Why below target inflation is a big problem

Much of the coverage of deflation seems to miss the key point. Deflation is a sign that resources are being wasted. The lower inflation is, other things being equal, the more resources are being wasted. Wasted resources are probably a bit economics speak. What it means is that society as a whole - you and I - are worse off for no reason. There are also good grounds for thinking the sums involved could be very large, dwarfing the numbers the media normally frets about. [1]

Once you look at it this way, lots of rather silly debates become clear. First and most obviously, there is nothing magic about the number zero. Other things being equal, zero inflation suggests more resources are being wasted than if inflation is 1%, but resources are still being wasted when inflation is 1% and the target is 2%.  

Economists have worried about some of the knock on effects that deflation might have. In particular, because deflation means that the real value of debts fixed in nominal terms is rising, that may induce debtors to cut back spending, with no matching increase in spending by creditors. This will make the waste of resources worse. However this effect is not a non-linear one that kicks in when inflation is zero. If this effect is important, debtors will still be more inhibited by their debt if inflation is 1% compared to 2%. And, of course, even if this effect is unimportant resources are still being wasted if inflation is below target.

This is also why looking at some measure of core inflation is important. If below target inflation is just due to lower oil prices, say, which in turn are just lower because of increased supply, say, [2] then this is no reason to think resources are being wasted. Just as inflation targeting central banks should largely see through any inflation caused by higher oil prices, they should also do the opposite. However in the UK, US and Eurozone core inflation is significantly below target, suggesting resources are being wasted everywhere.

The really interesting thing about the current situation is that in all three places nominal wages seem to be going nowhere fast. This could be partly because plenty of domestic spare capacity exists, but partly also because workers are aware of the potential employers have to use overseas labour as an alternative. In either case, the really good news that this implies is that we can allow the economy to grow at an above average rate for some time. (It also suggests that current fiscal projections may be too pessimistic.)

This is only good news if we take the opportunity it presents. We should use the monetary and fiscal tools we have at our disposal (and invent some new ones if need be) to do so. There is no magic to raising demand - we have various tried and tested means of doing so. The basic barrier to raising demand has been and always will be inflation, so when that barrier is nowhere in sight (in fact appears to be moving further away) it is a criminal waste not to expand demand.

But what of those who advocate caution. We should raise interest rates now, so as to avoid rapid increases later? I am sure some people who argue this way are genuine, but just wrong because they have not realised the implications of the position we are now in, and in particular the balance of risks involved. But I cannot also help noticing that some on the right have been arguing for higher interest rates for some time, and refuse to admit they were wrong. They are confirming Kalecki’s idea that although what he called full employment was good for society, it may not be good for some particular parts of society. Those pursuing this line should not be dismissed: they should be laughed into obscurity.   

[1] This would be clearer if all central banks had a dual mandate.

[2] Which in the current situation is probably not true, so this is just to make the point.

Let us hope for a Syriza victory

If you think this sentiment is dangerous, because you have read that if this left wing party formed a government after the forthcoming Greek elections the Eurozone would be plunged into crisis, I suspect you should reconsider where you get your information from.[1] Here is why.

Syriza wants to reduce the burden of Greek government debt by various means, which would clearly benefit Greece and mean losses for its creditors. Its bargaining position is strong because the government is running a primary surplus. This means that if all debt was written off and the Greek government was unable to borrowing anything more, it would be immediately better off because taxes exceed government spending. In contrast the creditors’ position in such a situation is normally very weak, which is why some kind of deal is usually done to reduce the debt burden. Creditors take a hit, but not as bad a hit as they would if all debt was written off.

It might appear as if the creditors have an extra card in this particular case - they can throw Greece out of the Eurozone. Be absolutely clear, that is a threat being made by the creditors. Greece under Syriza has no intention of leaving the Euro, even if they defaulted on all their debt, so they would have to be forced out. I have never seen it set out clearly how the rest of the Eurozone would force Greece to leave without compromising the independence of the ECB, but let’s assume that they have the power to do so. Would the Eurozone ever carry out this threat?

