A simple guide to the UK fiscal deficit

Confused about the government’s deficit? Are we most of the way there, as the Prime Minister has claimed, or is there rather more to find, as the IFS suggest? And what is 'there' anyway - what are we aiming for exactly?

The first way to make things intelligible is to express everything as a percentage of annual GDP. So if you see a figure in £ billion, just divide by something a bit larger than 17 to get it as a percentage of annual GDP. (UK GDP in 2013 was £1713 billion.)

The second thing to get clear is what the reference point should be. When is a deficit too big? The answer that some would like to suggest is that any deficit is too large, and that we should aim to eliminate the deficit completely. However for economists a more natural reference point given our current position is to ask what level of deficit would keep the ratio of government debt to GDP stable. Public sector net debt, which is the definition the OBR tends to use, is approaching 80% of annual GDP. If the economy grew by 4% in nominal terms each year, then a deficit (‘public sector net borrowing’) of 3.2% of GDP would keep the debt to GDP ratio stable at 80%. (0.04 x 80% = 3.2%.)

How does that compare with where we are now? The most relevant figure here is the cyclically adjusted deficit excluding Royal Mail and APF transfers, which the OBR estimated in March was 5% of GDP for financial year 2013/4. [1] That was the OBR’s best guess at what the deficit would have been in 2013/14 if the economy was on track, with a zero output gap.

That is looking at the position in the recent past. Of course the government already has policies designed to make additional future savings, so to factor these in we need to look at where the OBR expects us to be in the first year of a new government, which will be financial year 2015/16. In March it expected a cyclically adjusted deficit excluding transfers of 3.4% of GDP for that year. In other words, the government will have just about got us to a position where the debt to GDP ratio is no longer rising, if it implements planned savings and everything pans out as the OBR expects. As a result, the OBR suggests 2015/16 will be the year debt/GDP peaks.

That means a lot of ‘progress’ has been made compared to a peak actual deficit of just over 10% of GDP in 2009/10. [2] I personally would not call it progress, because I would have increased the deficit in 2010 to help end the recession more quickly, but this post is just about trying to make sense of the numbers.

The fact that by 2015/16 we will have roughly stabilised the debt to GDP ratio might surprise many people (but not all, as this poll discussed by the FT indicates). Are not the papers full of all the additional austerity there is still to come after the next election? One reason they suggest that is that all political parties are not content to just keep the debt to GDP ratio constant at 80%. They think this number is too large for the long term health of the economy, and there are a number of reasons why they may be right, which I discuss with Jonathan Portes here. But the speed at which debt is reduced is a choice - one that I have discussed here, here and here - and not some imperative that must be done or something terrible will happen.

One final point to note. I have talked about the deficit above, which includes public sector investment. Figures are often quoted for the current budget, which excludes this investment. So, for example, while the Chancellor plans to eliminate the total deficit by 2018/19, Labour intends to achieve only a zero current balance, and has left open the possibility that its target might not be achieved until 2020. Currently investment is around 1.5% of GDP, so just add this to any current balance deficit to get a rough idea of what the implied total deficit would be. So if we start from a cyclically adjusted deficit of 3.4% in 2015/16, the Conservatives aim to get this down to zero in 2018/9, but Labour only aim to reduce it to around 1.5%, possibly at a later date. That implies much less austerity under Labour’s plans, even if we make no allowance for additional Conservative cuts to finance the tax breaks Cameron announced. For a much more detailed analysis, which comes to similar conclusions, see this from the Resolution foundation.

If that also comes as a surprise, because you had read that all parties would have to undertake painful austerity, it is because Labour seem quite happy to give that impression. Having argued in 2010 that the Conservative plans were too far, too fast, and lost that election (and according to mediamacro, lost the argument more generally), they do not want to fight on that territory again. The aim of this post is to help distinguish important real fiscal choices from the spin that often surrounds them.

