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.

Interest rate vs fiscal policy stabilisation

One divide between mainstream and many heterodox economists is on whether monetary or fiscal policy should be used for macroeconomic stabilisation (controlling demand to influence inflation and output). What makes a good instrument in this context? As I have argued before, a key difference between the mainstream and MMT involves different answers to this question. I think the following issues are critical.

1. How quickly do changes in the instrument (e.g. increases in interest rates) influence demand?
   
   
2. How quickly can the instrument be changed? Are there limits to how far it can be changed?
   
   
3. How reliable is the impact of the instrument on demand? In other words how uncertain is the impact of a change in the instrument on demand?
   
   
4. How certain can we be that whoever has power over the instrument will use it in the necessary way?
   
   
5. Does changing the instrument have ‘side effects’ which are undesirable?
   
   

If we apply these questions to whether to use interest rates or some element of fiscal policy, what answer do we get?

Before doing that, it is worth noting this is all about the quickest and most reliable way to influence demand. It is quite separate to how demand influences inflation (as long as we are talking about underlying inflation).

The first question is important because long lags between changing the instrument and it influencing demand mess up good policymaking. Imagine how good your central heating would be if there was a day’s delay between it getting cold and the heating coming on. It is also perhaps the most interesting question for a macroeconomist. A full discussion would take a textbook, so to avoid that I’m going to suggest that the answer is not critical to why the mainstream prefers monetary to fiscal stabilisation.   

The second question is as important for obvious reasons. If an instrument can only be changed every year, that is like having very long lags before the instrument has an effect. On this question monetary policy seems to have a clear advantage given current institutional arrangements. Some of this difference is difficult to change: it takes time for a bureaucracy to move. As I noted with the fiscal expansion implemented by China after the crisis, about half of the projects were underway within a year. Others delays are in principle easier to change: there is no reason why tax changes need only happen during Budgets in the UK, for example.

The second part of the second question is a clear negative for interest rates, because they have a lower bound. This is not the case for fiscal instruments: you can always cut taxes further for example. Because this is a critical failure for interest rate policy, effectively the discussion in this post is just about what happens when interest rates are not at the lower bound. Even so, potentially having two different instruments for different situations is a count against monetary policy.

The third question is often not asked, but it is absolutely critical. Imagine raising the temperature on a room thermostat which not only had no calibration, but which acted in different ways each day or even each hour. OMT is a clear example of a poor instrument because central banks have far less idea of how effective it is than interest rate changes, partly because of less data but also because of likely non-linearities.

Are interest rate changes more or less reliable than fiscal changes? The big advantage of government spending changes is that their direct impact on demand is known, but as we have already noted such measures are slow to implement. Tax changes are quicker to makes, but many mainstream economists would argue that their impact is no more reliable than the impact of interest rate changes. In contrast some heterodox economists (especially MMTers) would argue interest rate changes are so unreliable even the sign of the impact is unclear.

The fourth question is only relevant if the power to change interest rates is delegated to central banks. Let me assume we have a UK type situation, where the central bank has control over interest rates but it has to follow a mandate set by the government. A strong argument is that, by delegating the task of achieving that mandate to an independent institution, policy is less likely to be influenced extraneous factors (e.g. there is no way interest rates rise until after the party conference/election) and therefore policy becomes more credible. (There is a whole literature involving similar ideas.)

This advantage for monetary policy simply follows from the fact that it can be easily delegated. However even if it is not delegated, fiscal policy has the disadvantage that changes are either popular (e,g, tax cuts) or unpopular (tax rises). In contrast interest rate changes involve gains for some and losses for others. That makes politicians reluctant to take deflationary fiscal action, and too keen to take inflationary fiscal action. So even without delegation, it seems likely that interest rate changes are more likely to be used appropriately to manage demand than fiscal changes.

The fifth and final issue could involve many things. In basic New Keynesian models the real interest rate is the price that ensures demand is at the constant inflation level. Therefore nominal interest rates are the obvious instrument to use. Changing fiscal policy, on the other hand, creates distortions to the optimal public/private goods mix or to tax smoothing.

