no reason to believe that they wouldn’t do it again in any future recession. The only major party that has a fiscal framework that would automatically move to fiscal expansion when interest rates hit their lower bound is Labour.

In the Eurozone there is also too little recognition among senior politicians that fiscal stimulus is required when ECB interest rates are at the lower bound. This is why Eurozone inflation is still below target. The OECD point to a crying need for more fiscal stimulus. Germany in particular has a great need for additional public investment, but is restrained by a fiscal rule that is worthy of an economic stone age. Efforts to create a Eurozone budget that could act in a countercyclical way have also been blocked by politicians, despite support from the ECB.

We can hope for a change of political attitudes in both the UK and Eurozone, but central bankers should not be content with hope. They have been delegated the task of stabilising the economy, and if they fail to complete this task in economic downturn after downturn many will come to believe that delegating monetary policy to central banks was a huge mistake. In addition, it is not the case that all central banks can do when interest rates hit their floor is unreliable types of unconventional monetary policy.

A fail safe way for a central bank to bring a recession to an end when interest rates are at the lower bound is to create money and give it directly to citizens. It could also create money and give it to borrowers by subsidising borrowing rates. The former is called helicopter money, a term due to Milton Friedman, and would require cooperation from government. The latter has been undertaken by the ECB in the past (see Eric Lonergan here), and so could be done to a greater extent without involving government. In essence it involves cutting interest rates on borrowing to well below the lower bound, but keeping rates for savers at the lower bound, and funding the difference by creating money.

Central banks in most of the major economies have been happy to create money during a recession, but nearly always this money has been used by central banks to buy assets. The impact on the economy is then difficult to predict, because no one's income has increased and the interest rate for borrowing has not fallen significantly. Giving the money directy to people rather than buying assets would have a direct and more predictable impact in stimulating the economy, as Frances Coppola argues in her new book.

So why do central banks not do this? There are two major reasons. First, they worry that increasing people's income is the job of elected governments, although I would argue that it is central bank's job to stabilise the economy if the government does not. (See my article with Mark Blyth and Eric Lonergan for more on helicopter money.) Second, if they create money to buy assets, when the economy recovers they can if necessary take money out of the economy by selling those assets. If they give that money away they wil not have those assets to sell. However this problem could be dealt with by governments guaranteeing the supply of assets a central bank needs.

Besides these arguments, I think there is a third argument why most central banks have not proposed doing these types of measures in a major way, and that is conservatism with a small c. The problem is that, if politicians unprepared to undertake fiscal expansion in a recession remain in power, that conservatism may be very costly both to us and to central banks themselves.

Haldane on alternatives to QE, and what he missed out

Andrew Haldane, Chief Economist at the Bank of England, gave a typically well researched and thoughtful talk recently. The main subject matter was the problem of the Zero Lower Bound (ZLB): why we may hit it much more often than we would like, and why QE is not a great instrument for dealing with it. To quote:

“QE’s effectiveness as a monetary instrument seems likely to be highly state-contingent, and hence uncertain, at least relative to interest rates. This uncertainty is not just the result of the more limited evidence base on QE than on interest rates. Rather, it is an intrinsic feature of the transmission mechanism of QE.”

In the past I have emphasised the point about lack of evidence simply because it is obvious. But as Haldane’s discussion shows, the problems are more basic than that. Some people argue that we can always get the result we want with enough QE. Yet if the central bank and the public never know how effective any amount of QE will be, then lags make it a poor instrument. It is refreshing to see a senior member of the Bank finally acknowledge its limitations.

Haldane considers two alternative ways of dealing with, or avoiding, the ZLB: a higher inflation target and getting rid of cash so that negative interest rates of whatever size become possible. The first is obviously welfare reducing, but as Eric Lonergan argues the second is likely to be as well. (See also Tony Yates.) But what is really strange about Haldane’s analysis is what is missing from his discussion.

One omission is a discussion of the possibility that targeting something other than inflation might help. The other omission is any discussion of helicopter money. There are some basic contradictions in the Bank of England’s views on helicopter money, but because central bankers tend to talk to each other I suspect they remain concealed. One argument is that helicopter money will somehow reduce confidence in the currency, but then the Bank seems happy to research getting rid of cash and imposing negative rates on money as if this is all about technicalities. [Postscript - meant to link to John Cochrane's discussion, and here is a reply by Miles Kimball.] I should have referenced  Another argument is that helicopter money will threaten the Bank’s independence because it will have to rely on government to (if necessary) recapitalise it, when at the same time the Bank has already obtained an underwriting guarantee for losses on QE. Also strange is the argument that independence will be threatened once the Bank does a 'helicopter drop' because governments will want the money for themselves, as if politicians had not noticed the amount of money being created under QE. After all Jeremy Corbyn's proposal was a response to the reality of QE, not the possibility of helicopter money.