 

[1] The OBR expected in March that the ‘headline’ deficit for financial year 2013/14 would be 5.8% of GDP. However this figure is flattered by some one-off (Royal Mail and APF) transfers, and so a more meaningful number excludes these, which is 6.6% of GDP. The OBR estimate that 1.6% of that 6.6% is simply the result of the currently depressed economy.

[2] The OBR estimate that about a fifth of that deficit was a temporary result of the recession, so they estimate a cyclically adjusted deficit of 8% that year, which is the more relevant benchmark if you want to think about the proportion of austerity we have already had compared to what might be still to come.  

Why are the Conservatives so incompetent at running the economy?

If that question seems odd to you, you are one of the majority in the UK who think the Conservatives are better at managing the economy than Labour. Why do people think this? My guess is that it is very simple. The financial crisis happened while Labour was in power. This led to the largest recession since the Great Depression.

But surely everyone knows that the financial crisis was a global phenomenon that started in the US? Surely everyone knows that if the Conservatives had been in power there would have been just as little financial regulation, so the impact of the crisis on UK banks would have been much the same?

The problem is that most people do not know this. What they hear is the Conservatives repeating relentlessly that it was all Labour’s fault. In his latest party conference speech Cameron says: 

“A few weeks ago, Ed Balls said that in thirteen years of Government, Labour had made ‘some mistakes’. ‘Some mistakes’. Excuse me? You were the people who left Britain with the biggest peacetime deficit in history…who gave us the deepest recession since the war…who destroyed our pensions system, bust our banking system…who left a million young people out of work, five million on out-of-work benefits – and hundreds of billions of debt. Some mistakes? Labour were just one big mistake.”

This line is repeated by the majority of the UK press. It is hardly ever challenged by reporters in the BBC or other TV media. It has become so pervasive, that even some of my non-macro colleagues repeat elements of it back to me. [1]

So what if we take the financial crisis out of the equation, on the basis that it would have happened whoever had been in power. Here is average UK output per head (GDP per capita) since the 1970s.

I have drawn a trend line at 0.55% per quarter, so we can separate any evaluation into trends and deviations from trends. In terms of trends, there is no obvious difference between administrations. The Conservatives were in power from 1979 to 1997, but the trend rate of growth was not obviously better or worse during this period compared to the 1997 to 2007 period that Labour were in power. Fortunately that broad diagnosis is confirmed by those who look at these things more scientifically. [2]

In terms of deviations from trend, we have the major recessions of the early 1980s and 1990s, and the period since the Great Depression. Now the early 1980s was a global recession following a second oil price shock, where all countries were trying to get inflation down, so in fairness I ought to take that period out of the equation along with the Great Recession. However it should be noted that this period of Conservative administrations started with a radical new macroeconomic policy of targeting the money supply, which in its own terms was a disaster as the targets were never met, and the policy was abandoned after a few years. Hardly a great example of being able to manage the economy.

The 1990 recession was more home grown. It was partly a result of excessive inflation caused by bad fiscal and monetary policy under Conservative chancellor Nigel Lawson, but it was made worse by fixing Sterling to the DM at an overvalued exchange rate. So a pretty clear case of macroeconomic mismanagement under a Conservative administration. Then we have 2010 onwards. Rather than recovering from the recession, income per capita has diverged further away from its pre-crisis trend. Now you might say in mitigation that this disappointing post-recession performance has been global, but the UK has been more disappointing than either Japan or the USA. Although the UK, the US, the Eurozone and Japan suffered a major recession, by 2013 both the US and Japan had exceeded their 2007 level of GDP per capita. Furthermore the recovery in the Euro12 was also more rapid than in the UK, but then fell back following the Eurozone crisis. As a result GDP per capita in both the Eurozone and the UK remains well below 2007 levels. The best that can be said for the UK recovery is that it has been as poor as the Eurozone, without the excuse of a government funding crisis. 

Of course there is much more to say about all this, but the point I want to make here is fairly simple. Once we recognise that the financial crisis was a global event, then the three remaining major departures from trend growth happened under Conservative led administrations. In all three cases they can be associated with poor policy decisions taken by those administrations: money supply targets under Thatcher, ERM entry under Major, and austerity under Osborne.

