A stimulus junkie's lament

One ‘stimulus junkie’ has already had a go at this FT piece by the chief economist of the German finance ministry, but let me add three points. The first is just factual. What is the unusual feature of this recovery compared to previous recessions? It is fiscal austerity. In the past governments have not generally cut spending or increased taxes just as recoveries have begun, but this time they did. Now perhaps the slow recovery and fiscal austerity are not related. But textbook macroeconomics, a large majority of economists, and all the macro models I know say they are. If German officials and economists continue to ignore this fact, they will lose international credibility.

Second, German officials need to be very careful before they claim that recent German macro performance justifies their anti-Keynesian views, because it might just prompt people to look at what has actually happened. Germany did undertake a stimulus package in 2009. But more importantly, in the years preceding that, it built up a huge competitive advantage by undercutting its Eurozone neighbours via low wage increases. This is little different in effect from beggar my neighbour devaluation. It is a demand stimulus, but (unlike fiscal stimulus) one that steals demand from other countries. This may or may not have been intended, but it should make German officials think twice before they laud their own performance to their Eurozone neighbours. If these neighbours start getting decent macro advice and some political courage, they might start replying that Germany’s current prosperity is a result of theft.

Third, they should also think twice before writing that a misguided concern about the impact of austerity “contrasts with much more convincing global action to repair the banking sector”. As this IMF analysis suggests, very little has been done to reduce the effective public subsidy to large banks in the major economies, and hence to avoid the ‘too important to fail’ problem. This is because politicians continue to ignore calls for much larger capital requirements. The financial system may have been partially 'repaired', but it still has the potential to create another global financial crisis.

There is a pattern here. Simple, basic economics is being ignored. That cutting demand or transfers from government reduces overall demand. That a country in a properly formulated monetary union that experiences a period of below average inflation will gain a short term competitive advantage, but it subsequently has to undergo a period of above average inflation to undo that advantage. That equity rather than debt for firms performs an important role as a shock absorber, and financial firms are no exception. It is not too hard to understand why these basic points are ignored. When the interests of politics and money collide with straightforward economics, economics does not stand a chance. If the incentives for getting the economics right are weak, the idea that economics loses out to money and politics is also just basic economics.  

Howes that

Geoffrey Howe will probably be first remembered as the politician who brought down Margaret Thatcher by delivering a devastating resignation speech to MPs. Its most famous line (see link above) is his description of negotiations with Europe

“It is rather like sending your opening batsmen to the crease, only to find... that their bats have been broken before the game by the team captain"

This cricket metaphor is one poor excuse for the title of the post: a second, equally poor excuse follows.

I personally will remember him as Chancellor when Margaret Thatcher came to power. In 1981 I was a young Treasury economist who happened to be in charge of calculating the economic effects of the budget using the Treasury’s macro model. I was too junior to go to most budget meetings involving ministers, but I did go to one. I was there as the technical backup in case the Chancellor asked a difficult question about the model simulations. I was naturally psyched up, but it turned out for no reason. There were no questions about the simulations, or even about any macroeconomic effects. The most technical any interrogation by the Chancellor got was to ask ‘how’s that figure arrived at?’, to which the reply was ‘by summing the numbers above, Chancellor’. As one senior civil servant told me afterwards, arithmetic was not Howe’s strong point.

Why was there so little interest in the macroeconomic effects of that notorious 1981 budget (of letter from 364 economist fame)? It is difficult to understate the culture shock that occurred in the Treasury after Mrs Thatcher’s election. Treasury ministers, including Nigel Lawson (who succeeded Howe as Chancellor and is now an active climate change sceptic), believed that Treasury advice - including anything from its macro model - was outdated Keynesian nonsense and that monetarism was the way forward. When internal Treasury model forecasts predicted their policies would create a recession within a year, they were dismissed with the assertion that the unemployment impact of tight monetary targets would be small and very temporary. (Unemployment doubled and only returned to 1979 levels in a sustained manner by the end of the century. We got classic Dornbusch overshooting, as this 1981 Brookings paper by Willem Buiter and Marcus Miller describes, probably followed by unemployment hysteresis.)

It may be that high unemployment was necessary to bring inflation down. It may even be that a contractionary budget in 1981 was sensible to achieve a better monetary/fiscal mix. What is almost certainly not true is that this was calculated by Howe, Lawson and Thatcher. Instead policy can best be described by another cricket metaphor. It was as if a batting side had made a respectable score not through skill, but instead by taking wild swings at the ball that went to the boundary by repeatedly just missing the hands of fielders.

One reason why monetary policy is preferred by New Keynesians

I promised to write something on this some time ago, so this post is overdue. It was inspired by markets in Provence, where I have been for the last week. (hence lack of posts, and delay in publishing comments).

There are practical reasons for preferring interest rate changes (when possible) to changes in government spending as the stabilisation tool of choice, although the extent to which these are inevitable or just conditional on current institutional arrangements is an interesting question. Here I want to give an economic reason for this preference.

