I’ve got a new theory to try out. Here it is:
If households accumulate too much wealth, an aggregate demand crisis must inevitably follow. There is a simple causation: when households become very rich, they slow down their spending. Because one household’s spending is another’s income, aggregate spending (income) will then subsequently fall.
My theory is perfectly consistent with the UK data, in which the 2008 recession directly followed an unprecedented rise in total household net wealth to £6.8tn in 2007 (Source: ONS Blue Book), a doubling of wealth in just ten years. If you owned £6.8tn would you carry on working? No, you’re not stupid. And UK householders are not stupid either – you don’t get to own £6.8tn of wealth by being stupid.
The recession was not good for UK households, with their total wealth falling by a cool £1tn in 2008. UK householders were not happy. By 2009, they had resolved to step up and get back to spending more money so they could build up their wealth again.
By 2011, the recession was long gone, and UK households had built up their total wealth to a staggering £7tn. Can you guess what happened next? Yup, that’s right. Boom. Another recession. The data are clear. If aggregate UK household wealth rises to around £7tn, the people of the UK kick back and stop spending as much.
Yes, that is a pretty silly theory. But this type of theory is what got me interested in macro. If you replace “assets” with “debt” in my story… does it make more sense? Or is it a confusion of correlation with causation? And if debt in the UK (and US) caused an AD crisis, why is Australia different? What if debt merely correlates with the level of nominal spending, and does not cause it?
This post is a roundabout way of saying that Nick Rowe’s post on who controls the size of the Sun is one of the most enlightening things I’ve read this year. If you’ve not read it, I recommend it to you very highly indeed.
Chris Giles has an excellent piece on ditching the output gap which I won’t quote fully to avoid the wrath of the crack team of copyright enforcement lawyers at the FT:
Ditching the output gap concept would not resolve the big economic debates of the day but it would at least free them from some unnecessary constraints. Monetary policy makers would no longer have to act so surprised that inflation has remained stubbornly high alongside economic weakness. In fiscal policy, the authorities would have to accept that they do not know how much of the deficit is structural and needs action, and how much will go away as the economy recovers.
The rest is just as good.
Chris Dillow’s response to my call for an NGDP target raised the (persistent) suggestion that the UK supply-side is not able to keep up with demand growth. This puts Chris in the same position as that held by inflation hawks like Andrew Sentance, I suppose – an odd alliance.
Jason Rave’s analysis is probably my favourite, as he nails inflation targeting as the source of all this woe, advising that we should ignore the “inflationary illusions“. Here, here!
I don’t really have much to add to all this discussion, but I’d like to attempt a quick defence of the much-maligned UK supply-side.
If we take the liberty of ignoring the effect of the VAT changes as Whitehall takes a larger cut of nominal spending, a supply-side constraint on demand growth just does not look that obvious. This graph shows the annual rate of change of both nominal GDP at basic prices, and real GDP (note this is the change over four quarters, not the more volatile quarter-on-quarter rate of change):
In 2011 as a whole, NGDP at Basic Prices – the income actually available to produce new stuff – increased just 2%. And there was a 0.7% increase in output. Is that really such a terrible supply-side performance?
So I think the VAT change is perfectly sufficient to explain the size of the “wedge” between 2011 NGDP (a pathetic 3% even including VAT) and output growth, and the UK supply-side performance gives little evidence for pessimism about whether faster demand growth would only be inflationary.
Chris Dillow produces this graph:
…and makes a rather grand claim:
You can read this chart as a refutation of neoliberalism. Neoliberals thought that if only taxes could be cut and labour’s bargaining power weakened, that capital spending would rise and economic growth follow. This has not happened. And it is, surely, unlikely that the corporate tax cuts Osborne announced in the Budget will significantly turn things around.
