UK Macro Policy, A Short Story

A short story for Jonathan Portes and Prateek Buch.  Is the use of deficit-funded capital spending a sensible way to fine-tune UK demand policy?  Opinions welcome.  (What would Krugman say?)

George Osborne writes to the Bank of England:

Dear Bank of England, please target 2% inflation!  Thanks!

The Bank of England meets and prepares its reply:

Dear George.  Here’s the path we’ve set out for the nominal economy.  You’re going to get above-target inflation and poor real GDP growth over the next two years, with the CPI rate hitting 2% after that.  Is that OK?

George replies:

Dear Bankers, thanks!  That’s really great.  I actually want a bit more inflation and faster nominal GDP growth.  But instead of telling you to provide a bit more inflation and/or NGDP, I am going to do a £30bn capital spending package over two years.  I have told my voters this will raise NGDP!  So take it as a subtle hint.

Bank of England to George Osborne:

Erm, really?  Do you want us to target 2% inflation or not?  We could just target higher NGDP growth, but we’ll probably get even higher inflation too.  Shall we do that?

George Osborne to Bank of England:

WOAH.  STOP RIGHT THERE.  What are you thinking?  Please target 2% inflation.  Gosh darnit guys, aren’t I making this clear?  Can you imagine what Ed Balls would say if I asked for more inflation?  I’d be crucified!   2%, 2%, 2%.  Got it?

One month passes.  Stuff happens… let’s say for the sake of argument that one of our major trading partners tips into recession.   The Bank meets to set monetary policy again.

Bank of England to George Osborne:

Well George, we’re going to target 2% inflation like you said.  Here’s the path we’ve set out for the nominal economy.   Exports are looking a lot worse than last month, but government spending is up!  So you’re getting an above-target CPI rate and poor real GDP growth over the next two years.  We’ll hit the 2% after two years – is that OK?

p.s. By the way George, the national debt is looking pretty ugly.  You might want to think about getting the deficit down.

George Osborne Correctly Rejects Fiscal Stimulus

George Osborne explained the Sumner Critique to the CBI tonight:

What’s more, without allowing inflation to climb even further above target, a fiscal stimulus three years ago would simply have been offset by less supportive monetary policy, with no net impact on demand.

With the independent MPC judging that the risks to inflation and output are evenly balanced, the same is true today.

So, just as the argument for fiscal stimulus three years ago was mistaken, so is the suggestion for a discretionary fiscal loosening now. Because we have sensibly allowed the automatic stabilisers to operate, our deficit is only just falling in nominal terms.

This is an improved version of the wording Osborne used last time.  Pedantically correct wording, noting the forward-looking nature of monetary policy.

Paul Krugman, Deficit Hawk

Forgive me for some cheap sniping at the great Professor, but I couldn’t resist.  Via Travis Allison here is Paul Krugman writing in 2000 about Japan:

Japan has the dubious distinction of being the first major nation since the 1930′s to experience a ”liquidity trap,” in which even cutting the interest rate all the way to zero doesn’t induce enough business investment to restore full employment. The result is an economy that has been depressed since the early 90′s, and that in 1998 seemed to be on the verge of a catastrophic deflationary spiral.

The government’s answer has been to prop up demand with deficit spending; over the past few years Japan has been frantically building bridges to nowhere and roads it doesn’t need. In the short run this policy works: in the first half of 1999, powered by a burst of public works spending, the Japanese economy grew fairly rapidly. But deficit spending on such a scale cannot go on much longer.

What is Paul Krugman’s 2000 policy recommendation for Japan?  The BoJ should set an inflation target and then do QE.

Here is Paul Krugman in a 2012 interview with Martin Wolf:

“The question is, what did [Ben Bernanke] do as we started to look more and more like Japan? At that point the logic says you have to find a way to get some traction. Fiscal policy might be great. But if you’re not getting it you should be doing something on the Fed side and I think that logic becomes stronger and stronger as the years go by. And it’s sad to see that the Fed has largely washed its hands of responsibility for getting us out of the slump.”

To complete the picture here is Paul Krugman writing in 2010 about how new UK Chancellor George Osborne should give up on the deficit-funded capital spending splurge, and should instead set an inflation target and print lots of money:

…

Oh, no, sorry, I couldn’t find that quote.

