Could austerity’s impact be persistent

How Conservative macroeconomic policy may be making us persistently poorer

I was happy to sign a letter from mainly academic economists published in the Observer yesterday, supporting the overall direction of Labour’s macroeconomic policy. I would also have been happy to sign something from the Liberal Democrats, who with a similar macroeconomic stance have the added advantage of being against Brexit, but no such letter exists. As I have said before about letters, it is the overall message that counts. We desperately need more public investment and more current spending to boost demand, which in turn will allow interest rates to come away from their lower bound.

If I could carry just one message into mediamacro to bring it more into line with macro theory, it is that nominal interest at their lower bound represent a policy failure. Unconventional monetary policy is a very unreliable substitute for interest rate changes and fiscal policy as a way of controlling the economy, and a temporary fiscal stimulus can reliably get interest rates off their lower bound. This was the big mistake that most advanced countries made in 2010, and painfully slow recoveries were the result. The UK is currently making the same mistake, which is why the macroeconomic impact of the Labour and LibDem programmes is so much better than the Conservatives’ continuing austerity.

In the textbook macroeconomic models, this policy mistake can have a large but temporary cost in terms of lost output and lower living standards. This is because in these basic models a short term lack of demand does not have an impact on supply. Output in the longer run is determined by the number of those wanting to work, the capital stock and technology, all three of which are assumed to be independent of short term demand shortages. However it looks increasingly like these textbook models can be wrong.

In a new study (pdf), Gustav Horn and colleagues at the IMK institute in Germany looked at how persistent the impact of negative fiscal shocks (higher taxes or lower spending) had been on output. Their analysis is a refinement of earlier studies by of Blanchard and Leigh, and more recently Fatas and Summers. They find that the impact of recent fiscal shocks have been persistent rather than temporary, at least so far.

Although this persistent impact is not part of textbook models, economists have explored effects of this kind (the collective name for which is ‘hysteresis’). There are many theories about why it could happen, such as theories of endogenous growth. I explored the idea of an innovations gap in a recent post. To see why this possibility is so important, take the example of UK austerity in financial years 2010/11 and 2011/12. A few years ago I took the OBR’s (conservative) assessment of its impact on GDP growth in those two years, and assumed that the impact of fiscal consolidation had completely unwound by 2013. That gave you a total cumulated cost of austerity of 5% of GDP (1+2+2), or £4,000 per household.

What happens if instead the impact of austerity is much more persistent? I can no longer use the OBR’s numbers, because they assume impacts die out over time. Instead, let me make the fairly conservative assumption that each 1% reduction in the cyclically adjusted deficit reduces GDP by 0.7%, but these effects are permanent. I’ve chosen 0.7 because that gives a similar answer for the cost of austerity by 2012 as my previous calculation. But rather than disappearing in 2013, these cost persist and grow with each additional act of consolidation. By 2016/17 GDP would be lower by nearly 4%, and a further 1% would be added by the planned additional austerity until 2019/20. If you accumulate those losses, it means that the average household would have lost a staggering £13,000 by 2016/17, rising to £23,000 3 years later.

If you think that sounds a ridiculously large number, just compare output or income relative to past trends. Here is a version from the IFS.

Once you see this data, claims that we have a strong economy become laughable. UK median incomes are currently over 15% below previous trends. That is more than enough room to accommodate 4% due to a permanent effect from austerity.

I do not have to argue that such permanent effects are certain to have occurred. The numbers are so large that all I need is to attach a non-negligible probability to this possibility. Once you do that it means we should avoid austerity at all costs. In 2010 austerity was justified by imagined bond market panics, but no one is suggesting that today. The only way to describe current Conservative policy is pre-Keynesian nonsense, and incredibly harmful nonsense at that. That was why I signed the letter.

Exploring one set of reasons why austerity happened

In a new paper (here or here) based on my talk at the IMK anniversary in Berlin, I discuss the intermediaries between academic economists and politicians. Very few politicians have much knowledge of economics themselves, and so rely on intermediaries to transmit that knowledge. One important intermediary, particularly if you are not in government, is the media, and another is what Paul Krugman called policy entrepreneurs. In government you have the civil service. In the case of fiscal policy, central banks are a potential intermediary.

In the paper I look at how needless austerity could represent a failure in that transmission mechanism. I do not think for one moment that they are as important a reason as political opportunism by those on the right that want a smaller state. But I still think they are important, particularly in helping to explain why so many on the left feel unable to counter the populist line that the government must ‘tighten its belt’ even in the midst of the deepest recession since the war.

It is also important in explaining how opportunist politicians can get away with it. Just imagine if central banks had used their models to quantify the impact of austerity, and had made that analysis public. Imagine also if there had been some authoritative way of conveying the wisdom of the majority of academic economists, like the National Academy of Sciences in the US or the Royal Society in the UK. In the UK and US I think that might have made a difference.        

