Very Serious People and the deficit

I'm glad Paul Krugman liked my General Theory of Austerity paper. But he wonders whether I might be missing something, in not explaining why Very Serious People (VSPs) in the US, or mediamacro in the UK, presume that deficit reduction is always a good thing. The constant call for deficit reduction seems to transcends party politics, and furthermore should be something that the wise always promote.

I do talk about the influence of the City/Wall Street and central banks, but perhaps there is something in addition which I talked about in a recent post: deficit bias. Keynes talked about 'practical men' who tended to absorb some of the wisdom of 'academic scribblers' of 'a few years back'. The wisdom in this case was deficit bias: the tendency that many economists discussed before the financial crisis for deficits and debt to tend to rise over time, across cycles.  Perhaps VSPs and mediamacro have absorbed this particular area of academic analysis?

I think you can tell a similar story about academic scribbling of years past when it comes to the roles of monetary and fiscal policy. In the UK George Osborne argued explicitly that the economic consensus was now that monetary policy should deal with stabilising output and inflation, while fiscal policy makers should look after their own deficit. I have called this the consensus assignment. If he, or his advisors, absorbed this piece of conventional wisdom, so may VSPs and mediamacro.

So the headline academic scribbling was governments should control deficits, not the economy, and they are bad at it. Some of the theories put forward to explain deficit bias involve politicians knowingly deceiving voters by pretending tax cuts or spending designed to capture votes were 'affordable', and relying on general lack of understanding of the government finances to not be found out. That gives VSPs and the media more generally a clear role in providing a public service to help counteract the wickedness of politicians. VSPs might even think it was their public duty to constantly advocate deficit reduction to counter deficit bias.

As they say, a little knowledge can be a dangerous thing. Those of us working on the front line of monetary and fiscal interaction, or who had studied economic history or looked at the lost decade in Japan, knew the conventional assignment broke down when interest rates hit their lower bound. We knew that a liquidity trap was absolutely not the time to worry about deficits, and if you did so you would cause tremendous damage. And we were right.

So if you believe this story, the lesson for VSPs and mediamacro is you really need to talk to economists in the front line more often.

Economists versus bankers

Nearly a year and a half ago I wrote a post about encouraging dialogue between economists and other social scientists. I concluded with the following three paragraphs:

“Let me take a real world economic problem: the response to the financial crisis. Some have suggested that banks have become too large and need to be broken up, or that the activities of high street banking need to be separated from the activities of the casino. Your economic analysis tells you that networks of many small entities can be as subject to crises as networks involving a few large banks. You are also able to devise a system of Chinese walls that mean that the activities of the casino can be separated from those of the high street even within the same company, and your political masters seem to prefer this approach. You recognise that different assets differ in their liquidity, and so you devise complex weighting algorithms for computing capital ratios. Your suggestions form the basis of negotiations between officials and bankers, and a set of rules and regulations are agreed.

Over the next few years you watch in dismay as your complex system begins to unravel. The CEOs of the large banks seem to constantly have the ear of politicians, who in turn gradually compromise your elaborate controls to render them less and less effective. Those in charge of administering the rules find it much more lucrative to work for the banks, and so regulators gradually lose expertise and resolve.

And you realise that right from the start you made the wrong choice. You decided to focus on what you knew, which was how to design systems that worked well as long as those systems remained unchanged, but which were not robust to intervention by self-interested parties. In short, they were too open to rent-seeking. You realise that actually the best thing to have done was to break up the banks so that their political power was forever diminished. And you recall a conversation with your social science colleague when this all started, who might have been trying to tell you this if only you had understood the words he was using.”

I was afterwards asked whether I had one particular UK economist, John Vickers, in mind when I wrote this. He chaired, at the government’s request, a commission on banking reform. He has become increasingly vocal about how his original commission’s proposals (pdf) are being watered down and how the Bank of England appears to be putting public money at risk once again. (For his detailed assessment, see this paper. And here is what another commission member, Martin Wolf, thinks about the financial sector. Adam Barber details how the attitude of the UK government has changed. In the US this very issue became an important point of difference between Clinton and Sanders.)