The graph Chris uses is confusing; it is hard to distinguish between cyclical movements in (private non-financial) corporate income (or retained earnings, gross saving) and movements in corporate capital formation. Here’s a graph of the two series in nominal terms:
I would hesitate to pull out any divergent trend between these series except at around 2002/3. This is curious, because for the UK economy as whole, gross capital formation has stayed roughly at 16-18% of GDP for a while, if we are permitted to count the late 1980′s as a cyclical boom and 2008 onwards as a cyclical slump:
The sectoral breakdown of capital formation does back the case that Business Investment was going sideways since around 2000. But total capital formation keeps growing. This is the graph of the volume of capital formation broken down by sector – sadly the ONS do not have data before 1997:
Housebuilding will contribute to PNFC income but not (greatly) to PNFC capital formation, because new houses are allocated to the household sector’s capital account. The growth in housebuilding might explain to a small extent the divergence between corporate gross saving (retained earnings) and corporate capital formation which Chris is looking for. I have not attempted to analyse that further, but it may well be an insignificant effect, for example if the UK housebuilders were distributing most of their income rather than saving it.
This story does offer up a possible explanation for the lack of PNFC capital formation: the real resources required for capital formation were scarce, and UK housebuilders simply outbid other firms. It wasn’t possible to build a lot of new houses and a lot of new factories, in other words.
This argument could be extended to the concurrent expansion of government investment; a simple “crowding out”, though the scale of expansion in fiscal investment spending is less significant prior to 2007 . Absent the expansion of deficit-funded fiscal spending under the Blair/Brown government, the Bank of England would have cut interest rates to keep nominal spending and inflation in line, a point Mervyn King has made before. Lower (real) interest rates could have encouraged more investment spending, ceteris paribus.
The causation could go the other way, of course, as Chris might claim; a lack of domestic capital investment opportunities freed up resources for housebuilding etc. Food for thought, anyway.
Will Hutton has outed Business Secretary Vince Cable as a supporter of NGDP targeting. The Guardian have Hutton interviewing Cable this weekend. Will Hutton frequently advocates for an NGDP target in his Observer/Guardian columns; it was also known that Cable’s Special Advisor, Giles Wilkes, was a reader of Scott Sumner’s blog and supporter of NGDP targeting. The influence of blogs on policymakers is revealed!
Here’s a transcript of the last four minutes of the video, discussing macro policy:
Hutton: Would you advocate pegging the pound to the Euro, not joining, pegging the pound to the Euro, to kind of lock in the competitive exchange rate we’ve got?
Cable: I don’t think that works. We’ve had all kind of experience of trying to peg exchange rates, not least what happened under Mrs Thatcher and it was a terrible mess you may remember. So I don’t think in practice that can be made to work. But I think you have put your finger on a very very big policy issue that we’ve hardly talked about actually in the last few years. Which is that the biggest consequence of economic policy since the last three years has been a big devaluation of the currency, it’s about 25% and it has provided a big push, “kick” if you like, to British industry.
It has partially worked, it is one of the reasons why the automobile industry is growing quite rapidly. I think it will continue to get us growing, but you quite rightly say it hasn’t had the dramatic effects it did have in the mid 1990′s for example.
The big question you raise about the exchange rate is this. That in the past, I think this has happened now 3 times, whenever the British real economy has started motoring, it’s been crushed by an overvalued exchange rate. In the Tory years it was done deliberately. In the Howe budgets, Howe/Thatcher budgets, 1980s, they used a very high exchange rate to crush inflation. And in the process destroyed quite a lot of manufacturing industry.
It happened again in 1990 and it happened in a less deliberate way through the long period of Labour government where the exchange rate was clearly overvalued, we had a big contraction in manufacturing industry. And under the last government I think it went down from 18% to about 10% of GDP as a result of the fact the exchange rate in real terms was too high.
The challenge you’re posing which I think is exactly the right one, is how we stop that happening again. Because if it happens again all the stuff I’m doing about promoting industry policy and apprenticeships and so on, it could easily be swept away if this experience is repeated.
Hutton: I have the solution. You’re going to give a yes or no answer. If you won’t peg the pound to the euro your other option to keep a competitive exchange rate is this.
That we change, we require, the Bank of England not to target inflation with its inflation target, but instead to target the growth of all goods and services in the economy, so called money…
Cable: Money GDP. I’m very attracted by that.
Hutton: You are in favour of moving from an inflation target to a money GDP target?
Cable: I’m attracted by that.
Hutton: Because that is the way of doing it. If you do that, you do two things. We would guarantee to our banks that their balance sheets would become more manageable over time. And we would also assure with QE that the exchange rate would remain competitive.
So I mean can I tease you, [are you] not just attracted to it Vince, come on – I’m for it, are you for it?
