What have Keynesians learnt since Keynes?

                That is the question asked by RobertWaldman (9th Feb) in a comment on my post, and also in a dialog with Mark Thoma. I’ll not attempt a full answer – that would be much too long – and Mark makes a number of the important points. Instead let me just talk about one episode that convinced me that one part of New Keynesian analysis, the intertemporal consumer with rational expectations, was much more useful than the ‘Old Keynesian’ counterpart that I learnt as an undergraduate.

                In the mid 1980s I was working at NIESR (National Institute for Economic and Social Research) in London, doing research and forecasting. UK forecasting models at the time had consumption equations which included current and lagged income, wealth and interest rates on the right hand side, using the theoretical ideas of Friedman mediated through the econometrics of DHSY (Davidson, J.E.H., D.F. Hendry, F. Srba, and J.S. Yeo (1978). Econometric modelling of the aggregate time-series relationship between consumers' expenditure and income in the United Kingdom.Economic Journal, 88, 661-692.) While the permanent income hypothesis appealed to intertemporal ideas, as implemented by DHSY and others using lags on income to proxy permanent income I think it can be described as ‘Old Keynesian’.

As the decade progressed, UK consumers started borrowing and spending much more than any of these equations suggested. Model based forecasts repeatedly underestimated consumption over this period. Three main explanations emerged of what might be going wrong. In my view, to think about any of them properly requires an intertemporal model of consumption.

1) House prices. The consumption boom coincided with a housing boom. Were consumers spending more because they felt wealthier, or was some third factor causing both booms? There was much macro econometric work at the time trying to sort this out, but with little success. Yet thinking about an intertemporal consumer leads one to question why consumers in aggregate would spend more when house prices rise. (I don’t recall anyone suggesting it changed output supply, but then the UK is not St. Louis.) Subsequent work (Attanasio, O and Weber, G (1994) “The UK Consumption Boom of the Late 1980s” Economic Journal Vol. 104, pp. 1269-1302) suggested that increased borrowing was not concentrated among home owners, casting doubt on this explanation.

2) Credit constraints. In the 1980s the degree of competition among banks and mortgage providers in the UK increased substantially, as building societies became banks and banks starting providing mortgages. This led to a large relaxation of credit constraints. While such constraints represent a departure from the simple intertemporal model, I find it hard to think about how shifts in credit conditions like this would influence consumption without having the unconstrained case in mind.

3) There was also much talk at the time of the ‘Thatcher miracle’, whereby supply side changes (like reducing union power) had led to a permanent increase in the UK’s growth rate. If that perception had been common among consumers, an increase in borrowing today to enjoy these future gains would have been the natural response given an intertemporal perspective. Furthermore, as long as the perception of higher growth continued, increased consumption would be quite persistent.

Which of the second two explanations is more applicable in this case remains controversial -see ‘Is the UK Balance of Payments Sustainable?’ John Muellbauer and Anthony Murphy (with discussion by Mervyn King and Marco Pagano) Economic Policy Vol. 5, No. 11 (Oct., 1990), pp. 347-395 for example. However, I would suggest that neither can be analysed properly without the intertemporal consumer. Why is this a lesson for Keynesian analysis? Well in the late 1980s the boom led to rising UK inflation, and a subsequent crash.  Underestimating consumption was not the only reason for this increase in inflation – Nigel Lawson wanted to cut taxes and peg to the DM – but it probably helped.

So this episode convinced me that it was vital to model consumption along intertemporal lines. This was a central part of the UK econometric model COMPACT that I built with Julia Darby and Jon Ireland after leaving NIESR in 1990. (The model allowed for variable credit constraint effects on consumption.) The model was New Keynesian in other respects: it was solved assuming rational expectations, and it incorporated nominal price and wage rigidities.

As I hope this discussion shows, I do not believe the standard intertemporal consumption model on its own is adequate for many issues. Besides credit constraints, I think the absence of precautionary savings is a big omission. However I do think it is the right starting point for thinking about more complex situations, and a better starting point than more traditional approaches.

One fascinating fact is that Keynes himself was instrumental in encouraging Frank Ramsey to write "A Mathematical Theory of Saving" in 1928, which is often considered as the first outline of the intertemporal model. Keynes described the article as "one of the most remarkable contributions to mathematical economics ever made, both in respect of the intrinsic importance and difficulty of its subject, the power and elegance of the technical methods employed, and the clear purity of illumination with which the writer's mind is felt by the reader to play about its subject. " (Keynes, 1933, "Frank Plumpton Ramsey" in Essays in Biography, New York, NY.)  I would love to know whether Keynes ever considered this as an alternative to his more basic consumption model of the General Theory, and if he did, on what grounds he rejected it. 

