Austerity: Nick Rowe's not so silly question

Nick Rowe has a silly question for those who oppose austerity. Actually he really means it is a question involving silly numbers: would you still advocate fiscal stimulus in a liquidity trap (with interest rates stuck at some lower bound - the ZLB) if government debt was ten times annual GDP?

It is not a silly question for two reasons. First, thinking of this kind of unimaginable extreme is often a useful way of clarifying ideas, which is what Nick is trying to do. Second, this is a variant of question I was actually asked in No.10 Downing Street half a dozen years ago. What follows is a better version of the answer I gave on that occasion. To make things easier, let’s assume GDP is 100, so government debt is 1000, but the negative output gap is near 10%, so GDP could be 110. Let’s also assume that the government does not want to default, and that it is willing and able to service or even reduce that huge debt once the output gap is closed. Finally, and this is critical for the answer I give, assume government debt is in the currency that is issued by the country’s own central bank.

One way I like to frame this issue is to think about different time frames. A large output gap is an immediate problem which can be dealt with quickly using fiscal stimulus if interest rates are at the ZLB. A high level of government debt is a medium to long term problem, which is much less costly to solve when interest rates are not at the ZLB. [2] So it is not a matter of trading off two conflicting objectives (see this recent post for example). You can satisfy both objectives by doing stimulus now and austerity later.

Does debt being ten times GDP change this logic? There are four main potential costs associated with high government debt. The first is that, by generating high real interest rates, it crowds out private capital. However at the ZLB long term real interest rates are likely to be low, not high. Second, paying the interest on that debt requires higher distortionary taxes. (In macro terms it is the distortion that matters here - if the debt is owned domestically the money is just being circulated.) However if there is an output gap the possibility that people are not supplying labour because income taxes are too high is not a current problem either.

A third issue with debt is the ‘burden on future generations’. How real that is or not, dealing with excessive debt is going to screw the current generation (who have to suffer the higher taxes or lower spending to get debt down), so asking them to also suffer continuing unemployment is hardly fair.

The final problem is that the markets might suddenly take fright that the tax burden implied by the debt is too large in political terms, and as a result the government may default. So the funding that enables the government to roll over the 1000 in debt might dry up. Now imagine two scenarios. In the first, the government eliminates the 10% output gap by means of a fiscal stimulus worth 10% of GDP, say. That increases the debt from 1000 to 1010, but GDP rises to 110, so the debt to GDP ratio falls from 10 to 9.2. In the second, there is no stimulus but austerity instead, involving a budget surplus of 10% of GDP. So debt falls from 1000 to 990. Even if we make the outlandish assumption that austerity on this scale does no further damage to GDP, which stays at 100, the debt to GDP ratio falls to 9.9. Which scenario is going to worry the markets more?

Suppose, despite this, the funding does dry up. You have your own independent central bank, so you print the money to cover the stimulus and any debt rollover required. That might require a lot of money creation - perhaps as much as central banks have actually undertaken as a result of Quantitative Easing (QE)! Just as with QE, the world does not fall in. Will that not lead to massive inflation? No, for exactly the same reason QE does not. The moment the output gap has been eliminated, and interest rates are off the ZLB, you can start the austerity programme that begins to roll back money creation. That stops the output gap becoming positive and therefore stops inflation. [1] People sometimes throw in an exchange rate crisis at this point, but as Paul Krugman has repeatedly pointed out, this does not change the basic logic.

So I think the answer to Nick’s question is not the answer he thinks. The logic is that every time and whatever the numbers you first eliminate the output gap and get off the ZLB. Only when that is done do you start taking action to reduce deficits.

[1] Various contributors to this blog tell me this is the key contribution of MMT. The fact that I do not describe it as such is simply because I also think this is what mainstream macro implies.

[2] As I like to point out to market monetarists, what they call monetary offset has always been central to the anti-austerity argument.

A campaign based on ignorance

If facts had anything to do with it, the economy should be the Conservatives’ weak point in the forthcoming UK election. Since 2010 we have seen the weakest recovery in at least the last 200 years. The government’s actions are partly responsible for that, and the only debate is how much. Real wages have been falling steadily, and only a fall in global oil prices might be finally bringing that to an end. Living standards have taken a big hit. Yet I keep reading how the economy is the Conservatives' strong card. How can this be?