So the case against fiscal policy as the main stabilisation tool outwith the lower bound might go as follows: it is slower to change and it cannot be delegated. Even if monetary policy is not delegated politicians may allow popularity issues to get in the way of effective fiscal stabilisation. While government spending changes have a certain direct effect, they are also the most difficult to implement quickly.

A potentially strong argument against monetary policy is the lower bound problem. You could argue that having monetary policy as the designated stabilisation instrument gets government out of the habit of doing fiscal stabilisation, so that when you do hit the lower bound and fiscal stabilisation is essential it does not happen. Recent experience only confirms that concern. I personally do not think mainstream macroeconomists talk enough about this problem.

The fiscal rule that Jonathan Portes and I developed, a version of which is Labour's fiscal credibility rule, does attempt to address this very issue. Switching from monetary to fiscal at the lower bound is a key part of the rule. It is also worth stressing that this rule does not prevent temporary changes in fiscal policy to counteract a downturn outwith the lower bound. (Anyone who says otherwise does not understand the rule.) For example if interest rates are already low, a fiscal expansion that is planned to last less than five years is consistent with the rule, and might be a sensible precautionary measure. (Public investment, which is outside the rule, could also be used in this way.) So Labour’s fiscal rule allows monetary policy to do its job, but fiscal policy is always there as a back up if needed.

Should Eurozone central bankers keep quiet about fiscal policy?

The Governor of the Irish Central Bank, Philip Lane, has called for higher taxes on savings and investment (property taxes). Frances Coppola, in a very clearly argued and well informed article, says this “attempt to dictate to the Government is a serious threat to Irish democracy.” Is it?

The conventional view is that there is an implicit quid pro quo between independent central banks (ICBs) and governments. Governments do not interfere with monetary policy and in exchange central banks do not suggest to governments what fiscal policy, or any other non-monetary policy, should be. It is important to note that this implicit quid pro quo has never seemed to extend to central bankers in the Eurozone, who have frequently pontificated on matters outside monetary policy, so in that context Lane’s comments are not out of the ordinary. But that does not make it right or wrong.

I have argued in the past that the situation where interest rates are at their lower bound requires ICBs to tell governments what to do, or at least say they can no longer do an effective job unless the government undertakes fiscal expansion. In that context I rather like the suggestion in a paper by Ed Balls and colleagues [1] that at the ‘Zero Lower Bound’ (ZLB) central banks should be mandated to write every three months to the government suggesting how much stimulus they think is required for the economy to get of the ZLB.

The situation for central banks in Eurozone countries is similar in the sense that cannot change interest rates (which are set by the ECB). They do, however, as Frances points out,  have responsibility for the health of the financial system in their own economies which requires macroeconomic expertise. So it seems reasonable to apply the quid pro quo to financial supervision by an ICB in a Eurozone country in much the same way it is applied to a ICB that is not in a currency union or fixed exchange rate regime.

But is the quid pro quo sensible in the first place? There is a real concern that an independent central bank might be intimidated by government politicians telling them what to do. That is understandable, as part of the whole rationale for ICBs in the first place is that their independence from politicians gives them additional credibility that they are not acting for political reasons.

The argument for a quid pro quo is that independent central banks should not abuse their authority to interfere with political decisions that have nothing to do with monetary or financial (macroprudential) policy. Let me put a counterargument that I sketched out in a different (UK) context here. While it is obvious no central banker should give advice on who should win the next General Election, that is not what we are talking about here. We are talking about issues were the central bank has some expertise.

Given that, it would be strange indeed if the central bank was prohibited from telling the government what its expertise suggested. You could see the outcry if the ICB guessed a recession was on its way, but kept that knowledge to itself and it subsequently turned out it was right. So in this case Lane would undoubtedly tell the government his views. What we are therefore talking about is secrecy. Is it best that this expertise is kept from the public so as not to embarass politicians when they ignore it? That does not sound so clever. More generally, the lesson of the last ten years is not one where governments would have made good macropolicy if only they hadn't been intimidated by central banks, but rather than in Europe central banks gave bad advice.  

