A short answer to Tyler Cowen’s question

The question, following the observation that UK real wages have fallen substantially, is “In the traditional Keynesian story, stimulus lowers real wages through nominal reflation.  Is that the Keynesian view here?  If so, why do Keynesians believe that British real wages need to fall more than 8.5%?”

Actually I think this question has nothing especially to do with the UK, and a great deal with Keynesian theory, or at least how Keynesian theory is often taught. The problem in the UK and nearly everywhere else right now is lack of aggregate demand, not the level of real wages. Why, asks Tyler, are not more workers being hired if real wages are so low? Well low real wages are having some effect – it is one factor behind the ‘productivity puzzle’ that is widely discussed in the UK. But when the problem is aggregate demand, low and declining real wages will not ensure ‘full employment’. Firms may employ more labour, but there is no reason to expect the labour market to clear.

I think what lies behind this question is the idea that aggregate demand matters because sticky wages are preventing the labour market clearing. So, to rephrase Tyler’s question, falling UK real wages do not look very sticky, so where is the problem? When I was studying macro, there were these debates about whether it was sticky wages, or sticky prices, which underpinned Keynesian theory.

The answer I would give, at least at the zero lower bound under inflation targeting, is neither. To get technical, imagine a toy model with imperfectly competitive firms who set a constant mark-up on labour costs, and a linear technology. Nominal wages could fall forever, but firms would cut prices to match, so the real wage would not change. So the question is then whether falling prices will raise aggregate demand. But why should they, particularly if nominal interest rates are stuck at zero, and the central bank puts a lid on expected inflation.

The price that is ‘wrong’ when aggregate demand is deficient is the real interest rate. This is one area where New Keynesian theory has helped sort out old Keynesian confusions. If falling wages and prices do nothing to change real interest rates, then aggregate demand need not rise. And if aggregate demand does not rise, unemployment can persist. But at the zero lower bound, with a central bank mandated to target inflation (and a government showing no signs of changing that mandate), the real interest rate cannot be reduced. So expansionary fiscal policy is needed to raise demand, not lower real wages. Or, in the case of the UK at the moment, contractionary fiscal policy is currently reducing demand and therefore output.

Austerity, debt burdens and hypocrisy

After the weekend march against UK austerity, I saw a government minister on the TV justifying their fiscal plans. One of the arguments he used was that it was necessary for the sake of our children. In these circumstances I can quite understand the urge to dismiss such arguments as invalid. Part of this urge comes from knowing that, in many cases, the argument about debt being a burden on future generations represents simple hypocrisy.

How do I know this? Because often exactly the same people championing austerity also argue that we cannot take action to reduce future climate change because the current costs will be too great. The UK government’s spin was that it would be the greenest government ever, but its policy is quite the opposite. The Republican Party in the US also resists any action to reduce climate change because of the current costs of doing so (at least when they are not denying climate change exists). The connection? Both issues involve trading off costs to the current generation (austerity, measures to reduce climate change) with costs to future generations (higher taxes, climate change itself). If you really believe that we must reduce debt right now (rather than after the economy has recovered) because of the impact debt will have on future generations, then you should also be doing everything you can right now to reduce carbon emissions.

But just because some of those who use the ‘we are doing it for our children’ argument to justify today’s austerity are doing so hypocritically does not mean the argument is wrong. I will not go over why it is not wrong again, except to stress a point I do not think I have made forcefully enough before. Arguments which look at the distributional implications of permanently higher government debt (debt incurred but never repaid), and then ponder whether real interest rates will or will not be higher than the growth rate, are analytically convenient but practically irrelevant. There are many strong reasons, which have nothing to do with intergenerational equity, why it would be foolish to not try and reduce the high levels of government debt we currently have when the economy recovers, and so additional debt issued today will need to be repaid (and not just financed) at some point in the not too distant future.

However, although concerns about intergenerational equity are valid, they are unlikely to be critical to the austerity debate. Probably most major economic issues involve some element of redistribution, and in practice the device of compensating the losers is not an option. Take monetary policy, for example. We currently have low real interest rates, which benefits some but harms others. Do we let the fact that savers are worse off as a result of this policy hinder the central bank from keeping interest rates low? Of course not.