George Osborne, New Keynesian

Pretend you have been appointed Chancellor of the Exchequer in May 2010, and you want to find out what what “bleeding-edge” macro research says you should do.

What do you find out?

If you’ve read New Keynesian Lars Svensson, you might be sceptical about the efficacy of deficit spending in boosting aggregate demand.  Like Svensson, you’ve watched Japan run large deficits for two decades, and seen that that the level of Japanese nominal GDP is unchanged after that all time, yet public sector debt has soared.  You don’t want to go down that route.  You might like the idea of a “Foolproof Way” to exit the ZLB, a price level target and currency devaluation, but you can see the UK CPI is already above target, and you are worried about the global politics of engaging in “currency wars”.

If you’ve read New Keynesian Ben Bernanke, you would be a strong believer in the unlimited power of the printing press in raising UK aggregate demand.

You would surely listen to New Keynesian Mervyn King, who is one of the UK’s most prestigious macroeconomists, and also happens to run your central bank.  He tells you in no uncertain terms to get the deficit down and let him get on with running  AD policy.  He tells you he tried out his printing press in 2009, and it worked very well indeed.  He’s got your back.

If you’ve read New Keynesian Paul Krugman, you’ll consider raising the inflation target to 3% or 4% as the best policy choice at the ZLB… but you get shot down by Mervyn King who thinks that’s a really bad idea, which might herald a return to the 1970s.

You’ll also believe that under New Keynesian inflation forecast-targeting, the central bank will internalize whatever fiscal policy decisions you make, and steer an appropriate course for UK aggregate demand.  Your new friend Mervyn has promised to print enough money to keep things ticking along nicely.

So maybe you get on with running fiscal policy to cut the deficit, and let the Bank take care of AD policy for a year, or two years, or three years.  Inflation stays well above target, and the jobs market, well, it could be much worse.  The printing press is duly deployed when necessary.

But bizarrely, all this time another bunch of “New Keynesian” economists are baying for your blood, admonishing you for making some kind of policy error.  They don’t seem to believe a word Ben Bernanke wrote.  They don’t believe in inflation forecast-targeting.  They tell you that monetary policy doesn’t work, and you’re an idiot for thinking it ever would.  They have nothing much to say about Japan.  And they have strange ideas about how fiscal policy can be used as a “magic money tree”, with “self-financing” deficits.  They tell you that increasing borrowing will reduce borrowing, yet reducing borrowing will increase borrowing!  They are hard to understand.

You also get advice that tells you maybe the central bank has been screwing up all along.  You find another New Keynesian, Dr. Escape Velocity – he tells you he can fix things if you let him loose with that printing press and give him room to move.  But another bunch of “New Keynesian” economists, the ones who are running the central bank, tell you in no uncertain terms that UK AD policy is working just fine.

Who do you believe?  The Bernanke/Svensson New Keynesians?  The New Crude Keynesians who think fiscal policy is all that matters at the ZLB?  The New Keynesians at the central bank who are screaming at you that everything is just fine?

You bet the farm on Dr. Escape Velocity… and throw in some interventionist fiscal policy for good measure.  Nobody’s very happy with you.

I must say I’d almost feel sorry for you after all that.  It’s a tough job at the top, isn’t it, when all you have is conflicting New Keynesian macro policy advice?

How Tight Money and Fiscal Stimulus Failed in 2008

Scott Sumner, Marcus Nunes and Simon Wren-Lewis have all commented on Charlie Bean’s speech on NGDP targeting.  With such illustrious company I doubt I can add anything of substance to the debate, but I wanted to pick up on what Marcus said since I think it helps better frame the debate that’s going on in the UK regarding the use of fiscal and/or monetary “stimulus”.

Thinking about monetary policy in terms of the central bank “doing things” is often unhelpful.  In late 2008 the Bank of England was “doing lots of stuff”.  They were very busy adjusting interest rates downwards; most people think of the Bank’s actions as “aggressive“.  Cutting Bank Rate from 5% to 0% in six months is “monetary stimulus” par excellence – right?

