Measuring the impact of austerity

Ben Chu has a good article disposing of some of the nonsense ideas associated with austerity (which refuse to die, because they are useful to politicians, and much of the media is generally clueless). Perhaps the most silly, which I encounter a lot, is that the UK has not really endured austerity because debt has been increasing, or some other irrelevant measure has been rising.

If trying to reduce the deficit - what economists call fiscal consolidation - had no adverse effects on the economy as a whole it would not be called austerity. Austerity is all about the negative aggregate impact on output that a fiscal consolidation can have. As a result, the appropriate measure of austerity is a measure of that impact. So it is not the level of government spending or taxes that matter, but how they change.

An obvious measure to use is the change in the deficit itself, generally adjusted for changes that happen automatically because output is changing. I have used that measure many times, because it is produced by the OBR, IMF and OECD among others. But it is not ideal, because the impact of changes in taxes on demand and therefore output is generally smaller than the impact of a change in government spending, because some of any tax increase comes from reduced saving. (This is also true, but perhaps to a lesser extent, of government transfers.)

There is no simple way of dealing with this measurement problem, because the amount of any tax increase people will find from their savings will depend in part on how long they expect taxes to be higher. As a result, some people prefer to focus just on government spending to measure fiscal impact (although the data you will easily find is government consumption, and as fiscal consolidation normally involves cuts to government investment it is important to add that on). However it is also possible to apply some simple average propensities to consume from tax cuts and transfers to get a fiscal impact measure.

This is what the Hutchins Center fiscal impact measure does for the US.

These are not multipliers (so are different from what the OBR does for the UK, for example [1]), but just the direct impact of government spending and taxes on aggregate demand and hence GDP. The average total impact is something like 0.4%, so this would be fiscal policy that was in this sense neutral.

Compare the mild 2001 recession with the much larger 2008/9 recession. In both cases during the recession fiscal policy was strongly counter-cyclical, helping to reduce the recession’s impact. After the 2001 recession ended, fiscal policy continued to support the recovery for around two years: these were the Bush tax cuts. The recovery in GDP was reasonably strong: growth from 2003 to 2005 of 2.8%, 3.8% and 3.3%.

In 2010, we had a much deeper and longer recession, but the fiscal support was only marginally greater than 2001, despite interest rates being stuck at their lower bound. On this occasion fiscal support was strongly opposed by the Republicans. It continued for another year and a quarter, and then became strongly contractionary from 2011 to 2015. GDP growth was slower than in the previous recovery, despite the deeper recession: from 2010 to 2014 2.5%, 1.6%, 2.2%, 1.7%, 2.4%. This is not surprising, as fiscal policy was reducing GDP by around 1% during 2011,2012 and 2013, rather than adding the normal 0.4%.

The speed and extent to which austerity was applied after the Great Recession was very unusual: the textbook says secure the recovery first, allow interest rates to rise, and then worry about government debt. There was no economic justification for switching to austerity so quickly after 2010: the motivation (as in the UK) was entirely political. It produced the slowest US recovery in output since WWII. (This is a very useful resource in comparing US upswings.) As I showed here using simple calculations, if total government spending from 2011 had remained neutral instead of becoming sharply contractionary, US output could easily have got close to capacity (as measured by the CBO) by 2013.

To subtract 1.5% from GDP would not matter if something (consumption, investment or net exports) filled its place. But that will only happen by chance or because of a monetary policy stimulus, and monetary policy was stuck in a liquidity trap. This is the real crime of austerity. Decreasing demand and output just when the economy is beginning its recovery from the deepest recession since WWII is as foolish as it sounds, but to do this at just the time that monetary policy was unable to effectively fight back is macroeconomic madness. As I will argue in later posts, it looks increasingly likely that this has made us all permanently poorer.

[1] If somebody publishes similar estimates for the UK, please let me know. Personally I think it makes more sense to publish data like this than use a multiplier based analysis, simply because these measures are more direct, and involve fewer ‘whole economy’ assumptions. Crucially, there are no implicit assumptions about monetary policy being made. It would be interesting to know why the OBR decided not to take this approach.

Kocherlakota’s argument for fiscal expansion in the US

Is there a macroeconomic case for tax cuts in the United States right now? Paul Krugman and I say no, using the following logic. The Fed thinks we are close to full employment, if we use the term to denote the level of employment that keeps inflation constant. Generalised tax cuts (rather than just tax cuts to the very rich) will tend to raise aggregate demand, which will lead inflation to increase. The Fed will therefore raise interest raise rates further to offset this increase in demand before it happens. As a result, the tax cuts will have no impact on demand, but simply make funding investment more expense.

There are clear grounds for saying that the Fed is wrong about the economy being close to full employment, and therefore any increase in aggregate demand from any source would not raise inflation. But a central bank that acts in the textbook manner will not wait for the higher inflation to materialise, but will anticipate it because it takes time for interest rates to influence demand and inflation. As a result, tax cuts will lead to higher interest rates and there will be no net impact on demand.

Narayana Kocherlakota, who used to be on the committee that sets US interest rates, presents another possible reason why an increase in demand will not raise inflation. He argues that aggregate supply has been suppressed by low demand, and that rising demand might itself stimulate supply. For example, a lot of technical innovations might have been shelved while demand was depressed, but would be brought into production if demand looked like expanding rapidly. As these technical innovations would expand the capacity of firms to produce more, they would not raise prices as a result of any increase in demand. As these innovations would produce more from the existing labour force, there would be no inflation pressure coming from wages either.

