Should we worry about temporarily raising government debt? - Blanchard’s AEA Address

This post not about the main part of this address, although as its my area and interesting I may write about it later. Instead I’m going to talk in a non-technical way about its premise, because that alone has implications that may be well known among economists but not elsewhere. The following is based on his presentation.

Should governments worry about temporarily paying for things by borrowing? One standard answer is yes, because although nothing obliges government to pay off this extra debt (it can be rolled over), it has to pay interest on that debt which requires higher taxes. If the government didn’t raise taxes to pay the interest on the debt, but instead just borrowed more to pay the interest, you would enter what is sometimes called a debt interest spiral, where debt goes up and up and eventually explodes.

But does a slow explosion in debt matter if the economy is also growing? A government (like a firm of individual) should look at debt as a ratio to its ability to pay, and the easiest way to do that is to look at the debt to GDP ratio. A company would not worry about increasing debt if its profits were rising even faster. For a given stock of debt, its growth rate is given by the rate of interest on the debt. So GDP rises faster than debt if its nominal growth rate (real growth plus inflation) is greater than the rate of interest on that debt. In shorthand, g > r.

Typically economists like me tend to assume that this is not true, and instead r > g. But the starting point for Blanchard’s lecture is that currently, and on average in the past, g > r. There has been only one decade since the 1950s when this hasn’t been true, and that is the 1980s when governments were pushing up interest rates to bring inflation down. Most of the time g > r. So the fact that g > r today may be the rule and not an exception.

Why do economists typically assume r > g when the opposite has generally been true? One answer is called financial repression, which is a label given to attempts by governments in the past to keep interest rates ‘artificially low’ in conjunction with various credit controls. The idea was that in a financially liberalised world where interest rates are used by central banks to target inflation there will be no financial repression, and real interest rates will be higher. So it made sense, the argument went, to assume r > g from now on even though g > r in the past. However what economists call secular stagnation suggests that the average interest rate required to keep inflation constant has actually been steadily falling, so Blanchard’s findings become relevant again. There is plenty of scope here for more research and debate.

So if normally g > r, does this mean we do not need to worry about debt? Not quite. What it means is that one of the standard objections to raising debt, which is that taxes will have to rise to pay the interest, no longer holds if g > r. If g > r the government can borrow to pay the interest, and yet the debt to GDP ratio will still gradually decline, because the economy is growing faster than debt. The objection to raising debt that taxes will have to rise in the future to pay for it disappears. Indeed the whole ‘burden on future generations’ objection to raising debt falls away, because the debt to GDP ratio declines by itself: there is no future burden.

An important proviso, however, is that we are talking about one-off increases in debt. Such one off increases would include, for example, increases in debt to build new public infrastructure or increases in debt caused by fiscal expansions to fight a recession. g>r does not mean we do not need to worry about persistent primary deficits (by which I mean spending permanently higher than taxes). A persistent primary deficit will add to the growth in debt, so the debt to GDP ratio will rise despite g > r.

This is just the starting point for Blanchard’s lecture, and if you are an economist I recommend watching it as it is very easy to follow. In policy terms I think it is the last nail in the coffin of what Paul Krugman calls the deficit scolds. Those who argued for austerity because of the burden on future generation, although on weak ground even if r > g, find their argument collapses if g > r. [1]

[1] Blanchard shows this remains true even if there are periodic shocks where r > g, as long as on average g > r.

The Brexit slowdown begins (probably)

When the Bank of England after the Brexit vote forecast 0.8% GDP growth in 2017, they expected consumption growth to decline to just 1%, with only a small fall in the savings ratio. But consumption growth proved much stronger in the second half of 2016 than the Bank had expected. As this chart from the Resolution Foundation shows, pretty well all the GDP growth through 2016 was down to consumption growth, something they rightly describe as unsustainable. (If consumption is growing but the other components of GDP are not, that implies consumers are eating into their savings. That cannot go on forever)

This strong growth in consumption in 2016 led the Bank to change its forecast. By February

their forecast for 2017 involved 2% growth in consumption and GDP, and a substantial fall in the savings ratio.