So the idea that the Conservatives are more competent at macroeconomic management is a myth, and if anything the opposite appears to be true. Now I’m not going to discuss here why recent major mistakes seem to happen under Conservative administrations, although that would be an interesting question. Instead I want to focus on why the myth of Labour incompetence persists in mediamacro, and therefore in the minds of most people? There are two obvious explanations. The first is that the media is totally incompetent, and thinks that because the Great Recession happened under Labour, it must all be Labour’s fault. The second is that the media takes its cue from either the right wing press, or from a financial sector that also has clear interests to pursue.

A third explanation I have heard on the few occasions I enter Labour circles is that they are partly to blame, perhaps because they allowed the Conservative narrative about fiscal profligacy to go unchallenged for too long, or because they fail to campaign strongly enough on issues that matter to voters. If you think that, you should read this article by the Australian economist John Quiggin. He says that complaints that the Australian opposition are pursuing a ‘small target’ strategy, focusing on minor differences with the government, rather than confronting the government on the major issues are misplaced. “In reality, some version of the small target strategy is effectively forced on the main opposition party by the way in which our political system and media now operate.”

As evidence for that in the UK, just think of Ed Miliband’s last speech, and the media reaction. As I wrote about here, after the speech the left of centre journalist Jon Snow asked Miliband what the greatest issue facing the next British government is. Miliband responded that it is getting the country to work for most working people rather than be stuck with a more unequal country. There it is - inequality - put at centre stage. But all Snow could do was respond that this was the second time Miliband had forgotten to mention the deficit, and proceeded to rant on about this.

When I wrote that post, it was before Cameron’s speech. I suggested that Cameron would fail to mention the productivity slowdown that is a key factor behind the UK’s poor recovery from the recession, but no journalist would bother to even mention this. He didn’t, and I do not remember anyone even noting this failure, even though Labour talk all the time about the decline in living standards that it has produced. In mediamacro, the deficit is all important, but the decline in average living standards not so much. And people wonder why many potential voters are disaffected from mainstream politics.

In a recent post, the US economist Robert Reich berates the Democrats for failing to campaign on falling median wages and the growing inequality that lies behind it. The reason he gives is simple: money buys votes in the US system, which Jeffrey Sachs calls a plutocracy. In the UK Labour has tried to raise the link between inequality and falling real wages, as my example above shows, but the UK media does not appear to want that discussion to take place. I would really like someone who knows the UK media from the inside to explain why.

 

[1] Isn’t the bit about the deficit just a little bit true? Yes exactly that. Labour’s fiscal policy could have been better, particularly in hindsight, as I detail here. But did it amount to fiscal profligacy - absolutely not. Did it have anything to do with causing the recession - absolutely not. Could a tighter fiscal policy have allowed Labour to do a little more in terms of fiscal stimulus to fight the recession - maybe, but remember that Cameron and Osborne opposed the countercyclical fiscal policy Labour did enact. In what world does that opposition show economic competence?

[2] See, for example, this from John Van Reenen. A less scientific response would be to claim that trend growth was falling under Labour, and that 2007 represented a large macroeconomic boom. You will find many in mediamacro who assert this as a fact, but the evidence just does not support this claim.

Postscript 13/11/14. To reinforce my point about inequality and Labour, here is an extract from Miliband's speech at the Senate House today: "Now I have heard some people say they don’t know what we stand for. So let me take the opportunity today to spell it out in the simplest of terms. It is what I stood for when I won the leadership of this party. And it is what I stand for today. This country is too unequal. And we need to change it." It will be interesting to see how this rather important statement is reported. 

Getting the Germany argument right

As the Eurozone experiences a prolonged demand-deficient recession, and given Germany’s pivotal role in making that happen, it is important to get the argument against current German policy right. It seems to me there are two wrong directions to take here. The first is to argue that Germany needs to undertake fiscal expansion because it has more ‘fiscal space’, to use a phrase the IMF use a lot which I dislike. The second is to argue that Germany needs to expand to help its Eurozone neighbours.