If this sounds like wishful thinking, remember than the US economy, like most, is still way below the level of output that pre-recession trends would have suggested were likely. Did research into new and better production techniques really slow down substantially during the recession years, or did the research still take place to be implemented at some later date?

Even if this argument is plausible, and I think it is, it would still be irrelevant if the Fed didn’t make any allowance for it. They would still believe that tax cuts would raise demand and inflation, and so they would raise interest rates and crowd out any increase in demand. Indeed, if the Fed believed this ‘endogenous supply’ argument, they surely wouldn’t have raised rates in 2016.

What Kocherlakota wants the Fed to do is follow an approach put forward by Federal Reserve Bank of Chicago President Charles Evans. He puts the case in this speech. Essentially the Fed should depart from the usual policy approach of targeting expected inflation, and wait for inflation to actually rise above target before it raises rates. This would mean that it ignored any fiscal stimulus (whether it be tax cuts or additional public investment), and focused simply on the actual inflation rate. If we were in fact below full employment, or if demand created its own supply, the fiscal expansion would raise output and welfare.

An important point that Kocherlakota makes, and I have made in the past, is that you do not need to believe with certainty that we are below full employment or that demand will create its own supply. All you have to do is give it some significant probability of being true. You then look at the costs and benefits of pursuing an Evans type monetary policy weighted by this probability. A key point here is that the costs of a short term overshoot of the 2% target are likely to be a lot smaller than the cost of missing out on a percent or two of national output for potentially some time.

Does this change my views on a prospective Trump stimulus package? Not really. There is a very strong case for more public sector investment on numerous grounds. But that investment should go to where it is most needed and where it will be of most social benefit, and I think it is very unlikely (along with I suspect most economists) that a Trump Presidency and a Republican House can deliver that. That extra public investment will give the economy the stimulus that could work with an Evans type monetary policy. From a macroeconomic viewpoint there seems no point in doubling up on stimulus through tax cuts, and in terms of how the Fed reacts it may even be counterproductive.

Left and Right in 2016

Before the Christmas break David Blanchflower asked me a question on twitter: “why do you think we have seen the move to right-wing rather than left-wing populism?” This is my reply. I’ll just talk about the US and UK because I do not know enough about other countries. (Here is an interesting analysis of populists in Eastern Europe.) I’ll take it as read that there are currently well understood reasons for people to want to reject established politicians, and the Blanchflower question is really about why that rejection went right rather than left.

In my answer I want to distinguish between two types of people. The first are those that are not that interested in politics, and are therefore not well informed. They depend on just a few parts of the MSM for their information. The second are those that are interested in politics and are well informed, using multiple sources which are not just confined to the mainstream media (MSM). I want to argue that this distinction is crucial in helping us understand what happened in 2016.

I also want to use the term populist for policies in its most simple form, as policies that are likely to be immediately popular with the public, without the negative connotations that I discussed here. Populist policies on the left would focus on measures to curb financialisation and the power of finance (‘bashing bankers’), and measures to reduce inequality (which are popular if expressed in terms of the 1%, or CEO pay). Right wing populist policies include of course controls on immigration, combined with constant references to national identity. The need to control international trade can be invoked by left and right.

Among those who are well informed, there is no evidence that dissatisfaction with existing elites broke right rather than left. Indeed membership of political parties in the UK suggests the opposite is true. Party members in the UK are almost by definition likely to be much more interested in politics than the average citizen, and will not be dependent on one or two elements of the MSM for information. As the Labour party leadership has shifted left and adopted some of the left wing populism I’ve described, its membership has exploded. The figures are remarkable. The Labour party currently has a membership of over half a million. This is probably [1] at least three times the membership of the Conservative party. UKIP, the populist party of the right, has a membership of only 39,000, which is below the membership of the Greens.

The Sanders campaign indicates both the popularity of left wing populism among political activists in the US, but also that left wing populist policies can be as popular with voters as those from the right when they get a national platform. Sanders put greater taxes on the rich and additional Wall Street regulation at the centre of his platform, as well as opposition to trade agreements. The campaign was largely funded by individual donations, in contrast to the other campaigns. With the exposure that an extended election process gave him, Sanders’ brand of left wing rhetoric got national coverage and proved pretty popular. Sanders claimed, with some justification, that he actually polled better against Trump than Clinton, and it remains an open question whether a populist from the left might have done better against Trump than Clinton, who epitomised the establishment.

During the Sanders campaign left wing populist ideas did get wide coverage in the MSM, but this is the exception rather than the rule. After the financial crisis there was a brief period of about a year when these more left wing themes were a major media focus, but since then they appear only occasionally in the MSM. In contrast parts of the MSM in both countries has for many years produced propaganda that supports right wing populism, and the non-partisan elements of the MSM have done very little to contest this propaganda, and on many occasions simply follow it.

Let me put these points in a slightly different way. For the few of us that do attach great importance to the media in understanding recent events, it would be a major problem if on occasions where alternative ideas were given considerable coverage in the media they were ignored by voters. It would also be a major problem if those who were much less dependent on one or two MSM sources for information behaved in the same way as the average voter. But fortunately for us both the Sanders campaign and UK party membership suggest neither problem arises, but instead these pieces of evidence provide support for our ideas.

So in both the US and UK, among those who are exposed to left wing populism or who access a much broader range of information than that provided by the MSM, there is no puzzle of asymmetry. Left wing populism continues to appeal. The asymmetry at the level of the popular vote, that gave us Brexit and Trump, can be explained by asymmetry in the media. Right wing populist ideas not only get much more coverage than left wing populist ideas, but sections of the MSM actively promote these ideas. Given that this focus on the importance of the providers of information is intuitive, it is really up to those who think otherwise to provide both theory and evidence to support their view that the MSM is unimportant.

