Inflation and pandemic recoveries in five major economies

My discussion about current inflation two weeks ago focused on the UK. Over a year ago I wrote a post called “Inflation and a potential recession in 4 major economies”, looking at the US, UK, France and Germany. I thought it was time to update that post for countries other than the UK, with the UK included for comparison and with Italy added for reasons that will become clear. I also want to discuss in general terms how central banks should deal with the problem of knowing when to stop raising interest rates, now that the Fed has paused its increases, at least for now.

How to set interest rates to control inflation

This section will be familiar to many and can be skipped.

If there were no lags between raising interest rates and their impact on inflation then inflation control would be just like driving a car, with two important exceptions. Changing interest rates is like changing the position of your foot on the accelerator (gas pedal), except that if the car’s speed is inflation then easing your foot off the pedal is like raising rates. So far so easy.

Exception number one is that, unlike nearly all drivers who have plenty of experience driving their car, the central banker is more like a novice who has only driven a car once or twice before. With inflation control, the lessons from the past are few and far between and are always approximate, and you cannot be sure the present is the same as the past. Exception number two is that the speedometer is faulty, and erratically wobbles around the correct speed. Inflation is always being hit by temporary factors, so it’s very difficult to know what the underlying trend is.

If driving was like this, the novice driver with a dodgy speedometer should drive very cautiously, and that is what central bankers do. Rapid and large increases in interest rates in response to increases in inflation might slow the economy uncomfortably quickly, and may turn out to be an inappropriate reaction to an erratic blip in inflation. So interest rate setters prefer to take things slowly by raising interest rates gradually. In this world with no lags our cautious central banker would steadily raise interest rates until inflation stopped increasing for a few quarters. Inflation would still be too high, so they might raise interest rates once or twice again to get inflation falling, and as it neared its target cut rates to get back to the interest rate that kept inflation steady. [1]

Lags make the whole exercise far more difficult. Imagine driving a car, where it took several minutes before moving your foot on the accelerator had a noticeable impact on the car’s speed. Furthermore when you did notice an impact, you had little idea whether that was the full impact or there was more to come from what you did several minutes ago. This is the problem faced by those who set interest rates. Not so easy.

With lags, together with little experience and erratic movements in inflation, just looking at inflation would be foolish. As interest rates largely influence inflation by influencing demand, an interest rate setter would want to look at what was happening to demand (for goods and labour). In addition, they would search for evidence that allowed them to distinguish between underlying and erratic movements in inflation, by looking at things like wage growth, commodity prices, mark-ups etc.

Understanding current inflation

There are essentially two stories you can tell about recent and current inflation in these countries, as Martin Sandbu notes. Both stories start with the commodity price inflation induced by both the pandemic recovery and, for Europe in particular, the war in Ukraine. In addition the recovery from the pandemic led to various supply shortages.

The first story notes that it was always wishful thinking that this initial burst of inflation would have no second round consequences. Most obviously, high energy prices would raise costs for most firms, and it would take time for this to feed through to prices. In addition nominal wages were bound to rise to some extent in an attempt to reduce the implied fall in real wages, and many firms were bound to take the opportunity presented by high inflation to raise their profit margins (copy cat inflation). But just as the commodity price inflation was temporary, so will be these second round effects. When headline inflation falls as commodity prices stabilise or fall, so will wage inflation and copy cat inflation. In this story, interest rate setters need to be patient.

The second story is rather different. For various (still uncertain) reasons, the pandemic recovery has created excess demand in the labour market, and perhaps also in the goods market. It is this, rather than or as well as higher energy and food prices, that is causing wage inflation and perhaps also higher profit margins. In this story underlying inflation will not come down as commodity prices stabilise or fall, but may go on increasing. Here interest rate setters need to keep raising rates until they are sure they have done enough to eliminate excess demand, and perhaps also to create a degree of excess supply to get inflation back down to target.

Of course reality could involve a combination of both stories. In last year’s post I put this collection of countries into two groups. The US and UK seemed to fit both the first and second story. The labour market was tight in the US because of a strong pandemic recovery helped by fiscal expansion, and in the UK because of a contraction in labour supply partly due to Brexit. In France and Germany the first story alone seemed more likely, because the pandemic recovery seemed fairly weak in terms of output (see below). 

Evidence

In my post two weeks ago I included a chart of actual inflation in these five countries. Here is a measure of core inflation from the OECD that excludes all energy and food, but does not exclude the impact of (say) higher energy prices on other parts of the index because energy is an important cost.

