The Falklands War: a simple cost benefit analysis

                It is the 30^th anniversary of Argentina’s attack on the Falklands islands. I was against the UK responding with a counter invasion. The key justification for taking the islands back by force was that the people there wanted to live under British rather than Argentinean rule. The population at the time was about 1,800. Nearly 900 soldiers lost their lives in that conflict. The financial cost for the UK was estimated at around $2 billion. 

                My argument at the time was very simple. The order of magnitude of the financial cost was pretty well known in advance.The UK government could have offered each islander $1 million dollars, either as compensation for living under Argentinean rule, or for being relocated in some part of the UK. (The Highlands of Scotland is pretty empty and would be the closest substitute.) The financial cost to the government would be the same, but no lives would be lost.

                There were various counterarguments to this ‘crude’ utilitarian reasoning. One was that, if the UK had not attempted to fight, this would set a precedent which would encourage other dictators to use force in a similar manner. All that was demonstrated, of course, was that the UK was prepared to fight to protect one of its dependencies, against another side it thought it could beat. I do not think the Falklands war has really stopped Spain invading Gibraltar. Another argument was that the UK had a moral duty to protect its citizens. Strangely, this moral duty seemed not to apply to the similar number of residents of Diego Garcia some 10 years earlier, who were removed by the British from their homes to make way for a US airbase.

                Unfortunately I think the actual decision to fight back had little to do with principles. The moment Mrs Thatcher was told she could win, it would have been too humiliating for her government not to go to war. What I find much more depressing is that the war was hugely popular in the UK. National honor was at stake. Just before hostilities began, an opinion poll had only 18% of people saying that the UK government had been too willing to use force. Tellingly, however, only 14% of those polled were prepared to sacrifice more than 100 UK servicemen’s lives to regain the islands. 

                The conflict had huge consequences for both countries. It helped keep Mrs Thatcher in power for another decade, but it was fatal for the Argentine junta.  The ‘Falklands factor’ may have encouraged Tony Blair’s military interventionism. This, together with a feeling of gratitude to the US for their intelligence support during the conflict, may have played a part when it came to UK involvement in Iraq. Any ex post cost benefit analysis is hugely complicated and uncertain, but I still think my ex ante crude utilitarian view is compelling.

                The UK declared war three days before my wife and I were due to fly to Peru for a month long holiday. We went as planned, despite knowing that Peru would be very supportive of Argentina. In the first three weeks the Peruvians we talked to regarded the whole thing with bemused curiosity, and there was no ill feeling towards us. The atmosphere changed a bit just before we left after the General Belgrano was sunk. Lives were being lost as two countries attempted to salvage their national pride.                

                 

Happiness and Paternalism

                Although I clearly do not agree with current UK macroeconomic policy, I did note at the end of a recent post that the government had taken the positive step of collecting more data on happiness. (It also deserves considerable credit for setting up the Office for Budget Responsibility, which it predecessor did not have the courage to do.) So I was interested to see a recent broadside from the Institute of Economic Affairs attacking this decision, and the whole happiness project more generally.

                Their collection of essays is slightly schizophrenic. It includes papers that try and show happiness is unrelated to equality, or employment protection legislation, and is negatively related to government consumption. However other papers and the introduction also argue that happiness data is an unreliable guide to wellbeing, and that the government should not use happiness data to promote wellbeing explicitly. What is the underlying problem? Why put so much effort into criticising a few extra questions in a survey?

                This is a question that the New Economics Foundation asks in a refreshingly restrained response to the IEA document. The answer they suggest is that the IEA, and many of its contributors, have a fear that happiness data will be used by governments to do things government thinks will make people happier, rather than allowing individuals themselves to decide what makes them happy. 

                I am sometimes asked by students whether economics as a discipline has an ideological bias. What they often have in mind is the role of markets. My response, which I think is reasonable, is that once you get beyond the welfare theorems in Econ 101, what most economists spend their time doing is analysing market imperfections. So if you want to know what is wrong with markets, ask an economist.

                However I think most economists do share one philosophical characteristic, and that is a deep distrust of paternalism.  This is something I share – by and large, if it does not adversely affect other people, individuals should be allowed to make their own choices. But the by and large here is crucial. Sometimes individuals do make choices which are clearly bad for them.