The honest answer is that I did not have him in mind. It was a fictional account designed to make a point, and so I took elements from different debates which together apply to no one country or individual. The point is that in finance good reforms are those that can best resist political or economic manipulation by banks, and perhaps economists in general have been slower to see that than some of their colleagues in other social sciences..

It would probably be fair to say that before the financial crisis economists got on pretty well with the financial sector. There was a common interest in monetary policy (although the motivation for that interest might have been different) and the sector was a useful source of funds for conferences and (for a few) consultancy. Most economists did not look too hard at what the financial sector was actually doing, although those that did often raised serious questions. Behind this nice piece by Ben Chu is an army of academic research which suggests that fees paid to manage funds are a waste of money.

The situation changed after the financial crisis, for obvious reasons. Since then economists have increasingly questioned whether the whole business model behind banking is sound. In particular they have questioned why banks should be so different from other companies in terms of the amount of equity capital they hold in relation to their assets. These economists include the previous governor of the Bank of England, Mervyn King. They have also questioned whether one of the side effects of current regulation is to maintain the monopoly power of big banks.

If all that was not bad enough, we have the influence that the financial sector has on monetary policy. Mainstream macro has put a lot of emphasis on the importance of day to day monetary policy being independent of politicians, and far too little on it being independent of the influence of finance and bankers. Paul Krugman has talked about the links between interest rates and bank profits and how that might ‘guide’ the views of bankers. If you want to see a clear case of that, read this FT op-ed by David Folkerts-Landau, chief economist at Deutsche Bank.

The article could not be more wrong. The reason the Eurozone has performed so badly compared to the US, Japan and even the UK is not because of lack of structural reform, but because of the relative reluctance of the ECB to stimulate the economy. Rates were raised in 2011, and Quantitative Easing delayed until 2015. The article is full of hopeless lapses in logic. If there is any sense here at all, it is that high unemployment is required as a political incentive to undertake structural reform. So the ECB “has become the number one threat to the eurozone” because it has allowed politicians to put that reform off.

Here I can do no better than quote Adair Turner. “Vague references to “structural reform” should ideally be banned, with everyone forced to specify which particular reforms they are talking about and the timetable for any benefits that are achieved. If the core problem is inadequate global demand, only monetary or fiscal policy can solve it.” In the Eurozone the core problem is lack of aggregate demand, as below target inflation shows.

Why this hostility from German bankers to low or negative rates? What the author does not tell you is that the profits of German banks, and the viability of other parts of the German financial system, are particularly (IMF pdf, box 1.3) vulnerable to low rates. (For those that can access it, Wolfgang Münchau in the FT provides an excellent summary.) And also that the profitability of Deutsche Bank is not great right now, as Frances Coppola notes. In the UK or US if this kind of nonsense from bankers appears in the press it gets a lot of kick back from economists - in Germany perhaps less so.

So who cares if economists have crossed swords with bankers? It matters because finance gets away with so much partly through a process of mystification. Mystification is how banks can perpetrate widespread fraud on consumers and businesses. When bankers say that being forced to ‘put aside’ more capital keeps money out of the economy it sounds plausible to many, even though it is completely false. (Admati and Hellwig (pdf) list 30 other similar false claims.) There is also a belief that because bankers are involved in financial markets, they must know something about how the macroeconomy works, a belief which the FT op-ed shows is clearly false. In all these cases, economists can provide demystification.

If we are ever to cut finance down to size (metaphorically, and perhaps also literally), economists are going to be vital in the battle to do so.

The Eurozone recovery

Which posted the strongest growth at the beginning of 2016: the US, UK or the Eurozone? The answer is the Eurozone. Growth at 0.6% for the quarter (about 2.5% at an annual rate) is nothing to write home about, but it is not the stuff of doom and gloom either. Reasonable growth like that should come as no surprise. The economy is receiving as much monetary stimulus as the ECB can currently muster, and fiscal contraction has come to a halt.

