The OBR, productivity and policy failures

Chris Giles had an article in the FT yesterday about the UK’s continuing dreadful productivity performance, and the implications this might have for forecasts of the public finances. It has the following chart comparing successive OBR forecasts and actual data.

I want to make two points about this. The first is about the OBR’s forecast. [1] It is easy to say looking at this chart that the OBR has for a long time been foolishly optimistic about UK productivity growth. Too often growth was expected to return to its long run trend shortly after the forecast was published but it failed to do so. Expect lots of articles about how hopeless macro forecasts are in general, or perhaps how hopeless OBR forecasts are in particular. It was obvious, these articles might say, that trend productivity growth in the UK has taken a permanent hit following the financial crisis.

Anyone saying this is ignoring the history of the UK economy for the 50 years before the GFC. After each downturn or recession, labour productivity growth has initially fallen, but it has within a few years recovered to return to its underlying trend of around 2.25% per annum. This means not just returning to growth of 2.25%, but initially exceeding it as productivity caught up with the ground lost in the recession. In a boom sometimes growth exceeded this trend line, but it soon fell back towards it.

This made sense. Productivity growth reflects technical progress and innovation, and they tend to continue despite recessions. A firm may not be able to implement innovations during a recession, but once the recession is over experience suggests they make up for lost ground in terms of putting innovations into practice.

Given this experience, OBR forecasts have always been pretty pessimistic. They have assumed a return to trend growth, but no catch up to make up for lost ground. If they had also forecast, in 2014 say, that given recent experience they expected productivity growth to be almost flat for the next five years that would have been regarded as extreme at the time. Why would UK firms continue to ignore productivity enhancing innovations when the macroeconomic outlook looked reasonable?

And of course in 2014 UK productivity growth was positive. This brings me to my second point, which follows from this quote from the FT article:

“In the Budget, both the OBR and Mr Hammond are likely to stress that the downgraded forecasts do not reflect a new assessment of the damage to the UK economy from Brexit, but a reassessment of likely productivity growth after so many recent disappointments.”

Chris may be right that they will say this, but is it remotely plausible? As my recent post tried to suggest, UK productivity growth can be seen as suffering from three large shocks: the recession following the GFC, the absence of a normal recovery as a result of austerity, and then Brexit. The first two of those shocks led to a period of intense uncertainty, causing UK firms to put on hold any plans to innovate. Just as they thought things had returned to a subdued version of normal they were hit by the third, Brexit. During periods of intense uncertainty, productivity stalls or may even decline a little, as firms meet any increase in demand by increasing employment but not investing in new techniques. [2]

This story involving uncertainty seems to fit the data. Once the recovery (of sorts) finally began in 2013, productivity growth picked up. That sustained growth came to a halt when the Conservatives won the 2015 election, and the possibility of Brexit began to be an important factor for firms. [3]

These two points are related in the following way. The experience of the 50 years before the GFC suggested that you could hit the economy with pretty large hammers, but it would eventually bounce back. However that may have been contingent on a belief by firms that if policymakers were wielding the hammer (using high interest rates for example) they would take it away fairly soon, and replace it by stimulus. That belief was shattered in the UK by the GFC and austerity, where policymakers decided to keep using the hammer. What little confidence remained was destroyed by Brexit.

Discoveries are still be being made in universities around the world, and we know innovations are still being implemented by leading UK firms. It seems completely far fetched to imagine the GFC is still having some mysterious impact on the remainder of UK firms such that they refuse to adopt these innovations. A much more plausible story is that we are seeing what happens when most firms lose confidence in the ability of policymakers to manage the economy.

[1] I am on the OBR’s advisory panel, but as our job when we meet once a year is to be critical of OBR assumptions, and as we have no role in producing their forecasts, I think what I say here can be completely objective.

[2] Productivity can initially fall because new employees are not as productive as those who have been working in the firms for some time, for example.
Postscript (7/10/17) For evidence on the impact of Brexit on productivity, see work by Bloom and Mizen here.