[1] I say probably because the latest data we have for Conservative party membership is 2013. However I think it is reasonable to speculate that lack of publication means numbers have been going down, not up.  

Reactionary Keynesianism

Under Donald Trump we might get what some have called Reactionary Keynesianism. But a stimulus is a stimulus, right, and for those of us who think most OECD economies should be ‘run hot’ to try and make up some of the ground still lost from the Great Recession any fiscal stimulus should be welcomed? So Martin Sandbu writes

“it is hypocritical of anyone to warn that Trump’s promised tax cuts will endanger the public finances if they called for fiscal stimulus under Obama and his putative Democratic successor. …. While the composition of tax cuts and spending increases may matter, the overall size of any deficit increase matters at least as much.”

If by this he means don’t worry too much about the composition, the overall size of the deficit is more important, I think this is terrible macroeconomics. It is foolish to believe that anything that raises the deficit will stimulate.

We know that a part of any Trump stimulus will be large tax breaks for the very rich. The very rich will almost certainly consume virtually none of this tax break in the short term. It is the one part of the population where Ricardian Equivalence almost holds. You might think that therefore it does at least do no harm to short term aggregate demand. But this could be wrong, because the logic of the intertemporal budget constraint still operates. Those tax cuts will not be paid for by higher activity in the short term, so they may mean higher taxes down the road. Now if people who are not very rich think that these might be their taxes that are increased down the road, they will reduce their consumption today. The net effect could be a drop in demand.

You may think that consumers may not be so foresighted, so demand will not actually fall. But the logic of the intertemporal budget constraint still holds. If tax cuts for the rich just raise the deficit with almost no short run demand boost, then that is a transfer to the rich today from the non-rich tomorrow. If tax cuts for the rich were paid for by tax increases on everyone else today many politicians would be up in arms. Delaying the tax increase on everyone else by borrowing is a trick that should be seen straight through.

Yet I fear this is still not the case, and talking about tax cuts for the rich as part of a stimulus just helps confuse politicians. Those on the right understand this: tax cuts for the rich are nearly always part of a general stimulus: when Nigel Lawson did this it helped bust the UK economy. We should just repeat again and again: tax cuts for the rich paid for by borrowing are really tax increases for everyone else.

The example of tax cuts for the rich is the example that refutes the general proposition that the composition of any fiscal stimulus matters less than the overall size of any increase in the deficit.

Trump has also said he wants more investment in public infrastructure. That is something the US desperately needs, but remember that Trump will usher in an era of crony capitalism and politics like never before. The infrastructure that you might get could be far from the infrastructure the US actually needs, and instead may be whatever buys votes or other kinds of deals that help a Trump administration. Now if that infrastructure was produced entirely by those who otherwise would be out of the workforce but would like the jobs involved, then aggregate welfare would still increase: it is Keynes’s famous digging holes example. But in practice that seems unlikely to be completely or even mainly true, and so these white elephants may in practice crowd out better projects. In that case US citizens would not be better off in the short term as a result of this fiscal stimulus, even if GDP did rise. And the stimulus would not pay for itself, so once again other people should worry about the government’s intertemporal budget constraint.

If the economics of Reactionary Keynesian is bad, I think the politics is even worse. Quite simply, by achieving very little beyond redistributing to the rich and unworthy, it gives Keynesian policy a bad name. But we can avoid that, when we can, by not calling every increase in the deficit a stimulus. And by saying tax cuts for the rich paid for by borrowing are really tax increases for everyone else.

Can central banks make 3 major mistakes in a row and stay independent?

Mistake 1

If you are going to blame anyone for not seeing the financial crisis coming, it would have to be central banks. They had the data that showed a massive increase in financial sector leverage. That should have rung alarm bells, but instead it produced at most muted notes of concern about attitudes to risk. It may have been an honest mistake, but a mistake it clearly was.

Mistake 2

Of course the main culprit for the slow recovery from the Great Recession was austerity, by which I mean premature fiscal consolidation. But the slow recovery also reflects a failure of monetary policy. In my view the biggest failure occurred very early on in the recession. Monetary policy makers should have said very clearly, both to politicians and to the public, that with interest rates at their lower bound they could no longer do their job effectively, and that fiscal stimulus would have helped them do that job. Central banks might have had the power to prevent austerity happening, but they failed to use it.

Monetary policy makers do not see it that way. They will cite the use of unconventional policy (but this was untested, and it is just not responsible to pretend otherwise), the risks of rising government debt (outside the ECB, non-existent; within the ECB, self-made), and during 2011 rising inflation. I think this last excuse is the only tenable one, but in the US at least the timing is wrong. The big mistake I note above occurred in 2009 and early 2010.

What could be mistake 3

The third big mistake may be being made right now in the UK and US. It could be called supply side pessimism. Central bankers want to ‘normalise’ their situation, by either saying they are no longer at the ZLB (UK) or by raising rates above the ZLB (US). They want to declare that they are back in control. But this involves writing off the capacity that appears to have been lost as a result of the Great Recession.

The UK and US situations are different. In the UK core inflation is below target, but some measures of capacity utilisation suggest there is no output gap. In the US core inflation is slightly above target, but a significant output gap still exists. In the UK the output gap estimates are being used to justify not cutting rates to their ZLB [1], while in the US it is the inflation numbers that help justify raising rates above the ZLB. (The ECB is still trying to stimulate the economy as much as it can, because core inflation is below target and there is an output gap, although predictably German economists [2] and politicians argue otherwise.)