I wanted to talk about this particular case because it perfectly illustrates this dilemma. Back in the early 2000s, while he was still a lowly academic, Philip Lane was one of the few public voices suggesting that the Irish Republic needed to use fiscal policy to cool down its economic boom. He was ignored, and the result was a financial and economic crash. He therefore not only has expertise but a reputation for being right on the very issue he is giving his advice about. Is it really better for Irish democracy that this advice is kept secret from the public?

[1] Balls, E, Howat, J and A Stansbury (2016) 'Central Bank Independence Revisited: After the financial crisis, what should a model central bank look like?' M-RCBG Associate Working Paper No. 67

The lesson monetary policy needs to learn

It seemed obvious to write a post about the Peterson Institute’s recent conference on ‘Rethinking Macroeconomic Policy’, but nowadays I find it more efficient to let Martin Sandbu do the job. We agree most of the time, and he does these things better than I do. It allows me to write something only in the unlikely event that I disagree, or if I want to take the discussion further.

I only have one quibble with Martin’s column yesterday. I think Bernanke’s suggestion that following a large recession (where interest rates hit their lower bound) central banks revert to a temporary price level target is rather more than the tweak he suggests. In addition, as Tony Yates pointed out, level of NGDP targets do not resolve the asymmetry problem that Bernanke’s suggestion is designed to address.

I also thought I could illustrate Martin’s final point that “admitting one has got things badly wrong is a prerequisite for doing better” by looking at some numbers. If we look at consumer prices, average inflation between 2009 and 2016 was 1.1% in the Euro area, 1.4% in the US and 2.2% in the UK. The UK was a failure too: average consumer price inflation should have been higher than 2.2%, because we had a large VAT hike and depreciation that monetary policy rightly saw through. If we look at GDP deflators we get a clearer picture, with 1.0%, 1.5% and 1.6% for the EZ, US and UK respectively.

You might think errors of that size are not too bad, and anyway what is wrong with inflation being too low. You would be wrong because in a recovery period these errors represent lost resources that, as the Phillips curve appears to be currently so flat, could be considerable. Or in other words the recovery could have been a lot faster, and interest rates could now be well off the lower bound everywhere, if policy had been more expansionary.

What I really wanted to add to Martin’s discussion was to suggest the main problem with monetary policy over this period, particularly in the UK and the Eurozone. It is not, in my view, the failure to adopt a levels target, or even the ECB raising rates in 2011 (although that was a serious and costly mistake). In 2009, when central banks would have liked to stimulate further but felt that interest rates were at their lower bound, they should have issued a statement that went something like this:

“We have lost our main instrument for controlling the economy. There are other instruments we could use, but their impact is largely unknown, so they are completely unreliable. There is a much superior way of stimulating the economy in this situation, and that is fiscal policy, but of course it remains the government’s prerogative whether it wishes to use that instrument. Until we think the economy has recovered sufficiently to raise interest rates, the economy is no longer under our control.”

I am not suggesting QE did not have a significant positive impact on the economy. But its use allowed governments to imagine that ending the recession was not their responsibility, and that what I call the Consensus Assignment was still working. It was not: QE was one of the most unreliable policy instruments imaginable.

The criticism that this would involve the central bank exceeding its remit and telling politicians what to do is misplaced. Members of the ECB spent much of the time telling politicians the opposite, Mervyn King did the same in a more discreet way, while Ben Bernanke eventually said in essence something milder than the above. Under the Consensus Assignment we have invested central banks with the task of managing the economy because we think interest rates are a better tool than fiscal policy. As such it is beholden on them to tell us when they can no longer do the job better than government.

A better criticism is that a statement of that kind would not have made any difference, and we could spend hours discussing that. But this is about the future, and who knows what the political circumstances will be then. It is important that governments acknowledge that the Consensus Assignment no longer works if central banks believe there is a lower bound for interest rates, and this has to start by central banks admitting this. Economists like Paul Krugman, Brad DeLong and myself have been saying these things for so long and so often, but I think central banks still have problems fully accepting what this means for them.       

