New versus traditional Phillips curves and the Great Recession

For economists

One of the questions I like asking students is whether inflation following the Great Recession has tended to favour the New Keynesian (NK) Phillips curve or its more traditional counterpart (TK). I like it because it allows me to draw a nice diagram, and also because it shows students how difficult it is to discriminate between theories in macro.

So first the theory. The two competing models are

• NK: Inflation at t = expected inflation at t+1 together with a term in the output gap
• TK: inflation at t = inflation at t-1 together with a term in the output gap

I’m ignoring discounting in the NK Phillips curve for simplicity. Assume expectations about inflation are rational, and suppose the economy is hit by an unexpected recession of known size and duration. The two models predict the following:

With the traditional model, inflation gradually falls as the recession continues, and once it comes to an end, inflation remains lower. In the New Keynesian model, assuming that the inflation target is credible, inflation jumps down when the unexpected recession occurs, and then inflation gradually rises towards its target as the recession progresses. (We assume here that the output gap is constant while the recession lasts, again for simplicity.) For the NK model, it is critical in drawing this diagram that the extent of the recession is known – more on this below. The patterns implied by the two models are distinct, and this difference is likely to persist even if each curve becomes flatter as we approach zero inflation because of nominal wage rigidities.

To see what has actually happened, see this nice post from Gavyn Davies. The immediate aftermath of the recession looked more like the NK model: a sharp fall followed by a gradual rise. Furthermore I would argue that – once the recession hit – most people expected it to be large and persistent, so my diagram is not totally unrealistic. But if we look at what has been happening in the last two years, it looks much more like the TK model, with inflation gradually falling below target.

That is probably as far as we should go without doing some econometrics, and also taking account of some of the complexities discussed here. We could probably get any pattern to fit the NK model by imagining a suitable sequence of expectations errors. In addition if we are looking at consumer price inflation we should account for commodity price changes, which neither model does. (If we look at GDP deflators, you could tell a story where agents were initially expecting a recession lasting three or four years, and have been surprised that the recession has persisted ever since.) That is why some proper econometrics is required, preferably looking at both price and wage inflation together with expectations data. (If such studies have been done, please let me know.)

However perhaps I can suggest two possible conclusions that such studies could test more rigorously. First, the traditional Phillips curve, where expectations are implicitly naive and backward looking, does not look like a promising basis for explaining inflation following the recession. Either the New Keynesian model, or some combination of the two models, looks more like providing an adequate foundation for a reasonable explanation. Second, an explanation based on the NK model that treats the size and extent of the recession (whatever that turns out to be) as one initially unexpected but then completely anticipated shock is also going to struggle to fit the data.    

The UK’s macroeconomic battleground to come

The Institute for Fiscal Studies’ (IFS) analysis of the specific measures in the Autumn Statement shows a certain degree of frustration. From their (economists) perspective, there seems no unifying theme or direction. For example transferable allowances for married couples adds a complication to the income tax system, without providing a major incentive. Free school meals for all children in the first 3 years of primary school benefits better off parents, as those on low incomes can already claim.

And then there is the continuing squeeze on the size of the state. The government has already reduced the share of government consumption in GDP, but that is nothing compared to its plans for the next five years, as I note here. It is pretty clear that both the IFS and the OBR regard this plan as incredible - it just will not happen. So what is the point in putting forward a plan for an unrealistically massive cut in the size of the state?

I am sure both organisations know why, but cannot say. It is, as ever with this Chancellor, all about the politics. For example, when it comes to the specific measures, the married couples allowance is an attempt to neutralise the impact on some conservative supporters of the Prime Minister’s support of gay marriage! Other popular tax giveaways are funded by ‘cracking down’ on tax avoidance - a win-win combination in political terms, even if the numbers might be unrealistic. In terms of the big picture, the Chancellor wants to ensure that Labour cannot pledge to match his spending, tax and deficit plans. As a result, he will be able to go into the next election accusing the opposition of either being dangerously imprudent, or planning tax increases.