Cable: Well look, one of the boring things about being a Cabinet Minister, is that the following day the Guardian says Minister instructs Governor of the Bank of England to do X or Y, and I’m not going to write your headlines for you. But no, look, the economic logic you’ve set out is impeccable, let’s leave it at that.
Hutton: Vince Cable, thanks very much indeed.
[Errors and omissions in the transcript are my own!]
Cable’s comment about the high exchange rate “crushing” the British economy under Labour seems somewhat odd. Manufacturing output shrunk between 2000 and 2003 but was otherwise growing modestly under Labour up to the beginning of 2008. Other more productive service industries grew faster, notably finance, so manufacturing as a proportion of GDP shrunk. That’s what’s supposed to happen in advanced economies. No big deal.
It’s not clear (to me) exactly why Hutton/Cable think NGDP targeting would benefit manufacturing industry in particular. Perhaps they envisage active pro-industrial fiscal policy being “enabled” by stable NGDP growth? NGDP targeting is surely not going to “stabilise” the real exchange rate, nor necessarily involve devaluation, which is what both Cable and Hutton appear to want.
But it is revealing that Cable knows what is coming; he is willing to take a position on NGDP targeting in an public interview, rather than take the easy road and defend the status quo.
H/T to commenter “anonymous” on Scott’s blog.
In March 2011, MPC dove-in-chief Adam Posen explained to the Guardian why he was concerned about weak demand, and not concerned about a wage/price spiral:
Consumers, he said, were unlikely to run down their savings in an attempt to maintain spending patterns, while the weakness of trade unions meant it would be hard for wage bargainers to push up pay settlements in response to higher inflation.
“Wages will be the dog that doesn’t bark,” he said.
That was an understatement. The Labour Market Statistics covering the three months to January 2012 show that despite CPI peaking above 5% in September 2011, nominal wage rises were muted through 2011. The growth rate of total pay has fallen to a mere 1.4% for the three months to January 2012 vs the same period a year earlier:
These figures are confused by the reclassification of half the British banking system as part of the Public Sector in late 2008, and distorted somewhat from attempts to smooth out the financial sector bonus season through seasonal adjustment. Those bankers do make things complicated.
With that caveat in mind, here are the levels, using the monthly figures now rather than the three-month average to show the downtick over the last quarter:
(The ONS figures for the public sector “ex financial services” show a smaller disparity with the private sector earnings.)
Looking at these figures, it is really hard to believe the MPC came close to tightening monetary policy in early 2011.
One silver lining in the latest estimate of the UK Q4 GDP figures is that the quarterly nominal GDP outturns appear to be fairly close to the Office for Budget Responsibility‘s estimates in the November 2011 Economic and Fiscal Outlook. Coupled with the (relatively) positive monthly borrowing data we might hope the OBR will not downgrade the fiscal position again in this month’s update.
Here’s how the OBR forecast has evolved, along with the current ONS data:
With the second estimate of UK 2011 Q4 GDP growth now published, we have the first estimate of nominal growth in that quarter, and of annual nominal GDP in 2011.
Looking at the (seasonally adjusted) annualized quarterly growth rates in Q4, NGDP growth was very weak at 1.9%; with the deflator growth at 2.6% we are left with a 0.7% fall in real GDP.
For the year as a whole we have an estimate of 3.1% NGDP growth against a 2.3% deflator:
Finally, here’s the picture of the “hole” – this projects out the 1997-2006 NGDP trend growth rate of 5.3% – in 2011 Q4 we are now 13% below the trend line:
(It is arguable whether the trend should be chosen to 2007 or 2006 but the results are similar in either case.)
Lars E.O. Svensson‘s “best practice” for inflation targeting is to target the forecast – to set the stance of monetary policy such that the forecast of the inflation rate remains on target, even if the current inflation rate deviates. With the inclination towards market inflation forecasts (as opposed to some mathematical model), Scott Sumner dubbed Svensson a “Market Keynesian“.
The Bank of England’s legal mandate does not strictly endorse targeting the forecast, setting their objectives as follows:
- to maintain price stability, and
- subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment.
The specific interpretation of “price stability” and HM Government’s economic policy are confirmed yearly in a letter from the Chancellor:
I confirm that the operational target for monetary policy remains an inflation rate of 2 per cent (measured by the 12-month increase in the CPI). The inflation target is 2 per cent at all times: that is the rate which the MPC is required to achieve and for which it is accountable.