[3] An alternative story is that the UK has settled into a new slow growth ‘equilibrium’, where the majority of firms are so pessimistic they hardly innovate at all.      

Could austerity’s impact be persistent

How Conservative macroeconomic policy may be making us persistently poorer

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

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

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

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

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

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

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

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

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

German Self-Interest

Michael Burda from Berlin’s Humboldt University has an interesting article in the Royal Economic Society newsletter, which is critical of views that I and others have expressed about the ‘problem with German (macro)economics.’ The key argument Michael Burda wants to make is that there is nothing peculiar or unusual about German economics, and what many of the critics interpret as either economic ignorance or distinctiveness is actually self-interest. To quote from his final paragraph: “It is not ordoliberal religion, but a mixture of national self-interest and healthy mistrust informed by experience that guides German economic policy today.”

Often trying to decide whether policies are the result of self-interest or particular ideas is difficult because both explanations fit the facts. What we really need are examples of German economic policy which follow self-interest but not dominant ideas, or vice versa. Now some might suggest ‘bailing out’ Greece and other periphery countries was a clear example, where the idea of European solidarity triumphed over self-interest. Unfortunately that will not work: the fact that Greece in particular did not default in 2010 and had only limited default in 2012 was in part to protect the interest of other EU banks. You could plausibly argue that Greece has suffered precisely because of German and other EU countries' self-interest.

In fact in many ways Germany has done rather well out of the EZ crisis. Henning Meyer points us to a study which suggests that, as a result of the crisis and Germany’s ‘safe haven’ status, the German government has saved more than E100 billion from 2010 to 2015 in debt interest. As Henning notes, this has helped Germany ‘set an example’ on deficits without having to do anything too painful. That is slightly more than its total loss if Greece completely defaults. It has also not done badly as a result of the profits the ECB has made on its lending.

Perhaps the largest benefit Germany has received from the Eurozone has been as a result of undercutting its fellow members around ten years ago. Everyone knows about the ‘excess inflation’ in the periphery during those years, but the story of insufficient wage inflation in Germany at the same time is not often told. This policy - which if it had occurred via exchange rates rather than domestic inflation would be called beggar my neighbour - may well have been accidental, but it is a key reason why Germany is the only Eurozone economy that has not suffered since 2010. Indeed, one interesting explanation of the general lack of interest in using fiscal policy for demand management in Germany is that for some time the country has been part of a fixed exchange rate system in which, with its particular wage bargaining system, it can fairly easily boost demand by changing domestic inflation.

What about the pressure from Germany on the ECB: first not to undertake the OMT programme in September 2012 which ended the non-Greek crisis, and then not to undertake QE? That is generally put down to extreme fears of inflation and fiscal dominance of monetary policy in Germany. Unfortunately it is also been in Germany’s self-interest. For example, if the ECB had been able to keep to its 2% inflation target, the earlier undercutting of its neighbours would have had to result in a subsequent period of German inflation above 2%. However Germany may well avoid this outcome as a result of Eurozone deflation, so that countries outside Germany will bear the cost of correcting the German competitiveness problem.

That self-interest is key to German policy gets important support from 2009 when alongside other counties Germany enacted a form of countercyclical Keynesian policy. Here we have a clear case where self-interest appeared to win out over a prevalent distrust of countercyclical fiscal policy.

In some senses I’m attracted to Michael Burda’s hypothesis. I once believed that the “problem with German macroeconomic policy is not that it is acting in the national interest, or otherwise, but that it is based on a discredited and harmful set of ideas”. But in my recent discussion on why these discredited ideas persisted, while I threw doubt on some popular accounts, I still failed to come up with a convincing story. There may also be an element of false optimism in focusing on belief in poor economic ideas rather than self-interest, if you also think (hope?) that these beliefs can be more easily changed.