The November 2008 MPC minutes are instructive.  Here is what the MPC discussed:

33.  The projections in the Inflation Report implied that a very significant reduction in Bank Rate –possibly in excess of 200 basis points – might be required in order to meet the inflation target in the medium term. However, a number of arguments were discussed for not moving Bank Rate by the full extent implied by those projections.

This says that the Bank’s internal models say they needed to cut Bank Rate by more than 2% to keep inflation on target at the forecast horizon.  They instead decided to cut by 1.5%, and give four reasons why they didn’t do more:

34.  First, the projections had used the normal convention that they were based on the Government’s most recent published tax and spending plans. The Government had already announced its intention to bring forward some planned spending commitments. Moreover, the changing composition of output would lead to a fall in effective tax rates from those assumed in the projections. Consequently, it would make sense for the Committee to reassess the required scale of monetary easing after the Chancellor’s Pre-Budget Report.

This is a demonstration of the “Sumner Critique”.  The Bank is offsetting fiscal stimulus by cutting interest rates less than they otherwise would have done if no fiscal stimulus had been planned.

The second reason for not cutting the rate the full 2% is that they don’t have a clue what is going on in the banking sector.  That seems like a good argument to do more not less, but then I’m not the one who bangs on about uncertainty all the time.

The last two arguments are what can only be described as a catastrophic policy error; my emphasis throughout:

36.  Third, a key concern was the degree of surprise to financial markets. Too large a surprise could pose upside risks to the inflation target if the resulting depreciation of sterling was excessive. There was a risk that such a move might be misinterpreted as a change in the Committee’s reaction function, which would damage the credibility of the inflation target. That suggested leaving some of the required monetary loosening until after the Committee had had an opportunity to explain its change of view on the outlook for inflation in the November Inflation Report, and to assess the market reaction to both the Report and the decision.

37.  Fourth, some members thought there was an argument for leaving some of the required policy loosening to the months ahead to support confidence as the economy weakened.

I know I tend towards the melodramatic, but I honestly believe that people reading those sentences today should be shocked and disgusted.

The MPC are deliberately cutting Bank Rate less than is necessary to keep forecast inflation on target because they are worried about the “credibility of the inflation target”.  Does that make any sense to you?  It should not.  It is the kind of nonsense which should get policy-makers removed from office with immediate effect.

And they are refusing to cut the rate so that they can later on “support confidence” as the economy weakens?  “Why, yes, Captain, I have just turned the ship in the direction of the iceberg.  This will allow me to later on swerve away from the iceberg so I can demonstrate my excellent navigation skills… if all goes to plan, ha ha!”

Now go and read the quote Marcus provides from Charlie Bean again; or this one:

But there is a danger of expecting too much from monetary policy. The Great Recession of 2008-9 was unlike earlier policy-induced downturns aimed at reining back excessive inflationary pressures.

It is true that there is a danger of expecting “too much”.  Monetary policy can’t solve supply side problems.  There is a perfectly reasonable argument that the demand shock which started in 2008 Q2 was not anticipated by the MPC.

But if you read the minutes above, how can you possibly agree that “reining back inflationary pressures” had no place in the MPC’s reaction to the crisis?  Or that, from the implication in the quote Marcus gives, the MPC did “as much as they could”?  Or that giving monetary policy makers total discretion over the policy stance is a really good idea?

Here is what happened to the three year market inflation expectations in 2008:

UK Market Inflation Expectations in 2008.  Source: Bank of England

Since index-linked gilts are based on the RPI not CPI, you should take off 0.5% to 1% to get the expected CPI.  By the start of December markets were expecting the Bank to provide three years of deflation.

Alistair Darling was talking about the UK being in a quasi-Depression in August that year, yet did nothing about Bank Rate being at 5%.  He proposed a fiscal stimulus package in the Pre-Budget Report of November 2008; from the PBR:

Discretionary action of £16 billion will deliver a fiscal stimulus package of around 1 per cent of GDP in total in 2009-10, in addition to the support provided by measures in 2008-09.

Annual nominal GDP fell by 3% in 2009, rather than the “0.5 to 1%” rise expected in the PBR forecasts.  Fiscal policy was the wrong focus in 2008, and it’s the wrong focus in 2013.  Regime change, please, Mr. Osborne.