Expelling Greece from the Eurozone because they wanted to renegotiate their debts would be an incredibly stupid thing to do. For a start, the creditors would lose everything, because obviously Greece would go for complete default in those circumstances. In addition, individuals and markets would immediately worry that the same fate might befall other periphery countries. (The story that Dani Rodrik tells is all too plausible.) What would be the gain?

The standard answer is that by exercising this threat you prevent other periphery countries trying to follow Greece’s example. Moral hazard - the sins that have been committed in your name! In reality the interest rate on part of Greek debt has already been reduced in earlier negotiations (see also Andrew Watt here). There is nothing compelling the core countries to treat each periphery country equally - as Ireland has found out to its cost. Peter Spiegel puts it clearly in the FT:

“How radical is Mr Tsipras’ idea of a Paris Club-style debt restructuring? So radical that, according to three officials involved in the discussions, eurozone officials actively considered such a plan in late 2012. The French-led initiative would have led to Greece’s debt obligations being cut in tranches — much the same way bailout aid is granted — after meeting a series of economic reform commitments.”

So even if some in Germany were stupid and cruel enough to suggest throwing Greece out, it seems inconceivable that the rest of the Eurozone (or the IMF) would allow it. In reality reducing the debt burden in Greece (and probably elsewhere [2]) would do the Eurozone a lot of collective good. Greece would be able to relax the crippling austerity that has had disastrous economic and social consequences. The core countries and the IMF could at least partially undo the mistakes they made from 2010 to 2012 in first delaying default, and then failing to impose a complete default, mistakes IMF staff [4] at least now recognise. German taxpayers might be encouraged to understand that the problem since 2010 has not been Greek intransigence but the actions of their own governments in trying to protect their own banks and in dispensing unrealistic degrees of austerity. Philippe Legrain argues the case in detail here. As Thomas Piketty succinctly puts it, Syriza “want to build a democratic Europe, which is what we all need”.  

Following a post like this I invariably get comments that tell me about all the terrible things that still go on in Greece. I want to make two final points here. First, if things have not changed following years of acute austerity in Greece, might this mean that we need something else besides more acute austerity? Might it mean we need a move away from the traditional governing elites? [3] Second, a widely recognised measure of fiscal stance is the underlying (cyclically corrected) primary balance (the deficit less debt interest). Here is the OECD’s latest estimate for 2014. Do not complain that Greece is backsliding on austerity! And before you tell me that the law must be followed, read a post I am proud I wrote.

Underlying government primary balances 2014, OECD estimates

[1] The preliminary decision of the ECJ today might have been much more dangerous. For an excellent discussion prior to the judgement see Ashoka Mody.

[2] Barry Eichengreen and Ugo Panizza doubt whether the primary surpluses that some countries would need to run without more debt relief are politically feasible. I’m a little more optimistic, but that is different from saying that some debt renegotiation would not be beneficial in the longer term.

[3] There would be the added bonus of seeing a well known economic blogger become a politician!

[4] My initial version just said IMF, but as Peter Doyle reminds me, this staff critique was not endorsed by IMF management. 

Why did Osborne not try to protect the recovery in 2010?

I see that George Osborne is giving the RES lecture this year. This post might be useful background, just in case what he says goes beyond simplistic electioneering of the '0.5% inflation is welcome news' kind. 

In an earlier post I outlined how a credible austerity plan could have been enacted in such a way as to protect the recovery. This is not what I would have done. We needed fiscal stimulus not austerity in 2010, and the threat from the financial markets was non-existent. However some have difficulty accepting this last point, so what I tried to show in that post was that a worry about the financial markets did not excuse the coalition’s actions.