What mediamacro generally fall back on are the polls, and it is true that people still believe the Conservatives are more likely to raise their living standards than Labour, even though they understand that they have become worse off over the last five years. There is no factual basis for the view that the Conservatives are better at managing the economy, and plenty to suggest the opposite. However this belief is not too hard to explain. The Labour government ended with the Great Recession which in turn produced a huge increase in the government’s budget deficit. With the help of mediamacro, that has become ‘a mess’ that Labour are responsible for and which the Conservatives have had to clean up.

The beauty of this story is that it pins the blame for the weak recovery on the previous government, in a way that every individual can understand. Spend too much, and you will have a hard time paying back the debt. Those that read stuff about economics vaguely remember Gordon Brown taking small liberties with his fiscal rules, and that half truth is enough to create a myth of past profligacy.

These myths and misunderstandings are easily dispelled with a few facts. The two charts at the end of this post can do most of the work. So it is an inevitable part of the Conservatives’ campaign to ensure that facts are kept out of it as much as possible. Sound bites are great. Endless discussion of so called ‘gaffes’ - perfect. Anything to keep the electorate away from useful information.

Ruling out a leadership debate with Miliband is part of this pattern. As Peter Oborne has observed, Miliband’s record as an opposition leader has included some impressive accomplishments. But his opinion poll ratings are low, because most people just see unglamorous pictures of him and note that he does not have that Blair appeal. That could be changed if they saw him in a one on one debate with Cameron, so there was never any chance that the Conservatives would let this happen. The debates last time had huge audiences, so no one can dispute that democracy has been dealt a huge blow as a result of what the FT rightly calls Cameron’s cowardice.

Some people say I go on about the media too much, but in an election like this you can see how critical a role they will play. If they see their job as getting as much information as possible to the electorate, the Conservatives will be in big trouble. If instead they go with stories based on fake indignation over who said what when (like weaponising the NHS) the Conservatives will be safe. If they do nothing but give politicians sound bites that is also fine for the Conservatives. As Janan Ganesh – always a useful barometer of the government's thinking - observed, the Conservatives can bore their way to victory.

Cameron’s refusal to debate one on one with Miliband is a key test for the media. Will they ‘play safe’ and let one side's spin doctors dictate what people are allowed to see? That is what Cameron is counting on. Or will they decide that it is their duty to allow the British people to see some sort of intensive debate involving their potential future Prime Minister, and that the ruling party is not able to decide how much democracy people are allowed?

Deflation, inflation, oil prices and asymmetries

When both headline and core inflation rose above target after the financial crisis, helped by rising oil prices, the Fed and Bank of England kept their nerve and did not raise interest rates. They saw through what was a temporary episode. The ECB’s judgement was not as good. Even in the UK it was close, with three out of nine MPC members voting for a rate increase for a few months. But it was the outcome that mattered - excess inflation was ignored because it was temporary. To what extent is what we are seeing right now just the mirror image of this period?

In terms of where inflation is and the monetary policy response, the situation today does indeed look like a mirror image. Headline inflation is or is about to be negative, and core inflation has fallen below target. As Tim Duy points out for the US, core inflation seems to be heading lower rather than returning to target. However I think that is where the symmetry ends. While the dangers of letting inflation rise above target because of temporary shocks are small, the dangers in the opposite direction are more serious. 

One of the arguments used by the inflation hawks when oil prices were high is that even if the impact of higher oil prices on inflation was itself temporary, there was a danger that inflation expectations would increase, and the central bank would lose its anti-inflation credibility. My response at the time was three-fold: first, the private sector can see the reason that rates are not being raised (the continuing recession), so credibility should not be in danger; second, the best indication that the expectations that matter have shifted is when nominal wage inflation starts to pick up (which it did not), and third when that happens it will be easy to restore credibility and reduce expectations by raising rates. [1]

None of these arguments apply with deflation today. Then unemployment was clearly too high. Today unemployment is not clearly too low. How far we are from the natural rate is unclear, but no one would argue that we are in a boom that is the mirror image of the recession a few years ago. The second argument is that we could use changes in nominal wages as a clear indicator that the inflation expectations that mattered had shifted. That argument is not symmetrical because of the well known resistance to nominal wage cuts. Finally if credibility does seem about to be lost, the central bank will find it very difficult to take action to restore it because of the Zero Lower Bound (ZLB).

