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.  

Japan and the burden of government debt

I don’t write enough about Japan, and now that some of my posts are very kindly being translated into Japanese I should try to remedy that. In fact there is currently a very good reason to write about the Japanese economy, and that is a very strong 2017 Q2 performance. Annualised growth was 4%, compared to 1.2% in the UK. What is particularly heartening about recent Japanese growth is that it is led by domestic demand rather than trade. In the past Japan seemed to have the opposite of the UK’s problem: growth was often led by trade, while domestic demand was weak.

This recent growth is not just making up for poor past performance compared to other countries. Comparisons of GDP growth are misleading for Japan because (unlike the UK and US) it has relatively little inward migration, so it is better to use GDP per head for such comparisons. (As Noah Smith points out, even this my bias comparisons against Japan because its population is aging.) Between 2006 and 2016, Japan increased GDP per head by a total of about 5.5%, compared to around 5% in the US and about 3% for the UK. Good compared to other countries, but all these countries should have had stronger recoveries from the recession.

Strong growth is good news because inflation is so low (around 0.5%): way below the 2% inflation target. The government is trying to stimulate growth using a modest fiscal stimulus and large scale quantitative easing (short and long interest rates are exactly zero) as well as implementing various structural reforms. But the striking thing about all this is that their net government debt to GDP ratio is 125% and rising (OECD Economic Outlook measure). This is higher than any other OECD country except Greece and Italy.

Does the conjunction of relatively strong growth and high government debt confound economic theory, as Bill Mitchell suggests? Like high powered money and inflation, any relationship between government debt and growth just does not work when interest rates are stuck at zero. High government debt could crowd out private investment (although some dispute this), but not when real long term rates are zero and inflation is near zero. Servicing high debt could discourage labour supply, but again not when interest rates are zero. Nor is debt a burden on future generations when the real rate of interest is well below the growth rate.

Of course most people think such high debt levels are a real concern because of ‘the markets’. But the markets will only stop buying this debt if they expect default or rampant inflation, and there is no way a government with its own currency can be forced to default. There is also no way it will choose to default with interest rates so low. This is the basic truth that our leaders in the UK choose not to tell us (and pretend otherwise).

But what happens when growth finally raises inflation, and interest rates rise. Will debt not be a problem then? Maybe, but only in the long term, so the government will have plenty of time to fix that roof when the sun shines. [1] Right now Japan does worry about its high levels of government debt, but it rightly worries about the combination of low growth and low inflation much more. In that sense it sets a good example to other countries.

[1] Fixing the roof while the sun shines is one of the Cameron/Osborne little homilies I approve of. The problem when they used it was the UK economy was actually in pretty poor shape, as we could tell because interest rates were so low.    

Whatever happened to the government debt doom spiral

A number of people, including the occasional economic journalist, are puzzled about why government debt at 90% of GDP seemed to cause our new Chancellor and the markets so little concern when his predecessor saw it as a portent of impending doom. I always argued that this aspect of austerity had a sell by date, so let me try to explain what is going on.

The 90% figure comes from a piece of empirical work which has been thoroughly examined, and found to be highly problematic. (Others have used rather more emphatic language.) Part of the problem is a lack of basic thinking. Why should the markets worry about buying government debt, beyond the normal assessment of relative returns. The answer is that they worry about not getting their money back because the government defaults.

If a government cannot create the currency that it borrows in, then the risk of default is very real. Typically a large amount of debt will periodically be rolled over (new debt sold to replace debt that is due to be paid back). If that debt cannot be rolled over, then the government will probably be forced to default. Knowing that, potential lenders will worry that other potential lenders will not lend, allowing self fulfilling beliefs to cause default even if the public finances are pretty sound.

The situation is completely different for governments that can create the currency that the debt they sell is denominated in. They will never be forced to default, because they can always pay back debt due with created money. That in turn means that lenders do not need to worry about forced defaults, or what other lenders may think, so this kind of self fulfilling default will not happen.