Inflation is still well below target, but the reason for that is straightforward enough (as Martin Sandbu points out): there is still a lot of spare capacity. Inflation will only stabilise at around the 2% target when that spare capacity has disappeared. Policy should be doing everything (more public investment!) to ensure that happens through strong growth rather than, as seems to have happened in the UK, a gradual contraction in supply. On inflation the ECB should make their target 2%, rather than the current ‘below but close to’ 2%, to avoid the Japan problem that Narayana Kocherlakota discusses here.

I went further when I wrote two weeks ago (the GDP figures came out a week ago) that “I also think we may see rapid Eurozone growth before [2020]”. By rapid growth I mean something in excess of 2.5%. I said that because I was adding one other factor into the mix of fiscal neutrality and monetary expansion, which is that the Euro has been pretty competitive for well over a year. As Martin points out, that has so far not contributed anything to recent Eurozone growth.

I have read in a few places recently people saying that the impact of international competitiveness is not what it was. I agree with Paul Krugman that this pessimism is unlikely to be warranted. I have spent a significant part of my working life estimating and applying trade elasticities (the impact of international competitiveness on trade and hence demand), and this experience has taught me that this effect is a bit like Milton Friedman’s description of how monetary policy works: there can be long and variable lags. So I expect that the Eurozone’s competitiveness gain over the last year and a half will begin to impact on Eurozone GDP at some point in the next year or two, and that might just provide more rapid growth than we saw at the beginning of 2016.

Explaining the last ten years

The Great Recession was larger than any previous post WWII recession. But that is not what it will be mainly remembered for. Unlike previous recessions, it appears to have led to, or coincided with, a permanent reduction in the productive potential [1] of the economy relative to previous trends. As unemployment today in the US and UK is not very different from pre-recession levels, then another way of saying the same thing is that growth in labour productivity and real wages over the last seven years has been much lower than pre-recession trends. (As employment has not yet recovered in Europe, I will focus on the US and UK here.)

I have posted charts showing this for the UK many times, so here is something similar for the US. It plots the log of real GDP (green) against the CBO’s (Congressional Budget Office) estimate of potential output (yellow). Unlike the UK, potential growth in the US does not appear constant from 1955, but the CBO has potential output growth between 3 to 3.5% in most years between 1970 and the early 2000s. The break created by the Great Recession is clear: potential growth fell to as low as 1% immediately after the recession, is currently running at 1.5%, and the CBO hopes it will recover to 2% by 2020.

US Actual (green) and Potential (yellow, source CBO) Output, logged. Source: FRED.

There seem to be two ways of thinking about this decline in potential output growth. One is that the slowdown in productivity growth was happening anyway, and has nothing to do with the global financial crisis and recession. This seems unlikely to be the major story. For the UK we have to rewrite the immediate pre-recession years as boom periods (a large positive output gap), even though most indicators suggests they were not. A global synchronised slowdown in productivity growth seems improbable, as some countries are at the technological frontier and others are catching up. As Ball notes, “in the countries hit hardest by the recession, the growth rate of potential output is much lower today than it was before 2008.” However the coincidence story is the one that both the OECD and IMF assume when they calculate output gaps or cyclically adjusted budget deficits. The CBO numbers for the US shown above adopt the coincidence theory to some extent, reducing potential growth from 3.5% in 2002 to 2.0% by the end of 2007.

If we stick to the more plausible idea that this is all somehow the result of the financial crisis and recession, we can again split explanations into two types: those that focus on the financial crisis and argue that crises of this type (rather than other types of recession) impact on potential output, and those that look at the impact of the recession itself. The distinction is important in understanding the impact of austerity. If the length and depth of the recession has permanently hit potential output, as Fatas and Summers suggest, then the cost of austerity is much greater than we could have imagined.

Looking at previous financial crises in individual countries, as Nick Oulton has done for example, does suggest a permanent hit to potential, but I have noted before that this result leans heavily on experience in Latin American countries, and Sweden’s recovery from its 1990 crisis suggests a more optimistic story. Estimates based on OECD countries alone suggest more modest impacts on potential output, of around only 2%.