In particular I noted that public investment could have stayed high, but instead was immediately cut back, even though there was no necessity to do so because it was not part of the coalition’s primary fiscal mandate. According to the OBR net public investment was 3.3% of GDP in 2009, but only 1.9% by 2011. A total multiplier of 1.5 for public investment is quite plausible, so that alone could account for around 3% less GDP. Good projects, like flood defences or school renovation, that were ready to go were instead cut back

Was this just a random (but very costly) mistake, or was there some logic behind it? Osborne has repeatedly talked about monetary activism. In September 2009 he said:

“Monetary activism to keep interest rates low and stimulate the economy. Fiscal responsibility to restore confidence and rebuild our battered public finances.”

It is of course true that this assignment does indeed reflect the academic consensus, as long as interest rates are not at or close to the Zero Lower Bound (ZLB). At the ZLB you have Quantitative Easing (QE), but QE is just not reliable in its impact on demand, so it does not make the ZLB problem go away.  

Osborne or his advisors knew this. UK interest rates hit their ZLB in March 2009. Here is a key excerpt from Osborne’s 2009 RSA speech, made shortly afterwards:

“[New Keynesian] Models of this kind underpin our whole macroeconomic policy framework – in particular the idea that by using monetary policy to manage demand and control inflation you can keep unemployment low and stable. And they underpinned the argument David Cameron and I advanced last autumn – that monetary policy should bear the strain of stimulating demand….”

Now if it is true that New Keynesian models underpinned their macroeconomic framework, they should have also known that the Zero Lower Bound (ZLB) problem is a big deal in those models. Furthermore in basic New Keynesian models QE does nothing. In these models there are ways of mitigating the ZLB problem, but they involve departures from the inflation target, and Osborne has never shown any interest in doing that.

In his Mais lecture of February 2010 he acknowledges the arguments of those that said fiscal consolidation should wait until the recovery was assured. Here is a key passage:

“To be fair, a more sophisticated version of the argument for delay also takes into account the complex interaction between fiscal policy and monetary conditions. It says that at the moment, and for as long as policy and market interest rates remain low, fiscal tightening should be as gradual as possible because there is little scope for more accommodating monetary conditions to accompany it, either through lower market interest rates or through the reaction function of the Bank of England. And only as and when monetary conditions begin to tighten can the pace of fiscal consolidation be accelerated.

But even this, more nuanced, version of the case for delay is too complacent. For it brings me to the second consideration: the realities of financial markets.”

So there is no attempt to dispute the validity of the ZLB problem. No attempt to argue that with QE the ZLB problem was not real. Instead the argument is that there is a still greater danger, which is that the markets might suddenly lose confidence in UK government debt.  

This suggests to me that Osborne, and the coalition more generally, never really believed in the position that QE alone could deal with the ZLB problem. Taking that position would rationalise what they did – in particular cutting public investment was fine in macro terms because the hit to GDP would be compensated for by more QE. However if that was the case, you might have expected to see that position explicitly stated, and as far as I am aware it has not been.

Instead I think we are being too sophisticated in trying to find a macroeconomic rationale for coalition actions. For what it is worth, I think policy was based on two political, not economic, imperatives. The first was to reduce the size of the state, and the deficit was always a pretext for that. Here he was just copying his US cousins. As a result public investment as well as consumption had to be cut even though this was not part of his main fiscal rule. Second, austerity could not be back loaded, even though that would have made macroeconomic sense, because that would mean doing unpopular things just before an election. As a result public investment had to be cut quickly rather than kept high to protect the recovery.

Under this interpretation, Osborne did what he did for essentially political or ideological motives, and just ignored the risk of potential costs that then came to pass. This is not to suggest that he intended to waste almost £100 billion, but just that he did not give sufficient regard to that possibility. As he lost every adult and child in this country something in the order of £1500 each, he deserves full censure. He certainly does not deserve a reputation for economic competence, unless you are mediamacro and equate competence with deficit cutting. 