For much the same reason I also think it is futile to try and convince Germany that it should embark on fiscal expansion ‘for the sake of the rest of the Eurozone’, partly because it contradicts self-interest, but also because Eurozone deflation means that we need fiscal expansion not just in Germany, but the whole of the Eurozone, so that ECB interest rates can be lifted above their lower bound. The problem over the last few years has not just been austerity in Germany, but austerity in the Eurozone as a whole.

So perhaps it is all just self-interest. But if that means there is nothing unusual about German economics, it does not let German economists off the hook. Germany was central to creating the second Eurozone recession through its insistence on fiscal austerity everywhere, together with unhelpful pressure on the ECB. Germany was also central in imposing harmful debt levels and austerity on Greece. Mainstream economics tells us this, but few German economists have been prepared to say so in public. German Keynesians who are involved in the policy debate that I have talked to tell me the prevailing climate is definitely anti-Keynesian. It is not the job of German academics to stay quiet about what mainstream macroeconomics tells us just because doing so suits the national interest.

Post Recession Lessons

If you are familiar with this blog, you will know that I regard 2010 as a fateful year for the advanced economies in their recovery from recession. That was the year that the US, UK and Eurozone switched from fiscal stimulus to fiscal contraction. Because we were at the Zero Lower Bound (ZLB), this policy switch is directly responsible for the weak recovery in all three countries/zones. A huge amount of resources have been needlessly wasted as a result, and much misery prolonged.

This post is not about justifying that statement, but taking at as given and asking what should we conclude as a result. [1] To answer that question, what happened in Greece (in 2010, not two days ago) may be critical. To see why, let me paint a relatively optimistic picture of the recent past. 

Greece had to default because previous governments had been profligate and had hidden that fact from everyone, including the Greek people. Recessions rather than booms tend to be when things like that get exposed. If Greece had been a country with its own exchange rate, then it would have been a footnote in global macroeconomic history: fiscal stimulus that had begun in all three countries/zones in 2009 would have continued (or at least not been reversed), and the recovery would have been robust.

Instead Greece was part of the Eurozone, a monetary union that had been implemented in such a way that it was particularly vulnerable to the threat of default by one of its members. Policy makers in other union countries prevaricated, partly to protect their own banks, partly because they worried about contagion. The ECB refused to act as a lender of last resort - we only got OMT in 2012. So the Greek crisis became a Eurozone periphery crisis. (For more detail, based on an IMF evaluation of their role in this affair, see this post.) This led to panic not just in the Eurozone but in all the advanced economies. Stimulus turned to austerity. By the time some in organisations like the IMF began to realise that this shift to austerity had been a mistake, it was too late. The recovery had been anemic.

Why is that an optimistic account? Because it is basically a story of bad luck, which we have no reason to believe will be repeated again. When the next crisis comes along, the Eurozone will have OMT in place, and hopefully there will be some rational system for deciding when a Eurozone country that gets into difficulties should get ECB help or should be allowed to default. If this was just bad luck, we do not need to rethink how macro policy is made.

Now for the pessimistic version. The political right in all three countries/zones was always set against fiscal stimulus. It is true that during 2009, when no one was sure how bad things might get, Germany enacted a modest (if fairly ineffective [2]) stimulus, but in the US and UK the political right opposed it. Without Greece, we still would have had a Conservative led government taking power in the UK in 2010, and we still would have had Republicans blocking stimulus moves and then forcing fiscal austerity. The right’s strength in the media, together with the ‘commonsense’ idea that governments like individuals need to tighten their belts in bad times, would mean that opposition to austerity within the political elite would be lukewarm, and so austerity was bound to prevail. While we might hope that this right wing opportunism does not happen again during a future crisis, there is no clear reason to believe it will not. Greece may have just voted against austerity, but there is every chance that in the UK the Conservatives will retain power this year on an austerity platform and the Republicans are just the presidency away from complete control in the US.

If the pessimistic account is right, then it has important implications for macroeconomics. Although it may be true that fiscal stimulus is capable of assisting monetary policy when interest rates are at the ZLB, the political economy of the situation will mean it may well not happen, and that instead we get the fiscal instrument moving in the wrong direction. That means that macroeconomists have to start thinking about how to fundamentally change the way policy is done at the ZLB.