What about the impact of the recession itself? Here it is helpful to go through the textbook story of how a large negative demand shock should impact the global economy. Lower demand lowers output and employment. Workers cut wages, and firms follow with price cuts. The fall in inflation leads the central bank to cut real interest rates, which restores demand, employment and output to its pre-recession trend.

We know why this time was different: monetary policy hit the zero lower bound (ZLB) and fiscal policy in 2010 went in the wrong direction. Yet employment has recovered to a considerable extent (although less so in the US than the UK). A recovery in employment but not output (relative to pre-recession trends) means by definition a decline in labour productivity growth. How could this happen?

The table below shows the rate of growth of real and nominal wages in the UK and US in pre and post recession periods.

US	2002-7	2008-15
Annual wage growth (1)	3.8%	2.1%
Annual price growth (2)	2.5%	1.5%
Difference	1.3%	0.6%
UK
Annual wage growth	4.5%	1.7%
Annual price growth	2.8%	2.1%
Difference	1.7%	-0.4%

1. Compensation per employee, source OECD Economic Outlook
2. GDP deflator, source OECD Economic Outlook

Nominal wage growth followed the textbook story. But price inflation did not fall to match, implying steadily falling real wages, particularly in the UK. This could just reflect the decline in productivity, which occurred either coincidentally or as a result of the financial crisis and recession.

The financial crisis could have reduced productivity growth if a ‘broken’ financial sector had stopped financing high productivity investment projects, or kept inefficient firms going through ‘pretend and extend’ lending. The recession could have reduced productivity growth by reducing investment, and therefore embodied [2] technical progress. Perhaps this loss of embodied technical progress occurs in all recessions, but we do not notice it because recoveries are quick and complete.

However the causality could be the other way around. Falling real wages led firms to switch production techniques such that they employed more labour per unit of capital. Workers priced themselves into jobs. The big question then becomes why did firms let this happen? Why did firms not take advantage of lower wage increases to reduce their own prices, and choose instead to raise their profit margins?

One story involves a secular increase in firms’ profit margins (Paul Krugman’s robber barons idea), either because of a reduction in goods market competition (profit margins are sometimes called the degree of monopoly), or a rise in rent seeking as Bob Solow suggests (HT DeLong). [3] However it is not obvious why this should be connected to the recession. If it is not, it is like the coincident and exogenous productivity decline. We will not get back to the earlier productivity growth path without reversing whatever caused this secular rise in profit margins.

Another, in some ways more optimistic, story involves different degrees of nominal rigidity: nominal wages are less sticky than nominal prices. As a result nominal wages led prices in reacting to the recession, but now prices are ‘catching up’ and profit margins will fall back. That would fit nicely with inflation continuing below target for some time, and real wages and productivity recovering. It is an optimistic story, because an additional demand stimulus would increase wage but not price inflation, and we would see rapid growth in labour productivity as firms reversed their earlier labour for capital substitution.

Unfortunately recent data suggests this is not happening. Instead core inflation is now above target in the US and rising to target in the UK.    

So is there some other way that a large recession in itself can cause a large reduction in potential output? Macroeconomists group such explanations under a general heading called ‘hysteresis mechanisms’: mechanisms whereby recent history can have permanent effects. Ball summarises the three main types of mechanism that economists have identified: “it appears that recessions sharply reduce capital accumulation, have long-term effects on employment (largely through lower labour force participation), and may slow the growth of total factor productivity.” If technical progress is embodied, we can link the first and last. That will be the subject of a later post.  

[1] For those not familiar with the term, a traditional way of thinking about potential output is that it is what output and incomes could have been if we had avoided booms and recessions, or equivalently if we had avoided domestically induced variations in inflation. Potential output can increase either because the labour force increases, or because labour productivity increases due to either technical progress and investment.

[2] Embodied technical progress is greater labour productivity brought about through new machinery i.e. it needs investment for it to happen.