The problem with the first argument is that it legitimises the fiscal rules which are ultimately the source of the Eurozone’s current difficulties. If we look at the Eurozone as a whole, its fiscal policy is tighter than in the UK and US. As Fraser Nelson notes, the UK has a larger structural deficit than any other EU country. With interest rates at their zero lower bound, this shows that UK policy - while far from appropriate - is not quite as inappropriate as in the rest of the EU. The right policy when you are in a liquidity trap is to have a fiscal stimulus large enough to get you out of that trap. Within the Eurozone, the only countries that might be exempted from this fiscal expansion are those on the periphery. Otherwise we need a fiscal expansion in France, Italy, Spain, the Netherlands etc, as well as Germany.

The problem with the second argument is twofold. First, it tunes in with the popular sentiment in Germany that the country is yet again being asked to ‘bail out’ its Eurozone neighbours. Second, it implicitly suggests that the current German macroeconomic position is appropriate, but that Germany must move away from this position for the sake of the Eurozone as a whole. The obvious German response is to list all the reasons why their economy is currently on track (see, for example, Otmar Issing in the FT recently), and suggest therefore that other countries should look at their own policies for salvation. This is how we end up needlessly discussing structural reforms in France, Italy and so on.

The uncomfortable truth for Germany, which both the previous arguments can miss, is that the appropriate macroeconomic position for Germany at the moment is a boom, with inflation running well above 2%. The current competitiveness misalignment is a result of low nominal wage growth in Germany over the 2000 to 2007 period, which was in effect (and perhaps unintentionally) a beggar my neighbour policy with respect to the rest of the Eurozone. Germany’s current position is unsustainable, as its huge current account surplus and relative cyclical position shows. It will be corrected by undoing what happened from 2000 to 2007. Over the next five or ten years, German inflation will exceed the Eurozone average until its long term relative competitive position is restored.[1]

The only choice is how this happens. From the perspective of the Eurozone as a whole, the efficient solution would be above 2% inflation in Germany, and below 2% inflation elsewhere. That is what would happen if the ECB was able to do its job, and Germany would get no choice in the matter. Normally above 2% inflation in Germany would require a boom (a positive output gap), but if it can be achieved without that fine, although I would note that current German inflation is only 0.8%. Arguments that point to currently low unemployment and a zero output gap in Germany are therefore irrelevant while German inflation is so low. The inefficient alternative solution is for 2% or less inflation in Germany, and actual or near deflation outside. Why is this solution inefficient? Because to get inflation that low outside Germany requires the Eurozone recession we are now experiencing.

This is where structural reforms enter. Many German commentators say ‘why cannot other countries do what we did from 2000 to 2007’? But low nominal wage growth in Germany from 2000 to 2007 was accompanied by a recession in Germany! Furthermore, that recession was not so bad as the current Eurozone position, because the ECB was able to do its job and cut interest rates, so inflation outside Germany was above 2%. So from 2000 to 2007 many countries had to experience above target inflation because of low nominal wage growth in Germany, [2] yet many in Germany want to avoid above target inflation while imbalances are corrected.

If your starting point is what happened in Germany from 2000 to 2007, then current German arguments can look incredibly self-centred. They seem to say: we suffered a recession from 2000 to 2007 which led to a beggar my neighbour outcome, now you have to suffer a worse recession to put right the problem we created. But as I have argued before, and which comments on my recent posts and readings confirm, I think the German position is more about ignorance than greed. I also suspect there is a great deal of macroeconomic ignorance outside Germany as well, which is why Germany has been able to impose a recession on the rest of the Eurozone. Take for example this paper by Michael Miebach, who speaks from the left of centre in Germany.