I think these differences are details. In both cases the central bank is treating potential output as something that is independent of its own decisions and the level of actual output. In other words it is simply a coincidence that productivity growth slowed down significantly around the same time as the Great Recession. Or if it is not a coincidence, it represents an inevitable and permanent cost of a financial crisis.

Perhaps that is correct, but there has to be a fair chance that it is not. If it is not, by trying to adjust demand to this incorrectly perceived low level of supply central banks are wasting a huge amount of potential resources. Their excuses for doing this are not strong. It is not as if our models of aggregate supply and inflation are well developed and reliable, particularly if falls in unemployment simply represents labour itself adjusting to lower demand by, for example, keeping wages low. The real question to ask is whether firms with current technology would like to produce more if the demand for this output was there, and we do not have good data on that.

What central banks should be doing in these circumstances is allowing their economies to run hot for a time, even though this might produce some increase in inflation above target. If when that is done both price and wage inflation appear to be continuing to rise above target, while ‘supply’ shows no sign of increasing with demand, then pessimism will have been proved right and the central bank can easily pull things back. The costs of this experiment will not have been great, and is dwarfed by the costs of a mistake in the other direction.

It does not appear that the Bank of England or Fed are prepared to do that. If we subsequently find out that their supply side pessimism was incorrect (perhaps because inflation continues to spend more time below than above target, or more optimistically growth in some countries exceed current estimates of supply without generating ever rising inflation), this could spell the end of central bank independence. Three counts and you are definitely out?

I gain no pleasure in writing this. I think a set-up like the MPC is a good basic framework for taking interest rates decisions. But I find it increasingly difficult to persuade non-economists of this. The Great Moderation is becoming a distant memory clouded by more recent failures. The intellectual case that central bank independence has restricted our means of fighting recessions is strong, even though I believe it is also flawed. Mainstream economics remains pretty committed to central bank independence. But as we have seen with austerity, at the end of the day what mainstream economics thinks is not decisive when it comes to political decisions on economic matters. Those of us who support independence will have to hope it is more like a cat than a criminal.

Postscript (11/04/16). If you think that those who are antagonistic to central bank independence are only found on the left, look at the Republican party, or read this. 

[1] Unfortunately I think some of this survey data is not measuring what many think it is measuring. More importantly, not cutting rates after the Conservatives won the 2015 election was a major mistake. That victory represented two major deflationary shocks: more fiscal consolidation, plus the uncertainty created by the EU referendum. So why were rates not cut?

[2] But not all German economists, as this shows.         

Telling lies

What do you do when a well known macroeconomics blogger says you have made a claim which you have never made? You have in fact clearly said the opposite, and the claim you are supposed to have made is obviously silly. Ignore it maybe? But then you get comments on your own blog expressing surprise at how you can make such a silly claim. There is only one thing you can do really - write a post about it.

Some background which is important because it makes it clear why this is no simple misunderstanding or mistake. I had been reading stuff about how US growth in 2013 refuted the Keynesian position on austerity. 2013 was the year of the sequester, when many economists had voiced concerns about how a sharp fiscal contraction could derail US growth. Growth in 2013 turned out to be modest, and this led some to argue that this modest growth had refuted Keynesian economics.

So I thought I’d do a simple calculation, discussed here. I took the data series for government consumption and investment (call it G), and computed what growth would have been if we assumed an instantaneous multiplier of 2 and no austerity. If the 2013 experience really did refute the Keynesian position, then my counterfactual calculation of growth without austerity would have given some implausibly large number. I choose a multiplier of 2, because that rather large number would give the Keynesian analysis a real test. I did the same for earlier years. The counterfactual number I got for 2013 growth was 3.7%, rather than actual growth of 2.2%, with similar growth rates for earlier years. Hardly an implausible number for a recovery from a deep recession with interest rates still at zero, so no obvious refutation.

Scott Sumner then wrote a post where he said three things in particular.

1)    “Simon Wren-Lewis also gets the GDP growth data wrong”

2)    “He claims that RGDP growth was 2.3% in 2012 and 2.2% in 2013”

3)    “austerity began on January 1st 2013”

(1) and (2) were a rather strange way of saying that I should have used Q4/Q4 growth rather than annual growth. On (3), I wrote a new post simply plotting the data series I had used, which shows a pretty steady fiscal contraction starting in 2011 and continuing in 2013. [1]

Which brings us to his latest post. He writes, about those two original posts:

“He [sic] second claim is to deny that austerity occurred in 2013.”

He goes on to say that this claim is absurd, which of course it is. The only problem is that I never made it, or anything like it. In fact I obviously thought the opposite.

Could this be a simple misunderstanding? There are two reasons why not. The first was that my counterfactual with no fiscal contraction had raised growth from 2.2% to 3.7% in 2013. That would not happen if there had been no austerity in 2013. The second was that I had reproduced the data which clearly shows continuing austerity in 2013! So this was no misunderstanding, or even exaggeration. It is difficult to know what else to call it other than a straightforward lie.

[1] Sumner also says in this latest post that I’m using the wrong variable: rather than G I should use a more comprehensive measure including taxes and transfers, because G is not the variable used to measure austerity in the Keynesian model. But he must know that macroeconomists use both G and some measure of the deficit to look at short term fiscal impacts, for a simple reason. Consumers can smooth the impact of tax and transfer changes, while the impact of G is direct. So equating a $ worth of cuts in G with a $ tax increase, as a deficit measure would do, is wrong: particularly if timing is important, which in this case it is.