[3] Postscript (just): Here is Martin Sandbu on the same issue   

Two related confusions about helicopter money

Confusions about helicopter money is something of a generic title (although Martin Sandbu is thankfully not confused). Because a discussion of helicopter money (HM) cannot normally be found in the textbooks (which have only just caught up with central bank independence), the scope for misunderstanding is huge. Here I want to talk about two related confusions. The first is about whether HM would lead to an increase or decrease in nominal interest rates, as discussed in a recent interchange between Tony Yates and Paul Krugman. The second is whether HM is in competition with the use of fiscal policy to get us out of recessions.  

On HM money and nominal interest rates, there is of course the standard and very basic point that in a market you cannot control both quantity and price, still less move them in opposing directions. So if we want to think about a market for money, you cannot raise the supply of money and raise its price - the nominal interest rate - at the same time.

But this observation ignores what else is going on when you have HM. HM is a large fiscal expansion. Please none of this ‘but if Ricardian Equivalence (RE) holds’: we are talking real world policy here not doing thought experiments, and we have all the evidence we need that RE does not hold (for reasons that are not difficult to understand). Let's also not fall into the trap of doing IS-LM. We are in a world of inflation targeting, and anything that raises demand (as a fiscal expansion will) will tend to raise inflation, and so the monetary authorities will tend to raise nominal interest rates. Any temptation to say ‘yes but in the short run’ becomes dubious because of expectations effects. 

So it is really quite simple. Either the nominal interest rate lower bound constraint continues to bite, which means helicopter money will leave nominal interest rates unchanged (but the economy better off), or there is no constraint (or that constraint is removed), in which case rates will rise (sooner) with HM.

The second confusion is that helicopter money in some way precludes undertaking countercyclical fiscal policy. It does not. Right now, for example, governments could and should announce large increases in public sector investment (where I am using investment in the economist’s sense to include investment in human capital, rather than in a national accounts sense). This would negate any immediate need for HM. Monetary policy adapts to fiscal policy.

When people ask me which we should have, helicopters or fiscal expansion, I'm tempted to say I would love to have the choice! If I did have that choice, right now I would take additional public investment over a helicopter drop, because the micro case for investment is in many cases (and countries) very strong, interest rates are low and investment improves the supply as well as the demand side. In any future severe recession where the interest rate lower bound was likely to be hit [1] I would also advise bringing forward public investment. However I do not see this as a competition (countercyclical fiscal action vs HM) for two reasons.

First, one lesson of the Great Recession is that we cannot rely on governments to do the right thing with fiscal actions, so HM is an insurance policy in that sense. If governments do spend more or tax less as we approach the ZLB, that insurance policy may not be needed. [2] Second, even if governments do the right thing, either lack of good projects [3] or information delays may mean they do not do enough, and so the very quick action that central banks could take with HM could be a useful complement. To put it another way, helicopter money is best seen as an alternative to QE rather than as an alternative to fiscal action.

[1] Because of implementation lags, a fiscal response to an impending deep recession should not wait until nominal interest rates actually hit their lower bound. If that fiscal response involves investment, used in an economists rather than national accounts sense, then there is no great loss if the deep recession does not happen, because it is wise to invest when real interest rates and wages are relatively low.

[2] In the proposals put forward in Portes and Wren-Lewis (2015), the central bank would directly tell the government the probability of the lower bound being hit.

[3] I think the argument that the amount of public investment cannot be adjusted to match macro conditions is often overstated. We are not talking HS2 here (the proposal to build a high speed train line between London and Birmingham and beyond), but improving flood defences, repairing roads and schools etc.

Confidence as a political device

Some technical references but the key point does not need them

This is a contribution to the discussion about models started by Krugman, DeLong and Summers, and in particular to the use of confidence. (Martin Sandbu has an excellent summary, although as you will see I think he is missing something.) The idea that confidence can on occasion be important, and that it can be modelled, is not (in my view) in dispute. For example the very existence of banks depends on confidence (that depositors can withdraw their money when they wish), and when that confidence disappears you get a bank run.

But the leap from the statement that ‘in some circumstances confidence matters’ to ‘we should worry about bond market confidence in an economy with its own central bank in the middle of a depression’ is a huge one, and I think Tony Yates and others are in danger of making that leap without justification. Yes, there are circumstances when it may be optimal for a country with its own central bank to default, and Corsetti and Dedola (in a paper I discussed here) show how that can lead to multiple equilibria.