Of course a government can still choose to default. It may do so if the political costs of raising taxes or cutting spending is greater than the cost of defaulting. But for advanced economies there is an easier option if the burden of the public finances gets too much, which is to start monetising debt. That is what Japan may end up doing, and what others may also do if QE turns out to be permanent. But this is a very different type of concern than the threat of default. And it does not, in the current environment, lead to the emergence of large default premiums and market panics.

How can I be so sure? Because with QE we have had actual money creation, and it has not worried the markets at all. It seems hard to tell a story where markets panic today about the possibility of monetisation in the future, but are quite sanguine about actual monetisation today.

So for economies that issue debt in currency they can create, there is no obvious upper limit anywhere near to current debt/GDP ratios when economies are depressed and inflation is low. Japan shows us that, and we must stop treating Japan as some special case that has no lessons for the rest of us. (How often did we hear of their lost decade in the 1990s that it couldn’t happen anywhere else.)

It was good that the IFS suggested Hammond has a look at Labour’s fiscal rule. As I explained in this post, Hammond’s new ‘rule’ is pretty worthless. But one key part of Labour’s rule that keeps being ignored but is crucial in today's environment is the knockout if interest rates hit their zero lower bound. It is for the reasons described above that this knockout is there and is perfectly safe: when interest rate policy fails you can completely and safely forget the deficit and debt and use fiscal policy to ensure the recovery. It is the basic macro lesson of the last 6 years that is fairly well understood among academic economists but still remains to be learnt by most people who talk about these things. Whether senior economists in the UK Treasury need to learn it or just keep quiet about it for other reasons I do not know.

Mistakes

My guess is that the majority of pieces of empirical work by economists will contain at least one error somewhere. Errors become almost inevitable when large and diverse data sets are involved, like those constructed by Reinhart and Rogoff and Thomas Piketty. So finding these errors is not headline news. Nor, for this reason, is it particularly embarrassing for the economists concerned when these errors are found, particularly if they have made their data public or available to others.

If you think that shows up empirical economists in a bad light, the best economic theorists can also make errors. One celebrated paper from my youth, Does Fiscal Policy Matter? by Alan Blinder and Robert Solow, contained an algebraic error (pdf). And if you think this shows up all economists, probably the most famous mathematical event of the last few decades - the Andrew Wiles proof of Fermat’s Last Theorem - contained what a journalist would call an error in its original form.

It is also often necessary to adjust data for a number of reasons. In an ideal world each adjustment would be carefully documented, but they rarely are. Of course official data series often involve many similar adjustments before they are published. If you can, it is always a good idea to talk to the statisticians involved in constructing your data before you use it, although it can put you off doing any empirical work ever again!

Errors and adjustments only matter if they influence key results. The Blinder and Solow algebraic error was not critical to the main results in their paper. The gap in the original Andrew Wiles proof was critical, but after what must have been an agonising year, he found he could bypass the problem and the revised proof was sound. The Reinhart and Rogoff spreadsheet error had a relatively minor impact on its own - the really important issues lay elsewhere.

With all this in mind, I have very mixed feelings about Chris Giles’s Financial Times splash. I applaud a journalist who is unwilling to take academic results or official figures on trust, and is prepared (and I guess has the resources) to get their hands dirty with data. Chris has consistently done this. For example, when David Cameron claimed mysteriously that George Osborne’s first austerity budget would increase public sector employment compared to Labour’s plans, Chris got to the bottom of how this trick was achieved. Yet I groaned when reading his latest FT article, with its emphasis on “mistakes and unexplained entries”. As far as I can see (read Ryan Avent here, and the longer Chris Giles post here, and Jonathan Hopkin here), the only issue of substance involves trends in the UK wealth income ratio, but of course an article headlined ‘Data sources on UK wealth income ratio differ’ would not have had the same punch.