What does not seem plausible is that his actions were designed to prevent the financial markets believing the UK would default. If you are still not convinced of this, consider one final, almost bizarre, piece of evidence. He plans if re-elected to pursue almost the same policy again (austerity in the early years of the government) while UK interest rates are at (or at best close to) the ZLB, and when there is not even the hint of any funding crisis for UK government debt. Here is Tony Yates on the folly of this strategy.

Thus those who suggest that the coalition had to undertake 2010 austerity to appease the markets are thrice wrong. First, the UK was never going to default and the markets knew it. Second, if that had been Osborne’s concern he could have designed a much more recovery friendly plan. Third, it now seems clear that he never undertook 2010 austerity for that reason. In the UK, as elsewhere, fiscal austerity justified by an imperative need to reduce the deficit was and remains a massive confidence trick.    

  

On the monetary offset argument

A number of us are highly critical of moving to austerity so early in the recovery from the Great Recession. Market Monetarists (MM) argue that this criticism is unfounded, because monetary policy can offset the impact of austerity on demand. Not when interest rates are at the Zero Lower Bound (ZLB), the critics of austerity respond. The ZLB is not a problem, MM reply.

I want to make a couple of observations. First, MM often imagine that they invented this offset argument. However it forms a key part of the austerity critics’ original objection. If the impact of fiscal consolidation on output is always the same, then the reasons for postponing deficit reduction until the recession is over become significantly weaker. [1] The whole point is to postpone deficit reduction until when the ZLB constraint no longer bites. At that point, monetary policy can offset the demand impact of fiscal consolidation, whereas at the ZLB it cannot (according to the austerity critics). Monetary offset is built into the austerity critics’ main case.

Second, if you are a fiscal policy maker, and you want to take the MM argument seriously, you have to believe two things. First, that monetary policy is capable of offsetting the impact of austerity as much now as later. Second, that this is actually what monetary policy makers will do. If you believe the first, but are not sure about the second, then fiscal consolidation now is a mistake. Sure, you can blame monetary policy makers for not offsetting when they could, but if you knew this might happen then you hold some responsibility.

This second point exposes how weak the MM argument is at the ZLB. They have to argue not only that unconventional monetary policy could offset fiscal contraction at the ZLB, but also that it will. We see immediately that the issue of NGDP targeting is beside the point. Central banks at the moment are inflation targeting, and are likely to continue to do so, so enacting fiscal contraction in the hope that they might change is highly irresponsible.

So the MM argument that the ZLB does not matter has to rely on Quantitative Easing (QE). But here there is a basic problem that MM has never to my knowledge answered. Just how much QE do you do to offset any fiscal contraction? We have no real idea, because we have so little experience. Lags between policy actions and reactions are such that we cannot just say whatever it takes, because we might have lost a lot of output (or created a lot of inflation) before policy makers get it right. In reality, policy makers are likely to be cautious, so almost certainly they will not offset enough, even presuming that QE is capable of offsetting completely. So once again, being realistic about what we know and what monetary policy makers will do, fiscal contraction at the ZLB is irresponsible. (I have talked about this in more detail before.)

These are abstract arguments, but they can be applied to two real examples. First the Eurozone. Here we currently have no QE. We should have QE - indeed I have argued we should think about having helicopter money, but to presume that these things would happen just when they are required would be highly unrealistic. It would also be silly to assume that the ZLB was never going to bite when the new fiscal regime was put together following the crisis. So fiscal contraction in the Eurozone is a major problem and highly irresponsible whichever way you look at it. 

In the UK it is often argued that 2010 austerity was not a problem, because given the rapid inflation that happened in 2011, if austerity had not happened, the MPC would have raised interest rates. However that is an argument made with hindsight [2]. It has no bearing on whether austerity was a good policy choice when it was enacted in 2010. In 2010 inflation was not expected to rise to 5%, so the coalition had no reason to believe that the ZLB constraint would cease to bite in 2011 (assuming that it did). Instead to justify 2010 austerity we have to assume that, if the 2010 forecast proved over optimistic (which it did), QE would have been applied to the required degree to get the economy back on track. Given the uncertainties noted above, that would have been a foolish assumption to make. So 2010 austerity was a costly policy choice which reflects badly on those who made it.