Core inflation is clearly falling in the US (green), and rising in the UK (red). In Germany (light blue) core inflation having risen seems to have stabilised, and the same may be true in France and Italy very recently. The same measure for the EU as a whole (not shown) also seems to have stabilised.

If there were no lags (see above) this might suggest that in the US there is no need to raise interest rates further (as inflation is falling), in the UK interest rates do need to rise (as they did last month), while in the Eurozone there might be a case for modest further tightening. However, once you allow for lags, then the impact of the increases in rates already seen has yet to come through, so the case for keeping US rates stable is stronger, the case for raising UK rates less clear (the latest MPC vote was split, with 2 out of 7 wanting to keep rates unchanged) , and the case for raising rates in the EZ significantly weaker. (The case against raising US rates increases further because of the contribution of housing, and falling wage inflation.)

As we noted at the start, because of lags and temporary shocks to inflation it is important to look at other evidence. A standard measure of excess demand for the goods market is the output gap. According to the IMF, their estimate for the output gap in 2023 is about 1% for the US (positive implies excess demand, negative insufficient demand), zero for Italy, -0.5% for the UK (and the EU area as a whole), and -1% for Germany and France. In practice this output gap measure just tells you what has been happening to output relative to some measure of trend. Output compared to pre-pandemic levels is strong in the US, has been pretty strong in Italy, has been quite weak in France, even weaker in Germany and terrible in the UK (see below for more on this).

I must admit that a year ago this convinced me that interest rate increases were not required in the Eurozone. However if we look at the labour market today things are rather different. Ignoring the pandemic period, unemployment has been falling steadily since 2015 in both Italy and France, and for the Euro area as a whole it is lower than at any time since 2000. In Germany, the US and UK unemployment seems to have stabilised at historically low levels. This doesn’t suggest insufficient demand in the labour market in the EZ. Unemployment data is far from an ideal measure of excess demand in the labour market, so the chart below plots another: employment divided by population, taken from the latest IMF WEO (with 23/24 as forecasts).

Once again there is no suggestion of insufficient demand in any of these five countries. (The UK is the one exception, until you note how much the NHS crisis and Brexit have reduced the numbers available for work since the pandemic.)

This and other labour market data suggests our second inflation story outlined in the previous section may not just be true for the US and UK, but may apply more generally. It is why there is so much focus on wage inflation in trying to understand where inflation may be heading. Of course a tight labour market does not necessarily imply interest rates need to rise further. For example in the US both wage and price inflation seem to be falling despite a reasonably strong labour market, as our first inflation story suggested they might. The Eurozone is six months to a year behind the US in the behaviour of both price and wage inflation, but of course interest rates in the EZ have not risen by as much as they have in the US.

Good, bad and ugly pandemic recoveries

The chart below looks at GDP per capita in these five countries, using the latest IMF WEO for estimates for 2023.

Initially I will focus on the recovery since the pandemic, so I have normalised all series to 100 in that year. The US has had a good recovery, with GDP per capita in 2023 expected to be five percent above pre-pandemic levels. So too has Italy, which is forecast to do almost as well. This is particularly good news given that pre-pandemic levels of GDP per capita were below levels achieved 12 years earlier in Italy.

Germany and France have had poor recoveries, with GDP per capita in 2023 expected to be similar to 2019 levels. The UK is the ugly one of this group, with GDP per capita still well below pre-pandemic levels, something I noted in my post two weeks ago. Unlike a year ago, there is no reason to think these differences are largely caused by excess demand or supply, so it is the right time to raise the question of why there has been such a sharp difference in the extent of bounce back from Covid. To put the same point another way, why has technical progress apparently stopped in Germany, France and the UK since 2019.

Part of the answer may be that this reflects long standing differences between the US and Europe. Here is a table illustrating this.

Real GDP per capita growth, average annual rates	2000/1980	2007/2000	2019/2007	2023/2019
France	1.8	1.2	0.5	0.1
Germany	1.8	1.4	1.0	-0.1
Italy	1.9	0.7	-0.5	0.8
United Kingdom	2.2	1.8	0.6	-0.7
United States	2.3	1.5	0.9	1.1

Growth in GDP per capita in the US has been significantly above that in Germany, France or Italy since 1980. At least part of that is because Europeans have chosen to take more of the proceeds of growth in leisure. However this difference is nothing like the gap in growth that has opened up since 2019. (I make no apology in repeating that growth in the UK, unlike France or Germany, kept pace with the US until 2007, but something must have happened after that date to reverse that.)