What was going on here? In August, the Bank reasoned that consumers would recognise that Brexit would lead to a significant fall in future income growth, and that they would quickly start reducing their consumption as a result. When that didn’t happen the Bank appeared to adopt something close to the opposite assumption, which is that consumers would assume that Brexit would have little impact on expected income growth. As a result, in the Bank’s February forecast, the savings ratio was expected to decline further in 2018 and 2019, as I noted here. Consumers, in this new forecast, would continually be surprised that income growth was less than they had expected.

The first estimate for 2017 Q1 GDP that came out yesterday showed growth of only 0.3%, about half what the Bank had expected in February. This low growth figure appeared to be mainly down to weakness in sectors associated with consumption (although we will not get the consumption growth figure until the second GDP estimate comes out). So what is going on?

There are three possible explanations. The first, which is the least likely, is that 2017 Q1 is just a blip. The second is that many more consumers are starting to realise that Brexit will indeed mean they are worse off (I noted some polling evidence suggesting that here.), and are now adjusting their spending accordingly The third is that consumption was strong at the end of 2016 because people were buying overseas goods before prices went up as a result of the Brexit deprecation.

If you have followed me so far, you can get an idea of how difficult this kind of forecasting is, and why the huge fuss the Brexiteers made about the August to February revision to the Bank’s forecast was both completely overblown and also probably premature. All Philip Hammond could manage to say about the latest disappointing growth data was how it showed that we needed ‘strong and stable’ government! I suspect, however, that we might be hearing a little less about our strong economy in the next few weeks.

Of course growth could easily pick up in subsequent quarters, particularly if firms take advantage of the temporary ‘sweet spot’ created by the depreciation preceding us actually leaving the EU. Forecasts are almost always wrong. But even if this happens, what I do not think most journalists have realised yet is just how inappropriate it is to use GDP as a measure of economic health after a large depreciation. Because that depreciation makes overseas goods more expensive to buy, people in the UK can see a deterioration in their real income and therefore well being even if GDP growth is reasonable. As I pointed out here, that is why real earnings have fallen since 2010 even though we have had positive (although low) growth in real GDP per head, and as I pointed out here that is why Brexit will make the average UK citizen worse off even if GDP growth does not decline. If it does decline, that just makes things worse.  

Breaking the ‘strong economy’ narrative

My last post talked about the gap between the macroeconomic narrative in the UK media (‘mediamacro’) and macroeconomic facts. The gap is created or encouraged to a considerable extent by narratives employed by the political right. So how might that change, to let reality back in?

As with other things, Labour under Miliband had the right idea but did not follow it through. They talked about a ‘cost of living’ crisis, but in doing so they implicitly suggested this was some unfortunate by-product of a strong economy. The aim should be to redefine a strong economy as one that delivers solid real wage growth.

To do so makes perfect sense in current circumstances, when we have just had a policy-induced large depreciation in sterling. GDP measures the output produced in the economy, but not how much people in that economy can buy. Welfare depends on the latter, not the former.

It also makes sense if real wages have fallen because workers have priced themselves into jobs, by in effect discouraging firms to invest in labour saving machinery. Boasts that employment is at record levels make no sense in that situation, because high employment comes from lower wages rather than from additional output. [1]

I have stressed in the past (including my last post) how weak recent UK performance has been by historical standards. But a favourite trick of the government is to make international comparisons, of GDP rather than the more appropriate GDP per head. So how does our economy look if we focus, more appropriately as I argue above, on international comparisons of real wage growth?

Luckily the ILO and Geoff Tily have already done the spade work. Here is a chart for all countries, with blue denoting OECD countries.

International comparison of average real wage growth since the crisis 

Source: Geoff Tily, ILO. 

Among OECD countries the answer is striking: only Greece has seen real wages falls greater than the UK. The UK is second best among the OECD at achieving a decline in real wages! Geoff looks at data from 2008, but a quick check suggests the result holds good if we start in 2010 instead.