In the case of reducing debt today through austerity, there are other factors which have distributional consequences going in the other direction. To the extent that we have austerity through lower investment in infrastructure or education, it is the young more than the old that will be hurt by this policy. As important, high unemployment among the young today can have lasting effects (pdf, HT TC) on their welfare, and their children's welfare, as this study (pdf) shows. More generally, if DeLong and Summers are right that the hysteresis effects of austerity today are significant, then an entire future generation may be worse off as a result.

So it is not that ‘burden of debt’ arguments are wrong, but that they are just not that important in the context of the current austerity debate. The welfare loss to future generations of delaying debt reduction by ten years is small relative to the massive loss of resources and welfare caused by austerity today. If we are worried about future generations, a far cheaper way of helping them is to take action to mitigate the impact of climate change. 

Different approaches to austerity

This is a really interesting chart from the IMF’s October 2012 Fiscal Monitor (HT Antonio Fatás). The red dots are the cyclically adjusted primary balance, the blue bars changes in government expenditure and the yellow bars changes in tax revenue.

It shows the extent of austerity (the red dots). Look how ludicrous is the idea that Greece is not trying hard enough – their current and planned fiscal contraction is literally off the scale! (Here are similar numbers from the OECD.) But what I want to focus on, which this chart clearly shows, is the tax and spend composition of austerity.

In many countries (Ireland, Spain and the UK) austerity is concentrated on the expenditure side. In some (e.g. US) it is more evenly balanced, while in a few (France in particular) it mainly takes the form of rising taxes rather than lower spending. Now how you regard this depends crucially on whether these measures are permanent or temporary (where by temporary, I mean lasting around ten years or less).

If they are permanent, then this is largely a political issue about the size of the state. Raising taxes protects the existing size of the state (taking on board any distortionary costs that permanently higher taxes may bring), while cutting spending aims to reduce the size of the state. In terms of short run demand impact - which is obviously important given the current state of demand deficiency in most countries - permanent tax and spending changes will have similar effects.[1]

On the other hand, if these measures are temporary, then in macroeconomic terms their impact will be rather different, because multipliers are different. A very broad generalisation is that theory suggests multipliers for spending cuts will be significantly higher than those for tax increases. The simple idea is that consumers will smooth the impact of income changes due to tax increases, whereas cuts in spending go straight into reducing demand. In addition, incentive effects on labour supply will be much less important if they are temporary and output is demand constrained.

We need to be careful, however, because this is a generalisation that applies to government spending on goods and services with a high domestically produced content. If the decline in government spending involves a temporary reduction in civil servants’ salaries, rather than building fewer hospitals or roads, then it is much more like a tax cut. As analysis later in the IMF’s report shows, cuts in wages make up a significant proportion of spending cuts in Portugal, but not much in the UK, where cuts in government investment are more important.

So are these austerity measures temporary or permanent? Normally governments do not say. An exception is a much remarked upon feature of the French austerity plans, which is the introduction for two years of a new top tax rate of 75% on incomes over €1m. We can be pretty sure that this is one group where the income effects of tax increases on consumption will be largely smoothed away (which is good), but where the incentive effects are the subject of debate which seems more ideological than evidence based. Of course whether such temporary tax measures will in fact be temporary is a moot point, as the Bush tax cuts in the US illustrate.

In the absence of reliable information from governments, people have to make their own assessments.  In the initial stages of a crisis, if either there is an unforeseen shock to government finances, or to the long run level of output, then it may make sense to regard any austerity as permanent. However as austerity proceeds, the goal is to get debt down from a high but sustainable level to a lower sustainable level. In these circumstances a rise in taxes (say) will be temporary, and will eventually be reversed as lower debt reduces debt interest payments and therefore taxes.

So it seems likely that a good part of current austerity plans involve temporary fiscal changes designed to reduce debt levels, and so the differences between the multipliers of tax and spending changes will apply. For countries like the UK, that have focused on spending cuts, the knock on effects on output will be relatively large, whereas for countries like France the impact of austerity may be more moderate (although still unwelcome).

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[1] Spending cuts may still have a larger impact on domestic demand because government spending tends to have a lower import content than private spending.