I have no idea why growth in the US since 2019 has been so much stronger than France or Germany, but only a list of questions. Is the absence of a European type furlough scheme in the US significant? Italy suggests otherwise, but Italy may simply have been recovering from a terrible previous decade. Does the large increase in self-employment that occurred during the pandemic in the US have any relevance? [1] Or are these differences nothing to do with Covid, and instead do they just reflect the larger impact in Europe of higher energy prices and potential shortages due to the Ukraine war. If so, will falling energy prices reverse these differences?

[1] If wage and price setting was based on rational expectations the dynamics would be rather different.

[2] Before anti-lockdown nutters get too excited, the IMF expect GDP per capita in Sweden to be similar in 2023 to 2019.

How the electoral system in the US, and to a lesser extent the UK, is biased towards social conservatism.

 

The UK is often torn between following the US or following Europe. We share a language with the US, and a lot of popular culture. But we also share a voting system that ensures the political right has a heavy built in advantage. The United States may be too far down that road to change, but in the UK there is still hope if only the current opposition leadership see sense.

Once we get over the relief that Donald Trump is no longer President, comes the realisation of just how bad the US election results really were for Democrats. Trump was a Republican, and the Republican party backed him almost without exception. Even in the current ludicrous situation where Trump is refusing to concede, many senior Republican politicians continue to back him.

It should come as no surprise that Republicans have an ambiguous relationship to democracy. Republicans see nothing wrong in distorting district borders to give themselves better election results in terms of seats than their polling numbers deserve. Gerrymandering is endemic, and it gives the Republicans an inbuilt advantage in one half of Congress, the House of Representatives. They also habitually make it hard for democrat voters (particularly black voters) to vote: the long lines we see during US elections are there for a reason.

Recently Republican senator Mike Lee said “Democracy isn’t the objective; liberty, peace, and prospefity [sic] are. We want the human condition to flourish. Rank democracy can thwart that.” This view is not unusual among Republican politicians, it is just that most are not so foolish as to say it out loud.

But Trump’s attempt to cling to power is not the problem. The problem is that the Republican party won seats in the House, and is likely to retain its majority in the Senate. Why the Democrats did so badly in both of these contests is something that will be analysed by others at length later. But I suspect what few outside the US understand is just how difficult it is for the Democrats to win big in the Senate.

As Shaun Lawson explains in an excellent piece, the Senate is constructed such that each state has two senators, whatever its population. To take the most extreme example, Wyoming with a population of 563,626 gets the same representation in the Senate as California with a population of 37,253,956. Now if political support was evenly distributed among big and small states alike this would not be an issue . However it is not: Wyoming has two Republican senators and California has two Democratic senators. The Senate structure influences the Electoral College used to choose a President.

The basic problem with the Senate is that it gives rural and small town states much more political clout than their population warrants. With political polarisation increasingly between liberals and social conservatives (the culture war), and with liberals concentrated in the big dynamic cities and conservatives in the rest of the country, anything that gives the latter an advantage relative to their number is a political problem.

The example of the US senate is far more extreme than anything in the UK, but that does not mean that the problem does not exist here. We saw that very clearly with Brexit, which is essentially a culture war issue. The referendum of course involved the whole population, and we all know the result of that. But if a general election had been held on just that issue, it is estimated that Leave would have won a landslide: 406 Leave | 242 Remain.

We can do a similar calculation for the 2019 election. If you add up the vote totals of parties supporting a second referendum, it was just more than 50%, but of course the Conservatives won a landslide and Brexit went ahead. That partly reflects the fact that the second referendum vote was more divided among different parties than the Brexit vote, but it also reflects the way the social liberal/conservative divide is split among parliamentary seats.

Socially liberal votes are concentrated in the cities. Seats outside the cities have many social liberals as well, but they are typically outnumbered by social conservatives. However you will find very few social conservatives in big city seats. That means that even if social liberals are in a small majority in the population as a whole, they are outnumbered in terms of seats. When it comes to culture war issues, the First Past The Post (FPTP) UK constituency system for general elections represents accidental gerrymandering favouring social conservatives.

An illustration of this is to compare the 2017 and 2019 elections. In 2017 both main parties backed Brexit and the Remain movement hardly existed, so Labour could focus on a relatively popular economic programme and do relatively well. In contrast, the 2019 election was mainly about Brexit, and the seat totals (once you allow for other parties) was not very different from those implied by the 2016 referendum result. 2019 also reflects the difficulty Labour had in focusing on economic issues given a slanted media.