Miebach presents a wide range of macroeconomic fallacies or irrelevant arguments. Germany’s fiscal position is not good (irrelevant in a liquidity trap), its macroeconomic position is not too bad (when it should have above 2% inflation, which probably requires a boom), fiscal expansion in Germany would have only a small impact on the periphery (but what we should be talking about is fiscal expansion in all the main Eurozone economies, which this paper confirms would help the periphery as well as France, Italy etc, and expansion in Germany would benefit countries like the Netherlands), and the old canard about how focusing on demand distracts attention from dealing with structural weaknesses in the Eurozone. But most revealingly we have this:

“Also, how can Germany demand fiscal discipline from other countries if it strips away its own principles at the first opportunity?”

You can only write this if you just do not get the idea of a liquidity trap, when demanding fiscal discipline from other countries is the source of the problem! What makes Germany’s current position unforgivable is not that it is refusing to undertake a significant fiscal stimulus of its own. It is that it is doing what it can to make other countries persist with austerity, and at the same time making it difficult for the ECB to do what it can to offset this. The ultimate problem is that what Germany sees at virtue is pre-Keynesian macroeconomic nonsense, nonsense that is doing other countries a great deal of harm. The best one can say in mitigation is that, in a sort of collective stockholm syndrome, too many in these other countries also mistake nonsense for virtue.

[1] Economists would naturally talk about real exchange rates here, rather than use the term competitiveness, because the latter invites a confusion between firms and nations. The first point to note is that if Germany had its own exchange rate, the impact of low nominal wage growth on competitiveness would be undone through a nominal appreciation. (There are no benefits of a nominal appreciation if everything real is unchanged.) The second point is that a competitive market is beneficial when it encourages improvements in productivity. For a single nation to gain a competitive advantage in a currency union by cutting nominal wages just causes problems.  

[2] Looking at consumer prices tends to mask national differences, because of imported goods. Over the 2000-2007 period average Euro consumer price inflation was 2.2%, and in Germany it was 1.7%. However if we look at output prices (the GDP deflator) we get a clearer picture: average Eurozone inflation was just above 2%, but inflation in Germany was 0.8%. 

The IMFs evaluation of 2010 austerity

The Independent Evaluation Office of the IMF has recently published its assessment of the IMF’s Response to the Financial and Economic Crisis. In many ways the IMF’s advice at the time mirrored the way the policy response to the crisis actually evolved. In 2008 and 2009 it recommended fiscal stimulus, and that is exactly what some countries, notably the UK and US, did. In 2010 it dramatically reversed its advice, and recommended austerity. At the same time the UK, US and Eurozone switched to austerity.

This independent evaluation argues the 2010 switch was a mistake. Here are some key quotes from the report (paras 32-34):

“The IMF’s call for fiscal expansion and accommodative monetary policies in 2008–09, particularly for large advanced economies and others that had the fiscal space, was appropriate and timely.”

“IMF advocacy of fiscal consolidation proved to be premature for major advanced economies, as growth projections turned out to be optimistic. Moreover, the policy mix of fiscal consolidation coupled with monetary expansion that the IMF advocated for advanced economies since 2010 appears to be at odds with longstanding assessments of the relative effectiveness of these policies in the conditions prevailing after a financial crisis characterized by private debt overhang. In particular, efforts by the private sector to deleverage rendered credit demand less sensitive to expansionary monetary policy, irrespective of its ability to maintain low interest rates or raise asset prices. Meanwhile, a large body of analysis, including from the IMF itself, indicated that fiscal multipliers would be elevated following the crisis, pointing to the enhanced power relative to the pre-crisis environment of expansionary fiscal policy to stimulate demand.”

“Many analysts and policymakers have argued that expansionary monetary and fiscal policies working together would have been a more effective way to stimulate demand and reduce unemployment—which in turn could have reduced adverse spillovers. Waiting longer to shift to fiscal consolidation might also have allowed for less aggressive monetary expansion, with less negative side effects.”

None of this will be a surprise to regular readers of this blog, but it is welcome nonetheless. Perhaps more interesting is the subsequent analysis of why the IMF got it wrong in 2010.