All That Matters is Nominal GDP, Fiscal Policy Edition

Was UK government spending “unsustainable” in 2008?  Is UK government spending “unsustainable” in 2013?  Is fiscal austerity “necessary”?

When I watch the neverending debate about fiscal austerity in the UK there is always something missing.  The closest economists come to answering the above questions is usually the dreaded “cyclically-adjusted budget deficit”, and that is little better than pulling numbers out of a hat.

I think you can only answer these questions if you consider the expected path of nominal GDP.  (You knew I’d say that, right?)

If you expect that UK nominal GDP is going to rise 8% every year for the next five years, then your answer to whether we “need” austerity right now is probably “no”.  Planning for Total Managed Expenditure rising 5% a year should not be too much of a problem at all.  In fact, it would be a breeze; the deficit will fall sharply as tax receipts rise in-line with NGDP, as is perfectly normal.

But if you expect that UK nominal GDP will be at the same level in 2018 as it was in 2008 – roughly what happened in Japan post 1991 – you’d want to make very different plans for TME.

The decision between “austerity” or “no austerity” seems like a false dichotomy.  We “need” austerity only to the extent that we have really bad monetary policy.  I see a simpler choice:

Plan A: We accept the current macro policy framework, and hence accept whatever path of NGDP the Bank of England decides to deliver.  Under the inflation target over the last five years, annual NGDP growth has varied between -3% and 5%; 2% on average.  The expected path of NGDP is very unclear.

Plan B: We change the macro policy framework to ensure the Bank of England provides growth of NGDP along the desired path.  Then set fiscal policy given that forecast path of NGDP.

Darling in his final 2010 Budget, and Osborne since, have both used some variation of “Plan A”; Ed Miliband and Balls offer no alternative.  Whether or not you do “fiscal stimulus” is highly unlikely to change the Bank’s desired path of NGDP; that if anything is the lesson of Japan (and I’d argue of 2008-2013 in the UK).

“Real” fiscal conservatives should not be content to stick with any variant of “Plan A”.  If you claim “Plan A has failed”, I’d agree with you; but you must realise that “more capital spending, maybe some tax cuts, and don’ t worry, I’m sure the Bank will do the right thing” is merely another variation of “Plan A”.  “Plan B” must be “better monetary policy”.

I do not wish to imply that we should change the macro policy framework because it makes fiscal policy “easier”, or because it will cut the deficit faster.  That would be a very bad way to set macro policy.  But I think it’s important to understand that fiscal policy has been “difficult” for the last few years for the same reason that the labour market has been “difficult”: nominal GDP fell sharply below the path that was expected in 2008, and has remained well below that path.

Those who cry that fiscal policy was “unsustainable” in 2008 are really making an absurd claim based on the presumption that the observed path of NGDP was the only possible path we could have followed.  That’s wrong.  Brown/Darling fiscal spending plans were neither cause of the crisis, nor the cause of the deficit (at least its unusual magnitude).  The pattern in this graph should be familiar:

UK Central Government Tax Receipts vs Trend. Source: ONS Series ANBV.

Every Budget since (and including) March 2010 has accepted an ever-larger “NGDP gap”, a greater deviation from the old trend growth path.  Adjusting the fiscal stance to a much lower path of NGDP is always going to be very difficult; you can’t easily knock 15% off your spending if your income happens to come in 15% below expectations.  Nominal shocks matter, and wage contracts (among others) are sticky in nominal terms.

Alistair Darling was (rather bravely, I thought) telling people to expect “cuts worse than Thacher” before the 2010 election because he accepted a lower trend path of NGDP (and hence tax receipts), not because he was ideologically opposed to public sector spending.  Much the same applies to George Osborne.

If anybody is pleasantly surprised to read such a view of New Labour fiscal policy on this blog, there’s a kicker: everything I’ve said above about the public sector applies equally to the private sector.  It will always be possible for aggregate private sector borrowing, hiring, or investment to appear ex post “unsustainable” if nominal GDP falls below well below the expected path.

Had the private sector taken on, in aggregate, “too much debt” in 2007?  That question is as misguided as asking whether fiscal austerity is “necessary” in 2013.  It all depends on the path of NGDP.