Central Bank Interest Rate Forecasts: It’s not about accuracy

                Charles Goodhart writes (FT-£) that “Proposals that central bankers report their expectations of official rates, beyond some short future horizon, are retrograde, pushed forward by fashionable theory without reference to empirical reality.” By short horizon here I think he means three or six months: much shorter than the recent move by the US Fed. Charles is usually right about most things, and similar comments have also been made by other experienced ex-central bankers, so I think it is important to set out carefully one important counter argument.

                Charles writes that “whether the publication of central bank predictions of the future path of interest rates is likely to be beneficial depends on the relative accuracy of such forecasts.” I disagree. I’m happy to assume they are no better than those of forecasters in general. What is then gained by publication?

                The key point is that central banks, or members of a central bank committee, have inside knowledge. Not about how the economy works, or of statistics a few days before they are published, but about themselves. Their forecasts for interest rates tell us what they are likely to do if events (inflation, growth etc) turn out as they expect, and if they are being consistent. So the important question is whether this information is useful.

                Central to the academic case for delegation of interest rate decisions to central banks is that they are less susceptible to the temptations of time inconsistency. (Those familiar with what this means can skip this and the next paragraph.) A classic example involves the trade-off between inflation and output. Suppose the monetary authority wants zero inflation, but would like output above the level consistent with zero inflation (the ‘natural’ level of output). Suppose the public share those preferences. The monetary authority announces a policy of achieving zero inflation, and people form expectations on that basis. Once those expectations have been set, the monetary authority realises that outcomes would be better if output was higher than the natural rate. This will raise inflation above zero, but given their and the public’s views on output, everyone would be better off with a little bit more inflation and higher output.  This is sometimes called reneging or cheating by the policy maker, but notice that everyone is apparently better off when it changes its mind.

                Now, if people are smart, they will know the monetary authority will behave this way, so they will not believe the initial announcement of zero inflation. In fact the only situation in which expectations prove correct is when they are so high that it is no longer in the monetary authority’s interest to renege. So the outcome is high inflation with no gain in output. In this situation it would be much better if the monetary authority could commit to zero inflation and not renege on this commitment. It is generally thought that central banks are more likely to be able to do this than politicians, in part because politicians will be too tempted by short term gains, and will discount the longer term repercussions.

                Being an independent central bank may increase your ability to commit to a policy in the face of the time inconsistency temptation, but it does not guarantee that result. Central bankers would like to be able to establish their credibility for commitment. (I gave a particular example when it might matter a lot here.) Publishing interest rate forecasts allows them to do this. If events turn out roughly as expected, yet the central bank does not follow its own forecast for interest rates, it might be because they are exploiting these time inconsistency possibilities. Following your own forecasts when nothing changes does not prove that you are resisting such temptations, but it is consistent with doing so.

                Now Charles Goodhart might respond, in the spirit of his article, by saying that events never turn out roughly as expected, and so interest rate forecasts can never be used in this way. However the critical question is as follows. Is the fog of news so dense that we can never say anything useful using these forecasts? I think not. For a start, we not only have the bank’s interest rate forecasts, but also the inflation forecasts that go with them. We often have no problem saying that the balance of news about the economy over some period is – say – that activity is stronger than expected, and so inflation is expected to be higher. If, despite this, the central bank reduced interest rates compared to their own forecasts, we would be suspicious that they were being inconsistent. However, if we do not know what they were expecting to do with interest rates (because these forecasts were not published), then we are no wiser about whether they are being consistent or not.

                Charles talks about the importance of putting error bands around forecasts in general (the fan charts), and I could not agree more. However in this particular case, we do not need such bands. To the first approximation, we only need to know what their best guess was for future interest rates, and the associated best guesses for inflation and other variables. This is because we are using the interest rate forecast to judge consistency, and not as a forecast per se.

                Now perhaps the importance of time inconsistency problems in monetary policy is not as great as implied by the academic literature.  However, I think the chances of the public being misled by the publication of interest rate forecasts is so small that on this occasion it is worth taking this academic idea seriously. I believe that in ten years time, when more central banks publish interest rate forecasts in this way, we will wonder what all the fuss was about.