The data in this comparison only goes to 2015. You could, rightly, argue that 2016 was a better year for the UK, but then you would have to address what will happen to real wages this year and next. [2] You could argue that this poor performance was a consequence of the 2008 depreciation (which had lagged effects): again you would be right, but the Brexit depreciation which is not yet in these figures is just as large.

Either way this data provides strong evidence of just how terrible UK economic performance has been over the last several years. [3] What is more, unlike GDP, it is data that directly relates to the experience of ordinary people. But as Miliband found out, to quote this data is not enough. What you need to do is start proclaiming that the UK economy under a Conservative Chancellor has performed worse than any other OECD economy besides Greece. Just that, no caveats, no qualifications, no ‘cost of living’ label. Only that way will you begin to shift the narrative that we have a strong economy.

[1] If you are worried that this might help justify calls to reduce immigration, fear not. What they show is that policymakers failed to create an adequate level of aggregate demand: another consequence of austerity.

[2] If we look at the ONS series for real average earnings, normalised to 100 for 2015, it was at 101.8 in May 2010, and in February 2015 it is 100.3, a fall of 1.5%

[3] It has even been fact checked: see here.              

To all UK journalists

who plan to talk about the economy over the next 100 days. Here is a very simple fact. [3] GDP per head (a much better guide to average prosperity than GDP itself) grew at an average rate of less than 1% in the four years from 2010 to 2014. [1] In the previous 13 years (1997 to 2010), growth averaged over 1.5%. So growth in GDP per head was more than 50% higher under Labour than under the Conservatives, even though the biggest recession since the 1930s is included in the Labour period!

You have all read, and perhaps written, that the Conservatives will focus on the economy, because they think that is their strong point. Compared to their performance on other issues, maybe it is their strong point. But relative to the previous administration, this simple fact suggests otherwise.

George Osborne says: “Britain has had the fastest growing major economy in the world in 2014.” However GDP per head in the UK in 2014 remains below 2007 levels, but it had exceeded those levels in the US and Japan by 2013. The UK is not bottom of the league in these terms only because the Eurozone’s performance has been so poor. That GDP per head growth under 1.9% in 2014 can be trumpeted as a great success when it is no more than average growth between 1971 and 2010, and when we should be recovering from a huge recession, and when there are signs that this growth may not be sustainable, shows how diminished our expectations have become.  

In terms of a historical comparison between the record of this government and the previous administration Labour has no case to answer, because its performance is miles better. I am sure a supporter of the current government would say at this point that they had to clear up the mess that Labour created. But just think what such an excuse implies:

(1)  The Great Recession was in 2009, so it is included in the Labour government’s growth average, not that of the current government. You can see the impact of the recession on the average (the red line) in the chart below. [2] Are they really saying that the mess Labour left was worse than the impact of the global financial crisis!?

(2)  This excuse implies that bringing the government deficit down rapidly (austerity) meant that GDP growth is bound to be lower. This is something that the government’s critics have long argued, and which the OBR agrees with [4], but the government has always denied. Are they now admitting that austerity was (really) bad for growth?

(3)  If a government was elected just after a major recession, you would normally expect the exact opposite from these figures to be true. The new government would benefit from the recovery from the recession, while their predecessors average would be weighed down by the recession itself. So in any normal world, you would expect GDP per head to have grown much more rapidly over the last four years than any long run average. The fact that it has grown by considerably less means that the government should have a lot of explaining to do.

Growth under Labour, including the Great Recession, was 50% better than under the Coalition. So please, if you want to make your reporting on the economy over the next 100 days objective, use this fact. If the Conservatives win this election because enough people believe that they are more competent than the previous government at handling the economy, it will be a devastating verdict - on the UK media and its journalists.  

