The US and the Eurozone 2012-3

If fiscal policy is important at the zero lower bound, why did the US recovery continue in 2012 and 2013 despite a large fiscal contraction? Or to put the same question in a comparative way, why was the Eurozone’s fiscal contraction in 2012/3 associated with a recession, but not in the case of the US?

GDP growth had been reasonable in both the US and the EZ in 2010 and 2011. While US growth continued into 2012/3, EZ growth collapsed. Yet as the chart above shows, fiscal tightening was only slightly greater in the EZ in 2012, and became considerably tighter in the US in 2013.

Before discussing this, it is important to make two important points. The first is that the macroeconomy is complex, involving important lags in behaviour and expectations of future events. For that reason alone, you will not get precise matches between causes and consequences by just eyeballing the data. Second, different fiscal measures have different effects, and trying to express the fiscal stance in one simple measure will always be a crude approximation. However, despite these qualifications, I think we can provide something of an answer to this question by just looking at the numbers. 

In comparative terms, there are two obvious answers looking at 2012. The first is the EZ crisis. Although this began in 2010, it reached a critical position in 2012, when Greece was almost forced out. It is hardly surprising in these uncertain circumstances that EZ investment fell by nearly 4% in 2012. The second is monetary policy. The ECB raised rates from 1% to 1.5% in 2011, and compared to the US there was no Quantitative Easing. Combining the two, monetary conditions tightened considerably in the periphery as a result of the crisis. There was no comparable crisis in the US, which allowed investment to increase by 5.5%.

Explaining 2013 seems more difficult. Monetary policy had eased in the EZ (although of course not by as much as it should have), and OMT had brought the crisis to an end. In the US there was considerable fiscal tightening. So why did the US continue to grow and EZ GDP continue to fall?

For the EZ one proximate cause was a sharp decline in the contribution of net exports. Net exports added 1.5% to GDP in 2012, but only 0.5% in 2013. If this contribution had been more even at 1% in each year, GDP would have fallen by over 1% in 2012, and stayed roughly flat in 2013. Fiscal policy continued to tighten, which also would have reduced growth.

In the US something else happened: the savings ratio, which had been elevated at 5.5% or above since 2009, fell to 4.5%. This could have been a result of fiscal tightening, but it seems more probable that it represented the end of a prolonged balance sheet correction. (The US savings ratio averaged 4.5% between 1996 and 2007 and the OECD’s forecasters expect it to fall further this year and next.) The OECD estimates that the US output gap in 2013 was -3.5%, which was much the same as their estimate for 2012. So growth of 2% did nothing to close the output gap in 2013. This was despite a large fall in the savings ratio, perhaps bringing to an end the balance sheet correction that began with the Great Recession. So US growth in 2013 should have been very strong, and the obvious explanation for why it was not is very restrictive fiscal policy.

How to change the inflation target

The longer interest rates stay at the Zero Lower Bound (ZLB), the stronger the case (pdf) for raising the inflation target becomes. (No, that is not a good reason to raise interest rates today, but perhaps it helps explain why some are so keen to do so!) However there seem to be two political barriers to this happening. Central banks seem to live in mortal fear that any move to raise inflation targets will shatter their ‘hard won credibility’ and inevitably lead to inflation ‘taking off’ and inflation expectations becoming ‘unhinged’. Where politicians have control (as in the UK), they worry the public will interpret any increase in the inflation target as a further erosion of their living standards. Yes, I know Abe raised the target rate in Japan, but only to the 2% that has become the consensus for the major developed economies.

Tony Yates suggests a very British solution to this problem. In the past, a standard way that UK politicians have handled such tricky questions has been to establish an independent commission to examine the question. (One famous example in the past was the Macmillan committee, set up after 1929 to establish the causes of the UK depression. Keynes’s role on that committee is vividly described by Peter Temin & David Vines in their recent book.) Tony calls it the Inflation Remit Review Commission. This commission could take evidence (from the central bank and others) on issues such as what the medium term natural real interest rate is likely to be, and compute the costs and benefits of any change. This sounds like a good way of trying (as far as possible) to depoliticise the issue, and putting the central bank’s inflation paranoia in context.