So using G is a pretty standard thing to do. In this case, however, it does not seem to make much difference. Here is the IMF WEO series for the US structural deficit. It shows a very similar pattern to G. Austerity starts in 2011, and continues thereafter. 

Default panic and other tall stories

People still say to me that the UK or the US had to embark on austerity, because otherwise the markets would have taken fright at the ‘simply huge’ budget deficit. How do they know this? Because people ‘close to the market’ keep telling them so.

What can I do to show that this is wrong? The most obvious point is that interest rates on UK or US government debt have been falling since 2008, but the response I sometimes get is that rates have only stayed low because of austerity policies. So how about looking at one very short period, around the UK general election of 2010. The election itself was on 6th May, but Gordon Brown only resigned on 10th May, and the coalition agreement was published on 12th May.

Labour were proposing a more gradual reduction in the deficit than the Conservatives, but the Liberal Democrats (the eventual coalition partners) were during the election closer to Labour. So if there was any default premium implicit in yields on UK government debt, it should have fallen between 5th May and 13th May, either because Labour were defeated, or because the LibDems capitulated on the deficit. Now you may say that the markets were anticipating a Conservative victory, but even if that is true, on 5th May there was some doubt about that, which should have been reflected in the price. The coalition agreement published on 12th May clearly states a commitment to “a significantly accelerated reduction in the structural deficit”, so that doubt should have disappeared by then. If there was a default premium in rates before 6th May, it should have fallen by 13th May.

Yield on 10 year UK government debt: source Bank of England

As you can see, rates were higher on 13th May compared to 5th May. More to the point, there was no noticeable decline in rates because fiscal consolidation was going to be greater. Now of course other things may have happened over these few days to offset any default premium effect, and you can always spin stories about how markets were concerned about a coalition government so maybe the accelerated deficit reduction was not going to happen, etc. But they are stories: in terms of the data, there is no obvious effect.

The more sophisticated defence of austerity, as here from the Permanent Secretary at the UK Treasury in reviewing William Keegan’s new book, is that there exists a ‘tipping point’ somewhere: some level of the deficit at which the markets will take fright. It is then suggested, with reference to the Eurozone crisis, once you reach that point it is very hard to return, because a vicious circle sets in. Interest rates rise, making any new debt more expensive to service, which raises the deficit itself, making default even more likely. As we do not know where that tipping point is, it is best to stay well away from it by taking precautionary action before it is reached. The problem with this argument is that having your own central bank makes a key difference, not just to the chance of a funding crisis, but to its dynamics as well.

Having your own central bank does not rule out the possibility of default. As Corsetti and Dedola explain, the costs of inflation created by monetising the debt may exceed the costs of default. Markets know that, so they may still at some point begin to suspect that default could happen. It therefore follows that the markets could get it wrong: they may begin to suspect default even when there is absolutely no intention within government to let this happen.

Suppose this fate had befallen the UK or US governments in 2010. The markets suddenly panic that the government may default, even though the government has no intention of doing so. Interest rates start rising on government debt. But both governments have a Quantitative Easing programme, which is designed to keep long term interest rates low, so their central banks respond by buying more government debt. The cost of servicing government debt does not rise, because additional money is created, so there is no vicious circle. There is plenty of time for the government to take whatever action it wishes to take to reassure the markets. And unlike the model of Corsetti and Dedola, because there is a recession and a liquidity trap, the extra money created does not immediately lead to inflation. [1]

Having your own central bank, which is already undertaking Quantitative Easing, does not just make a funding crisis a lot less likely, it also crucially changes the dynamics. If a crisis occurs, the government is not trapped in a vicious circle. This in turn means that there is no obvious reason to act in a precautionary way. So why did no one make this point nearer the time? The answer of course is that they did.

[1] If you think that in these circumstances a foreign exchange crisis will get you, you need to explain why Paul Krugman’s analysis is wrong. 

Sticky wages both sides of the Atlantic

At the beginning of last year, there were many who were predicting a rise in UK interest rates in 2014. By then UK unemployment had been falling for many months, and we had had four quarters of solid growth. However I said that if rates did rise in 2014 it would be extraordinary. One of the reasons I gave was that there was absolutely no sign of any increase in nominal wage inflation. I thought it would be particularly odd if UK rates rose before US rates, given that the UK’s recovery was lagging a few years.

Unemployment continued to fall rapidly. By June 2014 even the Bank’s governor, Mark Carney, was giving indications that rates might rise sooner than some were expecting. US monetary policymakers showed no signs that they were about to raise rates, and I still thought they should be the first to move, but I was worried that the MPC was sounding too itchy. Sure enough in August two MPC members voted to raise rates. But wage inflation showed no signs of increasing.

Move forward to March 2015, and the prospect of rate increases seem to be receding on both sides of the Atlantic. On Wednesday the FOMC revised down their forecasts for inflation, and also revised down their estimate for the natural rate of unemployment. The reason is straightforward: despite continuing falls in unemployment, wage inflation refuses to budge. John Komlos argues that this state of affairs is unlikely to change anytime soon.

Much the same seems to be true in the UK, as this excellent account from Andy Haldane makes clear. In the UK there is an additional twist. To quote Haldane: “Back in 2009, the MPC’s judgement was that the benefits of cutting rates below 0.5% were probably outweighed by their costs, in terms of the negative impact on financial sector resilience and lending. With the financial sector now stronger, the MPC judges there may be greater scope to cut rates below 0.5%.” It now looks like the Zero Lower Bound (ZLB) may actually be zero.