Quarter on previous year's quarter growth in UK GDP per head, 1997Q2 to 2014Q3

[1] The ONS data can easily be found here. The fourth quarter data is not out yet, so I have taken the ONS data updated on 21st January, and assumed growth of 0.5% in the final quarter, which is the first estimate of GDP growth in that quarter. That is obviously an overestimate, as it assumes no population growth in that quarter.

[2] The chart uses quarter on previous year’s quarter growth rates for the actual data (no estimates), and the average shown there is simply the average of these growth rates.

[3] A tweet from Ann Pettifor inspired this post, but of course responsibility for it is entirely mine.

[4] The OBR estimate, somewhat conservatively, that austerity reduced GDP growth by 1% in both FY 2010-11 and 2011-12. That alone would raise the average growth in GDP per head over the four years from 0.9% to 1.4%. Research by Jorda and Taylor suggests austerity had larger and more prolonged effects. 

Growth vindicates Greek Austerity

I cannot resist quoting from this editorial in today’s Greek edition of the FT.

Greek government and Troika’s austerity policy vindicated

Since unveiling its austerity strategy to reduce its yawning budget deficit in 2010, the Greek government together with the Eurozone’s Troika has faced immense pressure to change tack. An alliance of Keynesian economists and opposition parties has accused them of choking off growth. The prophets of doom predicted years of stagnation with soaring unemployment and falling living standards.

After a run of positive growth numbers this year, the Greek government and Troika have reason to feel vindicated. They have won the political argument. True, the Greek economy is still a quarter smaller than its pre-crisis peak. But the current acceleration looks like the beginning of a sustained recovery. The anti-austerians grumble that the upturn would have come earlier had the Greek government and Troika eased up on the fiscal squeeze. This is impossible to prove as economic history offers no counter-factuals. What we do know, however, is that the critics overstated the obstacles standing in the way of a recovery. Their position was too extreme and they have found themselves snookered.

OK, the FT here is the Fictitious Times, but otherwise I have kept pretty close to the beginning of this real Financial Times editorial about somewhere else. The numbers may be different, but the reason why this editorial would be ridiculous are exactly the same as why the original editorial was. And yes, I know I have complained about it a few times, but because the FT is a quality financial paper that generally gets things right, and which other journalists look to for economic expertise, it is important not to forget the occasional lapse from otherwise high standards. And the FT are not the only respected economists who sometimes mistakenly treat growth from a deep recession as an indicator of a successful policy.

Confusing levels and rates of growth

It was entirely predictable. Once growth returned to the UK economy, those with a political axe to grind, but also some who do not, and even some who should know better (uneconomical has a good detailed response), will start saying that any aggregate demand problems have gone away. The simplest argument suggesting otherwise is NIESR’s well known chart, the latest version of which is reproduced below.

Of course this does not prove that the UK still has an aggregate demand problem. Perhaps something unprecedented has happened to UK supply over the last five years. After all, consumer price inflation (CPI) is still above target. Well, as I pointed out here, CPI was above target in 2008, and 2009, and 2010 ….. so unless you want to suggest that the UK never had an aggregate demand problem, the behaviour of the CPI today is not very reliable evidence.

The main point, however, is that aggregate demand problems are about the level of GDP, not its rate of growth. In a demand induced recession, aggregate demand will fall: consumers start saving more; firms reduce the level of investment etc. As a result, resources are underutilised, the clearest indication of which is an increase in unemployment. We start a recovery when aggregate demand starts rising again at a rate that exceeds the rate of growth of underlying supply (labour force growth and technical progress). That might have just started in the UK.  GDP growth in the last quarter was 2.4% at an annual rate, which if you were pessimistic might be above trend. The chart shows the recovery started in 2010 but then stopped, but better late than never.

However that is just the start of a recovery. As the chart again shows, we should really be looking for rates of GDP growth of 4% or more if we are going to start utilising those resources which are currently being wasted (i.e. if we want to reduce unemployment). The aggregate demand problem only disappears when those resources are utilised again, and unemployment goes back to its non-inflationary rate (NAIRU). (And no, CPI inflation does not tell us that has already happened - average earnings are increasing at rates well below CPI inflation, which strongly suggests unemployment is well above the NAIRU.) As yet, falls in UK unemployment have been tiny relative to the increase that occurred during the recession.