                This was cogently argued by Richard Thaler and Cass Sunstein in a short paper provocatively entitled ‘Libertarian Paternalism’ (American Economic Review, 2003, Vol. 93, pp. 175-9). A great deal of behavioural economics is all about departures from rationality, and these in turn can lead to people making choices that are not optimal. Thaler and Sunstein point out that sometimes government cannot avoid making decisions that influence choices. An example they give is enrolment in employment based savings plans. Should people be given the choice to opt in or opt out?  What is called ‘status quo bias’ means that which happens will influence people’s choice. Given this, surely it is best for the government to choose the option that makes people better off in its judgement.  The authors have subsequently developed these ideas in their book Nudge. The Economist has a nice summary of this position, and some arguments against it, here. Nudge has been very influential among policymakers, both in the UK and the US.

                Decisions on whether to make savings schemes opt in or opt out, and similar nudges, seem fairly innocuous even if they are important. But what about forcing people to do things they might definitely decide otherwise not to do? Like wearing seat belts. Some economists have difficulties with making the wearing of seat belts compulsory, and regularly cite the possibility that it might encourage drivers to drive more dangerously. This belief seems fairly impervious to contrary evidence, and this post  from philosopher/psychologist J.D.Trout has a justifiable go at economists as a result. The unfortunate truth is that individuals are rather bad at assessing low probability high risk events, and as a result it makes sense – at least in this case – to take away their choice. Can anyone think of a recent similar example with rather more global consequences?!

                So the bad news for the IEA and similar devotees of absolute individual sovereignty is that sometimes people do systematically make bad decisions, and the state is right on those occasions to do something about it. Equally, the state is often too paternalistic, and interferes when it should not. The state can also make bad choices. Given this, the more data we have that allows us to sort out whether government is helping or meddling the better. That is why happiness data is useful, because it can help us do this.

Comparing the UK and US recoveries

                There has been a little discussion of why the UK ‘recovery’ has been poorer than in the US following Adam Posen’s speech (a quick summary of which is here). Adam Posen makes a number of interesting points, particularly regarding bank credit. However some of the discussion has focused on fiscal policy: is greater austerity in the UK part of the explanation? In an earlier post I compared the degree of austerity in the US, UK and Euro area using OECD data, but only by comparing forecasts for 2013 with 2010 outturns. Here is a bit more detail.

Underlying budget balance, OECD Economic Outlook Nov 2011

The broad story is unchanged. All three are tightening policy, but the UK is tightening more than the US, and the Euro area even more.[1]

                Notice however that on these figures the UK did not tighten more than the US from 2009 to 2011. It is 2012 and 2013 where a clear difference emerges. If we had later years this would probably continue – the underlying deficit is forecast to be in balance in the UK by financial year 2016/7. The lack of divergence from 2009 to 2011 is noted by Ryan Avent here. Does this mean that, looking at the poor performance of the UK relative to the US over the last two years, we can discount the role of fiscal policy?

                Of course not. Expectations matter. You might worry about invoking rational expectations in some contexts, but in this case there was no lack of information, and there is not much discussion of the UK government reneging on these plans. As Jason Rave notes, the cuts were framed as "drastic" and unprecedented. It is second nature now to talk about expectations of interest rates when considering the impact of monetary policy. You could legitimately argue that when it comes to thinking about fiscal policy in 2016/7, whatever impact that might have on activity will be offset by expansionary monetary policy. However making that assumption about 2012/3 would be exceedingly optimistic. (There is also an important point about the composition of cuts, which Adam Posen discusses.)

                However I wanted to emphasise an additional point. Here I claimed that “we must add [the announcement of additional austerity in] 2010 to a list of major macroeconomic policy errors made in the UK since the war.” For this claim, we require the following things to be true:

1) The output gap has been/will be significantly negative for a number of years after 2010, and this gap is not required to restrain inflation.

2) Monetary policy will not close this gap.

3) Fiscal policy has a significant impact on the output gap for given monetary policy.

4) There was and is no constraint (like a growing risk premium on government debt) that 

forced the government to adopt additional austerity in 2010 and maintain it subsequently.

What we do not require is for poor growth to be mainly due to fiscal policy –the Euro crisis could be more important, for example. It is the counterfactual that matters: output growth would have been significantly stronger as a result of less austerity. Nor is it legitimate to argue that the UK government was unlucky, because of the unexpected severity of the Euro crisis, or higher oil prices, or whatever. Good policy takes account of risks, and what you can do about them. Being at the zero lower bound means that you do not do things that deflate demand unless you believe growth will be strong anyway. If that is what the government believed in 2010 they were foolish indeed.