Is this not a dangerous hostage to fortune? If the Conservatives win the next election, will this mean that they will have to admit their previous plans were hopelessly unrealistic? Perhaps, but I suspect the OBR’s assumptions about the output gap will be too pessimistic, and so economic growth will bring larger than expected falls in the debt to GDP ratio. So even if the Chancellor does not achieve cuts in government spending on the scale planned, deficit targets might still be met.

In a rational world (i.e. one where the economics made sense) the opposition could argue that the government’s plans aimed to cut debt too fast. But the ‘too far, too fast’ argument has already been judged to have failed by the political class, which has swallowed the myth that Labour’s fiscal policy played a large part in creating our present problems. So Osborne hopes that his unrealistic plans will paint Labour into a difficult corner, and the LibDems for that matter.

Yet it is far from obvious that this trick will work this time. Labour can take these numbers at face value, and say that they can only be achieved by cutting funding to the NHS, or education (see Declan Gaffney here - HT Alex Marsh). While government austerity may (perversely) be accepted in bad times, when the economy is growing it may be more difficult to argue that we cannot afford to maintain existing levels of public spending.

The government’s attempts to gain political advantage where none should lie also tie its hands. Labour’s major theme at the next election will be the decline in living standards for most income groups. This in turn is largely down to the UK productivity puzzle. It is not obvious that this decline in productivity growth is the result of government actions. Yet, as I note in this Free Exchange piece on the Autumn Statement, the government’s attempts to claim credit for growth in employment means that they cannot publicly address the subject of the productivity puzzle, still less argue that it is none of their doing. Here is a slightly amended graphic from my Free Exchange commentary that might look good on a Labour Party election billboard.

Conservative Lessons in Lost Output

So the battleground for the next election is set out. Labour will argue that living standards have shown an unprecedented decline (true), and the fault for this can be laid at the government’s door (half true at best). The Conservatives will argue that austerity has enabled the economy to grow again (false), and that continuing growth requires yet more austerity (completely false). Which will win out will be fascinating if you are interested in political spin, but it will all be pretty excruciating for any macroeconomist.

Two observations on the Autumn Statement

I may come back to some of the detailed measures announced in the 2013 Autumn Statement at a later stage, but here I just want to make two points about the overall strategy. The first comes from the OBR’s accompanying forecast. They calculate that government plans imply that “government consumption of goods and services falls from 23.2 per cent of nominal GDP in 2009 to 16.1 per cent by the end of the forecast period, its lowest on record in data back to 1948.” The document mentions this at least three times, perhaps because they find it a little unbelievable. Yet it certainly indicates the scale of George Osborne’s ambitions to shrink the size of the UK state.

This reduction in government spending could allow immediate and large reductions in taxes. However the government wants to bring down debt fast. Here is a nice chart from the Autumn Statement document.

The government’s preferred strategy is to go for something like 1% surpluses, bringing debt back to pre-recession levels by 2034/5. As Chris Dillow also notes, small budget deficits would still bring down debt, but more slowly.

Now let’s imagine that at some stage in the not too distant future the UK recovers much of the enormous amount of ground it has lost since 2007, and interest rates are no longer at their lower bound. At that point aggregate fiscal policy should be all about choosing between paths like these (or, of course, something in between). I think this is a very important debate to have. It would be a tremendous advance if we could have this debate without confusing it with the issue of how large the state should eventually be.

Yet neither this Autumn Statement, nor the speed of the recovery, alters in any way my view that this is not what should govern fiscal decisions today. UK GDP per capita is over 15% below the trend that it has followed since the 1950s. The more fiscal tightening we have, the longer it will take to recoup this lost ground. 

Could aggregate fiscal decisions ever be delegated?

The political battle over delegating decisions over monetary policy to central banks has been fought and won. There may be serious concerns about accountability in some countries, and mandates in others, but there seems to be a political consensus in most places that delegation in this respect is a good thing. (I know some readers disagree with this consensus, but this post is a question about what could happen, rather than what ought to happen.)

There is no major country which delegates decisions over aggregate fiscal policy. I stress aggregate here: I’m not suggesting decisions about particular tax rates or types of spending could be delegated. Instead an independent fiscal institution could set a target level for the budget deficit, and leave it up to the government how that target was achieved. Furthermore the choice between meeting the deficit target using tax changes or spending changes would remain with politicians, so key questions about the size of the state would stay under democratic control.