I have just one suggestion to add. This commission, at the same time, should examine whether it remains appropriate that the inflation target should just involve the consumer price index (and in particular, whether the rate of change of wages should also be targeted), and whether the target should involve the inflation rate or a path for prices (a price level target), or indeed national income. These questions naturally go together with the choice of the level of any inflation target. If there is a target for the path of prices rather than its rate of change, then the consequences of hitting the ZLB are less severe, for example. In addition, the possibility of ending the tyranny of the consumer price index, or changing to a level target, suffer from much the same conservative bias from politicians and/or central banks as the value of the target itself.

Whether the idea of a commission would work in the US I do not know. In the Eurozone there are strong grounds for setting up a similar body, not only to review the questions set out above, but also to permanently oversee the performance of the ECB. At present the ECB has minimal accountability. Appearing every three months before the European Parliament just does not count, I’m afraid. (For further discussion, see this Bruegel paper by Claeys, Hallerberg and Tschekassin.) This in itself is a strange state of affairs for an institution with such power. In addition its performance since 2011 (at least) has been very poor relative to the Fed and Bank of England. (See for example this post written over a year ago which I think reflected the clear consensus among macroeconomists at the time.)

Tony does not suggest who might sit on this commission, except to say that they should not be part of the government, or the central bank. My own view is that it is vital that at least some are academic macroeconomists, because academic macroeconomists do understand these questions better. For the UK obvious candidates are ex-external members of the Monetary Policy Committee, unless you think they have become (or were perhaps selected because they were) too indoctrinated with the central bank view. Suggestions on who might comprise an oversight commission for the ECB would be very welcome.      

What we do know

After reading all about the latest ECB moves, I happened to read this by Noah Smith (HT MT). It made me unusually irritated, but it is not really Noah’s fault. He is right that there is much that we do not know in macro, and also right that there are many different views around. Alternative assessments of how effective the ECB’s policy changes will be illustrate that. Noah puts all this down to lack of data, rather than politics. When it comes to unconventional monetary policy this is also right. However there are some things where the data is pretty clear, and where any macroeconomist with an open mind should be able to come to a clear conclusion. But somehow this does not happen.

When pouring over the detail of what are minor moves by the ECB, there is a huge elephant in the room: fiscal policy. Too often this is portrayed by those outside as a game with two sides: the PIIGS, where austerity is a necessity because of difficulties in funding debt, and Germany, where there is no domestic interest in offsetting periphery austerity with fiscal expansion. However there is a third bloc of countries in the Eurozone, where there has been no debt funding crisis, but where there exists a large amount of spare capacity. This bloc is dominated by France (2014 output gap -3.4% as estimated by the OECD), but also includes the Netherlands (output gap -4.4%), Belgium (output gap -1.7%), Austria (output gap -3.2%) and Finland (output gap -3.8%). The chart below shows what is happening to fiscal policy in those countries.

Underlying Primary Balances: OECD Economic Outlook May 2014

All of these countries are tightening their fiscal policy this year and next: in the case of France, Finland and the Netherlands quite substantially. So the focus on Germany as a country (as opposed to its influence on Eurozone institutions), where the OECD projects some very modest fiscal expansion, is misleading. Damage is being done elsewhere, and for this group of countries where negative output gaps are large fiscal policy is just perverse.

The theory and evidence behind this last statement should not be controversial. The theoretical framework used by monetary institutions almost everywhere says that fiscal contraction at the zero lower bound will do serious damage to output and unemployment (and therefore reduce core inflation). The evidence overwhelmingly confirms this proposition. While the reasons for the Great Recession may still be controversial, the major factor behind the second Eurozone recession is not: contractionary fiscal policy, in the core as well as the periphery. So this is something we really do know. Yet too many macroeconomists seem reluctant to acknowledge this. There are the anti-Keynesians who want to deny the monetary policy consensus; there are others, who want to deny the importance of the zero lower bound; and still more, who for some other reason want to deny the importance of fiscal policy.  

This allows policymakers to continue to press for fiscal consolidation in the Eurozone, largely ignoring those economists who do challenge this policy because they just represent 'one view' within the discipline. Every reluctant and far too late bit of stimulus by the ECB is undone by the actions of the Commission and the political consensus behind austerity in Europe. As far as economists are concerned, although our macroeconomics is much better than it was 50 years ago, in this case our collective influence on policy has gone backwards. 