Haldane goes through in great detail the possible reasons why wage inflation seems so sticky. Moving to the monetary policy implications, he talks about asymmetries, and many of the issues that I raised here he also raises. However he ends with something that I think is even more telling. The chart below shows an optimal interest rate path, using the Bank’s COMPASS model, and assuming a ZLB of zero.

What it does is confirm a suspicion that both Tony Yates and I had about the MPC’s current stance. The policy of doing nothing, and waiting for the inflation rate to gradually converge towards 2%, does not look optimal even if the Bank’s forecast is completely correct. 

The size of the recent macro policy failure

In my Vox piece, I did a simple exercise to show how important fiscal austerity has been in the US, UK and Eurozone. If government consumption and investment had grown by 2% from 2010 onwards, and assuming a multiplier of 1.5, GDP could be around 4% higher in all three ‘countries’. [1]

It cannot be emphasised enough what a huge waste of resources this represents. If 1% growth was lost each year, then by 2013 that gives a cumulative loss of 10% of GDP. That approximation works well for the US. It also roughly fits with Eurozone estimates based on simulations of the NIGEM and QUEST models described here, but the Rannenberg et al study that I have discussed generates cumulative GDP losses up to twice as large. The UK is different from the US because austerity was concentrated in the early years. Using the same methodology (i.e. a multiplier of 1.5) you get a cumulated loss of around 14% of GDP.

For the UK I’ve often quoted a smaller figure of a 5% loss, but based on an analysis which I have always been careful to describe as conservative. It takes OBR estimates of the impact of austerity, which uses lower multipliers (although it does include the impact of higher taxes, which I ignore), and then assumes that all this lost GDP was recouped in 2013. Both differences are equally important in going from 14% to 5%.

Why, for the UK, do I tend to quote the conservative estimate? Four reasons. First, the government is fond of using OBR analysis when it suits them, because their work has some authority. Second, the OBR analysis is more detailed and comprehensive, and it implicitly allows for some monetary policy offset, which may be reasonable given how high inflation was in 2011. (I discuss this issue in much more detail here.) Third, I thought there was some poetic justice in assuming that all of the GDP growth in 2013 was simply a bounce back from earlier austerity, given that many people argue that 2013 growth vindicated this policy. [2] Fourth, losing 5% of GDP is bad enough, so there seemed no gain in using a higher figure, particularly when most of mediamacro act as if the number is zero. But if you asked me what my best guess is, it is nearer 14% than 5%. [3]

As I show in the Vox piece, if US GDP was 4% higher in 2013 it would be above the CBO’s current estimate of potential. The same is true for OECD estimates of potential for the UK and the Eurozone. But all three estimates assume that ‘trend’ or ‘potential’ GDP, or whatever you want to call it, has slowed substantially following the Great Recession. In a subsequent post I want to consider how reasonable it is to assume potential GDP is independent of actual GDP, and why even my 10% (14% for the UK) figure could be an underestimate.

Whether it is 5% of GDP, or 10%, or more, it is numbers like this that I had in mind when I wrote these two posts. They illustrate all too clearly the asymmetric risks that I talked about there. If these numbers are right, but monetary policy makers are nevertheless broadly content with their performance over the last five years, they either have a completely distorted view of the costs of inflation [4], or they have become fooled by a belief in the divine coincidence: that they only need to look at inflation to judge performance. (They could believe that they did not have the tools for the job, or that they had the wrong target, but if that is what they thought that is what they should have said.)

Going from the past to the present, Paul Krugman recently talked about the difference between insiders and outsiders on policy. This also reflects my own experience in the UK. How do we outsiders change this? I think the best place to start is by getting the insiders to think about the costs of fiscal austerity. Once you do that, you realise how large the recent failure of macro policy (but not macro theory) has been, and therefore how important it is not to carry on making the same mistake.  

[1] I write could, because any extra demand growth might - or might not - have been offset by a tighter monetary policy. If it had been offset, in this counterfactual world I would then be writing posts about the foolishness of monetary policy.

[2] We would then have a perfect example of my ‘closing a part of the economy down to boost future growth’ repost, which I used when people wanted to describe 2013 UK growth as vindicating austerity. Paul Krugman prefers being hit by a baseball bat.

[3] So rather than my conservative estimate that austerity lost every adult and child in the UK £1500, my best guess is nearer £4,000. (That is £10,000 per average UK household.) The equivalent number for the US (10% of GDP per capita) is just over $5,000, and for the Eurozone  E3,000.

 

[4] A weak recovery probably shaved the odd percentage point off inflation between 2011 and 2014, but if you ask most people how much they would have been prepared to pay for this, I doubt if the answer would be in the thousands of dollars, euros or pounds.

Faith based macroeconomics

When you just know something is true, like fiscal policy never matters much and NGDP targeting would have avoided the Great Recession, everything becomes about proclaiming your faith in the most effective way possible. It becomes a debating contest. The best example I know of someone like this is Scott Sumner. Here is what he had to say about something I wrote recently.

“Simon Wren-Lewis also gets the GDP growth data wrong, in a way that makes austerity look worse. He claims that RGDP growth was 2.3% in 2012 and 2.2% in 2013 (the year of austerity in the US.) But that’s annual y-o-y data, and since the austerity began on January 1st 2013, you need Q4 over Q4 data. In fact, RGDP growth in 2012, Q4 over Q4, was only 1.67%, whereas growth in the austerity year of 2013 nearly doubled to 3.13%.”