Please allow me to get technical for just one paragraph, which can be safely skipped. As has often been pointed out, the ZLB means that there are two steady states in the economy associated with a given real interest rate: the ‘intended’ equilibrium with target inflation, and the ‘ZLB equilibrium’ when inflation is negative. I recently discussed a paper that treated agents views about which equilibrium was appropriate as a ‘belief’ and that perhaps the liquidity trap could be a manifestation that agents believed we were heading for the ZLB steady state. The controversial aspect of this analysis is the suggestion that this belief could be shifted by the monetary authorities raising rates. I find that very unconvincing, but it would be a mistake to dismiss the exercise completely on that account. In that post I did suggest an alternative rationalisation for why we might be heading for the ZLB equilibrium: agents no longer believed that the monetary authority had the means to stop it happening.

This last asymmetry is the one that troubles me the most, and why I am not as relaxed as monetary policy makers appear to be about deflation. There are three interpretations of this relaxed attitude to negative headline inflation. The first is the one I suspect monetary policy makers actually hold, which is that the beneficial impact of lower prices on demand will with a year or so push inflation back to target, so there is no reason for concern. [2] I think the probability is that they are correct, but good policy does not just think about the most likely outcome, but should also be robust to risks, particularly risks with large consequences.

The second interpretation that the private sector could give for the relaxed attitude by central banks in the US and UK is that deviations above and below 2% are not treated symmetrically. In theory this should be more of a concern in the US than the UK, because in the UK asymmetry is against the central bank’s mandate. However I’m not sure the private sector thinks that is as important as MPC members do. There is one obvious additional asymmetry between now and a few years ago: many of those calling for higher rates back then are still pushing for higher rates today.

The third interpretation about why central banks are doing nothing is there is nothing they can do. Quantitative Easing seems to have come to a permanent halt either because it has stopped having a useful effect, or because policy makers fear it is having undesirable consequences. Under this interpretation the inflation target loses credibility not because the private sector no longer believes policy makers’ stated objectives, but because they no longer believe they have the means to achieve them. 

This possibility is the one that should really be worrying central banks right now. It is a scenario that is quite consistent with what is currently happening, and it puts at risk central bank credibility in a most fundamental way. Quite simply, central bank credibility is destroyed because people believe they have lost the ability (rather than the will) to do their job, and there is very little central banks can do to get it back because of the ZLB. This is what should be giving central banks nightmares. Strangely, however, they seem to be sleeping just fine.

[1] A footnote for macroeconomists: this is why I have never been convinced by Cochrane’s worries about using the inflation target as a transversality condition.

[2] Resistance to nominal wage cuts may also dampen any the deflationary path, giving time for these positive effects to come through. However resistance to nominal wage cuts does not mean the ZLB equilibrium will never occur – in the paper I discuss in this post, it is the reason why that equilibrium is associated with high unemployment.

  

Fiscal policy, correlations and causation

I have a sense that Paul Krugman wrote this post out of exasperation with those who cherry pick data to draw incorrect conclusions about the importance of fiscal policy. I know the feeling. Here is my version of what Paul did, using OECD data. We take growth in government consumption (G) [x axis] and GDP [y axis] for a whole bunch of countries for each year from 2010 to 2013, and plot the two variables against each other.

Paul’s point in that post was not that this positive correlation proves fiscal policy matters, but that there is a lot of variation, and so it will always be possible to find a case where G fell and GDP rose, or vice versa, but the general pattern is that the two variables are positively correlated.

I think that is as far as this should go. As Paul also said, you can quite legitimately argue that the relationship is not causal. Here is a very good argument about why it will not be. Imagine an ideal world where growth was always steady, and everything generally went according to plan, but some countries grew faster than others. If every country planned to keep the ratio of G to GDP constant, in the fast growing countries you would be likely to see high growth in both GDP and G, while in the others you would expect slower growth in both variables. What you would observe is lots of points close to a 45 degree line. This would tell you nothing about how a shock to G would influence Y. If you tried to read the 45 degree line as telling you about a G multiplier you would get implausibly large numbers.