UK Unemployment

If this all sounds too ‘Old Keynesian’, we can retell the story in New Keynesian terms. In a recession the natural real rate of interest falls below the level the actual rate can reach. Whatever shock caused the fall in the natural real interest rate (initially a need to adjust balance sheets, later compounded by fiscal austerity and a Euro recession), that shock can gradually dissipate, allowing the economy to grow. However, the aggregate demand problem only disappears when the natural real interest rate rises to equal the actual real interest rate. We should know when that happens because unemployment will fall to the NAIRU. Recessions do not just last as long ‘as it takes prices to adjust’, because we are at the zero lower bound.

The reason why this is so important is that it may be too easy to settle into a political equilibrium, where the economy is growing roughly at trend, but unemployment is not falling. It is a political equilibrium because the unemployed have very little political voice, and sections of the media encourage politicians (I’m being as polite as I can here) to label the unemployed as workshy. This may not have happened in the US since the war, but with fiscal policy being tightened as a result of Tea Party fundamentalism it could well do this time. In the UK there are some similarities with the 1980s, when unemployment stayed above 10% until near the end of that decade. Luckily no one in the UK has started arguing that current levels of unemployment are ‘structural’, but given the rhetoric about strivers vs skivers it will not be long before they do, and of course if you wait long enough to reduce unemployment you are in great danger of creating a structural problem.

So we will stop having an aggregate demand problem when unemployment falls to near pre-recession levels, and (assuming rational monetary policy) nominal interest rates start rising significantly. It would be great if that happened very quickly because of rapid growth, and while I can think of reasons why that might be unlikely, I know enough about forecasting to know it is also quite possible. However that will have no impact on the costs of austerity that have already been incurred, which is why I wrote my ‘final verdict’ on the current Chancellor six months ago.

Even earlier, over a year ago, I wrote this: “come 2015, the spin “we have done the hard work and the strategy has worked” will accord with (relatively) strong growth, while talk of output gaps and lost capacity will have less resonance. True, unemployment will still be high, but not many of the unemployed are Conservative voters, and the immunising spin about lack of willingness to work can be quite effective.” Paul Krugman described this post as ‘remarkably cynical’. I fear it will be one of my better forecasts.  

The UK economy in three charts

It is a measure of the state we are in that the latest quarterly growth number for the UK, at 0.3% (1.2% annual rate) for 2013Q1, should be regarded as a political plus for the Chancellor. [See postscript at end.] So here is the first chart:

This extremely weak growth from a starting point of a deep recession should spell disaster for employment. But it has not, as this second chart from the Bank of England’s February Inflation report shows.

The upside of this incredibly poor productivity performance is that employment has been much more buoyant than the GDP numbers would normally imply. However a moment's thought reveals that this could be really bad news, because it might imply that the recession has led to a permanent reduction in what the UK economy can produce. I say ‘could’ and ‘might’ advisedly, because the reasons for this productivity disaster are almost totally mysterious, as I discuss here. Yet it helps explain why inflation has remained above target, and gives us a reason (although not in my view a justifiable one) why monetary policy has not been more expansionary.

Is this a reason for thinking that in fact policy in the UK has not been too bad, and that really we are suffering from some unexplained malady that the usual medicine (continuous monetary expansion and fiscal stimulus) could do nothing to cure?  So we come to my third chart, which is UK unemployment (source ONS).

Despite strong growth in private sector employment, which with stagnant GDP gives us our second chart, unemployment remains high. Low earnings growth suggests that this level of unemployment is keeping real wages low, so there is no suggestion that this increase since the recession is in any way structural. (The wages Phillips curve in the UK continues to work as normal, with a natural rate way below 8%.) It reflects in part a significant increase in labour force participation (again quite different from the US), but that is no excuse to allow it to remain high.