The OBR’s risk assessment lacks context

In its recent report on fiscal risks, the OBR talks a lot about all the shocks that could make the government debt to GDP ratio rise again. It then says the following:

“None of this should be taken as a recommendation to refrain from particular spending increases or tax cuts, or to avoid particular fiscal risks – that would lie beyond our remit. And there are those who believe fiscal policy is still too tight, given the pace of economic growth and the looseness of monetary policy. But ….”

Should I be grateful for the second sentence, being one of ‘those’ who think that way?

I think the reverse is true. The OBR has played the tune the government wanted, but it is the wrong tune, and this now mature and independent organisation is capable of much better than this. I will first deal with a particular issue to do with monetary policy, and then talk more generally about the concept of ‘fiscal risks’.

Our macroeconomic institutional architecture is based around what I have called the consensus view about macroeconomic policy. This consensus involves what economists call an assignment. The stabilisation of output and inflation is assigned to independent central banks operating monetary policy. Fiscal policy should be confined to managing the government’s deficit and debt, and to help it with that task there should be a combination of fiscal rules and independent fiscal institutions (aka fiscal councils, like the OBR).

In a consensus assignment world, the job of a fiscal council is to stop deficit bias: the tendency clearly observable in some countries before the global financial crisis for deficits to creep up over time. In particular, when all is going well and the deficit appears not to be an issue, it is their job to tell the government to 'fix the roof while the sun shines’.

As I and others have noted many times, this consensus assignment has an Achilles Heel, which is that nominal interest rates cannot go below a number close to zero, the so-called Zero Lower Bound (ZLB). In the absence of some mechanism to allow interest rates to become significantly negative, that ZLB problem means that sometimes fiscal policy makers have to help monetary policy in its stabilisation role. The simple consensus assignment breaks down.

Although most academic macroeconomists recognise that, our institutions find it hard to do so. Monetary policymakers in the UK and Eurozone find it very difficult to say that they have lost their main instrument, and that therefore they can no longer reliably do their job. It seems that our fiscal council, the OBR, has similar problems.

We are currently at the ZLB. The most immediate risk we therefore face is that we are hit by a negative shock and monetary policy is unable to respond effectively. Hence the quote from their document above. But as far as I can see that is it. In their section in the Executive Summary on the risk due to a recession I would have thought the ZLB problem was worth at least mentioning, but it does not appear. Indeed I’m not sure the term ZLB or liquidity trap appear anywhere in the document.

I’m sure the OBR would in defence say two things: assessments of fiscal risks generally look at risks to fiscal sustainability not macroeconomic stabilisation, and their remit precludes them from talking about alternative fiscal policy paths. This is all true. The Treasury wanted a report that would enable them to say we must continue with austerity because of all the risks identified by the OBR. The Treasury also wrote the OBR’s current remit. 

But the OBR is supposed to be independent. Just because the government tries to pretend that there is no Achilles Heel to the consensus assignment, that does not mean it has to go along with that act. In particular, it will (I hope) have noted that the main opposition - which came close to defeating the current government - has a fiscal rule that explicitly says that fiscal policy needs to switch from stabilising debt to stabilising the economy when interest rates are at their lower bound (like now). In this context, I think something beyond a single sentence alluding to the ZLB would have been appropriate.

Tony Yates said similar things yesterday. He also made another important point: a key role of government in many areas is to be a risk absorber. It assumes risks, because it is beneficial to take risks away from individuals or individual generations and spread them more widely, and often the state is the only institution that can do this. In addition, its deficit and debt should be a macroeconomic shock absorber. Given all that, why exactly should we be concerned if various shocks increase government debt? That is what is supposed to happen!

To put the term risk and attach it to some level of debt or deficit, giving us ‘fiscal risks’, is questionable. It is a bit like saying their is a risk that your central heating will come on if it gets cold: that is not a risk, but why it is there. The OBR would no doubt respond that the government has a mandate in terms of a deficit or debt target, and it has been asked to look at risks that this may not be met. But that should not stop an independent OBR from asking more fundamental questions.

Implicit in the idea of ‘fiscal risks’ is either a belief that there is an optimal level of debt which is below current levels, or a view that there is some level of debt so high that markets would start worrying about the government choosing to default. If we are worried about a debt burden on future generations, does it make sense to put all that burden on a current, already disadvantaged, younger working generation? Unless these key issues are addressed, all the risk assessment the report undertakes is meaningless, or worse still just provides support for the government’s misguided policy. It is time the OBR stopped being constrained by its remit, and started providing the public with a useful framework in which to think about ‘fiscal risks’.