Imagine a monetary economy made up of independent producers, each of whom produces a unique good, where these goods are exchanged in a market. The government can be a buyer in this market, and transforms the goods it buys into useful public goods. Total consumption is what each producer chooses to buy from other producers in the market, plus the public goods they receive. Producers have preferences over private and public goods which are independent of income, and let’s initially assume that the government provides just the right amount of public goods so as to achieve the optimum balance between private and public consumption. Because people can choose to use their income to buy goods or hold money, there is potentially an aggregate demand problem.

Suppose, for example, individuals decide for some reason that they want to hold more money. They expect to sell their output, but plan to buy less. If everyone does this, aggregate demand will fall, and producers will not sell all their output. If goods cannot be stored, and if producers cannot consume their own good, this could lead to pure waste: some goods remain unsold and rot away. (If all producers immediately cut their prices, then a new equilibrium is possible where producers’ desire to hold more real money balances is achieved by a fall in prices. So we need to rule this possibility out by having some form of price rigidity.)

The government could prevent waste in two ways. It could persuade consumers to hold less money and buy more goods, which we can call monetary policy. Or it could buy up all the surplus production and produce more public goods, which we could call fiscal policy. Both solutions eliminate waste, but monetary policy is preferable to fiscal policy because the public/private good mix remains optimal.

Three comments on this reason for preferring monetary policy. First, if for some reason monetary policy cannot do this job, clearly using fiscal policy is better than doing nothing. It is better to produce something useful with goods rather than letting them rot. We could extend this further. If for some reason the impact of monetary policy was uncertain, then that could also be a reason to prefer fiscal policy, which in this example is sure to eliminate waste. Second, the cost of using fiscal rather than monetary policy obviously depends on the form of public spending. If the public good was repairing the streets the market was held in one year earlier than originally planned the 'distortion' involved is pretty small. Third, another means of achieving the optimal solution, besides monetary policy, is for the government to give everyone the extra money they desire.

Nonsense on data revisions

Following publication of revised GDP figures today, Robert Peston writes:

"a particular school of Keynesian economists may choose to re-examine their contention that only a fool or a liar would say there is a legitimate debate about whether George Osborne's policies were good or bad for the recovery."

Sorry Robert, but this is just nonsense: complete and utter nonsense. This "particular school" has never based their assessment on observing what is still the weakest UK recovery since anyone can remember and looking for something to blame. They based it on what macro theory and the great majority of empirical studies tell us would be the impact of the fiscal austerity that happened. At the conservative end of such assessments is the OBR, who calculate austerity reduced GDP growth by 1% in each of the financial years 2011 and 2012. Estimates of this kind are completely independent of data revisions for one period in one country. We might doubt such estimates if they implied that without austerity we would have had implausibly rapid growth, but for this recovery they do not. 

The other point completely missing from Peston's account is that the UK's growth performance even with these revisions is still terrible. As I have often pointed out, high inward migration in recent years means you really have to look at GDP per head to make comparative statements about this recovery. As the ONS point out, this new data still shows that only in this year has GDP per head exceeded its pre-recession peak. Assuming recent data revisions have not changed this, average growth in GDP per head between 1955 and 2008 was about 2.25%. Any recovery from such a deep recession should have seen growth rates well in excess of this. Instead the revised data give us 1.1% growth in 2011, 0.5% in 2012, 1.5% in 2013. Only by 2014 had we got near the long term average growth rate. This is still an absolutely terrible performance for a recovery.

That is not some "particular school" talking. That is just basic stuff that any good economic journalist should point out: see Ben Chu for example. I suspect it would also be what Robert Peston would point out if this was not all so political and the government were not breathing down the BBC's neck. The mediamacro problem is still very much with us.

On giving advice

I was happy to agree to be on an advisory panel for Shadow Chancellor John McDonnell MP. There are only two reasons why I would say no to any major political party who asked me to give them their advice. The first is if this restricted what I would otherwise write on this blog or elsewhere. No such request has been made, although if you are hoping that I will reveal in posts accounts of what happens at panel meetings you will also be disappointed.

The second reason why I might have said no is if I thought the advisory panel was for presentation only, and all advice would be ignored. I have no reason for believing that in this case, and some grounds for thinking the opposite, which I discuss today in the Independent. In particular their position on fiscal policy is similar to the one I suggested here, although getting the message clear probably requires some work. 

One rather sad comment on the formation of this group is that those joining it will be forever tainted by associating themselves with a "hard left dinasours". Or to put it another way, its members should have said no to the Labour party leadership because they now have pariah status. As I pointed out in the Independent article, the current leadership will have to come to some kind of accommodation with the rest of the parliamentary party, and so Labour policies are unlikely to be the kind of far-left platform that many in the media seem happy to imagine. As Labour are the main opposition to the current government, and I think their macro policies are pretty awful, it would have been bizzare indeed if I had said no to this invitation.

Robert Peston has a short blog post on this new panel. He asks a very good question, which is why previous party leaderships have not done anything similar. I would quibble about one phrase in his post though, and that is this group is designed "to establish an economic ideology outside the mainstream". As I have often said, my own macro is pretty mainstream. What has happened since 2010 is that macro policy has departed from that mainstream.      