This is not an academic point. Look at the three points involving 8% or more growth. They are for Estonia and Turkey. Growth in G in those cases happened to be quite low but positive, but no one would seriously suggest that this meant there was a huge multiplier in those countries. But these observations drag any trend line to be closer to 45 degree line. Indeed any trend line fitted to this data would come close to having that slope.

The other extreme numbers on the negative side are mainly Greece. Now there this reverse causation argument is less convincing: we know that negative growth in Greece did not cause the Greeks to reduce government spending. However the correlation there can still not be taken as causal because of another elementary econometric problem: omitted variables. Austerity did not just involve cuts in government consumption, but many other fiscal variables that will also have had a large impact on GDP.

All this is of course why people do proper econometrics on this question. Unfortunately the fact that there has been so much econometric work looking at multipliers itself creates a similar problem. Because difficulties involving omitted variables, simultaneity and other issues are difficult to solve, and because of different data sets, not all econometric work is going to come up with identical answers, and it will be possible to cherry pick among those as well.

One way of dealing with this problem is for new studies to start by replicated their predecessors where they can, as Jordà and Taylor do for example. (This is part of what David Hendry calls encompassing.) An alternative is to look at meta studies, like this recent example from Sebastian Gechert. To quote from his abstract: “We find that public spending multipliers are close to one and about 0.3 to 0.4 units larger than tax and transfer multipliers. Public investment multipliers are found to be even larger than those of spending in general by approximately 0.5 units.” Fortunately that is consistent with what theory might suggest. A subsequent meta analysis by Gechert and Rannenberg shows that multipliers are "systematically higher if the economy suffers a downturn", a result which is also key in Jordà and Taylor.   

Despite the number of econometric studies already done, I'm sure there is plenty still to do. Sharp disagreements still exist that remain unresolved, although I suspect a lot will be sorted out when the monetary regime in place is adequately controlled for. Of course we have very few recent observations of the ‘Zero Lower Bound/QE’ regime. Leaving QE to one side, what basic New Keynesian models tell us is that multipliers observed under fixed exchange rates probably act as a lower bound for ZLB multipliers, which is why what has happened in the Eurozone periphery is of some relevance to the UK, US, Japan and Eurozone as a whole. We already know enough from both theory and evidence elsewhere to suggest that at the ZLB multipliers could be large, but just how large remains unclear. However I doubt our knowledge will be improved by drawing more scatter plots. 

Eurozone fiscal policy - still not getting it

The impact of fiscal austerity on the Eurozone as a whole has been immense. In my recent Vox piece, I did a back of the envelope calculation which said that GDP in 2013 might be around 4% lower as a result of cuts in government consumption and investment alone. This seemed to accord with some model based exercises of the impact of austerity as a whole, but others gave larger numbers.

We now have another estimate, which can be thought of as a rather more thorough attempt to do what I did in the Vox article. This paper by Sebastian Gechert, Andrew Hughes Hallett and Ansgar Rannenberg uses multipliers and applies them to the fiscal changes that have occurred in the Eurozone from 2011. Apart from the later start date, the first difference compared to my back of the envelope calculation is that they include all fiscal changes, and not just government consumption and investment. As a large part of the fiscal consolidation in the Eurozone has involved reducing fiscal transfers, this is important.

The second, and more interesting, difference is that rather than pluck a multiplier out of the air, as I did, they use a meta analysis of other studies. I have previously mentioned this meta analysis by Gechert: this paper is based on a follow up by Gechert and Rannenberg. [Correction from original post.] The studies on which these meta analyses are based are not ideal from my personal point of view (more on this later), but what this second paper shows is that fiscal multipliers are larger in depressed economies. Applying these ‘meta multipliers’ to the Eurozone fiscal consolidation implies that GDP was 7.7% lower by 2013 as a result. These numbers are more in the ballpark of the Rannenberg et al paper that I have discussed before.

All these estimates point to huge losses, which monetary policy has neither been willing or able to counteract. Yet the speed at which those in charge of the Eurozone begin to realise the mistake that they have made is painfully slow. Take this recent Vox piece by Marco Buti and Nicolas Carnot. Thankfully they ignore all the Eurozone’s tortuous and sometimes contradictory rules, and just look at two numbers: a measure of ‘economic conditions’ (like the output gap), and a measure of the fiscal gap, which is the difference between the actual primary balance and what it needs to be to get debt falling gradually.