“In articulating its concerns [in 2010], the IMF was influenced by the fiscal crises in the euro area periphery economies (see Box 1), although their experiences were of limited relevance given their inability to conduct independent monetary policy or borrow in their own currencies.”

As the evaluation also notes, interest rates on US, UK and Japanese government debt were at historic lows. So the report essentially says that the IMF became spooked by the Eurozone crisis. That is why it is tempting to call the 2010 switch to austerity a Greek tragedy.

This is an assessment of the IMF’s view. Of course policymakers in both the UK and US had other motivations. We will never know if the switch to austerity in 2010 would have happened anyway even if the IMF had not changed its view, or whether it would have happened if politicians in Greece had not borrowed too much and attempted to deceive everyone else about this.

As the FT reports, Christine Lagarde has defended the advice the IMF gave in 2010. It was appropriate given the IMF’s forecasts of a reasonable recovery, she suggests. However that seems to miss the point. This report clearly suggests that the IMF were mainly misled by what was happening in the Eurozone and not by an overoptimistic forecast. If they had interpreted the Eurozone crisis for what it was, they would probably have concluded that the recovery was still fragile, and that therefore this was not the time for austerity outside the Eurozone periphery. Better still, they might have made their participation in the Troika conditional on a quick and full Greek default (as an earlier self evaluation by the IMF suggested), and better still on the ECB implementing OMT much sooner.

Another imponderable concerns macroeconomic theory. By 2011 Paul De Grauwe had provided a convincing explanation of why the debt crisis was confined to the Eurozone, and by the end of 2012 when the ECB’s OMT had ended that crisis it was clear he was right. If we had known in 2010 what we know now, would the IMF have taken a different view? I suspect not. Austerity is a sort of default mode for the IMF, for understandable reasons, and although there are many opinions within the IMF, it is still ultimately run by a political body. But at least we can be thankful that this IMF evaluation, untainted by political face saving or ideology, has given a clear verdict. The 2010 switch to austerity was a mistake. The conclusion is not qualified: it was a mistake in the UK, the US, and in the Eurozone as a whole. 

George Osborne’s European triumph

Today, as a result of negotiations with EU finance ministers over the UK’s additional contribution to the EU budget following upward revisions to UK GDP, George Osborne said:

“Today I can say this: instead of footing the bill, we have halved the bill, we have delayed the bill, we will pay no interest on the bill.”

This would have been quite a result, given that any reduction in the UK’s contribution would have meant some other EU countries getting less than they expected. All the more remarkable given that the Financial Times reports that:

“Officials involved in the closed-door negotiations between finance ministers said Mr Osborne did not complain about the overall bill. Instead, the debate focused on delaying the payment, which will allow the British government to pay after the general election in May.”

So was “halving the bill” a last minute gift from other EU finance ministers? Had the Commission gifted the UK some money without telling anyone else what it intended to do? Neither, of course. The Chancellor had made that bit up. He had simply subtracted the UK rebate, which the UK was going to get anyway. Treasury officials tried to suggest that this rebate had been in doubt before separate talks with the Commission, but the FT reports Commission officials as saying that the rebate was never, ever in doubt.

So while the rest of the world reported that the UK had failed to get its additional contribution cut, the UK media dutifully repeated the Chancellor’s claim that it had been halved. BBC journalists were clearly suspicious about what had gone on, so their website led with “Osborne's EU budget claim challenged”. But they couldn’t bring themselves to actually report that Osborne’s claim to have negotiated a halving of our additional contribution was wrong. After all, he is the UK Chancellor, so surely he wouldn’t pretend he had done something he had not. Some lowly MP might play fast and loose with numbers, but not the man in charge of the UK’s finances. I suspect many in the media have still not fully appreciated what a unique Chancellor George Osborne is. 