Privatisation and government debt

Possibly the worst argument for privatising part of the public sector is a supposed ‘need’ to reduce public sector debt. I think the problem with this argument is obvious to most economists, but as it is repeatedly ignored by politicians, it is worth spelling it out.

As I argued in a previous post, decisions to privatise or contract out should be based on considering the microeconomic pros and cons, which will vary from case to case. This analysis should include political economy considerations, like the extent of public sector corruption, or the ability of firms to extract rents from the public sector.

Suppose that such an analysis left the decision to privatise evenly balanced. Should macroeconomic factors, like the need to reduce public sector debt, ever be used to sway the decision in favour of privatisation? In our recent paper, Jonathan Portes and I argue (here or here) that a government should have some view about what the long run desirable level of public debt relative to GDP should be. Two arguments that could be used to argue for lower long term debt are that paying interest on debt requires raising taxes, which are ‘distortionary’ (they tend to reduce GDP and welfare), or that public debt may crowd out private capital and investment (assuming those are thought to be too low).

If we start out with public debt above its long run target, why not use privatisation to help get us towards that target? To see why that is nonsense, consider the two reasons for reducing debt given above. The first was to reduce the need to raise taxes to pay interest on that debt. While privatisation might reduce debt, it will also reduce future revenues or increase future public sector payments. Privatisation will either mean that the public sector loses the revenue that the privatised activity produced, or the private sector will have to be paid to undertake the outsourced activity. So the net impact on taxes will be zero.

What about the point that public debt may crowd out private investment? Once again privatisation does nothing to encourage additional private sector investment. All that happens is that existing capital and any investment that goes with it are relabelled private rather than public. No additional savings are released to encourage new private sector activity.

Consider an extreme example: Greece. The country is desperate to show that debt can be at least be brought to some sustainable level. So what is wrong with selling off some state asset, like part ownership of a water company for example, to help reduce this debt? Now there may or may not be good microeconomic reasons for doing this, but is there a good macro reason? Selling the asset would allow the Greek government to reduce its debt, but it would also have to raise future taxes, or cut future spending, to make up for the revenue lost from no longer owning that company. If microeconomic efficiency is unchanged, this sale would make no difference to the balance between taxes and spending required to make debt sustainable. Debt interest payments would fall, but so would receipts.

To make the same point another way, if we valued public sector assets and calculated the public sector’s net asset position, privatisation would have no effect on that net number. So why should anyone think that the position of the Greek government had been improved by this asset sale?

Obvious though this point may be, it illustrates a problem with most fiscal policy rules. Most rules need to involve what Jonathan and I call realisable operational targets: goals that politicians can aim for (and be judged by) within the lifetime of administrations and parliaments. Privatisation is one of a number of devices that flatter the short term public finances with no impact (or worse) on the long term position. (Considerably worse if the asset is sold far too cheaply, as in the most recent UK case for example.) Because fiscal rules inevitably focus on the next few years, politicians will always be tempted to use these devices to in effect cheat those rules. This is why it is vital to have effective fiscal councils to work alongside any rules. These independent institutions need to be able to shout when they believe only the letter and not the spirit of these rules is being met. The UK’s fiscal council, the OBR, does not have this kind of mandate, and can therefore only note when policies have this kind of effect (see here, paras 1.8-9).  

Reforming Econ 101

Noah Smith has some good ideas on this, and the CORE project (here is a presentation at INET’s annual conference) should have a new curriculum by the end of this year. But the reactions of many will echo Noah’s: there is just no room for any new stuff. It is certainly true, speaking about the macro component, that there is a danger we teach much too much material at this level. Some of what we teach appears contradictory: like the AS curve and the Phillips curve.

So my first point, which I have made before, is that we can get rid of a lot of stuff that is simply out of date. Like the LM curve (and theories of money demand that go with it). And the Aggregate Demand curve which is derived from it. And Mundell Fleming which is an open economy version of it (and inconsistent with UIP to boot). And the money multiplier (which, apart from being very misleading, is unnecessary if we stop fixing the money supply). But why not really get this bonfire going? Do we need to teach the Keynesian multiplier? As there are good reasons to think that the closed economy government spending multiplier (with a given level of real interest rates) is around one, what is the point?