                I have talked about the motivations behind austerity before. What I suspect is that one part of the coalition government thought we were about to become like Greece, so (4) did not hold. I can to some extent forgive this given the panic at the time, but they should know better now. And as Jonathan Portes points out, when information changes you should change policy. Believing that (3) is not true is more difficult to forgive. As I continue to be surprised at the number of very good and sensible economists who seem reluctant to acknowledge that fiscal policy matters for demand when monetary policy is constrained, I fear they might have been led astray in part by (selective) advice received.

                However, I am still not sure. As the recession hit, Osborne consistently argued against fiscal stimulus. In April 2009, George Osborne gave a speech which included a short history of macroeconomic thought, even including references to the Lucas critique. It ended up with New Keynesian models, and he then said this:

“[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 - an argument echoed by the Governor of the Bank of England last month when he said that "monetary policy should bear the brunt of dealing with the ups and downs of the economy". We now appear to be winning that argument hands down.”

The previous month, the Bank of England reduced interest rates to 0.5%, where they have remained ever since. So a month after interest rates hit the zero lower bound, Osborne gives a speech which included a perfectly sensible account of macroeconomic policy, except when you hit a zero lower bound. So perhaps they were after all ‘very foolish indeed’.

---

[1]  These numbers are now a little old, but the most recent OBR forecasts for the UK have hardly changed compared to their November forecast, so for the UK at least these numbers are probably still OK.

Is Eurozone Austerity Self Defeating, and is it all Germany's fault?

                Suppose DeLong and Summers (full paper here) are right, and at the zero lower bound temporary fiscal stimulus leads to an eventual reduction in the debt to GDP ratio because of hysteresis. Does that mean that all this austerity in the Eurozone is counterproductive? This is the question raised by John McHale. Here is an attempt at an answer, followed by some more general remarks on European austerity.

In the stylised picture above, the black line represents the debt to GDP ratio under ‘austerity’. The budget deficit is being reduced rapidly, first to stabilise the debt to GDP ratio, and then to bring it down to safer (more optimal?) levels. ‘Stimulus’ involves in the short term cutting government spending less (at least). Unless multipliers are implausibly large this will raise both deficits and the debt to GDP ratio in the short run (the red line). What DeLong and Summers argue is that the negative effects of austerity on output in the medium term will mean that the two paths for debt to GDP will at some point cross. In other words stimulus will at some point lead to a better outcome for the debt to GDP ratio.

                For any government not having to pay a large risk premium on their debt, and not likely to encounter such a premium, this is an important argument. If true, it does indeed suggest that the rapid austerity being undertaken by countries such as the UK will eventually make their fiscal position worse. In addition, arguments that we have to follow the austerity path because the stimulus path is not credible are beside the point, as I argue here (and see also Summers here). Nor does the argument that we cannot change course now make much sense. In the UK and US fiscal policy does not have to be credible, it just needs to be sensible.

In the case of Ireland and other Eurozone countries the immediate motivation for austerity is a high risk premium on government debt. What potential investors in Irish government debt are worried about is not where debt is likely to end up, but the likelihood of default before we get there. Here the credibility argument does apply.

                One reason why government might default is a political inability to cut spending or raise taxes enough to get the primary budget balance into surplus. Governments can demonstrate that they do have that ability by cutting the deficit rapidly now. Promises to cut it in the future carry much less weight, and so as a result have less impact on the chance of default. Even when the primary balance is in surplus, a government may decide it is in the country’s best interest to default, because any damage to its reputation will be offset by the advantages of not having to cut spending or raise taxes still further to pay the interest on its debt. Once again, a government can demonstrate that it is not minded to do this by reducing its debt as quickly as possible.

                In either case, default is less likely if debt follows the black line (austerity) rather than the red line (stimulus). The markets are, quite rightly, not very interested in what happens into the medium term, because by that time default risk under either policy has all but disappeared. So if the overwhelming priority is to reduce the risk premium on government debt, austerity makes sense. In addition, as I have said often before, a long period of economic stagnation is required in many Eurozone countries to reverse the competitive disadvantage they accumulated relative to Germany in the early years of this century.

                Which brings us to Germany. In the past I and others have written as if this Hobson’s choice faced by periphery Eurozone countries could be partially relieved if only Germany would expand more rapidly. However, as I outlined here, this was not a very realistic wish. Not because Germany is addicted to current account surpluses –Kantoos rightly argues that this idea is not exactly part of the German macroeconomic objective function. The reason we will not see rapid expansion in Germany is because the economy is doing all right as it is. While inflation of 5% in Germany would certainly be very useful for Spain et al, it would not be in the national German interest. The only possible exception might be if the Eurozone as a whole looked like coming apart, in which case it might be in Germany’s interests to incur these costs.