More on Schools of Thought

                The main task of this post is to try and answer the following question: why do schools of thought seem to fragment mainstream macroeconomics but not microeconomics? However before tackling that issue, I need to clear some ground raised by some interesting comments on my earlier posts on this issue.

                One point I did not make clear enough in my earlier discussion is a distinction between mainstream and heterodox economics. The latter might include neo-Marxists, post Keynesians, Austrians and others. My concern was about mainstream macroeconomics becoming fragmented into schools of thought. I can see why those challenging the mainstream might find schools of thought both convenient and useful. I also think it is very important that the mainstream should be continually challenged.

                I also may not have emphasised enough the downside of the microfoundations project. I do worry that it may help to exclude good ideas, as James Galbraith suggests, and have written about how this could be dangerous for policymakers who rely on the mainstream. However I still believe that microfoundations, if interpreted flexibly, bring net benefits. But that is not the focus of what I wanted to say on schools of thought.

                The success of the microfoundations project is also why I agree with Steve Williamson that academic work in macro is probably not as fragmented as it was in the 1970s. (I was not an academic at the time, so I cannot be sure.) In that sense, academic macroeconomists when doing academic work can still locate what they do within a common, mainstream framework. We all use models that abstract from many things to focus on what we think is important for some particular issue, and we receive criticism about whether those abstractions are valid or not. My concern about schools was more with the interface between academia and policy, which includes the advice academics give, what economic journalists write, and what politicians pick up.

                The kind of thing I had in mind here include politicians thinking that austerity would not increase unemployment, because those that worried that it would were from the same misguided Keynesian school that opposed Margaret Thatcher’s monetarism in 1981. Journalists who find it easier to slot every debate into one between schools rather than address issues on their merits. And academics who attempt to argue that certain views are not worthy of consideration because they were confined to the dustbin 30 years earlier. Jonathan Portes gave similar examples in his post.

                One of the interesting things about schools of thought in mainstream macroeconomics is that there does not seem to be anything similar in microeconomics. Now such a generalisation invites counterexamples. Some might point to the debate over the methodology of behavioural economics, for example. However most of my academic colleagues who I have road tested this idea on do agree that macroeconomics seems more prone to schools fragmentation than microeconomics. If this is true today, it is strange, because macroeconomics has become microfounded.

                One simple answer to this paradox is that schools of thought are associated with macroeconomic crises, and macro synthesis follows periods of calm. Keynesian theory itself was born out of the Great Depression. The first Neoclassical Synthesis arose from the period of strong growth and low inflation in the post-war period. Monetarism gained strength from the rapid inflation of the 1970s. The more recent synthesis may be a child of the Great Moderation, and now we have the Great Recession, schools of thought have returned. Because these crises are macroeconomic, and there are no equivalent crises involving microeconomic behaviour or policy, then fragmentation of the mainstream into schools will be a macro, not micro, phenomenon.

                Attractive though this account seems, I think it misses some important points. As one of the comments on my original post pointed out, the New Neo-classical Synthesis was in many ways a celebration of New Keynesian theory which was not shared by many freshwater departments in the US. Now I think there are good reasons why New Keynesian economists might have imagined that their analysis was an uncontested part of the mainstream. As I noted here, it is used in nearly all central banks as their main tool in carrying out monetary policy. With monetary policy somewhat depoliticised through central bank independence, the Great Moderation allowed this division among academic departments to remain dormant.

                On the other side, there was a belief that New Classical economics had been revolutionary: a successful counter-revolution against Keynesian ideas.  Once again there were good reasons to support this belief. Nick Rowe in his comment on my Anti-Keynesian School post noted how many Monetarist ideas, opposed at the time by many Keynesians, were now part of the mainstream. We could do the same for the battles between New Classical and Keynesian economists: on consumption, rational expectations, the Lucas critique and more, traditional Keynesians had unsuccessfully opposed New Classical ideas. Furthermore, many of the leaders of New Classical thought did not want to update Keynesian thinking, they wanted to destroy it.

                There is a lot more that could be said here, but it would lead me to the conclusion that this counter-revolution failed. It led to fundamental and largely progressive changes in Keynesian analysis, and macroeconomics more generally, and Keynesian analysis survived and prospered. Yet, for many reasons including ideological ones, the would-be counterrevolutionaries did not want to give up their counterrevolution.