The path from deficit concern to deficit deceit

I have always written that the arguments in 2010 for focusing fiscal policy on reducing debt were understandable. They were wrong, but you could understand why reasonable people might make those arguments. In particular at the time the problem of the recession appeared to be over, recovery was under way, and the Bank of England seemed confident in the power of unconventional monetary policy. It seemed reasonable to move attention to the deficit.

So when 20 economists and policy makers wrote in February 2010 apparently supporting George Osborne’s deficit reduction plans, I was not surprised. The majority of macroeconomists, like me, disagreed, and we were right, but I could understand where they were coming from. One of those signing that letter was Lord Turnbull, head of the Civil Service and Cabinet Secretary between 2002 and 2005. By August 2012 around half of those that signed the letter had the good sense and honesty to backtrack on what they had written. The Chancellor may also have (wisely) revised his original plan to end the current deficit within 5 years, but his zeal to bring down debt rapidly by cutting government spending had not disappeared. When he was re-elected in May, it was for a programme of renewed austerity.

But the story does not end there. A few days ago Lord Turnbull had the opportunity to question the Chancellor on his drive for further austerity. This is a part of what he said.

“I think what you are doing actually, is, the real argument is you want a smaller state and there are good arguments for that and some people don’t agree but you don’t tell people you are doing that. What you tell people is this story about the impoverishment of debt which is a smokescreen. The urgency of reducing debt, the extent, I just can’t see the justification for it.”

A former head of the civil service, who had initially supported Osborne on the deficit, was now accusing him of deliberate deceit. Big news you might have thought. And quite a turnaround in just 5 years.

Yet it is not surprising. Osborne’s fiscal plans really have no basis in economics. That leaves two alternatives. Either Osborne is just stupid and cannot take advice, or he has other motives. George Osborne is clearly not stupid, which leaves only the second possibility. It is therefore entirely logical that Lord Turnbull should come to agree with what some of us were saying some time ago.

What a strange world we are now in. The government goes for rapid deficit reduction as a smokescreen for reducing the size of the state. No less than a former cabinet secretary accuses the Chancellor of this deceit. Yet when a Labour leadership contender adopts an anti-austerity policy he is told it is extreme and committing electoral suicide. Is it any wonder that a quarter of a million Labour party members voted for change.

What do macroeconomists know anyway?

In an article in the Independent today I argue that what goes for a ‘credible’ economic policy among politicians and the media is often very different from what an academic economist might describe as credible. Which invites the obvious response: who cares, what do academic economists know anyway? So I look at what I regard as the three major macroeconomic policy disasters in the UK over the last 35 years, and one success.

The success was the decision not to join the Euro in 2003. It is pretty clear that this was the right decision, and it was made after what may have been the most extensive academic consultation ever undertaken by the Treasury, coupled with substantial macro analysis. (I talk more about this here.) The Prime Minister Tony Blair was initially in favour of joining, but the analysis helped persuade him otherwise.

The first failure was Mrs. Thatcher’s monetarism, which was famously opposed by 364 economists. Those on the right have tried to spin this as a failure by the economists, but the actual policy framework of money supply targets was a complete disaster and was quickly abandoned, never to be tried again. (Here is a discussion, and here is an account from one of the two movers behind the letter.)

Current austerity we all know about: if not, read this.

The third disaster was the UK’s entry into the European Exchange Rate Mechanism (ERM) in 1990 at an overvalued exchange rate, and the subsequent recession and forced exit in 1992. My argument that this went against macroeconomic analysis needs some justification. At the time I was in charge of macroeconomic research at the National Institute (NIESR) in London, and I undertook with colleagues what was easily the most extensive analysis of the consequence of entry into the ERM at different exchange rates. This was subsequently published in 1991, but all the material was first presented before we entered the ERM.

We concluded that the UK’s actual entry rate was 10-15% above the equilibrium rate. The implication was unavoidable: either we would be forced out, or trying to stay would lead to a recession as part of an ‘internal devaluation’. I remember Sam Brittan, one of the main writers at the FT at the time, saying that he thought we had won the intellectual argument, but that his instinct was still that we should enter at a high rate.

After entry into the ERM the UK entered a recession, and we were then forced out just two years later. Our analysis was vindicated. It is true that the whole system eventually collapsed as a consequence of the tight monetary policy that followed German unification, but it is no accident that the UK was the first to go (Black Wednesday). On leaving the ERM sterling depreciated by 10%, and the UK recovered quickly from recession.

There is no doubt that had the Treasury taken our advice and entered at a lower rate, less jobs would have been needlessly lost. I have often wondered if I could have done things differently to make a more persuasive case. But honestly I doubt it: the almost macho appeal of entering at a ‘strong’ rate was too great, together with the idea that the market knew best. As I say in The Independent, macroeconomists are far from perfect, but the UK evidence suggests that you ignore their advice at your peril.