The italics are mine. When you read that someone got the data wrong, or that they claim the data is whatever, you expect to find that they made an excel error, or used old data. But Sumner is not using ‘wrong’ and ‘claim’ in their ordinary sense. He is in debating mode. What he means is that by choosing to use the (correct) annual data, I’m (accidentally, deliberately?) hiding something important. He then quotes two figures that supposedly prove his case. No analysis, no graphs – it’s a debate.

Well here is a graph of US real government consumption expenditure and gross investment, taken from FRED.

According to Sumner “austerity began on January 1st 2013”. Now look at the graph.

It gets worse. Tyler Cowan quotes from Scott’s post with approval, I guess because the guy shares the faith.

Now do you really want to follow those whose macroeconomics is so faith based that they do not even need to check the numbers? Do you want to follow someone who says (earlier in the post) “it would be useful to do a more systematic study of fiscal austerity”. What about the many studies that have already been done (e.g. here, here or here). Do they not count because they generally find that fiscal policy can matter a lot, and so fail to accord with the faith? Do you want your macroeconomics derived from faith or from careful academic analysis?  

Sachs and the age of diminished expectations

I do not normally talk much about the US economy, because there are so many others writing articles and posts that can do so with more authority. But I am getting increasingly fed up with people telling me that US growth disproves the idea that austerity is bad for you at the Zero Lower Bound (ZLB). Jeffrey Sachs just joins a long list.

Of course the proper way to tackle this is as Paul Krugman does. As he says other stuff happens (like a large fall in the US savings ratio in 2013), so you need to go beyond a single country and look at lots of data. However this might leave the impression that somehow the US case is unusual and does not fit a Keynesian story. In this respect I did a simple exercise, the results of which are shown in the chart. It shows actual US GDP, and a hypothetical path based on 2% real growth in government consumption and investment from 2009. So instead of austerity, we maintained government spending at the elevated levels seen at the bottom of the recession. In addition I’ve assumed quite a large (and instantaneous) multiplier of two on that extra government spending.

US GDP, billions of chained 2009 US dollars.

Now if the US recovery proved that Keynesian analysis was wrong, we should get nonsense out of an exercise of this kind. If the recovery was just fine with austerity then replacing it with something like fiscal stimulus and assuming a large multiplier should give us ridiculous rates of growth. Yet as you can see, the no-austerity GDP path looks perfectly plausible. What we get is 3.4% growth in 2010 (compared to an actual of 2.5%), followed by three years of 3.7% growth (compared to 1.6%, 2.3% and 2.2%). In other words we get a reasonably rapid recovery from a deep recession. Obviously there are more sophisticated ways of doing this kind of counterfactual, but maybe something very simple can make the point. With recent US experience, there is no case against Keynesian analysis to answer. 

This suggests to me two things. First, lots of people are desperate to show that critics of austerity at the ZLB are wrong, and are prepared to make nonsense arguments to that end. This may be particularly true if you very publicly proclaimed the need for austerity in 2010 (note the co-author: HT John McHale). Second, it is a sad day when anyone thinks that 2.3% growth is “brisk” when we are recovering from a deep recession and interest rates have remained at the ZLB. It is so very dangerous when these diminished expectations become internalised by the elite.     

The mythical Phillips curve?

Suppose you had just an hour to teach the basics of macroeconomics, what relationship would you be sure to include? My answer would be the Phillips curve. With the Phillips curve you can go a long way to understanding what monetary policy is all about.

My faith in the Phillips curve comes from simple but highly plausible ideas. In a boom, demand is strong relative to the economy’s capacity to produce, so prices and wages tend to rise faster than in an economic downturn. However workers do not normally suffer from money illusion: in a boom they want higher real wages to go with increasing labour supply. Equally firms are interested in profit margins, so if costs rise, so will prices. As firms do not change prices every day, they will think about future as well as current costs. That means that inflation depends on expected inflation as well as some indicator of excess demand, like unemployment.

Microfoundations confirm this logic, but add a crucial point that is not immediately obvious. Inflation today will depend on expectations about inflation in the future, not expectations about current inflation. That is the major contribution of New Keynesian theory to macroeconomics.

This combination of simple and formal theory would be of little interest if it was inconsistent with the data. A few do periodically claim just this: that it is very hard to find a Phillips curve in the data. (For example here is Stephen Williamson talking about Europe - but see also this from László Andor claiming just the opposite - and this from Chris Dillow on the UK.) If this was true, it would mean that monetary policymakers the world over were using the wrong framework in taking their decisions.

So is it true? The problem is that we do not have good data series going back very far on inflation expectations. Results from estimating econometric equations can therefore vary a lot depending how this crucial variable is treated. What I want to do here is just look at the raw data on inflation and unemployment for the US, and see whether it is really true that it is hard to find a Phillips curve.

The first chart plots consumer price inflation (y axis) against unemployment (x axis), where a line joins one year to the next. We start down the bottom right in 1961, when inflation was about 1% and unemployment 6.7%. Over the next few years we get the kind of pattern Phillips originally observed: unemployment falls and inflation rises.