Central Banks, Impotent or Incompetent? Koo vs Monetarism, UK Edition

This is how Richard Koo explained his “balance sheet recession” theory in December 2011:

More importantly, when the private sector deleverages in spite of zero interest rates, the economy enters a deflationary spiral because, in the absence of people borrowing and spending money, the economy continuously loses demand equal to the sum of savings and net debt repayments. This process will continue until either private sector balance sheets are repaired or the private sector has become too poor to save (i.e., the economy enters a depression).

To see this, consider a world where a household has an income of $1,000 and a savings rate of 10 percent. This household would then spend $900 and save $100. In the usual or textbook world, the saved $100 will be taken up by the financial sector and lent to a borrower who can best use the money. When that borrower spends the $100, aggregate expenditure totals $1,000 ($900 plus $100) against original income of $1,000, and the economy moves on. When demand for the $100 in savings is insufficient, interest rates are lowered, which usually prompts a borrower to take up the remaining sum. When demand is excessive, interest rates are raised, prompting some borrowers to drop out.

When an economy is in this “balance sheet recession” state, Koo says fiscal deficits are required to take up the slack.  Koo presents the flow-of-funds data for the UK and the US, and berates these countries for not running expansionary fiscal policy:

Yet policymakers in both countries, spooked by the events in Greece, have pushed strongly to cut budget deficits, with the U.K. pushing harder than the U.S. Although shunning fiscal profligacy is the right approach when the private sector is healthy and is maximizing profits, nothing is worse than fiscal consolidation when a sick private sector is minimizing debt. Removing government support in the midst of private sector deleveraging is equivalent to removing the aforementioned $100 from the economy’s income stream, and that will trigger a deflationary spiral as the economy shrinks from $1,000 to $900 to $810.

This seems like a clear and testable claim – fiscal consolidation will “trigger a deflationary spiral”, which Koo explains in terms of a falling “income stream” or “aggregate expenditure” – phrases synonymous with nominal GDP.  If you’d looked only at the Japan NGDP data, that is not a surprising conclusion to make -  Japan’s nominal GDP has not risen over the last twenty years.  It looks like Japan hit a “hard stop”.

Let’s look at the “deflationary spiral” induced by the “balance sheet recession plus ZLB plus fiscal austerity” policy combination in the UK, for those who are slow in etching the UK NGDP data to their retinas.  Here’s the path of UK nominal GDP since it’s pre-recession peak in Q1 of 2008; you can date “fiscal austerity” to 2010 or 2011 as you please, tax rises (VAT) began in January 2010:

Level of UK Nominal GDP, 2008-2012. Source: ONS Series YBHA

The UK economy’s “income stream” – nominal GDP – hit a record high in the second quarter of 2010.  Then another all-time high in the third quarter.  And another in the four quarter.  And again in the first quarter of 2011.  You get the picture.  It went up not down, as predicted by Koo’s theory.

An alternative theory is this: by virtue of its monopoly control over the value of money, the Bank of England has been perfectly able to keep the UK “income stream” rising in a manner which has been more than sufficient to hit – and overshoot – its nominal target, the CPI rate.  Neither the ZLB nor “fiscal austerity” have been a major obstacle in this exercise, except in that printing money and indirect tax rises both present a crisis of faith for conservative central bankers stuck fighting the battles of the wrong generation.

Which theory is more consistent with the UK macro data?  It seems pretty obvious from here.  Defenders of Koo might soften his argument, and claim that “fiscal austerity” has merely slowed the growth rate of nominal GDP – an argument at least worth engaging in.  But this puts Koo’s “Crude Keynesians” at odds with the real Keynesians, who argue that UK fiscal policy is unambiguously contractionary – I’ll be better off staying clear of that debate.

Montagu King and the Keynesians, A Short Story

Here’s a story about politics, economics and personalities.  Feel free to disagree with my characterisations…

In 1997 Gordon Brown gave the Bank of England independent control over UK monetary policy.  This, finally, freed UK demand management from the interference of meddling politicians, who could neveralways be trusted to inflate a little bit too much if there was an election on the horizon.  Brown’s economic adviser at the time was Ed Balls, and they set the Bank a simple nominal target: the inflation rate, inspired by the success of the Reserve Bank of New Zealand.