They argue that policy needs to balance the need to reduce both gaps. Looking at these two numbers, they conclude that Germany is overachieving on fiscal adjustment and has a need to increase activity, but although France and Spain also need to increase demand they have a long way to go to eliminate the fiscal gap, so this should dominate. The conclusion is that Germany should go for fiscal stimulus, but “moderate consolidation appears warranted in both France and Spain”. Overall “the Eurozone should conduct a close-to-neutral fiscal stance”.

Let’s deal with that last conclusion first. The mistake there is simple. When monetary policy is stuck at the Zero Lower Bound, it is crazy to balance the output gap with what is your main instrument for correcting that gap, which is fiscal policy. Getting the fiscal gap right is important in the longer term, but in the short term it is the means by which you get the output gap to zero. As the studies mentioned at the beginning of this post show, the current recession is the result of trying to correct the fiscal gap at completely the wrong time. The right policy is to get the output gap to zero, so interest rates can rise above the ZLB, and then you deal with the deficit. Readers of this blog and the blogs of others must be sick and tired of seeing us make this same point over and over again, but the logic has yet to get through to where it matters.

The same principles apply to countries within the Eurozone, except with an additional complication of within Eurozone competitiveness. If a country is too competitive relative to the rest of the Eurozone, it needs to run a positive output gap for a time to generate the inflation that will correct that position, and vice versa. For that reason Germany needs a large positive output gap at the moment (compared to an estimated actual negative gap), and therefore a much more expansionary fiscal policy - not because it is overachieving on debt adjustment. France and Spain now look roughly OK in terms of competitiveness relative to the average (see chart below, and assuming that entry rates in 2000 were appropriate), so there we need fiscal expansion to close the output gap.

So at both the aggregate and individual country level, the inappropriate bias towards fiscal contraction that caused huge losses in the Eurozone in the past continues to operate. Which means, unfortunately, that the needless waste of resources caused by austerity continues to get larger by the day.

Relative Unit Labour Costs, 2010=100, from OECD Economic Outlook

Tuition fees: a last throw as the election slips away

Mainly for those interested in the forthcoming UK general election

I do not remember much from my university days, but I remember one meeting where the subject was student finance. This was a time of student grants rather than loans, and the proposal being debated was to replace grants with some kind of loan or tax. Speaker after speaker went through how student grants amounted to a payment from those not attending university to those that did, while those that did benefited from the return on the ‘human capital’ a university education gave them. The logic on equity grounds for switching to loans seemed compelling. Then someone stood up, and talked of his background from a mining family in Wales, how he was the first of his family ever to go to university, and how this would never have happened if they had not had access to a grant. Those arguing for loans fell silent, and their proposal was lost.

Can the same logic be applied to Ed Miliband’s proposal to reduce the maximum tuition fee from £9,000 to £6,000? It is a very different starting point, as most UK students now pay this fee from a loan rather than a grant, but the distributional consequences are essentially the same. In the UK graduates only have to start repaying their loans once their income exceeds a threshold, and many will not pay some or all of it back as a result. Reducing the loan therefore mainly benefits those students towards the top of the income distribution. Labour’s proposal has mitigated that effect slightly by increasing the interest rate that high earners pay, but the IFS say that “mid-to-high-income graduates are the primary beneficiaries of this reform, with the very highest earners benefiting the most, despite the rise in interest rates that they would face.” The fact that the policy is being funded by cuts in pension relief which will hit similar groups is not really relevant, because that money could have been used for something else.

So why are Labour proposing to increase inequality in this way? Is it because they hope that lower fees will encourage those from poor backgrounds to go to university? One of the remarkable features of the Coalition’s decision to increase fees is that it does not seem to have reduced the numbers becoming full time students coming from such backgrounds, although the numbers are still very low. Of course we cannot be certain what might have happened to these numbers without the fee increase. It is also important to note that applications for part-time enrolment have fallen back as a result of higher fees.

However I doubt very much if encouraging the poor to go to university is what lies behind this policy announcement. Labour are slowly but steadily losing this election. Every time I look at the predictions for the number of seats, it seems as if Labour has dropped one or two at the expense of the Conservatives. Putting luck to one side, there seem no obvious events between now and May that will change this trend, while George Osborne has a budget that will be sure to include plenty of pre-election bribes to carefully selected groups, to add to the many already announced.