But just as Krugman wanted to emulate Woody Allen, I want to as well but this time pull Dani Rodrik from behind the sign. In his excellent new book (which I have almost finished reading) Rodrik talks about the fact that in economics there are usually many models, and the key question is their applicability. So you have to ask, for the US and UK in 2009, was there the slightest chance that either government wanted to default? The question is not would they be forced to default, because with their own central bank they would not be, but would they choose to default. And the answer has to be a categorical no. Why would they, with interest rates so low and debt easy to sell.

The argument goes that if the market suddenly gets spooked and stops buying debt, printing money will cause inflation, and in those circumstances the government might choose to default. But we were in the midst of the biggest recession since the 1930s. Any money creation would have had no immediate impact on inflation. Of course their central banks had just begun printing lots of money as part of Quantitative Easing, and even 5 years later where is the inflation! So once again there would be no chance that the government would choose to default: the Corsetti and Dedola paper is not applicable. (Robert makes a similar point about the Blanchard paper. I will not deal with the exchange rate collapse idea because Paul already has. A technical aside: Martin raises a point about UK banks overseas currency activity, which I will try to get back to in a later post.)

Ah, but what if the market remains spooked for so long that eventually inflation rises. The markets stop buying US or UK debt because they think that the government will choose to default, and even after 5 or 10 years and still no default the markets continue to think that, even though they are desperate for safe assets!? In Corsetti and Dedola agents are rational, so we have left that paper way behind. We have entered, I’m afraid, the land of pure make believe.

So there is no applicable model that could justify the confidence effects that might have made us cautious in 2009 about issuing more debt. There are models about an acute shortage of safe assets on the other hand, which seem to be ignored by those arguing against fiscal stimulus. Nor is there the slightest bit of evidence that the markets were ever even thinking about being spooked in this way.

Martin makes the point that just because something has not yet been formally modelled does not mean it does not happen. Of course, and indeed if he means by model a fully microfounded DSGE model I have made this point many times myself. But you can also use the term model in a much more general sense, as a set of mutually consistent arguments. It is in that sense that I mean no applicable model.

Now to the additional point I really wanted to make. When people invoke the idea of confidence, other people (particularly economists) should be automatically suspicious. The reason is that it frequently allows those who represent the group whose confidence is being invoked to further their own self interest. The financial markets are represented by City or Wall Street economists, and you invariably see market confidence being invoked to support a policy position they have some economic or political interest in. Bond market economists never saw a fiscal consolidation they did not like, so the saying goes, so of course market confidence is used to argue against fiscal expansion. Employers drum up the importance of maintaining their confidence whenever taxes on profits (or high incomes) are involved. As I argue in this paper, there is a generic reason why financial market economists play up the importance of market confidence, so they can act as high priests. (Did these same economists go on about the dangers of rising leverage when confidence really mattered, before the global financial crisis?)

The general lesson I would draw is this. If the economics point towards a conclusion, and people argue against it based on ‘confidence’, you should be very, very suspicious. You should ask where is the model (or at least a mutually consistent set of arguments), and where is the evidence that this model or set of arguments is applicable to this case? Policy makers who go with confidence based arguments that fail these tests because it accords with their instincts are, perhaps knowingly, following the political agenda of someone else.     

Paris, climate change and the UK government

In a recent column, Paul Krugman bemoans the consensus view among Republican politicians that we should do nothing about climate change, and that many of the Republican nominees for president actually deny the science. He also complains about how the conventions of political journalism mean that public perceptions about the science become distorted as a result. He says that this situation - where parties on the right deny the need to take action on climate change - is unique to the US and Australia.