I’m reminded of this question not by the impending UK autumn statement, but because I have just received my copy of a new collection of essays edited by George Kopits. Its title is “Restoring Public Debt Sustainability: The Role of Independent Fiscal Institutions”. The story behind the book is interesting in itself. Its basis is a conference in Budapest organised by the former Hungarian Fiscal Council. Although a few fiscal councils [1] existed a decade ago, in the last ten years many more have been established, and that included one in Hungary that George chaired. All such councils are advisory - none can tell governments what to do. The meeting in Budapest was I believe the first international gathering of these councils, as well as a few academics that had a particular interest in these institutions. (It is what led me to create this website.)

The conference was a prelude to both success and failure. The failure was that soon after the conference the Hungarian Fiscal Council was effectively abolished by a new government. For that government this act was a good indication of things to come, as others have documented. The brief story of Hungary’s Fiscal Council is told in one of the chapters of this book. However, the success is that, with George’s help, the OECD took on the task of holding regular gatherings of fiscal councils, and it has issued a statement of principles which are an appendix to the book’s introduction.

A few of the essays in the book touch on the question I posed at the beginning of this post, including my own, which compares the delegation of monetary and fiscal policy. In a sense the demise of Hungary’s fiscal council explains why most of the discussion at the conference was happy to see such councils as advisory only. Giving governments advice they may well not want to hear is difficult and dangerous enough, and so fiscal councils need to be well established (and therefore less vulnerable) before we can think of going any further. One step at a time. 

Yet once these councils have been established, it becomes easier to imagine the possibility that delegation could go beyond advice to actual control. Take the UK case for example. The government sets its fiscal mandate (cyclically adjusted current balance in 5 years time), just as it does the inflation target. The OBR then tells the government what it needs to do to meet that mandate. So, having set the mandate, the amount of aggregate discretion left to the government in each budget is limited. It would seem quite a small step to let the OBR decide how quickly the mandate should be achieved. Another small step would be for the government and OBR to negotiate over the mandate itself (just as the central bank and government negotiate over the inflation target in New Zealand).

Small steps, but much too large in political terms right now, as I once discovered when giving evidence to the Treasury Select Committee. (See the second footnote to this post.) Yet in ten or so year’s time, when more of these councils are well established, I can see things might be quite different for two reasons. First, when the recession is finally over there will be a clear consensus that a slow (and state contingent) reduction in net debt levels is required, yet some governments may start to waver from this task for short term political gain. Second, it will have become even clearer that governments, by undertaking austerity at just the wrong time, inflicted substantial damage on their economies, and that maybe everyone would be better off if they were not given that opportunity again.

[1] I use the term fiscal council to cover much the same set that George calls Independent Fiscal Institutions. His term is probably more accurate, but I still prefer fiscal council! 

Here we go again

1) Government embarks on austerity, to try and maintain the confidence of the bond markets. We must preserve the AAA rating for our government’s debt, says the finance minister.

2) Austerity reduces demand, helping create flat or negative growth.

3) As a result, deficit targets keep being missed. Additional austerity is imposed, and growth declines again.

3) Country loses its AAA rating, and the credit rating agency gives concerns about poor growth as an important factor for the downgrade.

4) This confirms our fears, says the finance minister. We must redouble our efforts to reduce our debt.

This will sound familiar to UK ears, but it is also what has just happened in the Netherlands.

I do not like using decisions by the credit rating agencies as an excuse to write posts, because when it comes to the major economies they have no particular expertise. (Typically markets show no reaction to the ‘news’ that a country like the Netherlands has been downgraded.) This useful post by Bas Jacobs (HT MT) argues that the S&P analysis for the Netherlands does not deserve any serious attention. On credit rating agencies generally, see Jonathan Portes. The media report what these agencies say because downgrades are convenient hooks to hang existing stories on, and it is a shame and a continuing source of puzzlement that officials and politicians bother with them.