If you think this is just about Brexit, or that Cummings’ departure means that Johnson will reveal his true social liberal self, think again. The Conservatives were using immigration as a weapon against Blair under William “foreign land” Hague, and will continue to try and capture socially conservative voters after Cummings' exit, because it works at winning elections.

One solution is for Labour to try and do what it did in 2017, and effectively match the Conservatives on the key culture war issues. However, that creates two related problems. The first is that Labour’s current base is very socially liberal. The second is that other socially liberal parties exist. The danger is that we see a repeat of what happened in the period before the 2019 election, where voters defecting over Labour’s socially conservative stance leads to lost votes whatever choice it makes. I'm not saying that Labour cannot succeed doing this, but it is hard and divisive. 

Both this problem, and the problem of the socially liberal vote being split among parties, can be overcome by elections determined by some form of proportional representation (PR).

A traditional argument for the UK’s existing first past the post system, and the constitutional system in the US, is that it keeps out political extremes as both major parties strive to capture the centre ground. This has been completely refuted by events over the last decade. It appears, in fact, that both systems allow governments that are politically extreme to capture power.

While there seems little chance that the US will change its system, there is more hope in the UK. It requires a Labour government to be elected that is committed to some form of PR. It has to be a commitment before they gain power, because once elected every Labour government believes it can now become the natural party of government. One advantage of a prior commitment to PR is that it makes cooperation between Labour and other socially liberal parties easier during the election.

There is considerable support for electoral reform within the Labour party. Unfortunately any Labour leadership that thinks it can win power is also a leadership that prefers to remain in power rather than becoming part of a coalition that any subsequent PR election is more likely to bring. While we can appeal to statistics to show the dominance of Conservative governments, political leadership is naturally focused on its own short term.

If you enjoyed the last two years and want more of the same, vote for May’s deal

Trade negotiations happen after the Withdrawal Agreement (WA) is signed, so why don’t those wanting a softer Brexit just vote for the WA and argue about trade later? The Political Declaration which does talk about trade is vague and non-binding. The reason is straightforward. Parliament will get very little say on the framework for those trade talks. The only real chance most MPs will get to influence the type of trade relationship the UK has with the EU is by directing the government now, as the price of passing the WA.

However so far parliament has largely failed to do that, largely because Conservative MPs have put party unity above the future health of the country. So what will happen to politics and the economy if parliament votes to pass May’s deal, either today or in a few months time? The first and well known point to make is that nothing would immediately change as far as UK firms and citizens are concerned, because we would start a transition period where we remain inside the Customs Union (CU) and Single Market (but no longer have any say on the rules of either). There will be little economic bounce from ending No Deal uncertainty, for reasons outlined below. So the immediate action will be about the politics of negotiating what happens after the transition period ends.

If you want to know what that would be like, just look at the last year or two. Most of the arguments within the Conservative party over the last year or so have been about trade, and not the content of the WA. So signing the WA settles very little. It does mean that we have signed up to the backstop, but May still pretends that this backstop means we can still stay outside the CU. I cannot see Brexiters meekly accepting that the UK should join the CU either. We will continue to have endless discussion of unicorn ‘alternative arrangements’ for the Irish border designed only to avoid us being up to a CU. The inevitable truth of course is that the backstop implies some part of the UK has to be in the CU, but as the last two years have shown large parts of the Conservative Party refuse to accept reality when they don’t like it.

At some point during the transition period Theresa May could be replaced as Prime Minister. It seems very likely, given the views of Conservative Party members on Brexit, that a Brexiter will be elected in her place. The likely outcome of that, as far as Brexit is concerned, is either that nothing changes, or that the government attempts to persuade the EU to do the impossible.

For example Theresa May is determined that we should leave the Single Market (SM) because her primary aim is to end Freedom of Movement (FM). Any successor is likely to want to leave the SM because they do not want to be bound by EU regulations on minimum workers rights or the environment. Because of the economic damage that will cause (see below) the government will attempt to get a trade agreement with the EU that mitigates that harm. They will find out, yet again, that it is impossible to get anything close to the benefits of the SM without being in the SM. And because the UK will not want to accept that, the negotiations will go on and on.

But at least No Deal will be off the table? Unfortunately just as you think you have avoided one cliff edge, another appears. If no trade deal is done during the transition period, we crash out much like we would with No Deal now. And the Brexiters in government will be saying not to worry the EU always cave at the last minute. They will fight extending the transition period from 21 months, even though it is impossible to negotiate a trade agreement in that time, because the ERG wants to fall off a cliff.