                Kantoos’s final question in his post is: ‘So what else should Germany do?’ Germany should be reasonably relaxed about getting its own debt to GDP ratio down. What I have called ‘competitive austerity’ in Europe is not helpful. But being more relaxed on debt is not going to make a big difference to the rest of the Eurozone. So the realistic answer to that question is probably ‘not much’.

                Seeing the Eurozone as a single bloc, it makes sense to note that fiscal correction in this bloc is far more rapid than in the US or even the UK, and for the area as a whole that will be very damaging. If there was a Eurozone government, it should be undertaking a substantial fiscal stimulus in Germany right now. But to blame Germany for not doing this of their own accord is rather pointless, as Kantoos says in a more recent post.

                So the only real hope is monetary policy. I’m glad to see that Scott Sumner has decided to bury the hatchet, so let me say some more things that I think he will like to hear. While the arguments for price level or nominal GDP targets are pretty universal, I think they apply particularly to the Eurozone. The discussion above suggests that the barriers to fiscal stimulus in the Eurozone are not political but intrinsic to the union in its current conjuncture, so there appears to be no alternative to monetary stimulus. A change from inflation targeting may also be politically easier for the ECB, because it could be justified as a move back towards the ‘twin pillars’ approach and the Bundesbank’s money supply targeting. Perhaps with a new head the institution can make up for recent mistakes. A major obstacle may be that such a change would not be in Germany’s short term interests (for all the reasons noted above), in which case we may find out how independent the ECB really is from Germany.

Information, Money and Politics

A post that helps put the mainly in mainly macro

                A Conservative Party Treasurer is caught on camera trying to solicit £250,000 from businessmen by offering to, among other things, feed their suggestions into the policy process at No.10. Having just passed NHS Reform that will greatly increase the involvement of the private sector, David Cameron suggests privatising parts of the road network. Are we seeing either end of a single process here?

                To which one might respond, as Chris Dillow does, plus ca change. Others, like Stuart Weir, take a less sanguine view. Let us look to the US, which we often need to do to see what happens next. Here we find Paul Krugman helping to uncover the activities of the American Legislative Exchange Council (ALEC). According to Krugman ALEC drafts legislation which is often adopted word for word by US states, is funded by the usual right wing billionaires and corporations, and which has a particular interest in privatisation. It or associated organisations may as a result see advantage in having laws passed that increase business for some of those privatisations, like prisons for example, although of course they would never act on that interest. And equally evident is that this could not happen here.

                But what exactly is wrong with all this? Presumably it is legitimate for a lobbying organisation to draft legislation that furthers its interest. The organisation does not force legislators to pass it. And what is wrong with people with lots of money using it to fund such organisations? Of course corporations have interests, but it is up to politicians whether they are listened to or not.

                One thing we can object to is secrecy. It is generally regarded as good practice to declare personal interests where appropriate.  For similar reasons it seems appropriate that organisations and think tanks disclose the source of their funding. As George Monbiot has found, in the UK at least that is quite hard to persuade them to do. I cannot see any justification for keeping this information secret. The default position is that we should be automatically suspicious of any organisation that allows its benefactors anonymity, and discount its output accordingly.

                Why does disclosure matter? In an earlier post, I talked about how the media tends to have two ways of framing issues: either there is general consensus, or there are two sides to every question. With that two category model, it is quite important which category the media decides to put a particular issue into. Moneyed interests can manufacture controversy through think tanks, as has happened with aspects of the climate change debate. It is therefore important that everyone, including the media, know where organisations get their finance. More generally, the media needs to be a little braver in going beyond the spin and ‘following the money’.

                There are also limits on what money should be allowed to do in the political process. If some organisation or individual offered to directly buy your vote, this would be illegal in most places. Where it becomes less clear is when we move to political advertising. Now of course if we try and pretend that advertising is just about providing information, and that there are adequate safeguards to ensure advertised information is always ‘true’, then we might believe the more information people have the better. However those would be foolish things to believe.