What is it about German economics?

I recently had the privilege to speak in Berlin at the 10th anniversary celebration of the Macroeconomic Policy Institute (IMK). (The talk I gave, on the Knowledge Transmission Mechanism, is here if anyone really wants to watch it.) I had known about the IMK for some time through reading incisive posts by Andrew Watt on the Social Europe website, but more recently I had been citing important papers by other IMK economists looking at the costs of austerity. You could describe the IMK group within Germany in various ways (see below), but one would be an island of Keynesian thinking in a sea that was rather hostile to Keynesian ideas.

As my talk, and this subsequent post, focused on how Keynesian ideas are pretty mainstream elsewhere, this raises an obvious puzzle: why does macroeconomics in Germany seem to be an outlier? Given the damage done by austerity in the Eurozone, and the central role that the views of German policy makers have played in that, this is a question I have asked for many years. The textbooks used to teach macroeconomics in Germany seem to be as Keynesian as elsewhere, yet Peter Bofinger is the only Keynesian on their Council of Economic Experts, and he confirmed to me how much this minority status is typical. [1]

There are two explanations that are popular outside Germany that I now think on their own are inadequate. The first is that Germany is preoccupied by inflation as a result of the hyperinflation of the Weimar republic, and that this spills over into their attitude to government debt. (The recession of the 1930s helped create a more serious disaster, and here is a provocative account of why the memory of hyperinflation dominates.) A second idea is that Germans are culturally debt averse, and people normally note that the German for debt is also their word for guilt. The trouble with both stories is that they imply that German government debt should be much lower than in other countries, but it is not. (In 2000, the German government’s net financial liabilities as a percentage of GDP were at the same level as France, and slightly above the UK and US.)

A mistake here may be to focus too much on macroeconomics. Germany has recently introduced a minimum wage: much later than in the UK or US. I think it would be fair to say that German economists generally advised against this. In the UK and US the opinion of economists on the minimum wage issue is much more balanced, largely because there is a great deal of academic evidence that at a moderate level the minimum wage does not reduce employment significantly. So here German economics also appears to be an outlier.

Many people have heard of ordoliberalism. It would be easy to equate ordoliberalism with neoliberalism, and argue that German attitudes simply reflect the ideological dominance of neo/ordoliberal ideas. However, as I once tried to argue, because ordoliberalism recognises actual departures from an ideal of perfect markets and the need for state action in dealing with those departures (e.g. monopoly), it is potentially much more amenable to New Keynesian ideas than neoliberalism. Yet in practice ordoliberalism does not appear to allow such flexibility. It is as if in some respects economic thinking in Germany has not moved on since the 1970s: Keynesian ideas are still viewed as anti-market rather than correcting market failure, and views on the minimum wage have not taken on board market distortions like monopsony. But that observation simply prompts the question of why in these respects German economics has remained isolated from mainstream academic ideas. [2]

One of the distinctive characteristics of the German economy appears to be very far from neoliberalism, and that is co-determination: the importance of workers organisations in management, and more generally the recognition that unions play an important role in the economy. Yet I wonder whether this may have had an unintended consequence: the polarisation and politicisation of economic policy advice. The IMK is part of the Hans-Böckler-Foundation, which is linked to the German Confederation of Trade Unions. The IMK was set up in part to provide a counterweight to existing think tanks with strong links to companies and employers. If conflict over wages is institutionalised at the national level, perhaps the influence of ideology on economic policy - in so far as it influences that conflict (see footnote [1]) - is bound to be greater. 

As you can see, I remain some way from answering the question posed in the title of this post, but I think I’m a bit further forward than I was.  

[1] The ‘Hamburger Appell’ of 2005, signed by over 250 German economists, is clearly anti-Keynesian. The intellectual rationale given there is unclear, but one theme is that a more effective way of increasing employment is to increase international competitiveness by holding down domestic costs. Now if you are part of a fixed exchange rate regime or a monetary union, and you have - for institutional reasons - an ability to influence domestic wage costs that other countries that belong to the regime do not have, then it may make perfect Keynesian sense to use that instrument. This is exactly what happened (deliberately or not) from 2000 to 2007, which of course is a major reason why Germany is currently not suffering the recession being experienced by the Eurozone as a whole. (Of course, unlike a fiscal stimulus, it is a beggar my neighbour policy, because demand increases at the expense of other countries in the regime: for the regime as a whole a flexible exchange rate will offset the impact of lower costs on competitiveness.)

[2] On this isolation see Tony Yates here. At the end of this post Tony also references an interesting discussion regarding ordoliberalism and other issues in comments on a post of my own: see here.