So why am I writing this post? Because it seems important to record the progress of another country beside my own that is going down a depressingly predictable path. When I last wrote about the Netherlands, some positive growth was expected for 2014, but the OECD’s latest forecast shows GDP flat next year. These forecasts also have consumer price inflation below 2% in 2014 and below 1% in 2015. The output gap is currently over (negative) 4%, and is expected to reach -5.5% in 2015. Unemployment, which was only 4.3% in 2011, is expected to rise to 8.1% in 2015.

Like the UK, the Netherlands is a country with no problem selling its debt. It has no macroeconomic need to achieve an expected (by the OECD) underlying general government surplus by 2015. As Jacob’s notes, there is no question of an unsustainable long run fiscal position. The only major lever the government has to do something about lack of growth and rising unemployment is fiscal policy, yet it is using this lever in completely the wrong (pro-cyclical) direction, making everything worse.

A crazy policy. Yet it is followed by both centre-left and centre-right parties, even though this means these parties are haemorrhaging support to those further left and right. It is a policy supported by the central bank, which was one of those voting against the recent cut in ECB interest rates. The CPB, the country’s fiscal council that used to be a voice of sanity on fiscal matters, appears silent on the issue. Everyone can blame the Eurozone’s Fiscal Compact of course, but among the political centre they do not.

Coen Teulings, the former head of the CPB, speculated about why politicians seem so attached to austerity, when it is so clearly doing their popularity such harm. They seem to be stuck in an equilibrium (the ‘austerity trap’) where they fear that if any of them broke free, by declaring austerity harmful, they would lose out because other parties in the centre would declare them irresponsible, or ‘not serious’ to use Paul Krugman’s language. Yet they would all be better off, in terms of not losing support to the further left or right, if they could simultaneously break free of the austerity trap. Within any single Eurozone country the ‘irresponsibility’ charge is reinforced by the Eurozone’s Fiscal Compact, which in turn keeps the Eurozone as a whole in the austerity trap.   

UK banks and the productivity puzzle: it may not just be about limited lending

Banks, in providing - or not providing - loans for start-ups, or for small firms to expand, can potentially play an important role in aggregate productivity growth. In the UK, Small and Medium Sized Enterprises (SMEs) make up about half the private sector economy in terms of turnover and employment. UK SMEs remain dependent on banks for the large majority of their external funding. So banks decisions on whom to fund, and who to no longer fund, could make a big difference.

The concern that I have discussed before is that a reduction in UK bank lending to SMEs, as banks try to rebuild their balance sheets, would hurt the ability of the more productive SMEs to expand. This in turn would impact on economy wide productivity. There is a longstanding concern that banks that have balance sheet problems of their own will keep ‘zombie firms’ alive to avoid writing off loans, and that this will restrict their ability to lend to new more dynamic firms. UK liquidations have been unusually low in this recession. 

The Funding for Lending Scheme (FLS) attempted to encourage greater aggregate lending by banks, although it did not initially discriminate between lending to SMEs and household mortgages. Subsequently the government’s Help to Buy programme threatened to divert more of the scarce resource - bank lending - from SMEs. (The possibility that lending to households could ‘crowd out’ lending to firms is examined in this study.) So it is to the Bank of England’s credit that they recently decided to focus FLS on SMEs, and the Chancellor - perhaps grudgingly - agreed.

However there may be another process behind the UK's productivity puzzle that has to do with banks, but not the volume of bank lending. About a third of bank lending to SMEs is accounted for by one bank: the Royal Bank of Scotland. (At the time of the financial crisis its market share was 40%: see the Independent Lending Review commissioned by RBS, page 25.) It has become increasingly clear that the RBS has been a seriously mismanaged bank. At the end of 2011 the Financial Services Authority issued a report which was extremely critical of the quality of management at RBS. Part of that poor management included a huge expansion in property based loans before the financial crisis. When those loans went bad, it was many of their SME customers who took the hit, according to a report just issued by Lawrence Tomlinson, the "entrepreneur in residence" at the Business, Innovation and Skills Department. Among other things the report alleges that RBS has been forcing viable businesses with short-term cash flow problems into its corporate restructuring arm with the aim of forcing foreclosure and then making a profit from selling off property assets.