                In a previous post I wrote ‘money buys votes’. Immediately on writing that my academic self thought, hold on, should I not qualify that a bit, but then I thought don’t be silly. Of course advertising in elections, as one commentator pointed out, does not guarantee that votes will follow, just as advertising a commodity can be more or less successful. But the correlation is surely positive. If advertising is about persuasion, or more pejoratively manipulating minds, then should we allow one political party a greater opportunity to do this than another? If the answer is even a qualified no, then I think we are entitled to put limits on how much money political parties or their supporters can spend. (In the UK this is done at election time, but the logic implies limits should operate at all times.) It also, in contrast to Chris Dillow’s view here, suggests that there should be limits on how much individuals are allowed to contribute to political parties. 

Microfoundations and Central Bank models

                When the need for internal theoretical consistency (microfoundations) and external empirical consistency (matching the data) conflict, what do you do? You might try and improve the theory, but this can take time, so what do policy makers do in the meantime? 

                There are two ways to go. The first is to stick with microfounded models, and just deal with their known inadequacies in an ad hoc manner. The second is to adapt the model to be consistent with the data, at the cost of losing internal consistency. Central banks used to follow the second approach, for the understandable reason that policymakers wanted to use models that as far as possible were consistent with the data.

                However in the last decade or two some central banks have made their core macromodels microfounded DSGE models. I have not done a proper survey on this, but I think the innovator here was the Bank of Canada, followed by the Reserve Bank of New Zealand. About ten years ago I became heavily involved as the main external consultant in the Bank of England’s successful attempt to do this, which led to the publication in 2004/5 of the Bank’s Quarterly Model (BEQM, pronounced like the well known English footballer). I think it is interesting to see how this model operated, because it tells us something about macroeconomic methodology.

                If we take a microfounded model to the data, what we invariably find is that the errors for any particular aggregate relationship are not just serially correlated (if the equation overpredicts today, we know something about the error it will make tomorrow) but also systematically related to model variables. If the central bank ignores this, it will be throwing away important and useful information. Take forecasting. If I know, say, that the errors in a microfounded model’s equation for consumption are systematically related to unemployment, then the central bank could use this knowledge to better predict future consumption.

                BEQM addressed this problem by splitting the model into two: a microfounded ‘core‘, and an ad-hoc ‘periphery’. The periphery equation for consumption would have the microfounded model’s prediction for consumption on the right hand side, but other variables like unemployment (and lags) could be added to get the best fit with the data. However this periphery equation for consumption would not feed back into the microfounded core. The microfounded core was entirely self-contained: to use a bit of jargon, the periphery was entirely recursive to the core.

                Now at first sight this seems very odd. If the periphery equation for consumption was giving you your best prediction, surely you would want that to influence the core model’s predictions for other variables. However, to do this would destroy the internal consistency of the core model.

Let us take the hypothetical example of consumption and unemployment again. In the core model unemployment does not directly influence consumption over and above its influence on current and future income. We have found from our periphery equation that we can better explain consumption if it does. (Unemployment might be picking up uncertainty about future income and precautionary saving, for example.) However, we cannot simply add unemployment as an extra variable in the core model’s equation for consumption without having a completely worked out microfounded story for its inclusion. In addition, we cannot allow any influence of unemployment on consumption to enter the core model indirectly via a periphery equation, because that would destroy the theoretical integrity (the internal consistency) of the core model. So the core model has to be untouched by the ad hoc equations of the periphery.

                So this core/periphery structure tries to keep our microfounded cake, but also eat from the additional knowledge provided by the data using the periphery equations. Now the research goal is to eventually get rid of these periphery equations, by improving the microfounded model. But that takes time, so in the meantime we use the periphery equations as well. The periphery equations utilise the information provided by the statistical properties of the errors made by the microfounded model.

                I think this core/periphery structure does nicely illustrate the dilemma faced by policy making institutions. They want to follow current academic practice and use microfounded models, but they also want to use the information they have about the limitations of these models. The core/periphery structure described here can be criticised, because as I suggested this information is not being used efficiently without feedback to the core . However is there a better way of proceeding? Would it be better to compromise theory by changing the model so that it follows the data, which in BEQM’s case would merge core and periphery?

                It is sometimes suggested that this is a conflict between forecasting and policy analysis. The example involving consumption and unemployment was chosen to show that this is not the case. The data suggests that the microfounded model is missing something, whether we are forecasting or analysing policy, and the question is what we do while we figure out exactly what is missing. Do we continue to use the wrong model, confident in the knowledge that the stories we tell will at least be consistent, albeit incomplete? Or do we try and patch up the model to take account of empirical evidence, in a way that will almost certainly be wrong once we do figure out properly what is going on?