In short, if May’s deal is approved we can look forward to a politics dominated by internal squabbles within the Conservative Party, and the absence of constructive negotiations with Brussels, for perhaps the next four or more years. Much as we have seen for the past two years. This is because the WA does nothing to resolve internal Conservative conflicts, and more fundamentally conflicts inherent with Brexit itself.

If, despite it all, the government manages to negotiate a trade agreement with the EU, what will be the economic and political consequences for the UK? Will it all be worthwhile in the end? A good guide to the economics is the study involving a collaboration between the Centre of Economic Performance and The UK in a Changing Europe, which is both authoritative and representative of similar work. They believe that from 2030 onwards UK GDP per capita will be lower by between 1.9% and 5.5% as a consequence of leaving the Single Market. The midpoint of that range represents lost resources for each household of about £3,000 each year. There will of course be a large hit to the public finances, implying higher taxes or less public spending, even after allowing for an end to contributions to the EU.

Why such a large range? The 1.9% mostly comes from the direct effects of lower and more costly trade, using standard trade modelling techniques together with reasonable estimates of the barriers created by leaving the SM. The government using a similar model get similar numbers. The higher figure in the study’s range is based on empirical evidence for the impact of trade on productivity, which captures other effects such as lower foreign direct investment or reduced competition. Because the empirical evidence captures many more effects than the model, we would expect it to be larger. Those who dispute numbers of this scale in this range have to explain not only why the models, including those used by the government, are wrong but also why the simple correlations between trade and prosperity more than back the models up.

Our best guess is that we have already lost over 2% of GDP as a result of stagnant investment and sterling’s depreciation. As a result, most people will probably not notice the economic impact of ending the transition period, because most of the firms that were going to leave will have already left as a result of cliff edge uncertainty. Instead Brexit will be a gradual decline in the UK relative to the remaining EU.

What about Global Britain? Most trade agreements involve tariff reduction, so being in the CU largely limits the scope for Mr. Fox to do new trade deals. In addition, who would want to harmonise their regulations with the UK, when the gains from doing the same for the EU are much greater. A more likely outcome is that we harmonise our regulations with the US.

The government will be desperate to sign a trade deal with the US to show that ‘global Britain’ is more than a slogan, and that means the US will largely get their way in terms of regulations (including food standards) and participation in the NHS. Thus the longer term political consequence of parliament agreeing to May’s deal is the gradual transition of the UK into a US style economy.

In an age where the regulations governing trade in goods and services are increasingly decided by large regional blocks, the only rationalisation of Brexit that makes any kind of sense is that we move from the EU block to the US block. That is what a lot of the Brexiters want, which is why they resist the backstop so much, because that ties our tariffs to the EU. But the political consequences of tariffs are less important in shaping an economy than regulations on things like working conditions and the environment. That is why, even with the backstop, Brexit will mean we will become more like the US economy. Whatever the merits or otherwise of that, a big difference is that we had a say in how the EU is run but we will have none in what the US does. A 51st state without representation if you like. Taking back control it is not.

How the left stopped being a party of the working class

I’ve been meaning for some time to write about a recent paper by Thomas Piketty, which looks at what characteristics influenced voters to vote for the left or right in France, the UK and US since WWII. (Simon Kuper has a nice little summary with a great title.) Here is a chart that shows how after WWII educated voters tended to vote right, but now tend to vote left (even after controlling for income, age etc - see box)

In all three countries, the number of educated voters increased in all three countries, reflecting in part the need for higher skilled workers.

In contrast (and if we exclude the most recent elections in France and the US) the income profile for voting has not changed very much over time: poorer voters are more likely to vote left than richer voters, particularly if we control for education, although poorer voters are increasingly unlikely to vote. So the shift in voting patterns among educated voters demands an explanation and has fascinating implications.

Unfortunately the paper does not focus on this question, but it does suggest that part of any explanation may reflect the fact that more educated voters tend to have more liberal attitudes in general, and more liberal attitudes to migration in particular (see here for example). The positive correlation between social liberalisation and education is well documented (see [1] for example), as was evident in the Brexit vote.

I suspect there are other factors as well. There are possible reasons why the interest of human capital (as economists would call it) are different from the interests of business or financial capital, or no capital at all. For example a more meritocratic education system suits them better than one where income buys education, so they are likely to be stronger supporters of a state based education system (or indeed they may be part of it). They will also be more likely to consume state subsidised culture. More generally there may be a wish to break down traditional class based networks and replace them with more meritocratic structures. On the other hand because human capital generates an income, they will be less keen on tax based redistribution than workers. All this may create what some might call an education ‘cleavage’.