                So, perhaps unlike the first (post-war) neoclassical synthesis, the New Neoclassical Synthesis was partial in terms of its coverage among academics. This incompleteness was not apparent during the Great Moderation, because the synthesis was applied in nearly every central bank. The fault lines only became apparent when monetary policy became relatively impotent at the zero bound after the Great Recession, and fiscal stimulus was used both in the US and UK. Once that happened, what I called the Anti-Keynesian school re-emerged.

                This back story is important, because it raises the possibility of an optimistic (from a Keynesian point of view) way forward. This is that the New Neo-Classical synthesis becomes complete. (For possible signs that this has already begun, see here.) The microfoundation of macroeconomics does logically imply that mainstream macro should be as free from alternative schools as microeconomics. This would require freshwater macroeconomists to recognise that New Keynesian models are essentially RBC models plus sticky prices, and that the addition of price rigidity was not that offensive. All would recognise that the conditions in which fiscal policy was a major stabilisation tool were either rather unusual (the zero bound), or geographically remote (monetary union), and so not something to get so worked up about. Freshwater economists would come to realise that demand denial  just did not make academic sense.

                I fear a more realistic conclusion is that the Keynesian/Anti-Keynesian division is always going to be with us, because it reflects an ideological divide about state intervention. (For some supporting evidence, see here.) That divide occurs all the time in microeconomics, but because it involves arguing about many different externalities or imperfections it does not lend itself to fragmentation into schools. In macro, however, there is one critical externality to do with price rigidity, and so disagreements about policy can easily be mapped into differences about theory. Demand denial is attractive because it gives a non-ideological justification for what is essentially an ideological position about economic policy.

Budget deficits: changes, levels and risks

                One reasonable response to arguments that the UK, or US, needs less austerity and more fiscal stimulus is ‘deficits are already large’. Now there is an obvious trap here, which is that deficits in a recession are large because of the automatic stabilisers. However it remains the case that in many countries budget deficits are large even when they are cyclically corrected. Cyclical correction is a non-trivial task, and involves making judgements about output gaps which are far from easy at present, but it is better to try than to ignore the issue. The chart below plots ‘underlying’ budget deficits as calculated by the OECD in their end November 2011 Economic Outlook. (More accurately, they are the financial balance of general government as a percent of GDP corrected for the cycle and ‘one-offs’.)

Underlying budget deficits, OECD Economic Outlook Nov. 2011

                Cyclical adjustment takes a bit more than 2% of GDP off the 2010 deficit for the UK and the US, reflecting a view that the output gap was around 3.5% that year. So in 2010 cyclically adjusted budget deficits were still very large in both countries, reflecting in part a deliberate policy of fiscal stimulus. The chart also shows the underlying deficit projected for 2013. (Projected changes over these three years are smooth enough not to make the choice of particular years important.) In terms of withdrawing stimulus, or instituting austerity, the Euro area is expected to do more than the UK, and the US less than the UK. This raises a simple question: in judging the direction of policy, should we be looking at levels or changes?

The first thing to say is that we have to be careful relating budget deficits to the stance of fiscal policy because of forward looking behaviour. Suppose the government permanently increases spending, and finances this initially through debt, but Ricardian Equivalence holds. In that case we would get a budget deficit, which generates a matching private sector surplus because consumption falls, and there is no stimulus to aggregate demand. Perhaps a more relevant example in the current situation might be that the government promises to gradually reduce spending, making the current level of taxes eventually sustainable, but the private sector does not believe this, and instead expects taxes to be raised in the future. In this case consumers would save more to help pay for the expected increase in taxes. Once again there is no stimulus, this time because the government is not believed.

                For the sake of argument let’s put those concerns to one side, and assume in the case of the UK that long term plans to reduce spending without raising taxes are credible. We have a large private sector surplus not because consumers are saving to pay for future tax increases, but because they are increasing their precautionary saving, or because those that want to borrow cannot do so because banks are restricting lending. In that case, the question about levels or changes in deficits depends on what is likely to happen to private sector demand. If the private sector is expected to continue to save in this way, then we have the same demand gap, but less of it is filled by the public sector, so aggregate demand and output fall. In that sense fiscal policy is restrictive because deficits are falling. However if the increase in private saving is expected to come to an end, which it should at some point, then it is appropriate that the public deficit also declines at some point.

                It is all a question of timing, which of course is uncertain. However this uncertainty gives us a very strong argument for not reducing the size of public sector deficits too quickly. If high levels of private savings continue in the short term, then the appropriate policy is to maintain large deficits. But what if the private sector starts spending again? Will that not mean we have too much demand? Two points here. First, when there is a large degree of spare capacity, we can probably tolerate quite rapid growth in demand for a time, without this being inflationary. In fact it is a good thing, because we get rid of unutilised resources sooner. Second, if demand growth is too rapid and inflation rises (and we cannot cut government spending quickly enough because of well known institutional and implementation lags), then we can use monetary policy to cool things down.