Why recessions followed by austerity can have a persistent impact

Economics students are taught from an early age that in the short run aggregate demand matters, but in the long run output is determined from the supply side. A better way of putting it is that supply adjusts to demand in the short run, but demand adjusts to supply in the long run. A key part of that conceptualisation is that long run supply is independent of short run movements in demand (booms or recessions). It is a simple conceptualisation that has been extremely useful in the past. Just look at the UK data shown in this post: despite oil crises, monetarism and the ERM recessions, UK output per capita appeared to come back to an underlying 2.25% trend after WWII.

Except not any more: we are currently more than 15% below that trend and since Brexit that gap is growing larger every quarter. Across most advanced countries, it appears that the global financial crisis (GFC) has changed the trend in underlying growth. You will find plenty of stories and papers that try to explain this as a downturn in the growth of supply caused by slower technical progress that both predated the GFC and that is independent of the recession caused by it.

In a previous post I looked at recent empirical evidence that told a different story: that the recession that followed the GFC appears to be having a permanent impact on output. You can tell this story in two ways. The first is that, on this occasion for some reason, supply had adjusted to lower demand. The second is that we are still in a situation where demand is below supply.

The theoretical reasons why supply might adjust to demand are not difficult to find. (They are often described by economists under the jargon word 'hysteresis'.) Supply (in terms of output per capita) depends on labour force participation, the amount of productive capital in the economy, and finally technical progress, which is really just a catch all for how aggregate labour and capital combine to produce output. A long period of deficient demand can discourage workers. It can also hold back investment: a new project may be profitable but if there is no demand it will not get financed.

However the most obvious route to link a recession to longer term supply is through technical progress, which connects to the vast literature under the umbrella of ‘endogenous growth theory’. This can be done through a simple AK model (as Antonio Fatas does here), or using a more elaborate model of technical progress, as Gianluca Benigno and Luca Fornaro do in their paper entitled ‘Stagnation traps’. The basic idea is that in a recession innovation is less profitable, so firms do less of it, which leads to less growth in productivity and hence supply. Narayana Kocherlakota has promoted this idea: see here for example.

The second type of explanation is attractive, in part because the mechanism that is meant to get demand towards supply - monetary policy - has been ‘out of action’ for so long because of the Zero Lower Bound (ZLB). (The ZLB also plays an important role in the Benigno & Fornaro model.) However for some this type of explanation currently seems ruled out by the fact that unemployment is close to pre-crisis levels in the UK and US at least.

There are three quite different problems I have with the view that we no longer have a problem of deficient demand because unemployment is low. The first, and most obvious, is that the natural rate of unemployment might be, for various reasons, considerably lower than it was before the GFC. The second is that workers may have priced themselves into jobs. In particular, low real wages may have encouraged firms to use more labour intensive techniques. If that has happened, it does not mean that the demand deficiency problem has gone away, but just that it is more hidden. (For anyone who has a conceptual problem with that, just think about the simplest New Keynesian model, which assumes a perfectly clearing labour market but still has demand deficiency.)

The third involves the nature of any productivity slowdown caused by lack of innovation. A key question, which the papers noted above do not directly address, is whether we are talking about frontier research, or more the implementation of innovation (for example, copying what frontier firms are doing). There is some empirical evidence to suggest that the productivity slowdown may reflect the absence of the latter. This is very important, because it implies the slowdown is reversible. I have argued that central banks should pay much more attention to what I call the innovation gap (the gap between best practice techniques, and those that firms actually employ) and its link to investment and aggregate demand.

All this shows that there is no absence of ideas about how a great recession and a slow recovery could have lasting effects. If there is a problem, it is more that the simple conceptualisation that I talked about at the beginning of this post has too great a grip on the way many people think. If any of the mechanisms I have talked about are important, then it means that the folly of austerity has had an impact that could last for at least a decade rather than just a few years.