When some economists over the last few years began to push the idea of helicopter money, I was initially rather sceptical. The scepticism could be summed up by saying that helicopter money when you have inflation targets is identical to tax cuts plus Quantitative Easing (QE), so why not just argue for an expansionary fiscal policy? (There was also the point that tax cuts might be a rather poor form of stimulus compared to, for example, bringing forward public investment.)

However, if the pessimistic account is correct, then arguing with politicians for better fiscal policy is quite likely to be a waste of time, a lost cause. A more robust response is to argue for institutional changes so that politicians find it much more difficult to embark on austerity at the ZLB, or to allow others to effectively offset this austerity if it happens. Central banks have QE, but helicopter money would be a much more effective instrument. To put it another way, central bank independence was all about taking macroeconomic stabilisation away from politicians, because politicians were not very good at it. The last five years have demonstrated how bad at it they can be. However that move to independence was always incomplete because of the ZLB problem. We now need to make it complete.

This of course raises all kinds of questions. Do we want to give additional powers to the central bank, or should another independent institution be involved? If we do give central banks more power, could this be limited to enforcing a dialogue between central banks and government (along the lines suggested here), or should we go for something like helicopter money? If the latter, what are the knock on consequences to ensure the central bank can always tighten policy as necessary? Going down that road must in my view include thinking about how to make central banks a lot more accountable, so that they do not behave like the ECB. Arguably macroeconomics has been naive in suggesting that the more independent a central bank is the better.

However, we only need to go there if the pessimistic interpretation of the last five years is correct. Should we put the last five years down to bad luck, or to political economy forces that will not go away. I currently think the pessimistic interpretation is more persuasive, but I will be very happy to change my mind.

[1] Many argue that the recovery was weak because the recession was caused by a financial crisis, and it was always going to take a long time before banks would start to want to lend again. Even if you put a lot of weight on this argument, it implies a multiplier of one, not zero. It does not justify reducing public spending and employment i.e. making people unemployed when there was little chance they would find work in the private sector.

[2] The stimulus focused on tax cuts, which are less effective than increased government spending because some of the tax cuts will be saved. See Carare, A, Mody, A and F Ohnsorge (2009) “The German fiscal stimulus package in perspective” VoxEU  23/01/09. 

Left, Right and Macroeconomic Competence

The title of one of my recent posts was a bit of a cheat. It was meant to surprise, because it contradicted the prevailing view, but the post didn’t actually try to answer the question the title posed. This post does try to assess whether a political party’s place on the left-right spectrum might influence its macroeconomic competence.

It should be obvious that, for any individual country, looking at some macro outcome (like growth) and drawing some conclusion can be meaningless. For example, growth under Republican presidents has been far worse than under Democratic presidents, but that could so easily be down to luck rather than judgement. To make headway we need to think of mechanisms and particular instances when they applied.

In the US, for example, there is a belief on the right that cutting taxes will increase tax revenue, a belief that is also clearly wrong. So you would expect Republican administrations that acted on that belief to run up bigger budget deficits than their Democratic counterparts, and that seems to be what they do. That may not be the whole story, but at least it is a mechanism that seems to fit. However it seems like a story that is rather specific to the US, at least for the moment.

Just now you could argue that parties of the right are more prone to austerity, because they want a smaller state than those of the left, and austerity can be used as a cover to undertake policies that reduce the size of the state. In a situation where interest rates are stuck at zero that has the damaging macroeconomic consequences that we are seeing today. However this is a story that is specific to liquidity traps.

An alternative source could be different views about the relative costs of inflation and unemployment. You might expect governments of the left to have higher inflation and those of the right to have higher unemployment. While that mechanism loses much of its force when you have independent central banks, it can resurface in a liquidity trap.

A final left/right difference that might impact on macroeconomic outcomes is different views on the need for state intervention. Those on the right might favour less intervention, leading them to favour simple rules, and to argue against the use of fiscal policy for macroeconomic stabilisation.