Everything goes well for ten years.  But fast-forward to February 2009, and the UK is in a deep demand-deficient slump.  The Bank of England forecast the inflation rate falling to fall below 1% by the end of the year and staying around there for the rest of three year forecast period.  Their 2% target is not in sight.

In March 2009 Mervyn King cranked up his printing press to full speed, and promised to print and keep printing until nominal GDP was growing at a speed consistent with hitting the Bank’s 2% target.  It was probably the clearest form of “forward guidance” the Bank has ever given.  It was the closest the Bank has come to using NGDP as an “intermediate” target.  Most importantly, it worked.  Over the rest of that year, equity markets soared, gilt yields rose, the CPI rate recovered back up towards 2% much faster than expected back in February.

By the end of 2009, King was on top of the world.  He’d avoided the Japan trap, the dreaded deflation.  The CPI rate was firmly in his control.  Controlling the size of the monetary base worked just as well when short-term interest rates were at zero.  Q.E.D.

Then politics came along.  The UK government was running a large fiscal deficit – this was King’s fault too, but that’s another story.  Having awarded the Bank independent control over UK aggregate demand, the interfering politicians were busy arguing about how much and how fast they should cut the deficit, in fear of hurting aggregate demand.

This was a blatant challenge to the Bank’s independence.  King would not sit idly by in that debate.  He called for a tighter fiscal stance.  He made it absolutely clear that the Bank would offset whatever was happening with fiscal policy to maintain an appropriate path of AD – i.e. to keep hitting the inflation target.

An election came and went, and lo, the deficit stance was tightened (in fact, it was tightening regardless).  By the start of 2011 the GDP figures were looking weaker and the CPI rate was drifting upwards, heading well above 4%.  When pressed on the deficit policy King re-iterated his support for tightening the fiscal stance.

This was an outrage to Ed Balls.  Mervyn King – a mere civil servant – was interfering with government policy, and even had the cheek to claim he had control over UK aggregate demand!  Where did he get that idea from?  No lesser figure than Paul Krugman himself also expressed his disdain at King’s position, a disdain widely expressed by Keynesians since 2010.

Fast forward to 2013.  Mervyn King “successfully” navigates through three years of “tight” fiscal policy, continually missing his CPI target on the up-side and allowing real GDP to stagnate.

He then calls for… supply-side reform.  After all, his demand-side policy has been damn near perfect.  He’s never undershot the nominal target given to him by the elected government.  He allowed “base drift” in the face of supply shocks as a proper flexible inflation-targeter should.  He tolerated above-target CPI when growth was weak.  What more can you ask of him?  Clearly our problems are not demand-side!

So what say the Keynesians?  Is it the proper role for a Central Bank governor to call for supply-side reform, even though he may not speak of fiscal deficits or their impact on his ability to perform demand-side stabilisation?

I am waiting to hear the shock and outrage from Ed Balls and other Keynesians, on the unnecessary interference in government policy made by the Bank of England Governor this week.

(I’d also love to hear more about how the UK’s chosen path of demand stabilisation – a 2% inflation forecast-targeting “independent” central bank, has been such as success that so few economists seem interested in changing it.)

Why Are We Still Stuck in 1981?

There is a neat symmetry between 1981 and 2012 in the UK macro policy debate.

1) In both cases we have a Tory (ish) government which has been in power for two years, having replaced a Labour government which presided over disastrous macro policy failure.  (There’s an interesting argument about whether the 1970s were more or less disastrous than 2008-2010; that’s not the point of this post.)

2) In both cases the new government has spent its first two years – despite protestations to the contrary – more or less in continuation of the failing demand policy it inherited.  In 2012, that means 2% inflation targeting plus desperately low, unstable NGDP growth; in 1981 that means uncontrolled inflation and desperately high, unstable NGDP growth.  (The Keynesians would argue the Coalition has changed macro policy by tightening the fiscal stance, but that is only a matter of degree: “tightening fiscal stance, 2% inflation target” really was the Coalition’s inherited macro policy.)