The framework is based on the recognition that the actual inflation rate will on occasions depart from its target as a result of shocks and disturbances. Attempts to keep inflation at the inflation target in these circumstances may cause undesirable volatility in output.
(A note to those who call for a higher inflation target: HM Treasury, not the Bank, has the legal power to change the specific interpretation of “price stability” at any time; there would be no need even for Parliamentary approval. It is easier to change the inflation target than to change the fiscal budget!)
The Monetary Policy Committee seem to find enough leeway in their remit to adopt the language of forecast-targeting. For example, in October 2011, with annual CPI inflation at 4.5%, well above the target, the MPC was willing to ease policy, giving the following justification:
The deterioration in the outlook has made it more likely that inflation will undershoot the 2% target in the medium term. In the light of that shift in the balance of risks, and in order to keep inflation on track to meet the target over the medium term, the Committee judged that it was necessary to inject further monetary stimulus into the economy.
This begs the question how the “medium term” is defined. Fortunately, the Bank publish detailed forecast data. Here is a graph of the CPI forecasts produced at each quarterly Inflation Report, the forecast based on market interest rate expectations is used looking both two and three years out:
Had the MPC been targeting something close to the two-year forecast (red line) they should have eased in 2010. But they did not ease (or otherwise change) policy throughout the whole of 2010, nor through the first three quarters of 2011. Policy was loosened only once the forecasts across the curve dropped precipitously in the final quarter of 2011.
This presents a conundrum, because in 2008 the opposite was true: the justification for tightening in the first quarter can surely only come from an emphasis on the nearer-term forecasts which did spike upwards. Likewise in the third quarter of 2008, the three year forecast drops significantly below the 2% target, which would have indicated easing, whereas the three year forecast remains above – and the MPC fatally held rates at 5% through that entire quarter.
So even if the MPC are vaguely Svenssonian in its communication, it seems that they do exercise discretion over policy; or at least whatever policy rules they follow are kept well obscured.
If only our press corps could hold them accountable for these decisions, rather than imploring Sir Mervyn King to pontificate at length about Moody’s, the Eurozone, and SME financing; the pertinent issues for UK monetary policy makers?
Bank of England Inflation Report, November 2006:
Actual and expected changes in Bank Rate affect the level of nominal demand in the economy.
Bank of England Inflation Report, August 2007:
Monetary policy affects inflation via its influence on nominal demand.
Bank of England Inflation Report, August 2008:
Monetary policy affects inflation via its influence on nominal demand.
Bank of England Inflation Report, February 2009, about to hit the zero bound:
The MPC’s ability to influence the value of nominal spending and inflation in the economy, and hence achieve the inflation target, ultimately derives from the fact that the Bank of England is the sole supplier of sterling central bank money: banknotes and reserves held by the banking system at the Bank.
Regardless of how monetary policy is implemented, the objective for policy remains the inflation target. That means that, whatever the uncertainties about the strength of the transmission mechanism, the private sector should be assured that the MPC will take the steps necessary to bring inflation back to target. If the MPC were to adopt unconventional measures in the future, that commitment would be a crucial element in ensuring the efficacy of policy, helping (as now) to anchor inflation expectations and boost nominal spending.
Bank of England Inflation Report, August 2009:
In the United Kingdom, nominal GDP fell by 3% in Q1, the sharpest decline since the quarterly series began in 1955 (Chart 2.1). It was absolutely nothing to do with us, though. Nope. Not our problem, mate. Blame the bankers.
Bank of England Inflation Report, May 2011:
But the evolution of nominal spending over the remainder of 2011 is uncertain. The path of nominal spending since mid-2009 may provide a positive signal about households’ and businesses’ willingness to spend. In that case, steady nominal spending growth could continue. We don’t really know what will happen, to be honest. Economics is a complete mystery to us. La la la la. Nice weather, though.
Bank of England Inflation Report, February 2012:
Four-quarter nominal spending growth has fallen back somewhat since the latter part of 2010 (Chart 2.1). I didn’t do it. The dog ate my homework. Look! There’s a Eurozone crisis! Here, look at some pretty fan charts.
Minor embellishments my own.