So policy clearly has not and is not doing enough to expand demand. If it did do much more, with any luck productivity would start growing again and catch up some of the ground it has lost, but even if it does not this third chart shows us that expansion is the right policy. What has been happening instead is that fiscal policy has been working in the opposite direction, contracting demand, and monetary policy has been unwilling or unable to offset this. It is indeed one of the major UK macroeconomic policy errors since the second world war.

Postscript

As an illustration of this sad state, the normally excellent Stephanie Flanders describes 0.3% as "good news". A better description would be pathetic. How can an annualised growth rate of 1.2%, in an economy that pre-crisis had a trend growth rate above 2%, and at the bottom of a deep depression, be described as good news! If you think I'm biased, read John Van Reenen.

When growth returns: a prediction

                No, I’m not about to get into the forecasting game – I did enough of that when young. What I am prepared to predict is the reaction of some when growth does return (as it may be in the US, and as it might one day in the UK and the Eurozone). My prediction is that some people will say that growth shows those Keynesian prophets of doom were all wrong. Look, the patient has recovered just fine without the need for any fiscal stimulus medicine.

                If people do say this, they will be wrong on two counts. First, there are good reasons for believing that aggregate demand will start to recover at some point without any additional monetary or fiscal stimulus. One of the main reasons for the recession was the need to repair balance sheets, which for consumers meant less borrowing and more (precautionary) saving, and for banks building up capital by reducing lending. Once this process is complete, demand will begin to recover. Once it does so, firms will stop delaying new investment. There is a lot more that could be said about the dynamics of demand following the Great Recession, but a return to growth at some stage is almost inevitable.  

                Second, the argument was never about growth, but about the level of activity, and unemployment. Put simply, those of us who argue for more fiscal (and monetary) action want growth to come sooner and quicker, so that unutilised labour resources can get back to work. Unemployment is not only a waste of resources but also a major cause of unhappiness (see, for example, this paper by Blanchflower). Worse still, there is the likelihood that prolonged involuntary unemployment may lead to much more permanent reductions in supply, as workers become discouraged and deskilled (see, for example, this paper by Laurence Ball). 

                So that is my forecast. In one sense I cannot wait to see if it comes true.

P.S. The above has nothing to do with this from Tyler Cowen: Tyler can do no wrong after recently listing my blog. Those interested in that particular post should see Noah Smith.

UK Growth reveals a major macroeconomic policy error

The first estimate of UK growth in the last quarter of 2011 was negative. As these updated NIESR charts show, no other UK recovery has stalled in this way. Of course very little is ever certain, but we can be pretty sure that growth would have been significantly better if the current government had not imposed severe additional austerity measures beginning in 2010. (This is the counterfactual that matters, and just looking at GDP components can be a misleading way at getting at this for reasons I discussed here.) Of course growth might have been better too if the Euro crisis had not happened, but this government had no control over the Euro crisis, while it does decide fiscal policy.

                I do not have anything very new to say about this, in part because many people predicted growth would be harmed before the policy was introduced. (See, for example, this letter from 80 economists published during the 2010 election campaign.) What was the reason for this major macroeconomic policy error? For some I think it was a political calculation that it would be advantageous to get as much of the cuts out of the way early, well before the next general election. However I think others in the coalition were genuinely spooked by events in Greece and elsewhere. Unfortunately the key difference between economies in the Eurozone and those with their own central bank was not appreciated. Today the claim that if these additional austerity measures had not been introduced UK interest rates on debt would have suffered the same fate as many Eurozone countries looks pretty implausible. In Denmark we even have an example of a country that has recently undertaken stimulus measures, and where interest rates have continued to fall in line with other countries outside the Eurozone (see David Blanchflower here).

                So I believe we must add 2010 to a list of major macroeconomic policy errors made in the UK since the war. Like the failed monetarist experiment in the early 1980s, it is the result of a government adopting a policy which relied on a mistaken macroeconomic analysis that was not supported by the majority of academic opinion.  And like that earlier failure, it will leave unemployment significantly higher than it need to have been for many years.