The implication for parties on the left are that party members were increasingly from the educated middle class rather than working class, and this has gradually changed the structure, platforms and leaders of left parties. Together with the decline in trade unions, the counterpart to this will be a less visible representation of the working class. Piketty describes this as the emergence of the “Brahmin Left” elite, which can be compared to the “Merchant” elite on the right.

A consequence may be that the political elite as a whole becomes less interested in redistributive policies that used to favour the working classes, and helped continue the decline in wealth inequality before the 1980s that Piketty has famously documented elsewhere. That in turn makes it easier for the right to capture parts of the working class vote, particularly when these voters have socially conservative views. A recent book by Mark Bovens and Anchrit Wille takes a very dim view of these changes.

There is a less pessimistic take on all this. As right wing parties have increasingly relied on pushing socially conservative/authoritarian/anti-minority policies to gain votes, left wing parties find that this combined with wealth/income protection is an unbeatable coalition for their opponents. (Perhaps this helps explain the decline in so many centre-left European parties.) The only way to beat that coalition is to rediscover economic policies that help the working class.

This long paper has other interesting results. In France, like the UK, public attitudes have seen a decreasing hostility to immigration over time. He also notes that the right’s socially conservative turn has helped to sustain an almost complete loyalty to the left from Muslims in the UK and France, and from blacks in the US. Finally a parochial point of interest, which is also a point that Torsten Bell has stressed recently.

Piketty notes that the dominance of the left among the young in the UK in 2017, as well as being unprecedented in the UK, was higher than in any of the two other countries at any point in time. It may be that this is part of a trend since 1997, but it could be exceptional because of Brexit, which amounts to the old taking opportunities away from the young.

[1] Education-based group identity and consciousness in the authoritarian-libertarian value conflict. / Stubager, Rune. In: European Journal of Political Research, Vol. 48, No. 2, 2009. .

Measuring the impact of austerity

Ben Chu has a good article disposing of some of the nonsense ideas associated with austerity (which refuse to die, because they are useful to politicians, and much of the media is generally clueless). Perhaps the most silly, which I encounter a lot, is that the UK has not really endured austerity because debt has been increasing, or some other irrelevant measure has been rising.

If trying to reduce the deficit - what economists call fiscal consolidation - had no adverse effects on the economy as a whole it would not be called austerity. Austerity is all about the negative aggregate impact on output that a fiscal consolidation can have. As a result, the appropriate measure of austerity is a measure of that impact. So it is not the level of government spending or taxes that matter, but how they change.

An obvious measure to use is the change in the deficit itself, generally adjusted for changes that happen automatically because output is changing. I have used that measure many times, because it is produced by the OBR, IMF and OECD among others. But it is not ideal, because the impact of changes in taxes on demand and therefore output is generally smaller than the impact of a change in government spending, because some of any tax increase comes from reduced saving. (This is also true, but perhaps to a lesser extent, of government transfers.)

There is no simple way of dealing with this measurement problem, because the amount of any tax increase people will find from their savings will depend in part on how long they expect taxes to be higher. As a result, some people prefer to focus just on government spending to measure fiscal impact (although the data you will easily find is government consumption, and as fiscal consolidation normally involves cuts to government investment it is important to add that on). However it is also possible to apply some simple average propensities to consume from tax cuts and transfers to get a fiscal impact measure.

This is what the Hutchins Center fiscal impact measure does for the US.

These are not multipliers (so are different from what the OBR does for the UK, for example [1]), but just the direct impact of government spending and taxes on aggregate demand and hence GDP. The average total impact is something like 0.4%, so this would be fiscal policy that was in this sense neutral.

Compare the mild 2001 recession with the much larger 2008/9 recession. In both cases during the recession fiscal policy was strongly counter-cyclical, helping to reduce the recession’s impact. After the 2001 recession ended, fiscal policy continued to support the recovery for around two years: these were the Bush tax cuts. The recovery in GDP was reasonably strong: growth from 2003 to 2005 of 2.8%, 3.8% and 3.3%.

In 2010, we had a much deeper and longer recession, but the fiscal support was only marginally greater than 2001, despite interest rates being stuck at their lower bound. On this occasion fiscal support was strongly opposed by the Republicans. It continued for another year and a quarter, and then became strongly contractionary from 2011 to 2015. GDP growth was slower than in the previous recovery, despite the deeper recession: from 2010 to 2014 2.5%, 1.6%, 2.2%, 1.7%, 2.4%. This is not surprising, as fiscal policy was reducing GDP by around 1% during 2011,2012 and 2013, rather than adding the normal 0.4%.