When the UK’s leading supermarket chain, Tesco, discovered that they may have overstated their profits by mistiming some payments, four senior executives, including its UK managing director, were suspended while the matter was investigated. "Disappointment would be an understatement," said Tesco chief executive Dave Lewis. So will the UK’s chief executive, David Cameron, be reprimanding the Chancellor over his false claims? No, because given the stress that Cameron put on reducing the total additional contribution just before the negotiations, it is clear he was in on the deceit. Unlike Tesco, they think this kind of deception is just part and parcel of their business, and of course they also think that they can get away with it.   

Germany and pre-recession cost cutting

In a recent post I argued that many of the Eurozone’s current problems stem from low nominal wage inflation in Germany before 2008. In that post I also noted that this could be justified if Germany had entered the Eurozone at an uncompetitive real exchange rate, but that I thought there was little evidence for this. I want here to expand on that point.

One area that I have worked on extensively in the past is what might be called the empirical analysis of equilibrium exchange rates. The term equilibrium is short for where the real exchange rate is heading over a five year or so time horizon. While predicting exchange rate movements from day to day is impossible, this is not the case over the longer term. It was for this reason that the UK Treasury asked me to analyse what an appropriate entry rate for Sterling might be if we had joined the Euro in 2003.

There are two ways of describing the approach I take in this analysis. The first is to calculate the exchange rate that will achieve ‘external balance’. As John Williamson repeatedly points out, external balance does not mean current account balance, but the current account that is consistent with medium term trends in domestic supply and demand. This is why the approach is equivalent to a second way of describing it, which is to apply the ideas of the ‘new open economy’ literature that now dominates open economy macro.

In a 1998 study with Rebecca Driver for the (now called) Peterson Institute (which contained a key contribution from John Williamson and Molly Mahar) we calculated equilibrium rates for 2000 for France in the range of 3.06-3.74 Fr/DM, and Italy 927-1133 Lire/DM. The actual entry cross rates were 3.35 Fr/DM and 990 Lire/DM, which is pretty close to the middle of those ranges. In other words, according to our analysis Germany did not enter at a significantly uncompetitive rate compared to these two major economies.

A crude way of doing exactly the same analysis is simply to look at the current account balance. Here it is for Germany, as a percentage of their GDP. The problem with this simple approach is that the current account is a noisy signal, and it is exactly this problem that the analysis described above tries to deal with. But for the sake of argument let’s say that, because of well known lags, the current account in 2001 reflected the competitive position of Germany when the Euro was created.

Germany’s current account in 2001 was in balance, and according to the OECD its output gap that year was a positive 0.7%. So Germany could only be uncompetitive on entry to the Eurozone if that current account balance was unduly influenced by one off factors, or that it really should have been running a structural surplus because of relative demographics or some other reason. But such structural surpluses are normally of the order of 1% or 2% of GDP. Looking at the current surplus of over 7% of GDP, you just have to conclude that Germany currently has a hugely undervalued real exchange rate, which is just another way of saying that it is too competitive compared to its Euro partners. It achieved that competitive advantage from 2000 to 2007.

So where did this idea that Germany entered at an overvalued (uncompetitive) exchange rate come from? I suspect it derives its force from what happened to German GDP growth after the Eurozone was created. As the chart below shows, Germany entered a recession in 2003. In addition, in 2003 foreign trade subtracted from growth. However in terms of the contribution of trade to growth this was a blip: both before and after export volumes grew faster than import volumes, reflecting the growing competitive advantage it was gaining through low nominal wage growth. (A ‘sustainable’ pattern would have domestic demand growing at the same rate as GDP, with a foreign contribution averaging zero.) So if we consider the period 2002 to 2004, for example, the recession was despite a positive contribution from trade, so trade can hardly have been a cause of it. The real reason for the depressed German economy was a decline in domestic demand, coming from both consumption and investment.

Whatever the reason for depressed domestic demand growth, it was not permanent, with healthy growth in 2006 and 2007. By that time, however, Germany had through low nominal wage growth gained a large competitive advantage compared to its Eurozone partners, which was the subject of my earlier post.