We have an asymmetry of risks. If fiscal policy is too expansionary, we have monetary policy as a fall back. However, because of the zero bound for interest rates and uncertainty over the effectiveness of Quantitative Easing, we do not have a similar insurance policy if fiscal policy is tightened too quickly.

                This is why I think the speed of fiscal tightening implied by the chart above is too rapid. In the UK in 2010, for example, there was a clear risk that private sector demand would not pick up in 2011. The risk coming from the Eurozone was also apparent. In these circumstances, the prudent policy option was not to scale back public spending too rapidly, because there was no insurance policy in place if these risks materialised. They did materialise, and UK growth stalled. The Eurozone is making exactly the same mistake, in perhaps a bigger way.

                Now I have not mentioned the risks associated with rising debt, which is something I’ve discussed elsewhere. However one simple point is worth making again and again. If the recession reflects additional net saving by the private sector, they want to hold more assets. Furthermore, given the character of the recession, they want to hold relatively safe assets. There is a literature on the current shortage of safe assets. Budget deficits provide those assets, but still interest rates on debt are falling outside the Eurozone because there are not enough of them. This too points to budget deficits being cut too quickly. 

When growth returns: a prediction

                No, I’m not about to get into the forecasting game – I did enough of that when young. What I am prepared to predict is the reaction of some when growth does return (as it may be in the US, and as it might one day in the UK and the Eurozone). My prediction is that some people will say that growth shows those Keynesian prophets of doom were all wrong. Look, the patient has recovered just fine without the need for any fiscal stimulus medicine.

                If people do say this, they will be wrong on two counts. First, there are good reasons for believing that aggregate demand will start to recover at some point without any additional monetary or fiscal stimulus. One of the main reasons for the recession was the need to repair balance sheets, which for consumers meant less borrowing and more (precautionary) saving, and for banks building up capital by reducing lending. Once this process is complete, demand will begin to recover. Once it does so, firms will stop delaying new investment. There is a lot more that could be said about the dynamics of demand following the Great Recession, but a return to growth at some stage is almost inevitable.  

                Second, the argument was never about growth, but about the level of activity, and unemployment. Put simply, those of us who argue for more fiscal (and monetary) action want growth to come sooner and quicker, so that unutilised labour resources can get back to work. Unemployment is not only a waste of resources but also a major cause of unhappiness (see, for example, this paper by Blanchflower). Worse still, there is the likelihood that prolonged involuntary unemployment may lead to much more permanent reductions in supply, as workers become discouraged and deskilled (see, for example, this paper by Laurence Ball). 

                So that is my forecast. In one sense I cannot wait to see if it comes true.

P.S. The above has nothing to do with this from Tyler Cowen: Tyler can do no wrong after recently listing my blog. Those interested in that particular post should see Noah Smith.

Euro Deja Vu?

                I was giving a talk about the Euro crisis this week, and in preparation I looked at the new Treaty. Like Antonio Fatas I had that feeling that I had been here before. I remember reading the original Stability and Growth Pact (SGP) and wondering why the focus seemed to be entirely on debt ceilings, with no discussion of using fiscal policy as a countercyclical tool. Much the same could be said about this Treaty.

                To recap, this matters because there are two crises in the Eurozone at present: a debt crisis and a competitiveness crisis. General austerity might deal with the first, but because it includes austerity in Germany it makes the second worse: we have ‘competitive austerity’ that will lead to recession and will test the cohesion of the Eurozone. (For example, read Tim Duly and follow the links.) Both crises might have been avoided, or at least mitigated, if many non-German economies had undertaken much more aggressive fiscal tightening before 2007 as they saw their inflation rates exceed those in Germany. It is possible that the SGP itself may have discouraged such tightening, partly because politicians thought that if they were within the pact’s limits things were OK, and perhaps because of reasons I explore below.

                I cannot see anything in the new Treaty that encourages countries to think about their relative inflation and cyclical positions. If this Treaty had been in place in 2000 rather than the SGP, it seems likely that the crisis in competitiveness would still have emerged. Not only is the new Treaty unlikely to prevent such crises happening again, but it makes the current crisis worse, because there is no pressure on Germany to expand its economy by fiscal means.