What about the UK? While everyone remembers Cameron promising to make his 2010 government the ‘greenest ever’, three and a half years later the Sun reported him as ordering aides to "get rid of all the green crap" from energy bills. Of course actions speak larger than words. The Conservative’s hostility to onshore wind farms is well known, and subsidies are due to be phased out soon. Subsidies for solar also face severe cuts. The government has passed legislation ‘to maximise economic recovery of UK oil’. A scheme to encourage home owners to improve energy efficiency is to end, the aim to make all new homes ‘zero carbon’ is to be scrapped, the Green Investment Bank is to largely sold off, tax breaks for buyers of ‘green cars’ ended.

Now all this might be understandable if the UK was well ahead in the amount of power produced by renewables. In fact, among EU members, only 3 have a smaller proportion. The government expects its EU target of 15% by 2020 will be missed by a wide margin.

Does all this reflect climate change denial of the kind we see in the US, with the only difference being that the Conservatives are acting duplicity in still paying lip service to the aims of the Paris summit? Duplicity may be understandable given Cameron’s 2010 ‘greenest ever’ commitment. However the UK government have just signed a deal for a Chinese state-controlled company to help build a new nuclear plant at Hinkley Point. Ministers have undertaken to guarantee for 35 years an index-linked price of £92.50 per megawatt hour. That is more than twice the current market rate, and it is also higher than for every renewable source except offshore wind. Yet unlike renewables those subsidies will be paid by consumers when the plant starts producing around 2025.

Put alongside virtually abandoning measures to encourage renewables, and this seems more like economic incompetence than ideology. In a classic piece of irony, a wind farm application near to Hinkley was turned down by the government. It is not as if the UK is currently awash with energy capacity. Last month an unexpected surge in demand led the national electricity grid to ask heavy users to reduce consumption.

So it is difficult to tell whether this is about ideology masked with duplicity, or politically driven economic incompetence. Ideology, duplicity and incompetence: have I combined those words together before?

The centrality of policy to how long recessions last

For economists

Paul Krugman reminds us that one of the most misguided questions in macroeconomics is ‘are business cycles self-correcting’. This is a particular case of another mistake, which is to say that the duration of the business cycle depends on the speed of price adjustment. That answer is seriously incomplete, because it only holds for a particular set of monetary policy rules (plus assumptions about fiscal policy).

It is very easy to see this. Suppose monetary policy is so astute that it knows perfectly all the shocks that hit the economy, and how interest rates influence that economy. In that case absent the Zero Lower Bound the business cycle would disappear, whatever the speed of price adjustment. Or suppose monetary policy followed a credible rule that related real interest rates to the output gap rather than excess inflation. Once again the speed of price adjustment is not central to how long business cycles last. As Nick Rowe points out, if you had a really bad monetary policy recessions could last forever.

A better answer to both questions (self-correction and how long business cycles last) is it all depends on monetary policy. Actually even that answer makes an implicit assumption, which is that there is no fiscal (de)stabilisation. The correct answer to both questions is that it depends first and foremost on policy. The speed of price adjustment only becomes central for particular policy rules.

So why do many economists (including occasionally some macroeconomists) get this wrong? Why are textbooks often quite unclear on this point? It could be just an unfortunate accident. We are so used to teaching about fixed money supply rules (or in my case Taylor rules), that we can take those rules for granted. But there is also a more interesting answer. To some economists with a particular point of view, the idea that getting policy right might be essential to whether the economy self-corrects from shocks is troubling. They prefer to think of a market economy as being ‘naturally’ self-correcting, and to think that government intervention only has a role to play if there is some serious ‘market imperfection’. The market imperfection in the case of business cycles is price rigidity.

Focusing on this logic alone can lead to big mistakes. I have heard a number of times good economists say that in 2015 we can no longer be in a demand deficient recession, because price adjustment cannot be that slow. This mistake happens because they take good policy for granted. It is almost certainly true that no recession should last this long, because fiscal policy can substitute for monetary policy at the Zero Lower Bound. But with sub-optimal policy the length of recessions has much more to do with that bad policy than it has to do with the speed of price adjustment.

Just how misleading a focus on the speed of price adjustment can be becomes evident at the Zero Lower Bound. With nominal interest rates stuck at zero, rapid price adjustment will make the recession worse, not better. Price rigidity may be a condition for the existence of business cycles, but it can have very little to do with their duration.