So to conclude, the monetary policy offset argument is not a problem for critics of austerity at the ZLB but a key part of their argument. To believe that monetary offset will continue to apply to the same extent at the ZLB, you have to make quite unrealistic assumptions about what policy makers are capable of doing with Quantitative Easing, and also about what they will actually do.

[1] Convexity of the social welfare function would still be an argument to wait until the recession was over, although to set against that is the point that if the long run desired position involves some level of debt, the longer you leave deficit correction the more adjustment you have to make. This post discusses an IMF exercise which plays around with such things, but ignores the key ZLB argument.

[2] Even with hindsight I would argue it has little purchase, as the period during which 3 members of the MPC voted for higher rates lasted only 4 months in 2011. There is also an issue about whether the inflation caused by the VAT increase was really seen through by policy makers.     

Faith based macroeconomics

When you just know something is true, like fiscal policy never matters much and NGDP targeting would have avoided the Great Recession, everything becomes about proclaiming your faith in the most effective way possible. It becomes a debating contest. The best example I know of someone like this is Scott Sumner. Here is what he had to say about something I wrote recently.

“Simon Wren-Lewis also gets the GDP growth data wrong, in a way that makes austerity look worse. He claims that RGDP growth was 2.3% in 2012 and 2.2% in 2013 (the year of austerity in the US.) But that’s annual y-o-y data, and since the austerity began on January 1st 2013, you need Q4 over Q4 data. In fact, RGDP growth in 2012, Q4 over Q4, was only 1.67%, whereas growth in the austerity year of 2013 nearly doubled to 3.13%.”

The italics are mine. When you read that someone got the data wrong, or that they claim the data is whatever, you expect to find that they made an excel error, or used old data. But Sumner is not using ‘wrong’ and ‘claim’ in their ordinary sense. He is in debating mode. What he means is that by choosing to use the (correct) annual data, I’m (accidentally, deliberately?) hiding something important. He then quotes two figures that supposedly prove his case. No analysis, no graphs – it’s a debate.

Well here is a graph of US real government consumption expenditure and gross investment, taken from FRED.

According to Sumner “austerity began on January 1st 2013”. Now look at the graph.

It gets worse. Tyler Cowan quotes from Scott’s post with approval, I guess because the guy shares the faith.

Now do you really want to follow those whose macroeconomics is so faith based that they do not even need to check the numbers? Do you want to follow someone who says (earlier in the post) “it would be useful to do a more systematic study of fiscal austerity”. What about the many studies that have already been done (e.g. here, here or here). Do they not count because they generally find that fiscal policy can matter a lot, and so fail to accord with the faith? Do you want your macroeconomics derived from faith or from careful academic analysis?  

Heterodox laziness (or worse)

Tony Yates has recently been battling with some members and supporters of the heterodox economics community, and is clearly very annoyed by their portrayal of mainstream macro. Now Tony is a fully paid up member of microfounded mainstream macro, while I tend to be more critical of this orthodoxy (although I still work within it, and argue that it is a progressive research programme). So you might expect me to be less annoyed by heterodox attacks on the mainstream. Not so!

Here is an example of what gets me really cross. I would not normally post about a comment to my blog, but this was anonymous, and it is also not atypical. It said, following my criticism of the recent article by Jeffrey Sachs:

“Unfortunately, this is what happens when you contaminate the GT [General Theory] with inter-temporal economics.”

and

“Sachs is very much the quintessential Great Moderation New Keynesian.”

The implication is that modern intertemporal New Keynesian theory is somehow behind the view that austerity will not harm a recovery.