                What has this to do with academic macroeconomics? Perhaps not much for the macroeconomist who builds microfounded DSGE models and is not that involved in current policy. Microfounded model building is a very important and useful thing to do. For the profession as a whole it does matter, because the central banks that now use microfounded DSGE models do so because that is how policy is analysed in the better journals. Academic macroeconomists therefore have some responsibility in advising central banks how they deal with the known empirical inadequacies of those models. When the data tells us the model is incomplete, how do you best use that information?

The strange case of the disappearing productive capacity

                Have a very quick look at the chart below.

It looks like recent developments in actual output relative to potential. But it is not. It is various assessments of UK potential output against the pre-recession trend.

                It comes from the post-budget forecast produced by the Office for Budget Responsibility (OBR), the independent body that the UK government has contracted out the job of producing the official budget forecast to. It shows that the OBR, and other international forecasters, think that the recession will in a few years time have led to a permanent loss of UK output of over 10%. That is an extraordinarily large number. It makes the recent US debate on the subject look positively tame by comparison.

                The OBR estimates mainly come from survey evidence. The following chart is from a recent OBR working paper which describes their methodology.

We can see the problem by comparing 1981 with 2009. Between 1979 and 1981 UK GDP fell by about 3.5%, whereas between 2007 and 2009 it fell by 5.5%. Yet movements in the output gap look quite similar. More significantly, from 2009 to 2011 UK GDP grew at an average annual rate of just less than 1.5%, yet this survey evidence suggests the output gap was almost halved as a result!

                The OBR estimate that the current output gap is about 2.5%. Of this about 0.5% represents below trend levels of output per worker, with about 2% reflecting the gap between actual and potential employment. Unemployment is now around 8.5%, compared to about 5% before the recession.

                Other institutions use a production function approach to estimating productive capacity. The extent to which this is an alternative methodology depends in large part on how underlying total factor productivity (TFP) is estimated. (We can estimate the potential labour force from employment and unemployment, and the capital stock from investment data, but there is no data on changes in how efficiently those factors could be used.) If TFP is imputed from survey evidence on the output gap, we are going to get similar results.

                So if these numbers are correct, how can they be explained? The major explanation has to come from a slowdown in underlying productivity. Actual labour productivity has indeed fallen in most sectors: the chart below comes from the Bank of England’s Feb 2012 Inflation Report.

Now falls in labour productivity are what might be expected in a demand led recession, because it takes time for firms to adjust employment. However after a while one of two things should happen. The first possibility is that employment adjustment does occur as firms reconcile themselves to lower output, so productivity should rebound. It has not, particularly in services. The second is that firms are hoarding labour because they think output will recover to something like pre-recession trends. But in that case they should be reporting substantial spare capacity, which we have seen they are not. This behaviour in productivity appears to be the main difference between the UK and US estimates of potential output.

                It is still possible that the survey data is just wrong. This is a view taken by Bill Martin (see both his FT article and the more detailed analysis behind it). However the survey evidence does receive some support from inflation. Although I noted that wage inflation had been very subdued following the recession, and that the recent peak in consumer price inflation was largely caused by commodity prices and tax changes, it remains the case that movements in domestic profit margins appear to be reasonably consistent with the survey evidence on the output gap. Firms are not cutting prices in an effort to utilise substantial spare capacity. However this is fairly weak evidence: there may be other reasons why firms are not cutting prices.

If the survey evidence is correct, then we have a major supply side puzzle. Is it the case that innovation has really come to a halt following the recession, perhaps because of financial constraints? Or are there more subtle supply side factors at work? (Subtle is code here for ideas that maybe interesting, or maybe silly.) A further possibility is that hysteresis effects may have operated more quickly than anyone thought, which really would be an indictment of austerity. A crucial question either way, posed by Mark Thoma, is whether these changes are temporary or permanent.

In the UK, this is not just an academic puzzle. With inflation still above target, the size of the perceived output gap remains important for (unconventional) monetary policy. Furthermore, and unlike the US, the government’s main fiscal target relates to the cyclically adjusted budget deficit. As I noted here, downward revisions made to potential output by the OBR in November led to a tightening of the government’s austerity plans. This was admittedly put off for a few years, but expectations matter. It is important to get this right, because with hysteresis effects (see DeLong and Summers) there is a danger that pessimism about productive capacity and productivity, even if it is misplaced, may become self-fulfilling.