The speed and extent to which austerity was applied after the Great Recession was very unusual: the textbook says secure the recovery first, allow interest rates to rise, and then worry about government debt. There was no economic justification for switching to austerity so quickly after 2010: the motivation (as in the UK) was entirely political. It produced the slowest US recovery in output since WWII. (This is a very useful resource in comparing US upswings.) As I showed here using simple calculations, if total government spending from 2011 had remained neutral instead of becoming sharply contractionary, US output could easily have got close to capacity (as measured by the CBO) by 2013.

To subtract 1.5% from GDP would not matter if something (consumption, investment or net exports) filled its place. But that will only happen by chance or because of a monetary policy stimulus, and monetary policy was stuck in a liquidity trap. This is the real crime of austerity. Decreasing demand and output just when the economy is beginning its recovery from the deepest recession since WWII is as foolish as it sounds, but to do this at just the time that monetary policy was unable to effectively fight back is macroeconomic madness. As I will argue in later posts, it looks increasingly likely that this has made us all permanently poorer.

[1] If somebody publishes similar estimates for the UK, please let me know. Personally I think it makes more sense to publish data like this than use a multiplier based analysis, simply because these measures are more direct, and involve fewer ‘whole economy’ assumptions. Crucially, there are no implicit assumptions about monetary policy being made. It would be interesting to know why the OBR decided not to take this approach.

Kocherlakota’s argument for fiscal expansion in the US

Is there a macroeconomic case for tax cuts in the United States right now? Paul Krugman and I say no, using the following logic. The Fed thinks we are close to full employment, if we use the term to denote the level of employment that keeps inflation constant. Generalised tax cuts (rather than just tax cuts to the very rich) will tend to raise aggregate demand, which will lead inflation to increase. The Fed will therefore raise interest raise rates further to offset this increase in demand before it happens. As a result, the tax cuts will have no impact on demand, but simply make funding investment more expense.

There are clear grounds for saying that the Fed is wrong about the economy being close to full employment, and therefore any increase in aggregate demand from any source would not raise inflation. But a central bank that acts in the textbook manner will not wait for the higher inflation to materialise, but will anticipate it because it takes time for interest rates to influence demand and inflation. As a result, tax cuts will lead to higher interest rates and there will be no net impact on demand.

Narayana Kocherlakota, who used to be on the committee that sets US interest rates, presents another possible reason why an increase in demand will not raise inflation. He argues that aggregate supply has been suppressed by low demand, and that rising demand might itself stimulate supply. For example, a lot of technical innovations might have been shelved while demand was depressed, but would be brought into production if demand looked like expanding rapidly. As these technical innovations would expand the capacity of firms to produce more, they would not raise prices as a result of any increase in demand. As these innovations would produce more from the existing labour force, there would be no inflation pressure coming from wages either.

If this sounds like wishful thinking, remember than the US economy, like most, is still way below the level of output that pre-recession trends would have suggested were likely. Did research into new and better production techniques really slow down substantially during the recession years, or did the research still take place to be implemented at some later date?

Even if this argument is plausible, and I think it is, it would still be irrelevant if the Fed didn’t make any allowance for it. They would still believe that tax cuts would raise demand and inflation, and so they would raise interest rates and crowd out any increase in demand. Indeed, if the Fed believed this ‘endogenous supply’ argument, they surely wouldn’t have raised rates in 2016.

What Kocherlakota wants the Fed to do is follow an approach put forward by Federal Reserve Bank of Chicago President Charles Evans. He puts the case in this speech. Essentially the Fed should depart from the usual policy approach of targeting expected inflation, and wait for inflation to actually rise above target before it raises rates. This would mean that it ignored any fiscal stimulus (whether it be tax cuts or additional public investment), and focused simply on the actual inflation rate. If we were in fact below full employment, or if demand created its own supply, the fiscal expansion would raise output and welfare.

An important point that Kocherlakota makes, and I have made in the past, is that you do not need to believe with certainty that we are below full employment or that demand will create its own supply. All you have to do is give it some significant probability of being true. You then look at the costs and benefits of pursuing an Evans type monetary policy weighted by this probability. A key point here is that the costs of a short term overshoot of the 2% target are likely to be a lot smaller than the cost of missing out on a percent or two of national output for potentially some time.