Is any of the above helpful in looking at UK policy since 1979? I use this place and period as a case study because I am most familiar with it. In the past I have talked about three major macroeconomic policy errors over this period, all of which occurred when the Conservatives were in power. However that alone proves nothing: Labour was in power for fewer years and might have been lucky. [1] 

The period starts with Margaret Thatcher and the brief experiment with monetarism. Here you could use the inflation/unemployment contrast - the policy succeeded in getting inflation down very rapidly, but at high costs in terms of unemployment, which persisted because of hysteresis effects. A secondary question is whether, given any particular preferences between inflation and unemployment, the policy was inefficient because it attempted to run monetary policy according to a simple rule which failed. Many at the time argued it was, because it put far too much of the burden of lost output on the traded sector, which in turn was because the policy generated Dornbusch type overshooting effects (i.e. a large appreciation in the exchange rate).

The 1990 recession can also be linked to left/right influences. The rise in inflation that preceded the recession (and to some extent made it necessary) was partly down to Nigel Lawson’s tax cuts. I have been told by one insider that the key wish at the time was to cut the top rate of tax, but it was felt that to do this alone would be politically damaging, so tax cuts were made across the board. That was not the only reason for the late 80s boom - there was also the decline in the aggregate savings ratio that in my view had a great deal to do with financial deregulation - but it was a factor.

The macroeconomic failure that everyone knows about from that period was the forced exit from the ERM in 1992, and that was costly because it made monetary policy too tight beforehand. Although you could say fixing the exchange rate is a simple rule that the right might prefer, that would be stretching things: ERM entry was favoured by Labour as well (although with the notable exception of Bryan Gould). According to my own and colleagues analysis at the National Institute the entry rate was too high, which might follow from a preference for low inflation, although it could just have been a choice based on poor macroeconomic analysis.

Inflation targeting followed the ERM debacle, and it was augmented by central bank independence at the start of the Labour government of 1997. One major decision that, if it had gone the other way, we might be scoring as a major error would have been if the UK had joined the Euro in 2003. I have argued that the decision not to was based on an intelligent and well researched application of current academic knowledge (subsequently vindicated by additional but related problems that academics did not anticipate), rather than any left/right policy preference.

Which brings us to George Osborne. I have just finished the first draft of a paper that appraises the coalition’s macroeconomic policy, and an interesting question that arises from that is why the coalition went for austerity despite the liquidity trap. While the 2010 Eurozone crisis might explain the change of mind of the minority partners in the coalition, it does not explain Conservative policy, which was against fiscal stimulus in 2009. If you look at some of Osborne’s speeches (and I’m not sure there is much else to go on), the rationale for austerity was a belief that monetary policy was sufficient to stabilise the economy, even in a liquidity trap (see the second part of this post). At the time that represented a minority view amongst macroeconomists. It could be explained in left/right terms in various ways: a dislike of additional state intervention, taking a risk that would lead to higher unemployment rather than higher inflation, or a devious way of reducing the size of the state.

So we have three major UK macroeconomic policy errors: the monetarist experiment of Thatcher, ERM entry and exit (and the boom that preceded it), and current austerity. In all three cases it is possible to link these to some extent to right wing political preferences. It may be equally possible to go back further and link the increased inflation of the 1970s to a left wing dislike of unemployment, but I cannot do that from memory alone so it would require some additional work going over the detailed history of that period.

However one additional point strikes me. Two of these three errors can be attributed to following a minority academic view. That monetarism was a minority academic view in the UK in the early 1980s became clear with the famous letter from 364 economists in 1981. In UK right wing mythology that episode represents the triumph of Thatcher over the academics. I have also noted that the Labour/Brown period perhaps represented a high point in the influence of academic economists within government, and the analysis behind the 2003 entry decision was an example of that. A belief that fiscal policy is not required in a liquidity trap is a minority academic view.