Heterogeneity at the IMF

Right now, the IMF appears to some to be on the side of the angels. Their self criticism about the impact of austerity is both unusual and commendable in equal measure. They also appear to recognise that pushing Greece further than it can or should go is stupidity of the highest order. They are producing some of the best policy orientated empirical macro research at the moment (e.g. here and pdf). Yet this is the same IMF that in May co-hosted a conference on Latvia that looked very much like a PR job for the benefits of short sharp shock austerity. (For some links, see here and here.) The IMF’s attitude to austerity remains nuanced and country specific (as noted here, for example).

I’m not going to try and see if those apparently different views can be reconciled. Instead I will offer a more institutional explanation for any apparent confusion. The first point to make is that the IMF is a very large organisation: there are around 150 economists in the European department alone, and that department is one of many: some geographical, some functional (e.g. fiscal affairs, research). These are highly trained, very bright and often very experienced macroeconomists: the shear intellectual fire power can seem overwhelming.

The second point is that, for the moment, there seems to be no strong rigid party line imposed from the top. The country teams that conduct and write the annual Article IV reports appear to have a degree of independence, and so they do not have to completely subordinate their analysis to the political sensitivities of the Board or Managing Director (as was evident for the UK, for example).  There is far from complete independence of course: there are mechanisms to try and ensure some consistency of approach, but these mechanisms are not strong enough to achieve total homogeneity.

With so many talented individual macroeconomists, with such a diverse knowledge of particular economies, and in the absence of a strong command and control structure, differences of opinion are not surprising. Indeed, we might expect to see the range of opinion outside the organisation (among academics and policymakers) reflected to some extent within. It would also not be human if country teams were not just a little bit influenced by the dominant macroeconomic perspectives within those countries. After all, the influence of the IMF in most cases is marginal at best, so being attuned to those perspectives is essential.

Having said all this, it might still seem puzzling to find within one organisation such diversity over time as we have seen in the last few years. In 2008/9 the IMF was calling for expansionary fiscal policy to support the world economy, but by 2010 it was arguing for fiscal consolidation. Now the pendulum is swinging back again. One explanation, to possibly misquote a British Prime Minister, is “events, dear boy, events”. In 2009 the panic was the prospect of another Great Depression. In 2010 that possibly had receded, but then the panic was Greece.

A deeper explanation is the argument that the default mode within the IMF has in the past involved imposing austerity on governments that have overspent. So the 2010 switch to advocating austerity was a return to familiar ground. From this perspective it was the championing of stimulus during the worst of the recession that was the more interesting development for the organisation. To quote from the excellent account by Farrell and Quiggin[1]

“The Keynesian resurgence was not entirely a product of the crisis. A Keynesian analysis and associated prescriptions had already begun to emerge in expert debate in January 2008, before the crisis proper hit. Dominique Strauss-Kahn, the Managing Director of the IMF, had announced at Davos that “a new fiscal policy is probably today an accurate way to answer the crisis", prompting Larry Summers to note that “This is the first time in 25 years that the IMF managing director has called for an increase in fiscal deficits" [Giles and Tett, 2008]. Both Strauss-Kahn and the IMF's chief economist, Olivier Blanchard, were pragmatic Keynesians, with a theoretical bent that differed markedly from the previous consensus position at an institution notoriously fond of advocating fiscal retrenchment for countries in difficulty.”

This change in position in 2008/9 probably reflects a pragmatic yet informed response to the unique (after the 1930s) position that the global economy found itself in, with interest rates at the Zero Lower Bound. What is interesting is that the IMF was able to make this change, despite its reputation for promoting fiscal discipline, while other institutions such as the ECB or European Commission (and sections of academia) were less adaptable. Perhaps in comparison the IMF was relatively free of political influence, so basic Keynesian logic was able to win the day, but that would just be speculation on my part. Anyhow, it is good to see this view reasserting itself after the disastrous shift to austerity in 2010. 

   

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[1] Farrell, H and Quiggin, J (2012) Consensus, Dissensus and Economic Ideas: The Rise and Fall of Keynesianism During the Economic Crisis. 