Does this change my views on a prospective Trump stimulus package? Not really. There is a very strong case for more public sector investment on numerous grounds. But that investment should go to where it is most needed and where it will be of most social benefit, and I think it is very unlikely (along with I suspect most economists) that a Trump Presidency and a Republican House can deliver that. That extra public investment will give the economy the stimulus that could work with an Evans type monetary policy. From a macroeconomic viewpoint there seems no point in doubling up on stimulus through tax cuts, and in terms of how the Fed reacts it may even be counterproductive.

Left and Right in 2016

Before the Christmas break David Blanchflower asked me a question on twitter: “why do you think we have seen the move to right-wing rather than left-wing populism?” This is my reply. I’ll just talk about the US and UK because I do not know enough about other countries. (Here is an interesting analysis of populists in Eastern Europe.) I’ll take it as read that there are currently well understood reasons for people to want to reject established politicians, and the Blanchflower question is really about why that rejection went right rather than left.

In my answer I want to distinguish between two types of people. The first are those that are not that interested in politics, and are therefore not well informed. They depend on just a few parts of the MSM for their information. The second are those that are interested in politics and are well informed, using multiple sources which are not just confined to the mainstream media (MSM). I want to argue that this distinction is crucial in helping us understand what happened in 2016.

I also want to use the term populist for policies in its most simple form, as policies that are likely to be immediately popular with the public, without the negative connotations that I discussed here. Populist policies on the left would focus on measures to curb financialisation and the power of finance (‘bashing bankers’), and measures to reduce inequality (which are popular if expressed in terms of the 1%, or CEO pay). Right wing populist policies include of course controls on immigration, combined with constant references to national identity. The need to control international trade can be invoked by left and right.

Among those who are well informed, there is no evidence that dissatisfaction with existing elites broke right rather than left. Indeed membership of political parties in the UK suggests the opposite is true. Party members in the UK are almost by definition likely to be much more interested in politics than the average citizen, and will not be dependent on one or two elements of the MSM for information. As the Labour party leadership has shifted left and adopted some of the left wing populism I’ve described, its membership has exploded. The figures are remarkable. The Labour party currently has a membership of over half a million. This is probably [1] at least three times the membership of the Conservative party. UKIP, the populist party of the right, has a membership of only 39,000, which is below the membership of the Greens.

The Sanders campaign indicates both the popularity of left wing populism among political activists in the US, but also that left wing populist policies can be as popular with voters as those from the right when they get a national platform. Sanders put greater taxes on the rich and additional Wall Street regulation at the centre of his platform, as well as opposition to trade agreements. The campaign was largely funded by individual donations, in contrast to the other campaigns. With the exposure that an extended election process gave him, Sanders’ brand of left wing rhetoric got national coverage and proved pretty popular. Sanders claimed, with some justification, that he actually polled better against Trump than Clinton, and it remains an open question whether a populist from the left might have done better against Trump than Clinton, who epitomised the establishment.

During the Sanders campaign left wing populist ideas did get wide coverage in the MSM, but this is the exception rather than the rule. After the financial crisis there was a brief period of about a year when these more left wing themes were a major media focus, but since then they appear only occasionally in the MSM. In contrast parts of the MSM in both countries has for many years produced propaganda that supports right wing populism, and the non-partisan elements of the MSM have done very little to contest this propaganda, and on many occasions simply follow it.

Let me put these points in a slightly different way. For the few of us that do attach great importance to the media in understanding recent events, it would be a major problem if on occasions where alternative ideas were given considerable coverage in the media they were ignored by voters. It would also be a major problem if those who were much less dependent on one or two MSM sources for information behaved in the same way as the average voter. But fortunately for us both the Sanders campaign and UK party membership suggest neither problem arises, but instead these pieces of evidence provide support for our ideas.

So in both the US and UK, among those who are exposed to left wing populism or who access a much broader range of information than that provided by the MSM, there is no puzzle of asymmetry. Left wing populism continues to appeal. The asymmetry at the level of the popular vote, that gave us Brexit and Trump, can be explained by asymmetry in the media. Right wing populist ideas not only get much more coverage than left wing populist ideas, but sections of the MSM actively promote these ideas. Given that this focus on the importance of the providers of information is intuitive, it is really up to those who think otherwise to provide both theory and evidence to support their view that the MSM is unimportant.

[1] I say probably because the latest data we have for Conservative party membership is 2013. However I think it is reasonable to speculate that lack of publication means numbers have been going down, not up.