As I wrote
recently, the economic debate on
the impact on austerity is over bar the details. Fiscal contraction when
interest rates are at their zero lower bound is likely to have a significant
negative impact on output. Of course the popular
debate goes on, because of absurd claims that recovering from austerity somehow
validates it. Next time you get a cold, celebrate, because you will feel good
when it is over! Which means more articles like this will have to be written.
An interesting question for an economist then becomes why
austerity happened. There are some groups who have a clear self interest in
promoting austerity: those who would like a smaller state, for example. While
arguments for ‘less government’ are commonplace among the more affluent in the
US, in Europe there is much less natural antagonism to government. As
a result, as Jeremy Warner said, you can only really make serious inroads
into the size of the state during an economic crisis. Large banks also have a
direct interest in austerity, because they need low debt to make future bank
bailouts credible, enabling them to carry on paying large bonuses from the implicit
state subsidy that this creates. So, from a cynical point of view, for this
and other
reasons those close to finance will always talk up the danger of a debt funding
crisis just around the corner.
However there is a large middle ground who genuinely believes
austerity was required to prevent the chance of a funding crisis, particularly
after Greece. Yet Quantitative
Easing (QE) fundamentally changes this. If the central bank makes it known
that QE drastically reduces the chance of a debt funding panic, and anyway they
have the means to offset its impact if it occurred, any contrary advice from
the financial sector might be defused. The middle ground might be persuaded
that fiscal stimulus is possible after all.
Now this was never going to happen at the ECB. It takes every opportunity to promote austerity. It
took two years of continuing crisis to get it to introduce OMT. I do not follow
the US closely enough to know what, if anything, the Fed said about the impact
of QE on the prospect of a bond market panic, but I do know Bernanke was not
afraid to warn of the dangers of excessive austerity in
his final days in charge of the Fed. Which brings us to the UK, and the
coalition agreement of 2010. The Conservatives may well have advocated their
austerity programme whatever the Bank of England had said: it was a golden
opportunity to reduce the size of the state. However their coalition partners,
the LibDems, had campaigned on a more gradual deficit reduction plan similar to
Labour. Mervyn King’s advice during this period is often credited with helping
persuade the LibDems to accept the Conservatives’ proposals. (See, for example, Neil Irwin, or for more detail Andrew Lydon).
So why did King advocate austerity, rather than telling
politicians that with QE in place, a funding crisis was both much less likely
and less damaging. We may get a clue from something recently published by the Bank, as part of its stress
test scenario for UK banks (HT Britmouse). The application is to 2014 rather
than 2010, but it may still indicate what the Bank’s thinking might have been
four years earlier. It talks about “concerns over the sustainability of debt
positions” leading to a “sharp depreciation in sterling and a build-up of
inflationary pressures in the UK.” As a result, monetary policy is tightened
and long term interest rates rise - presumably because QE stops.
In one of my first blog posts two and a half years ago I wrote that “austerity is not even a sensible
precautionary policy when we have QE”. Does this scenario give me cause to
doubt that verdict? It does not, for two reasons. First, what makes a funding
crisis so scary when you cannot print your own currency is that it is a bit
like being blown off a cliff. Once interest rates start rising because of fears
of default, this in itself makes default more likely. We have a clear nonlinearity, such that it may become too late
to retrieve the situation once the process begins, as periphery Eurozone
countries found out. Depreciation in the exchange rate when rates are floating
is not like that. The further the exchange rate falls, the more attractive the
currency becomes, because trade in goods ties down the medium term level of the
currency.
The second reason why a loss of confidence in a currency is not
like a debt financing crisis is that the former cannot force default, whereas
the latter can. That makes all the difference. Without QE the markets have to
worry about what others in the market think. The government may not intend to default,
but if they cannot roll over their debt, they do not get that choice. With QE
the government cannot run out of money, so the markets no longer need to worry
about a self-fulfilling market imposed default. All that matters is what the
government will do, and there was never any serious chance that the UK would
default on its debt whoever won the election.
However it is possible to see why the Bank might still have worried
in 2010. Output had only just stabilised after the worst recession since WWII.
They wanted to keep interest rates as low as possible to help a recovery. Yet
inflation was more than 1% above target, partly as a result of the depreciation
of 2008. The MPC believed their remit was to target 2% inflation two years
ahead. If sterling had fallen further, they would have found it very difficult
not to raise rates. Yet Mervyn King would not have wanted to go down in history
as the Governor who raised rates during the depths of a recession.
I think this says a lot about whether we had the appropriate
monetary policy framework. (For further discussion of the economics see this post and links therein.) But my main point is
this. It is all speculation, because as far as I am aware the Bank said very
little officially. The Governor let his views be known in private, and publicly
endorsed the government’s austerity plan after the election (much to the annoyance of some MPC members), but there was
no open debate about the issues. The Bank could have initiated this debate, but
chose not to.
So when the next recession hits, and interest rates go to zero
and budget deficits increase, will anything be different? The central bank is
in a position to make it clear what the risks of a market panic really are when
QE is in place - indeed you could say that it has a responsibility to do that.
Or instead it can publically argue that it still has all the tools it needs to
manage the economy, and advocate austerity in private. Mervyn King once said (pdf) “Central banks are often accused of being
obsessed with inflation. This is untrue. If they are obsessed with anything, it
is with fiscal policy.” Is this always going to be the case?