It may seem odd to some that those on the right might be more disposed to ignore mainstream academic opinion within economics, but of course academic economics can be described as the analysis of market failure. No one looking at debate in the US would dispute that minority academic views, or a more general anti-intellectualism, finds an easier home on the right than the left at the moment. Of course you can also find anti-intellectualism on the left - see here for a recent UK example - and my distant memories of the UK in the mid 1970s suggest that during this period they might have been at least as prevalent as those on the right. What may have happened over the last few decades is that what is currently called the left has become ideology light, and therefore more receptive to academic expertise and evidence based policy.

[1] If you want to call the gradual liberalisation of financial controls that facilitated the financial crisis a macroeconomic policy error that would make four, but I do not think anyone would seriously argue that this occurred under Labour because they were more predisposed to market liberalisation than the Conservatives.

What we do know

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

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

Underlying Primary Balances: OECD Economic Outlook May 2014

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

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

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

Humility and Chameleons

Macroeconomics tells you to (temporarily) raise, not cut, government spending when we have a recession caused by deficient demand and interest rates are at their lower bound. That is the claim that some of us make. Others say we are being far too sure of ourselves and our subject, in part because there exist models where this is not true. As a result, we should not loudly complain when politicians do not follow this advice. A bit more humility please.

If you think we should have more humility, imagine the following. The UK or US government tomorrow abolishes their independent central bank, and immediately raises rates to 5%, saying it was about time savers had a better deal. Well macroeconomists generally think that independent central banks are a good idea, and we nearly all believe that raising interest rates when inflation is below target and unemployment is high is crazy. But wait a minute. There are models that suggest keeping interest rates low is causing low inflation, and that raising rates could stimulate the economy - I discuss one here. So perhaps we should not be critical of a government that did this. We should be humble, and leave the politicians to do as they please while we get on with our research. Let us make sure we are absolutely sure before shouting too loud.

Why is that wrong? Two reasons. First, the existence of a model that says higher interest rates could stimulate the economy is not in itself evidence that it might. In an interesting paper, Paul Pfleiderer talks about Chameleon models. He defines a chameleon model as “built on assumptions with dubious connections to the real world but nevertheless has conclusions that are uncritically (or not critically enough) applied to understanding our economy.” The model that I discussed where higher rates could stimulate the economy assumes (among other things) agents believe the inflation target is negative, and that raising rates will show them they are wrong. Possible, but highly improbable.

Second, economic policy always takes place in an uncertain environment. Raising interest rates might have reduced inflation in the past, but maybe this time is different? If we wait until we are all absolutely sure about the impact of a policy change, we will wait forever. However, if we are more than 90% certain that raising interest rates, or cutting government spending, will make the recession worse, we should say so. If politicians ignore this advice, we should make sure everyone knows. This is no intellectual game - people’s welfare is at stake.

Bold macroeconomic policy changes for a new government

One of the features of the incoming 1997 Labour government was that it undertook significant and progressive changes in macroeconomic policy. Not only was it right to give independence to the Bank of England [1], but the institutional framework they created for this was innovative and effective. As I have written recently, the fiscal framework established a year later was also clear and progressive compared to past practice and what was being done elsewhere.

So could the government that gets elected in 2015 be equally bold? I think it could be. Furthermore, the suggestions I make below apply to many advanced economies. Yet why look two years ahead now, when recovery from recession is either far from complete, or for many countries has not begun? One reason is that the lags in policy making can be quite long. A new government will not have spent the year before an election working out its policies - it will have been too busy campaigning. Policies get decided much earlier. To have a chance in that decision making process, ideas need to be bounced around earlier still.

On monetary policy, the new government needs to acknowledge that the recession has indicated clear problems with the inflation targeting regime. Three things need to change. First, the medium term inflation objective should be accompanied by an objective of minimising the output gap - in other words the UK should have a dual mandate like the US. Second, nominal GDP should be adopted as an intermediate target, to guide the MPC as to how best achieve these two objectives. Third, the inflation target of 2% is too low, because it increases the risk that we will soon suffer another Zero Lower Bound (ZLB) recession. In the UK the government fixes this target (which is one reason why the 1997 decision was progressive), and it should raise it. All of these changes will assist the process of recovery as well as help in the longer term.