                Is there anything positive to say about the Treaty? Maybe one thing. The idea of an automatic correction mechanism if deficits stray from the cyclically adjusted balanced budget rule is modelled on the Swiss and German debt brake idea. This mechanism has some attractions (see this paper by Charles Wyplosz), although I think the devil is in the detail. A debt brake with conditionality related to relative inflation rates might work, as some research I was involved with a few years ago suggests.

                The other big problem (besides ignoring countercyclical fiscal policy) which I have with the Treaty is the continuing emphasis on imposition ‘from above’. One thing that we have clearly learnt from the crisis is that it is in each country’s national interest to have adequate budgetary control. In contrast, a key idea behind the original SGP was that without it individual countries would free ride on the union, and that therefore union level control was required. This seems much less relevant today. The danger with control on individual countries coming from the union is that it becomes a ‘them and us’ game. If it is in the national interest to free ride at the union’s expense, then activities such as fiddling the figures may also be seen as in the national interest, when clearly they are not. If austerity is imposed from above rather than from within, the political dangers to the Eurozone itself are obvious. It would, in my view, be much better for individual countries to take ownership of the control of their own national budgets. This could be done through a combination of national institutional reform and nationally determined fiscal rules. Calmfors and Wren-Lewis (2011) show how this combination is becoming increasingly popular. I do not think forcing countries to pass laws to follow balanced budgets really qualifies as taking national ownership!

Chris Giles on UK Austerity

According to Chris Giles in today’s Financial Times, “..the area in which Britain still leads the international debate is fiscal policy”. This might come as a surprise to many, such as Paul Krugman. I should emphasise that Chris does make one point which I totally agree with. Gordon Brown was quick to recognise the need for fiscal stimulus in 2008, and he applauds that. So, unlike some, the argument is not that fiscal stimulus is always and everywhere wrong. Instead it is that fiscal stimulus was appropriate in the downturn, but that once a recovery began, it was necessary to switch sharply from stimulus to austerity. This argument has of course been made for other countries, including the US, as well as the UK.

                Chris gives some arguments against austerity that he says range from ‘mad to bad’. The first, which he attributes to Labour politicians, is the suggestion that austerity is entirely responsible for the recent downturn in UK growth. Well, if anyone said this, they are obviously wrong (although not quite mad): there are other important deflationary forces, of course. But it is equally wrong to infer that austerity has little or nothing to do with the recent poor performance. I know of no evidence to suggest that is likely. Indeed it would be rather strange if stimulus had been effective in moderating the downturn, as Chris acknowledges it was, but that withdrawing that stimulus (and more) had no impact.

                The second argument against austerity which he describes as ‘bad’ is that low borrowing rates imply that we can “go on a spending spree”. Let’s forget about the ‘spending spree’ language. What I do take exception to is the suggestion that this is a bad argument. It could be wrong, but the idea that the market price might tell you something about demand and supply is hardly bad. What Chris and others seem to have in mind here is a rather unusual demand curve. Lenders want lots of UK debt under current austerity plans, but if these plans were moderated or delayed, or if a temporary stimulus package was laid on top of them, they would suddenly panic. It is possible that they might behave this way, but I think it is unlikely for various reasons.

                The source for this sudden panic idea is of course the Eurozone. However I think it is generally accepted now, among economists if not coalition politicians, that the Eurozone is different, because individual countries do not have their own central banks, and the ECB’s attitude is ambivalent. Certainly market panic does seem to be confined to the Eurozone. Indeed, with Quantitative Easing in place, the UK is in a particularly good position to respond to any market panic, as I argued here. We also have some evidence that, outside the Eurozone, the market does not panic at the first suggestion of stimulus. This does not seem to have happened in Denmark, as David Blanchflower noted, and it has not happened in the US. Also, as Olivier Blanchard of the IMF said recently, if we are concerned about market psychology we should be worried about growth as well as debt. 

It is far from clear why the current government’s rapid move to austerity is just sufficient to avoid market panic, but anything more moderate (like the previous government’s plans) would send them into a tizzy. The reduction in UK interest rates on debt that we have seen is part of a worldwide trend, and not an indication that the UK leads the world in finding the appropriate policy stance. Meanwhile, the UK recovery has stalled in a major way, and the scale of unutilised labour resources is large and growing. The view exemplified by Chris’s article that we should wait and see what happens, and hope that Quantitative Easing might yet do the trick, is much too complacent. It was wrong two years ago, and it is even more wrong today.