Perhaps Labour’s only hope is that they can galvanise those who traditionally do not vote: the young. The old are much more likely to vote than the young. In 2010 just over 50% of the 18-24 age group voted, but nearly 75% of those 65 or over voted. And the young vote left.

The chart below shows the ‘age gap’ by party, where the age gap is the percentage of the 18-24 age group who voted for a party, less the same percentage for the 65+ age group. The data for ‘now’ is taken from this Populus poll (Table 3). The age gap for the Conservatives has been steadily increasing over time. The LibDems benefited hugely from young voters in 2005 and 2010, but perhaps partly as a result of their change in policy on tuition fees that gap has completely disappeared. The youth vote has gone back to Labour as never before, but it is vulnerable on two counts. First there are the Greens. In this Populus poll 16% of the 18-24 group said they would vote Green (compared to just 2% of the 65+ group), but in this YouGov poll they were on level pegging with Labour. This volatility suggests there is all to play for. (Only 5% of the 18-24 group intended to vote for UKIP, compared to 17% for the over 65s.) Second, there is the question of how much this group will vote. 

UK voting age gap between young and old. Source (actual elections): IPSOS Mori

Labour therefore need to galvanise the youth vote, and to do this it needs a cause. The collapse in the LibDem vote among the young suggests tuition fees could be a potent force, whatever the actual distributional consequences of the policy are. This against a background where young people are finding it more and more difficult to buy a house, and the distribution of income and wealth is moving in favour of the old. This is an election more than ever before about a clash of interests between the old and the young. The Conservatives have already given their fair quota of bribes to the old, so it really was a no brainer that Labour would do the same to the group that could just save this election for them. 

Disaster

William Keegan, while discussing my NIER article on the UK government’s macro record, writes:

After the collapse of output of some 6-7% engendered by the financial crisis, output per capita grew by “just under 2%” from 2010 to 2013, whereas in 1981-84 and 1992-95 growth was over 8%. Wren-Lewis comments: “In short, the performance of the coalition government has been a disaster.” “Disaster” is a strong word from such a rigorous academic as Wren-Lewis, but I fully agree with him.

I like the idea - which is probably true - that rigorous academics generally refrain from calling things a disaster in print. Does that mean I’m not as rigorous as Keegan believes? I thought I’d try and justify my departure from this norm with some more data. It comes from a newly released dataset put together by the Bank of England. I’ve used it to calculate GDP per head over a much longer time horizon than I’ve shown before. Here it is.

It is a story of two trends: one from 1820 to WWI, and another from the end of WWII until the financial crisis. Now whether this really is a good way to describe how the economy evolved over the last two centuries I will leave to others, but it is remarkable how well this simple idea of deviations around a constant trend seems to work for the UK economy. To see this more clearly, here is 1820 to 1913 with the trend drawn in.

 The trend growth rate is just under 0.9% per annum. Here is the equivalent graph since 1950.

The trend growth rate, estimated from 1950 to 2010, is more than double that of the 1800s, at about 2.25%. Quite when and why the growth rate increased so much between the two world wars is a huge question, but my concern here is with deviations from these trends. Apart perhaps from two booms - the 1870s and the 1970s - large deviations from trend are short lived, with correction back towards the trend occurring pretty quickly.

The big exception, of course, is what has happened since the Great Recession. The deviation from trend just kept on getting bigger, and even with a fairly generous estimate for 2014 the best that can be said is that we might have started growing at trend again, so the gap has stopped getting any bigger. Even after the slump of 1919-21, GDP growth for the next four years was well above trend. What has happened since the financial crisis is unprecedented. This below average growth in GDP per head is one reason why real wages have been falling steadily over this period, which is also unprecedented.

It could of course be that what we are seeing is part of an adjustment to a new lower trend growth rate that was going on behind the scenes before 2010. That is what the methods used by the OECD and IMF (but not the OBR) assume. However they imply that 2007 was a huge boom in the UK, whereas all the other evidence says any boom was decidedly modest. It could be that these trends can suddenly shift after traumatic events. What is abundantly clear is that the last few years are no success story, and the constant drum beat in macromedia that the economy is doing well is completely inappropriate. A much better way of describing the last four years is to say it has been a disaster.