Misusing cyclically adjusted budget deficits

Chris Dillow alerts us to new claims that the UK government’s finances were in a terrible state before the financial crisis. Latest estimates from the IMF and OECD put the UK’s cyclically adjusted budget deficit in 2007 at around 5% of GDP, and the usual suspects have used these numbers to justify the theme that the Labour government was grossly irresponsible in fiscal terms before the recession. Chris explains why this might be quite acceptable to offset surpluses being run in the private sector. However as these figures appear to contradict what I argued about the Labour government’s fiscal record in this post, I want to explore a little bit where this number comes from.

The actual budget deficit in 2007 was just under 3% of GDP. As I argued in that earlier post, somewhat larger than the deficit required to keep debt to GDP constant, and therefore larger than it should have been, but not outlandishly so. The debt to GDP ratio in 2007 was much the same as when Labour took office ten years earlier. So to get a cyclically adjusted deficit of around 5% from an actual deficit of below 3%, the IMF and OECD must be assuming that 2007 was a boom year for the UK economy. That is exactly right – the OECD now estimates that UK output was 4.4% above trend in 2007.

Funny how it didn’t seem like that at the time. Indeed, the OECD in 2007 thought that the output gap that year was about zero, which was pretty much the consensus estimate. In which case the cyclically adjusted deficit would be much the same as the actual deficit. So what is going on? Why have the OECD and IMF changed their minds so radically about the state of the economy in 2007?

The answer, of course, is what happened after 2007. This was not just the recession, but the lack of recovery thereafter, and the absence of firms today saying they have spare capacity. I discussed the case of disappearing UK potential output (the ability or desire to produce output if demand is there) in this post. It is the same issue as our apparently poor productivity performance since the recession, which the longer it continues looks less like a temporary cyclical decline.

Now the capacity to produce output does not evaporate overnight. Capacity depends on three main things: capital, labour and productivity. Earthquakes aside, machines that could produce output yesterday can still do so today. The labour is still around, which is why we have high unemployment. Productivity is about how efficiently we use labour and capital to produce output. Once again, productivity should not fall overnight: we don’t just forget how to produce things efficiently. But the growth rate of productivity can fall to very low levels, if no innovation is taking place.

But even if productivity growth slowed dramatically after 2007, it cannot explain why apparent productive capacity is so low today. So if we believe productivity is really so low today, it must have started slowing down before the recession. In other words, productive capacity in 2007 must have been much lower than we thought at the time. Hence the actual level of output must have been well above productive capacity, leading to current estimates of a 4-5% positive output gap.

Three points follow from this. First, claims based on these figures that UK fiscal policy was grossly irresponsible before the recession are simply silly. None of the major institutions that analyse the macroeconomy thought in 2007 that the UK was in the middle of a major boom. Even if we assume that what the IMF and OECD now estimate about 2007 is correct, the government – like these organisations – did not have a crystal ball. In 2007 they, and pretty much everyone else, thought the economy was close to trend, and the government based their policy on that judgement. If the government at the time had tried to argue that the economy was in the middle of a major boom, they would have been ridiculed. 

Second, 2007 did not feel like a boom, so maybe it was not. In an overheating economy we normally see shortages pushing up wages and prices, but that was not happening in 2007. To argue that, despite this, 2007 really was a boom, you have to find reasons why it did not show up in inflation. Maybe in time we will, but nothing obvious springs to mind. This is why the UK productivity puzzle is so puzzling – it really does look as if we either have to rewrite history, or productivity just disappeared in the recession. Alternatively, of course, perhaps productive capacity today is really much more (and the output gap much larger) than people currently think, as some have suggested (most recently here).

Third, does this mean looking at cyclically adjusted budget deficits is a bad idea, if the adjustment itself is so uncertain? The answer is clearly no. It makes sense to run surpluses in a boom and deficits in a recession. We do the best we can to estimate when we are in a boom and when we are in a recession. Much of the time it is pretty obvious. It was obvious from inflation data, for example, that periphery Eurozone countries were experiencing boom conditions before the recession, and that therefore they should have been running bigger budget surpluses. Sometimes, particularly in extraordinary times like these, we may get things wrong, but that does not imply that we should give up trying.   

When policy ignores evidence: badgers and austerity

In the wood next to our house live at least one fox and maybe some badgers. We have seen badgers around, but it was only this summer that we first saw a badger walking (or more accurately sniffing) its way through our garden. It caused great excitement. On a walk from our house is someone who keeps on their smallholding a small number of alpacas. Except the last time we passed two were missing. They had been put down, because they had tested positive for TB. The risk that the others, and nearby cattle, might get the disease was too great. Tragically, autopsies found no trace of TB: the initial tests are not 100% accurate.