Of course a lot of this would come back, in some form, in a more advanced macro course. However I have always thought the acid test for what should be included in an introductory course is whether it is something that a person who studies no more economics really needs to know. I would submit that all of the above fail this test.

What has to stay in? The IS curve of course: monetary policy is all about using interest rates to control aggregate demand. However I agree with John Cochrane that this should be based on the two period consumption model (which students with large loans can relate to), and not investment theory. The Phillips curve is central to how pretty well everyone thinks about macro, so that has to be there. It can be taught as an empirical regularity, introducing the macro history of the 1970s at the same time.

Sometimes people have told me that you need to say something about money if you want to talk about Quantitative Easing (QE). I think exactly the opposite is true: QE shows up how ridiculous the LM curve stuff is. QE represents a huge increase in bank reserves - and the money supply hardly moves (thank you money multiplier). How much simpler, and more realistic, to just talk about short and long interest rates. Dispensing with money allows us to spend time talking about the zero lower bound, and events since the financial crisis. I would use this to motivate a discussion of fiscal policy and debt.

Would I replace the LM curve with a ‘monetary policy curve’, expressing preferences over inflation and output, or a Taylor rule? I’m tempted not to, because when you do something like this, students stop thinking about monetary policy as a choice. The example I sometimes use is an accidental (not countercyclical) temporary fiscal expansion that is foreseen. So many students let that increase output and inflation, and then have a Taylor rule react. But of course if the fiscal shock is known, any sensible monetary authority would attempt to completely counteract the impact of that shock.

What about the ‘supply side’. I agree with Mankiw’s text that we can treat labour supply as fixed at this level. Together with a medium term assumption of fixed capital gives us all we really need to motivate a Phillips curve with a natural rate. Deriving a labour demand curve from profit maximisation tells us that increases in labour saving technology do not lead to increases in unemployment, which is nice, but it has the cost of confusing students (and policymakers) when we subsequently assume demand determined output.

I would replace Mundell Fleming with a combination of a net export function (which gives us a relationship between aggregate demand and competitiveness) and Uncovered Interest Parity (UIP). A key idea that should be taught at this level is that in a small open economy, it is the real exchange rate and not the real interest rate that ensures aggregate demand equals supply in the medium term. I think introductory macro should also say something about fixed exchange rate regimes.  

So there you have it. Econ 101 with just three basic relationships: an IS curve, a Phillips curve and UIP. I would use some of the space created to talk about basic issues and common confusions, like the relationship between price flexibility and output gaps, or between involuntary unemployment and wage flexibility, or why Says Law does not hold and why the General Theory got written. Comments welcome on anything else that really should be in there. 

Tyrie and the IMF on austerity

Suppose you were given advice about the UK economy every year, and these were the outturns for growth. What, in retrospect, would you complain about? I think most people would complain that you should have been advised more robustly that growth would be weak in 2011, and non-existent in 2012. But Andrew Tyrie, chair of the Treasury Select Committee, seems unconcerned about that. He complains that when the IMF did become increasingly worried (as in April 2012 for example), it should have kept quiet. 

GDP Growth rates: source OECD Economic Outlook 2014:1

This is of course just another example of the establishment’s attempt to deny the evidence about austerity. It is particularly rich because the Treasury was also becoming increasingly worried that growth would not return before the election, which is why it eased off on austerity and brought in Help to Buy. Anyone who tells you they just knew the UK savings ratio would fall sharply in 2013 and so there was no need to worry is either lying or a fool.

There are two other absurdities in Mr Tyrie’s article worth noting. The first is that he says the IMF should have been more robust in its advice to the Eurozone. Apart from the fact that it was pretty robust, just exactly what does he expect the IMF to have said that might have prevented the second Eurozone recession? It should (and did) say less austerity, which is understandable given the central role austerity played in that second recession. That is the same austerity that in 2010-12 Mr. Tyrie thinks was sensible policy in the UK.

The second is this line. “Most ill-considered of all was the IMF’s specific policy recommendation to bring forward capital investment. Big infrastructure projects are hard enough to agree on, design and manage as it is.” Would that be infrastructure projects like flood protection for example, which were already on the drawing board but which were postponed?