When a bank does close down a firm, there is usually a difference of opinion over long term viability, and so the process is bound to be unpleasant. But from an economy wide perspective, you would hope that a bank was reasonably efficient at protecting those firms with innovative potential, because these firms will not only end up repaying their loans, but will be the basis for a mutually profitable future partnership. But Hamish McRae argues that gradually this ‘duty of care’ that banks once had with their customers has been replaced by a desire to flog products. And as the PPI scandal illustrates, banks seem not to worry about whether their customers need these products, as long as the sale is made. In terms of SMEs, some of the major damage may have been done by interest rate swaps: often complex hedging products which buyers may have not understood, or may have been missold. RBS appears to be heavily exposed to compensation claims involving these products.

This example nicely illustrates the problem that appears to be at the heart of banking today. Products like interest rate swaps could potentially be useful to small businesses, protecting them from risk. This is how the expansion of the banking sector was portrayed by the banks themselves - they were selling innovative products that benefited their customers, and therefore the economy as a whole. But if these products are mis-sold, either to those who did not need them or by false claims about what they do, it is just a case of successful rent seeking (using the term in its wider sense): obtaining money from bank customers and providing nothing useful in return.

It is very easy to get carried away with indignation at all this. As scandal after scandal emerges involving the UK banking sector, the only thing that seems to keep pace is the growth in bankers’ salaries. Growth which the UK government is trying as hard as it can to protect. And in the case of RBS, last year this bank even failed to keep its most basic service of operating a payments system going! But this post is designed to pose a rather different question.

Is it possible that this combination of rent seeking and incompetence by the UK’s foremost provider of loans to SMEs had impaired the ability of the bank to ensure that firms that were more efficient and productive survived? Did this bank, and perhaps other banks, become so engrossed in selling products to customers that it no longer allocated what loans it did make efficiently? Could this, alongside low levels of overall lending, be a factor behind the puzzle that recent UK productivity growth has been so low both historically and in relation to other countries? We will probably never get good aggregate data on this, but that does not mean it has not happened.

Bertrand Russell’s chicken (and why it was not an economist)

When that pioneering economist David Hume wrote about the problem of induction, he talked about the possibility that the sun would not rise one morning. There is no way we can know ‘for sure’ that it will rise. (In contrast, we know for sure that 1+1=2.) Just because the theories we have suggest it will rise each morning, and those theories have been right so far, does nothing to ensure they will continue to be right.

The problem with this example is that it is very difficult to imagine the sun not rising every morning. Bertrand Russell had perhaps a better example. The chicken that is fed by the farmer each morning may well have a theory that it will always be fed each morning - it becomes a ‘law’. And it works every day, until the day the chicken is instead slaughtered.

When I used to lecture about economic methodology, I liked to say that this chicken was not an economist. Now you might say that no chicken is an economist, but suppose that chickens were as intelligent as the farmer who keeps them, so they could be an economist. Economics is at a disadvantage compared to the physical sciences because we cannot do so many types of experiments (although we are doing more and more), but we have another source of evidence: introspection. So if Bertrand Russell’s chicken had been an economist, they would not simply have observed that every morning the farmer brought them food, and therefore concluded that this must happen forever. Instead they would have asked a crucial additional question: why is the farmer doing this? What is in it for him? If I was the farmer, why would I do this? And of course trying to answer that question might have led them to the unfortunate truth.

I thought of this when reading through the fascinating comments on my post on rational expectations, and posts others had written in response. You can see why the habit of introspection would make economists predisposed to assume rationality generally, and rational expectations in particular. (I think it also helps explain economists’ aversion to paternalism.) It only works to use your own thought processes as a guide to how people in general might behave, if you think other people are essentially like yourself. So if your own thoughts lead you to postulate some theory about how the economy behaves, then others similar to yourself might be able to do something like the same thing.

 

But of course this line of reasoning could also be misleading. An economist who introspects does so with the help of the economic theory they already have, so their introspection is not representative. A psychologist or behavioural economist might come to very different conclusions from introspection - what biases do I bring to this problem, they may ask. Economists may also be fooled into thinking their introspection is representative, because they are surrounded by other economists. So this conjecture about introspection does little to show that assuming agents have rational expectations is right (or wrong), but it may be one reason why most economists find the concept of rational expectations so attractive.