Badgers get, and spread, TB. As a result, the UK government is about to begin a large scale cull of badgers in Gloucestershire and Somerset. No one likes the idea of killing badgers. But cattle (or occasionally alpacas) dying from TB is no fun either. So the badger cull is just one of those necessary bad things that have to be done to prevent something even worse happening. Environmentalists are up in arms, but that is just because badgers look cute and cattle do not.

Except that is not what the evidence suggests. Following various small scale randomised badger culling trials, the UK government set up an independent group of scientists (the ISG) to evaluate the evidence. In 2007 the government published the report (pdf). It concluded as follows:

“The ISG’s work – most of which has already been published in peer-reviewed scientific journals – has reached two key conclusions. First, while badgers are clearly a source of cattle TB, careful evaluation of our own and others’ data indicates that badger culling can make no meaningful contribution to cattle TB control in Britain. Indeed, some policies under consideration are likely to make matters worse rather than better. Second, weaknesses in cattle testing regimes mean that cattle themselves contribute significantly to the persistence and spread of disease in all areas where TB occurs, and in some parts of Britain are likely to be the main source of infection. Scientific findings indicate that the rising incidence of disease can be reversed, and geographical spread contained, by the rigid application of cattle-based control measures alone.”

On Sunday 30 eminent UK and US scientists published a letter in the Observer. They write: “As scientists with expertise in managing wildlife and wildlife diseases, we believe the complexities of TB transmission mean that licensed culling risks increasing cattle TB rather than reducing it.” One of the signatories described the government’s policy as crazy, and suggested vaccination and biosecurity was a better solution. The Guardian reports the chair of the ISG as saying “I just don't know anyone who is really informed who thinks this is a good idea." The current government chief scientist said: "I continue to engage with Defra [the relevant government ministry] on the evidence base concerning the development of bovine TB policy. I am content that the evidence base, including uncertainties and evidence gaps, has been communicated effectively to ministers." In other words, ministers know what scientists are saying and have decided to ignore them.

So what is going on? One of the strongest pressure groups in the UK is the National Farmers Union (NFU), and many of their members naturally care a great deal about the health of cattle. To say that the NFU has a strong influence on policy at Defra is a bit like saying that the position of the sun has a strong influence on whether it is night or day. The NFU are convinced that culling badgers will reduce the incidence of TB in cattle, and government policy is following that belief, rather than the scientific advice it commissioned. (For more details, see George Monbiot here.) The BBC reports Defra Minister David Heath as saying "No-one wants to kill badgers but the science is clear that we will not get on top of this disease without tackling it in both wildlife and cattle." Dare I say weasel words.

I would not be the first to draw a link between research and evidence in epidemiology and macroeconomics. (Here is Peter Dorman on bees.) Neither is a science where experiments can be easily devised to definitively prove ideas right or wrong.  In both fields evidence can be messy. With austerity we did not have randomised trials: we had one almost globalised trial, starting in 2010, and one eighty years earlier. The evidence this time round is becoming clear: the harmful effects are much greater than many had assumed.

As I know about macroeconomics rather than epidemiology, I’m tempted to think the policy on badgers is the greater political sin. I’m all too aware of the conflicting messages the academic community have been giving policymakers. Although TB in cattle is an emotionally charged issue, I doubt that it attracts the ideological baggage that seems to infect macro. However, perhaps the two cases are not so different. The problem with austerity is that too many people of influence just know that high government debt is always and everywhere a bad thing. Too many think it is just obvious that when a country has difficulties in selling debt that must imply cutting it back as quickly as possible, in the same way that it is obvious that killing badgers must reduce the spread of TB. And perhaps too many people see badger culls as part of a battle between farmers and environmentalists, just as austerity is a weapon in a battle over the size of the state. 

Maybe we are just naive in thinking that as the evidence against austerity accumulates, and as those that were once for it change their mind, the policy will change. As Wolfgang Munchau writes (FT): “As hordes of frustrated European economists know only too well, macroeconomic analysis in general does not play a role in eurozone policy making.” So the policy goes on, in both the UK and the Eurozone, and I do not like to think about what might happen in the US if Romney wins. While I would never advocate a totally uncritical acceptance of the views of scientists, we are an awfully long way from that position, as unfortunately many badgers are about to find out. 