Now you might say, as journalists always do, that people who become famous - including economists like Reinhart and Rogoff or Piketty - have to accept having their work treated in this way. They become ‘fair game’. I actually think that is wrong. Misleading reporting and commentary - by journalists or bloggers - is what it is: misleading. The fact that it can be commonplace does not excuse it. I understand the temptation to hype up simple spreadsheet errors even when they have no significant consequence, but I’m glad to say I did not succumb to this temptation in the case of Reinhart and Rogoff spreadsheet affair.

It is perhaps worth noting one other point. The Reinhart and Rogoff affair became notorious because governments had used this work to justify their austerity policies. The spreadsheet error was brought to light as a result of work by academics rather than by any journalist. In the case of Piketty, no policies have yet been implemented using the results in his book as justification. In that rather important sense, the two stories are different. Whether this asymmetry reveals anything of interest I will leave you to judge. 

An Understandable Mistake

No, I’m not talking about coding in excel - as someone who has in the past done plenty of empirical work, my overriding reaction is empathy with the researchers concerned. There - not so much by the grace of god but because no one bothered to check what we did - go us. What I’m talking about is the weak global recovery and a primary reason for it. But there is a link, which I will come to at the end.

To be honest, this post is really just to encourage you to read this Vox piece by Kose, Loungani and Terrones, which comes from the recent IMF WEO report (pdf). It tells a story in pictures (particularly comprehensive and clear pictures) that I and others - most notably Paul Krugman - have been telling for some time. In the past I have often used cyclically adjusted primary deficits as a summary measure of fiscal stance, because they are readily available and comprehensive. However as an indication of fiscal demand impact they are not ideal - just think of the standard Ricardian Equivalence experiment. So occasionally I have looked at just government spending, which is what Kose et al do in their analysis. The key chart is below.

What the chart shows is that government spending in the advanced economies has grown at a much slower rate in this recovery than in previous recoveries, and of course this recovery has been significantly slower as a result. In contrast, government spending in the emerging economies has been as rapid during the recovery as before the recession, and they have recovered rapidly from recession. Go into detail within the advanced economies group, and the pattern is clear: the greater the contraction in government spending relative to previous recoveries, the slower the recovery has been.

Their analysis also shows us one of the reasons why this happened. The advanced economies started the recovery with debt to GDP almost twice its average level in previous recoveries. At the start of the recession this was not the predominant concern, and we saw some attempt at countercyclical policy in the US, the UK and Japan, as the chart shows. But this was short lived in the UK, and was also reversed in the US and Japan, as debt concerns took over.

Kose et al also illustrate why this was a mistake. Interest rates hit the zero lower bound, so monetary policy could not offset what fiscal policy was doing. Yes, we have had Quantitative Easing (QE), but I think Jonathan Portes puts it rather nicely here. “It seems to me the idea that you risk the government’s credibility by borrowing an extra couple of percent of GDP for investment but there would be no risk to credibility by doing something [QE] which nobody in modern times in an advanced developed country has ever tried and that is generally considered to be last ditch strategy is an odd conclusion.” (The link is to a nice site by the way - on it you will also find Andrew Scott saying: “the right response for those governments wanting to hold on to AAA, whether it be Japan, US, Germany or the UK, is for government debt to show huge increases into triple digits versus GDP.”)

So we have one clear reason why the recovery from the Great Recession has been weak, and it also explains why it has been weaker in some countries than others. I’m sure its not the only reason, but is anyone seriously arguing anymore that it is not an important factor explaining our weak recovery? So the real mistake that Reinhart and Rogoff made was to push the high debt issue at the wrong time. It was I believe an honest mistake: high government debt is a concern, if only (but not only) because it makes politicians do the wrong thing in a serious recession. And of course the mistake would have happened anyway (in part because of Greece, and partly because of those who see reducing the size of the state as the overriding priority) - academics probably overestimate the importance of the research that politicians use as cover.  But when history tells the story of why the Great Recession was so prolonged, charts like the one here will be what is shown.