The really ironic argument is that helicopter money is too like fiscal policy, and that there should be democratic control over fiscal policy. This is what central bankers mean when they talk about blurring the lines between monetary and fiscal policy. The argument is ironic because I am sure that if you actually asked most people which they would prefer - being charged to hold money, 4% average inflation, or occasionally getting a cheque from the Bank - the answer would be emphatic. So we rule out helicopter money because its undemocratic, but we rule out a discussion of helicopter money because ordinary people might like the idea.

There is also an element of hypocrisy. It is sometimes argued that helicopter money is unnecessary because it has a very similar impact to conventional fiscal policy. This is true, but it deliberately ignores the fact that governments around the world have gone for fiscal contraction because of worries about the immediate prospects for debt. It is not as if the possibility of helicopter money restricts the abilities of governments in any way. If governments undertake fiscal stimulus in a recession such that helicopter money is no longer necessary, it will not happen.

So it is good that some people at the Bank are thinking about alternatives to QE, which is a lousy instrument with unfortunate, and potentially permanent, distributional consequences. It is a shame that the Bank is not even acknowledging that there is a straightforward and cost free solution to this problem. My last two posts have involved defending central bank independence, but with independence comes a responsibility not to exclude discussion of particular policy options simply because they break some kind of taboo.      

We want helicopters, and we want them …

Not now exactly. In the UK, for example, the MPC has scope for some further reduction in interest rates. (I think they should use that scope now, but that is for another day.) But, as Mark Blyth, Eric Lonergan and I argue in the Guardian, if something serious goes wrong in the next year or two, or if another financial crisis happens in the next decade or two, monetary policy is under equipped.

Does this mean that I no longer think it is a good idea to have a fiscal stimulus in a recession when nominal interest rates are at their floor? Of course not, because helicopter money is essentially just like a tax cut. What is true is that helicopter money is not my ideal form of fiscal stimulus, partly because there is some uncertainty about how much of it will be spent. I would much prefer additional public investment, for which there is a strong microeconomic as well as macroeconomic case. [1] Michael Spence [2] is one of a huge list of eminent economists, which includes Ken Rogoff, who think additional public investment across the OECD would be beneficial.

We should continue to urge governments to recognise this, but we also have to accept the awkward fact that they are not listening. In political terms, the need to reduce deficits trumps pretty well anything else. (Perhaps things are turning in the US, but until the Republicans start losing power I’m not counting chickens.) One of the many depressing things about the Conservative election victory in the UK is that it looks like deficit obsession is an economic strategy that can win, as long as the austerity is front loaded, which is why Osborne fully intends to do it all over again. 

Because helicopter money is mainly a form of fiscal stimulus, and because the case for fiscal stimulus in a liquidity trap is largely agreed by most academic macroeconomists, the debate over helicopter money is essentially an issue in political economy. Persistent demand deficiency is clearly preventable, and represents a huge economic cost to society. Politicians will not do what economists call a bond financed fiscal stimulus because spreading scare stories about public debt is a vote winner. That leaves us with a money financed fiscal stimulus, of which helicopter money is one form. With independent central banks, that means giving these banks the power to undertake helicopter money.

I think the biggest obstacle to helicopter money is probably central banks themselves. This is for two reasons. First, they seem far too optimistic about the efficacy of creating money to buy financial assets (QE), even though they almost certainly need to create far more money by this route than they would through helicopter money, with a far less certain impact. Second, there is this residual worry that creating money now will mean they will lose the ability to control inflation in the future, as if a modern government in an advanced democracy would ever refuse to provide them with the assets they need.

The consensus among macroeconomists is that independent central banks are a good idea. The belief is that the business of macroeconomic stabilisation is best achieved if the task is delegated. But making central banks independent is not the same as completely delegating the task of macroeconomic stabilisation, because of the problem of the lower bound for nominal interest rates. Indeed independent central banks made the obvious way of getting around the lower bound problem, which is a money financed fiscal expansion, more difficult to achieve. Helicopter money is a way of making the delegation of stabilisation policy complete. 

[1] I have suggested how (see here and here and here) we could have ‘democratic helicopter money’ that could encompass additional public investment, but I’ll happily settle for the plain vanilla kind for the moment.

[2]  HT Diane Coyle