3) In both cases we have a monetarist vs Keynesian divide.  UK academics famously thought Howe’s 1981 Budget tightened fiscal policy, um, “too far, too fast”; 364 of them writing to The Times.  Ramesh Ponnuru and David Beckworth pick up this theme in their recent article for The Atlantic:

The Bank of England vividly demonstrated the power of central banks to offset fiscal policy at the dawn of the Thatcher era. In 1981 her government introduced a budget that would sharply reduce the deficit in the midst of a recession. Most economists opposed it on Keynesian grounds, with 364 of them signing a now-famous letter arguing there was “no basis in economic theory or supporting evidence” for it. Yet the Thatcher government implemented its plan and by late 1981 the economy was recovering. The Bank of England at the same time had begun a cycle of monetary policy easing, and the economists had underestimated its effects.

This slightly overstates the role of the BoE.  HM Treasury was wholly in control of monetary policy in the 1980s, and set the Bank target ranges for broad money growth.  If you’re new to this debate it is worth reading the IEA paper from 2006, “Were 364 Economists All Wrong?“, if only for monetarist hero Tim Congdon’s epic contribution which tears chunks of flesh out of the British academic establishment, with regression analysis to boot.

I don’t want to stretch the analogy too far.  But when I see comments like this, from Duncan Weldon:

The renewed debate on the UK’s monetary policy regime is a welcome development (and it probably matters a great deal in the long run) but it shouldn’t breed a false complacency – I struggle to think of any monetary regime that could restore decent growth alongside the government’s current fiscal policy.

… it does seem like the UK macro policy debate is still stuck in 1981.

A slightly cheeky question: how many Keynesians believed that the Bank would fail to hit (as in undershoot) its nominal target (the 2% CPI rate) in the presence of the Coalition’s fiscal consolidation? I guess Danny Blanchflower counts as one, he has been consistent in warning about deflation.  But whilst I do remember reading lots of dire warnings about low growth from tight fiscal policy, I don’t remember many about sub-target inflation.

Here’s the thing.  Anybody who thought we’d undershoot the CPI target was wrong.   Not just a little bit wrong.  The Bank not only hit but has consistently overshot its nominal target for every single month of the Coalition’s fiscal consolidation.  You can make good excuses (as I do) about why the overshoot was so bad, but that’s the evidence.

So why is there even a debate?  We’ve had a fiscal consolidation.  The Bank has done more than enough (provided sufficient nominal GDP growth) to continue hitting its nominal target in every single month of this fiscal consolidation.  Fiscal tightening has therefore been more than offset by monetary policy.  End of argument?

Perhaps not; that’s an unsophisticated way to think about either monetary or fiscal policy.  But I think the basic point is sound (as does Scott Sumner).  The last thing we should worry about is the Bank’s ability to hit their nominal targets.  We just need to give them the right nominal target.

In 1981 Geoffrey Howe welcomed the first monetarist counter-revolution to Britain.  George Osborne has the opportunity to introduce the second monetarist counter-revolution.  Will he take it?

OBR: Osborne’s Budget Wrecker

The OBR’s latest forecasts show they have given up hope of an eventual return to robust growth in nominal GDP.  The reason is two-fold: partly a downgrade to expected real GDP growth, and partly a downgrade to the deflator forecast:

3.98.  Nominal GDP growth is weaker throughout the forecast than in March, reflecting both weaker real GDP growth and the downward adjustment to the growth of the GDP deflator. These changes to the forecast reduce the level of nominal GDP in 2016 by 5.1 per cent relative to our March forecast.27 Of this, 3.2 percentage points is accounted for by the downward adjustment to our forecast for real GDP growth, with the remainder due to lower GDP deflator growth.

Failure to hit the government’s fiscal target of falling debt/GDP by 2015 can be attributed to this change.  It both reduces the level of that ratio’s denominator (nominal GDP) in 2015, and the expected growth rate of nominal GDP in any given year, and hence lower tax revenues and higher debt, ceteris paribus.

This is no way to run a country.  If the Bank of England is instructed to target the path of nominal GDP, the OBR could hold that fixed in their forecasts (rather than CPI inflation as they do now), as they should.

OBR Forecasts for Nominal GDP