This is absolute and dangerous nonsense. Having spent the last decade or two looking at fiscal policy in intertemporal New Keynesian models, I know that exactly the opposite is true. In these models temporary decreases in government spending have significant negative effects on output for given real interest rates. At the Zero Lower Bound (ZLB) the effects are greater still. I have written chapter and verse on this, and will not repeat any of that here. (For those who are curious, here is a relatively non-technical discussion and here is something more technical.) I was very critical when certain eminent economists associated with the right made the mistake of suggesting otherwise. Judging by the recent exchange, Paul Krugman is much more the “quintessential Great Moderation New Keynesian” than Jeffrey Sachs. Perhaps the problem with Jeffrey Sachs is that he just does not realise what a big difference the ZLB makes (although Paul Krugman has made this point so many times). Anyhow anyone who says that mainstream New Keynesian theory supports austerity does not know what they are talking about.

I get plenty of comments on my posts which display lack of knowledge of key macro models and ideas, and if I have time I like to think that I respond to these in a helpful and positive manner. However this comment (and others like it) makes me cross for the following simple reason. Many economists and non-economists of the right try and portray mainstream economics as naturally supportive of their political programme. Right wing think tanks name themselves after one of the pioneers of economics. It is normally nonsense: mainstream economics is all about market failure, diminishing marginal utility favours redistribution etc. Of course there are counter examples (Pareto optimality), so it would be wrong to say that economics leans to the left as well.

However when some of those on the left say yes, mainstream economics is all the things that those on the right say it is, they share a mutual conspiracy to distort the truth. When you are trying hard to convince policy makers and journalists that what those on the right are arguing for is not implied by mainstream thought, people from the left pop up to undermine what you say.

That last sentence probably exaggerates the importance of heterodox economics. In my view heterodox economics is far more dangerous in giving young students that lean to the left a distorted view of the mainstream which can have lasting damage. Been there, done that (briefly). I actually think that heterodox economists have some important criticisms to make, and I also think that mainstream macro orthodoxy can often discourage such fundamental criticism. However pretending mainstream economics is something that it is not just devalues these criticisms. 

Sachs and the age of diminished expectations

I do not normally talk much about the US economy, because there are so many others writing articles and posts that can do so with more authority. But I am getting increasingly fed up with people telling me that US growth disproves the idea that austerity is bad for you at the Zero Lower Bound (ZLB). Jeffrey Sachs just joins a long list.

Of course the proper way to tackle this is as Paul Krugman does. As he says other stuff happens (like a large fall in the US savings ratio in 2013), so you need to go beyond a single country and look at lots of data. However this might leave the impression that somehow the US case is unusual and does not fit a Keynesian story. In this respect I did a simple exercise, the results of which are shown in the chart. It shows actual US GDP, and a hypothetical path based on 2% real growth in government consumption and investment from 2009. So instead of austerity, we maintained government spending at the elevated levels seen at the bottom of the recession. In addition I’ve assumed quite a large (and instantaneous) multiplier of two on that extra government spending.

US GDP, billions of chained 2009 US dollars.

Now if the US recovery proved that Keynesian analysis was wrong, we should get nonsense out of an exercise of this kind. If the recovery was just fine with austerity then replacing it with something like fiscal stimulus and assuming a large multiplier should give us ridiculous rates of growth. Yet as you can see, the no-austerity GDP path looks perfectly plausible. What we get is 3.4% growth in 2010 (compared to an actual of 2.5%), followed by three years of 3.7% growth (compared to 1.6%, 2.3% and 2.2%). In other words we get a reasonably rapid recovery from a deep recession. Obviously there are more sophisticated ways of doing this kind of counterfactual, but maybe something very simple can make the point. With recent US experience, there is no case against Keynesian analysis to answer. 

This suggests to me two things. First, lots of people are desperate to show that critics of austerity at the ZLB are wrong, and are prepared to make nonsense arguments to that end. This may be particularly true if you very publicly proclaimed the need for austerity in 2010 (note the co-author: HT John McHale). Second, it is a sad day when anyone thinks that 2.3% growth is “brisk” when we are recovering from a deep recession and interest rates have remained at the ZLB. It is so very dangerous when these diminished expectations become internalised by the elite.