The problem is that with inflation rising to 5.5% in 1969, it made sense for agents to raise their expectations about inflation. (In fact they almost surely started doing this before 1969, which may give the line from 1961 to 1969 its curvature. For given expectations, the line might be quite flat, a point I will come back to later.) So when unemployment started rising again, inflation didn’t go back to 1%, because expected inflation had risen. The pattern we get are called Phillips curve loops: falling unemployment over time is clearly associated with rising inflation, but this short run pattern is overlaid on a trend rise in inflation because inflation expectations are rising. Of course the other thing going on here is that we had two oil price hikes in 1974 and 1979. The chart finishes in 1980.

Most economists agree that things changed in 1980, as Volker used monetary policy aggressively to get inflation down. The next chart plots inflation and unemployment from 1980 to 2000.

Inflation came down from 13.5% in 1980 to 3.2% in 1983 partly because unemployment was high, but also because inflation expectations fell rapidly. (We do have survey evidence showing this happening.) The remaining period is dominated by a large fall in unemployment. So why didn’t this fall in unemployment push inflation back up? In terms of the chart, why isn’t the 2000 point much higher? Again expectations are confusing things. One survey has inflation expectations at around 5% in 1983, falling towards 3% at the end of 1999. So inflation was being held back for that reason. A Phillips curve, and its loops, is still there, but pretty flat.

The final chart goes from 2000 to 2013. Note that the inflation axis has changed - it now peaks at 4.5% rather than 16%. The interesting point, which Paul Krugman and others have noted, is that this looks much more like Phillips’s original observation: a simple negative relationship between inflation and unemployment. This could happen if expectations had become much more anchored as a result of credible inflation targeting, and survey data on expectations do suggest this has happened to some extent. There are also important changes in commodity prices happening here too.

While the change in inflation scale allows us to see this more clearly, it hides an important point. Once again the Phillips curve is pretty flat. We go from 4% to 10% unemployment, but inflation changes by at most 4%. However from the previous discussion we can see that this is not necessarily a new phenomenon, once we allow for changing inflation expectations.

Is it this data which makes me believe in the Phillips curve? To be honest, no. Instead it is the basic theory that I discussed at the beginning of this post. It may also be because I’m old enough to remember the 1970s when there were still economists around who denied that lower unemployment would lead to higher inflation, or who thought that the influence of expectations on inflation was weak, or who thought any relationship could be negated by direct controls on wages and prices, with disastrous results. But given how ‘noisy’ macro data normally is, I find the data I have shown here pretty consistent with my beliefs.

    

US savings behaviour, and empirical research strategies

In this post I want to look at a paper by Chris Carroll, Jiri Slacalek and Martin Sommer for two reasons. The first is for what the paper tells us about US consumption behaviour, and potentially consumption behaviour in any advanced economy. The second thing I want to use it for is as an example of different ways of doing empirical research in a microfoundations world.

The mainstay of modern macroeconomics is the consumption Euler equation, where consumption is proportional to the sum of financial wealth and human wealth, where human wealth is the discounted present value of future labour income. This model implies consumption aims to smooth out erratic movements in income through borrowing and saving. In this model periods of high saving can reflect periods of temporarily higher income, or temporarily high real interest rates. Adaptations of this model that are commonplace are to assume that some proportion of consumers are liquidity constrained, and therefore consume all their income, or that consumption is subject to ‘habits’, which generates additional inertia. This model with or without these adaptations is not very helpful in explaining why savings rose sharply in the Great Recession.

Rather more worrying is that this model is not very good at explaining US savings behaviour before the Great Recession either. As I noted here, US savings rates fell steadily for about twenty years from the early 1980. You might think that explaining such a large and important trend would be a sine qua non of any consumption function routinely used in macromodels, but you would be wrong. Consistency with the data is not the admissibility criteria for a microfounded macromodel.

The Carroll et al paper finds two explanations for the pre-recession trend and the increase in savings during the recession. The first is easier credit conditions, and the second is employment uncertainty. The mechanism through which both work is precautionary savings. If the risk increases that your income will fall sharply because you will lose your job, you need to build up some capital to act as a buffer. The easier credit is to obtain, the less precautionary savings you need.

The reason why precautionary savings represents a significant departure from the basic Euler equation model is intuitive. If you want to hold a certain amount of precautionary savings, you have a target for wealth. A wealth target pulls in the opposite direction to consumption smoothing. If you have a one-off increase in income, consumption smoothing says you should consume it very gradually, perhaps only consuming the interest. The marginal propensity to consume that extra income is tiny. But this leaves wealth higher for a very long time. If you have a wealth target, your marginal propensity to consume that additional income will be larger, perhaps a lot larger.

Now for the methodology part. These empirical results are in sections 3 and 4 of their paper. They call their empirical results in section 4  ‘reduced form’, because they come from a regression relating saving to wealth, credit constraints and expected unemployment. However the authors feel that this is not enough. In section 2 they discuss a structural theoretical model. Because modelling labour income uncertainty is very difficult, their microfounded model assumes that once someone becomes unemployed, they become unemployed forever. Section 5 then estimates this structural model.

The authors describe a number of reasons why directly estimating the structural model may be better than estimating the reduced form. But in order to get their structural model they have to make the highly unrealistic assumption noted above. The reduced form, on the other hand, does not have this assumption imposed on it. So I do not think we can say that the results in Section 5 are more or less interesting than those in Section 4, which is why both are interesting, and why both are included in the paper. There does not seem to be any compelling reason to elevate one above the other.

OK, a last  - perhaps wild - pair of questions. Is it the case that, compared to a few decades ago, there are far fewer papers in the top journals that simply try and explain historical time series for a single key macro aggregate (like consumption or saving)? If that is the case, is this due to the difficulties in getting microfounded models to fit, or something else?