The Burden of Government Debt

The recent ‘exchange’ on this topic (see Nick Rowe here, here, here and here, and apparently on the other side Dean Baker, Brad DeLong, Paul Krugman and Noah Smith) may just have confused many, so here is my attempt to unconfuse. I’m doing this because (a) the issue is tricky (as I know from my own experience) (b) I’ve written about this before (c) I happen to be teaching this stuff right now (d) Nick Rowe needs some support (although no help). Bottom line: government debt can be a burden on future generations (the current generation can use it to take resources from future generations) even if there is no impact on future output, but it is also likely to reduce future output, so we really should worry about the size of government debt in the longer term. But none of these worries applies when the economy is demand constrained, as it is right now.

There are a number of ways that the current generation can exploit (take resources away from) future generations, and paying themselves using the device of government issuing debt is one. This can happen because generations overlap, and even if there is no impact on future output. Take the most basic example. At any point in time there are two generations: old and young. Only the young work and they produce 2000. They plan to save 1000 for their retirement, so consuming 1000 in each period of their two period lives. (Ignore interest payments for simplicity.) Now the old at time T get a gift of 100 from the government, paid for by issuing debt to the young. Suppose the young cut their consumption to 900 to purchase this debt. The old at T are better off by 100, and consume 1100 at T. The gift effectively comes from the young at T, but as the young bought an asset, they may think they will be OK at T+1, when they sell that asset and have consumption that period of 1100. The government then pays back its borrowing at T+1 by taxing the now (at T+1) old by 100. The T+1 old do indeed get their money back by selling the asset, but they are also taxed, so their consumption is 1000 in T+1, not 1100 as they had hoped. The economy at T+1 produces and consumes as much as it would have without this temporary creation of government debt, but the sum of consumption in both periods of the old in T+1 is 1900, while the sum of consumption in both periods of the old at T in 2100. It is as if the young just paid the old 100 at T, which is what would happen in a one-off unfunded social security scheme.

Now have the debt paid back at T+2 rather than T+1. The young at T, who are the old at T+1, are indifferent: they consume 900 at T and 1100 at T+1. The young at T+1 buy the debt from the old at T+1, and consume 900. It is when they become old at T+2 that they are worse off, when taxes rise to pay back the debt. If we call ‘society’ at some date the combination of the two generations living at that date, then we can say society at T is better off and society at T+2 worse off. But what if the debt is never repaid? I have misgivings about the relevance of this thought experiment (see here), but for what it is worth the standard result is that future generations get exploited if the real interest rate is greater than the rate of growth of the economy. However, no exploitation need occur if the debt is used not to increase the consumption of the old, but to invest in assets that future generations can benefit from (see here).

All this assumes that there is no impact on what society can produce. But that is not a realistic assumption. In the example above I just assumed that the young would be happy to postpone 100 of consumption to buy some government debt. But suppose instead they were not, and substituted that debt for 100 of their 1000 saving for their retirement. If that saving was in the form of productive capital, then the government debt ‘crowds out’ that capital. Now one for one crowding out like that is probably too extreme, but I think there are good reasons to believe that some crowding out occurs when investment in capital is governed by the availability of savings. This effect occurs not because government debt is in any sense necessarily bad – you can get exactly the same effect from investment in housing depending on who inherits houses. Indeed, if society has too much capital (which is theoretically possible), having government debt crowd out capital would be a good thing. However the balance of evidence is that society probably has too little rather than too much productive capital, which means we should be concerned about the long run impact of government debt.

Need this have any relevance to the debate on stimulus versus austerity? Absolutely not: indeed quite the reverse. No sensible person is arguing that current increases in debt should be permanent – instead they should be reversed, gradually, once the economy recovers. Until the economy recovers, investment is being held back by lack of demand, not a lack of savings, so the crowding out issue does not arise. I think you could make a good case that, by stifling the economy today through austerity, you are damaging productive capacity in the future. So in the current circumstances it is austerity, not increasing debt, which is harming future generations.