Of course this article is really just a shot across the IMF’s bows. In your forthcoming report lay of the criticism about things like Help to Buy because there is an election on the way. But what Mr. Tyrie should really write about is this. On austerity the IMF were too sanguine in 2010/11, but they (and particular Olivier Blanchard) have looked at the evidence and changed their minds. That is something the UK establishment, Mr. Tyrie included, have completely failed to do.

Scottish Independence

Martin Wolf is quite right when he says that the debate about Scottish independence should not focus on relatively short term macroeconomic costs and benefits. I personally would be very sad if Scotland became independent, but that has nothing to do with money and (just as for Martin) everything to do with a British identity of which Scotland is an important part. But I also understand, having lived and worked in Scotland for five years, how these issues are more difficult when you are a minority part of a bigger nation.

Nevertheless my expertise is in macroeconomics, so I should say something about recent claims by both sides. It seems fairly clear to me that the Treasury report is right when it argues that, for the next decade or so at least, people in Scotland will be significantly better off by staying in the Union. The main reason is that additional public spending in Scotland as part of the union exceeds any benefits Scotland would get from having more of the revenue from the North Sea. This is also the conclusion of independent bodies like the IFS or NIESR, and it is only avoided by the Scottish government because they have unusually optimistic projections, particularly for North Sea revenues.  

What the exact benefit is, who knows. The set-up costs assumed in the Treasury report look too high (although Brian Ashcroft would like to see the Scottish government's figures), but they are only a minor component of their £1,400 per person dividend. In the longer term the trends for Scotland do not look favourable: North Sea revenue will decline, but public spending needs will not. So on present plans the Union dividend will not disappear. It is true that the UK government could change its funding formulas in the future to ensure Scotland gets a smaller dividend, but I suspect the threat of independence is quite a powerful incentive against that happening.

So what about the Scottish government’s claims that Scottish people will be better off with independence? Basically these amount to the belief that on its own Scotland will be able to become more productive, work harder and attract more migrants than as part of the union. These are discussed in Chapter 4 of its recent report.

The one area where this chapter has something going for it is with migration. The UK government’s desire to halt net migration will harm the UK’s public finances. If an independent Scotland took a much more positive attitude towards immigration, this could have beneficial macroeconomic effects. (Brian Ashcroft makes the same point here.) But elsewhere the report amounts to little more than hopeful guesses. In terms of productivity improvements, it simply says that the Scottish government has some good policy ideas, and here is a number for the higher productivity growth that these could generate. Is that number based on any detailed economic analysis? Not as far as I can see - it seems to be plucked out of the air. What about the benefits of greater participation of women in the labour force? The Scottish government wants to make better child care provision a priority, but the impact that this might have on participation rates again appears no more than a guess.

However this does mean that speculation about factors that might influence long run macroeconomic trends is pointless. As the migration example illustrates, where UK policy appears to have negative effects on output or growth, and an independent Scottish government would avoid this policy, this is a plus for the yes side. Besides migration, the obvious example is Europe. There has to be a significant probability that the Conservatives will win the next UK election, and despite his efforts, Cameron could lose the referendum he is committed to. An exit from the EU would almost certainly be harmful to the UK, and an independent Scotland would avoid those costs.  

To set against that are the insurance benefits of being part of a larger union. An independent Scotland would be a small open economy heavily dependent on a commodity with a volatile price. Standard precautionary savings theory says that a country dependent on a resource with a volatile price needs a form of insurance as a buffer. For an independent country that insurance has to come from building up a financial fund, which implies lower current spending. As part of a much larger union, however, the union can provide the insurance. And then of course there are the benefits of being part of a currency union which, without going into all the ‘will they do what they say they will do’ stuff that I have talked about before, will be put at risk with independence.

One final consideration involves options. Rejecting independence now does not preclude independence in the near future. For example, if the UK did vote to leave the EU, the case for allowing Scotland another vote shortly thereafter would be difficult to resist. In contrast, if Scotland became independent, the new nation would be unlikely to want to consider union again for decades, and even if it did the terms the UK would impose would almost certainly be less favourable to Scotland. So, for this reason alone, the risks in voting yes are higher.