Germany’s undervalued real exchange rate - its competitive advantage compared to the rest of the Eurozone - cannot persist. It will be eroded by faster inflation in Germany relative to other Eurozone countries. The only question is whether this happens through a boom in Germany, or continued depression in the rest of the Eurozone. Yet failure to see the source of the problem as coming from Germany continues to mire the debate. There is endless discussion of the need for structural reform outside Germany that ‘must be part’ of any solution to the Eurozone’s current problem. Structural reform may or may not be desirable in many countries, and perhaps even Germany, but it has nothing to do with the need to raise the level of aggregate demand in the Eurozone as a whole. As far as competitiveness imbalances within the Eurozone are concerned, the problem is a result of a negative inflation shock in Germany. The natural place to look for a solution is not structural reform outside Germany, but a period of above target inflation within Germany, and it is in the interests of pretty well every Eurozone country other than Germany that this should happen.

A comment on Kocherlakota's suggestions for clarifying monetary policy objectives

In a recent speech (HT MT), Narayana Kocherlakota (who helps set US interest rates) makes two suggestions to clarify what US monetary policy is trying to do. The first I completely agree with. The Fed should make clear that the 2% inflation target is symmetrical. Inflation at 1% is just as much of a problem as inflation at 3%. We only need to look at the Eurozone to see the dangers of asymmetry (which in their case is explicit).

His second suggestion is that the Fed should articulate a “benchmark two-year time horizon for returning inflation to the 2 percent goal.” You can see why Kocherlakota is suggesting this change, particularly in the current context. A target which is only going to be achieved in the indefinite long term may cease to have value. However applying the two year benchmark to just the inflation target may create inappropriate pressures in different circumstances.

The UK’s Monetary Policy Committee operated until quite recently what appeared to be exactly this two year benchmark. As evidence for this, here is a chart of the Bank’s own forecast for inflation two years ahead. (The dates refer to when the forecast was made.) The inflation target was 2.5% until 2003, and 2% thereafter.

Until the Great Recession, the forecast was generally pretty close to the target. Since then, the dates on which inflation two years ahead was expected to be below target roughly correspond to dates on which the Quantitative Easing (QE) programme was expanded. (More details in this post.)

The problem with this strategy emerged in 2011. As a result of the delayed impact of the 2008 depreciation in Sterling, increases in sales taxes (VAT) and higher commodity prices, actual inflation briefly exceeded 5% in 2011. As a result, in 2011 the MPC came pretty close to following the Eurozone in increasing interest rates. (For a number of months, 3 MPC members voted to raise rates, and the remaining 6 voted for no change.) A major concern of those who voted for higher rates was that inflation would not fall back to 2% within 2 years, and that as a result the credibility of the inflation target would be damaged.

So the 2 year time horizon came close to having a very damaging impact in the UK. (Arguably it did cause some damage, because it inhibited additional QE.) Now it is of course true that the combination of cost-push shocks experienced by the UK during that period was unusual, but even if rules allow for opt-outs in exceptional circumstances, they can nevertheless exert inappropriate pressure in those circumstances. Arguably the 2013 paper issued by the UK Treasury on monetary policy was at heart a message to the Bank to no longer apply the two year ahead rule.

Luckily there is a simple way of avoiding this danger, by making a small addition to Kocherlakota's suggestion. This is to apply the two year time horizon to both the inflation target and the output gap. I can see no convincing argument why the two year horizon should not be applied to both elements of the dual mandate. The problem in the UK arose partly because the UK does not have a dual mandate. If it had had this dual mandate, and the two year horizon had applied to both elements of the mandate, then the pressure to raise interest rates in 2011 would have been much less. (Few expected the UK output gap to close by 2013, even without interest rate increases.)

There is a more general argument that is completely independent of what happened in the UK. Whatever the intention, if the two year horizon is applied to only one element of the dual mandate, there is a danger that it appears to give priority to that element over the other. So my own opinion, for what it is worth, is that Kocherlakota's suggestions are a good idea, as long as the two year time horizon benchmark is applied to both parts of the dual mandate.