On fiscal policy, we have to distinguish between policies pre and post recovery. If the government inherits an economy where the interest rate set by the Monetary Policy Committee is still at 0.5%, then its priority should be fiscal policies that promote recovery. I agree 100% with Paul Krugman that governments around the world have needlessly confused long term issues involving debt with this short run priority: here is one of many posts I have written arguing this. Yet the incoming government should also have a fiscal strategy post recovery.

This should involve both rules and institutions. Whatever fiscal rule is adopted, it should make three things clear. First, it does not apply at the ZLB. [2] Second, it should focus on a long term objective of reducing the debt to GDP ratio. Third, deficits have to be flexible in response to shocks in the short term. Now how you square these three things is tricky, and I still have an open mind on this, but for the moment you should read this very interesting proposal from Tony Dolphin at the IPPR as to how it might be done. That proposal utilises an enhanced UK fiscal council (OBR), which is the institutional leg of the reform.

Before discussing that, however, I want to say a bit more about why the policy goal should be to gradually reduce debt to GDP. I would give four main reasons. First, it allows room for fiscal policy to support monetary policy if it again hits the ZLB, without worrying about the bond markets. Second, it reduces real interest rates, which should encourage private investment (although the more open the economy the smaller this effect will be). Third, it reduces future distortionary taxation. Finally, future generations will need all the resources we can give them to help cope with their inheritance of hugely disruptive climate change.[3]

In the context of similar proposals from Hopi Sen [4], Chris Dillow recently raised some doubts. Some of these relate to the short term position: yes, investment probably responds more to expected future growth than the cost of capital, but with an active monetary policy, reducing debt to GDP should not inhibit growth. A more serious concern is that reducing real interest rates might increase the risk of hitting the ZLB, which is one reason why I propose raising the inflation target. [5]

The current government should be credited with setting up the OBR, but it did so with a very restricted remit. The OBR is not allowed to crunch the numbers on alternative policies, so it cannot even produce the raw material on which others can propose advice. Perhaps this made sense to avoid throwing a new institution into the middle of a fierce political debate in 2010, but it does not make sense in the longer term. At the very least the OBR should be given the freedom to look at alternative fiscal policies, but its role could go further still, as the IPPR proposal suggests.

[1] I should confess that before 1997 I was very dubious about central bank independence. In retrospect that was because I did not have the imagination to see how that the institutional set-up could be crucial. Despite my recent criticisms, I think the MPC has done much better than elected governments would have done. However my fears were that we would get something more like the ECB, so they were not groundless. I also worried that an independent central bank might be too conservative in the Rogoff sense, and that concern has also been realised. 

[2] Or equivalently, there should be a rule that directs policy in very different ways at the ZLB.

[3] In an ideal world, we would be dealing with climate change now, and perhaps - as I discussed here - using higher government debt to help pay for it. However we are not, and it does not look like this is going to change any time soon.
Postscript 24/6/13: As well as leaving capacity for fiscal stimulus after a large negative demand shock, Obstfeld argues that we need low debt to leave capacity for a (partial) bail out of the financial sector.

[4] I obviously disagree with Hopi on how the Labour party should respond to the myth that their fiscal mismanagement was responsible for the UK’s current plight. If you want to get into the apology idea, then it seems reasonable that governments should only apologise for major errors rather than every particular thing they could have done better. As I have argued before, there is no comparison between Labour’s fiscal errors and the current government’s mistakes. Governments that commit errors that go against expert opinion at the time bear a particular responsibility. Few (myself included) raised objections to the constant 40% debt to GDP ratio when it was adopted in 1998.

[5] In the UK I suspect that the main short term impact of a tighter fiscal regime will be a depreciation in the exchange rate rather than lower interest rates. In the context of the last Labour government, I think that would have been helpful.