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All That Matters is Nominal GDP, Fiscal Policy Edition

February 8, 2013 Leave a comment

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.

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.

Forward Guidance? No, Just More Of the Same

February 7, 2013 Leave a comment

FT Money Supply’s Claire Jones quoted the MPC announcement I referenced in my previous post, and noted the element of “forward guidance”:

The text tells us two things: first, that the MPC is likely to revise up its forecast for inflation, due out next week, to the extent that it shows there is a better chance than that inflation will not remain above the 2 per cent target for most of the forecast horizon. Second, that the MPC is concerned the market will (mis)interpret the forecasts as a signal that the committee will soon tighten policy.

The MPC statement sends a clear signal that policy will remain ultra loose even if inflation remains above for the next couple of years.

Classic forward guidance, then, mixed in with a very “flexible” approach to inflation targeting. The new boss will be pleased.

A reasonable argument, but I’d say two things:

Firstly; repeat after me: when NGDP is growing 10% or 20% a year you have “ultra loose” monetary policy.  That is what the 1970s were like.  When NGDP is growing 2% per year you have “ultra tight” monetary policy.  That is what we have now.

Secondly, when the Bank of England deliberately (or perhaps, accidentally) compresses nominal GDP growth down to 2-3% a year, and it knows it has has done that, and then it says:

The Committee agreed that it stood ready to provide additional monetary stimulus if warranted by the outlook for growth and inflation.

What are the markets going to think the Bank means?  Roughly that the Bank of England doesn’t think “additional monetary stimulus is warranted” right now when NGDP is growing at 2-3% a year, but maybe if things get a lot worse, they’ll step in.

Here is an analogy.  The Bank has driven the car half-way off the cliff, and it’s now dangling precariously over the edge.  The Bank does not admit that driving the car half-way off the cliff was an error; it says everything is just fine, and look at that lovely view!  Rather than indicating they will do something to remedy a bad situation, they bravely announce… that if the car tips any further forwards, they might shift their weight backwards a bit to prevent things getting worse.

Are you inspired?  I’m not.

Oh, You Want Flexible? We Can Be Flexible!

February 7, 2013 Leave a comment

James Zuccollo provides a good write-up of Carney at the TSC. Carney was very consensual and was avoiding controversy, as you’d expect.  My expectations were slightly too high, so I came out a little disappointed; Carney did provide a decent defence of NGDPLT but made it clear that he was strongly attached to flexible inflation targeting, and if anything was emphasizing the need for more “flexibility”.

The highlight for me was when Carney mentioned almost in passing the correct figure for the UK’s nominal GDP “gap” (the difference from trend) at 15% – I didn’t see him refer to notes, he just knows the data.  That is excellent!  Scott is surely right that NGDP will never again be forgotten – that’s progress at least.

Meanwhile, back on the farm, the MPC produced an unusually long statement after the conclusion of this month’s MPC meeting today.  Key quote:

CPI inflation is likely to rise further in the near term and may remain above the 2% target for the next two years, in part reflecting a persistent inflationary impact both from administered and regulated prices and the recent decline in sterling. But inflation is expected to fall back to around the target thereafter, as a gradual revival in productivity growth dampens increases in domestic costs and external price pressures fade.
The Committee discussed the appropriate policy response to the combination of the weakness in the economy and the prospect of a further prolonged period of above-target inflation.  It agreed that, as long as domestic cost and price pressures remained consistent with inflation returning to the target in the medium term, it was appropriate to look through the temporary, albeit protracted, period of above-target inflation.  Attempting to bring inflation back to target sooner by removing the current policy stimulus more quickly than currently anticipated by financial markets would risk derailing the recovery and undershooting the inflation target in the medium term.  The MPC’s remit is to deliver price stability, but to do so in a way that avoids undesirable volatility in output.  The Committee judged that its policy stance was fully consistent with that remit.  The Committee agreed that it stood ready to provide additional monetary stimulus if warranted by the outlook for growth and inflation.

Is somebody feeling a little bit defensive?  Why would they feel the need to emphasize that their policy is “fully consistent with [the] remit”?

It will be interesting to see the new forecast data after the quarterly Inflation Report next week; the claim that inflation “may remain above the 2% target for the next two years” is quite specific; the forecasts from November were much lower.  But it’s a good way to make clear how flexible you can be!

Flexible IT had a bad day today.  The hot topic in Parliament was the new kid in town with his bright new idea, NGDPLT.  The Old Lady of Threadneedle Street is feeling the heat – at last!

(Almost) Everything You Need to Know In One Sentence

February 6, 2013 Leave a comment

Almost everything you need to know is in this one simple sentence, via Lars:

Japanese shares rose, with the Nikkei 225 Stock Average heading for the highest close since September 2008, as the yen fell after Bank of Japan Governor Masaaki Shirakawa said he will step down ahead of schedule.

If monetary policy in Japan was “impotent” would this happen?  No.

If the discretion over the direction of monetary policy exercised by central bankers is irrelevant, would it matter if your central bank governor leaves a few weeks early?  No, no, no!

Read Lars for more.

Categories: Japan, Monetary Policy

UK Inflation and Administered Prices

February 6, 2013 3 comments

Ian McCafferty’s speech last month had an interesting analysis of the impact on the UK CPI figures of “administered prices” – roughly, government-determined rather than market-determined prices.  When explaining why inflation may come down only slowly to target, McCafferty noted the following:

The contribution of “administered” prices – those components of the CPI index that are determined less by market forces and more by administrative or regulatory decisions – is unusually high at present, and inflationary pressures from this sector are likely to persist. Higher university tuition fees will add to inflation in each of the next three years, while on the face of it the recent increases in utility and rail prices, driven by regulatory and investment targets, will also remain a feature in coming years.

Supply-side pessimists might scoff at this kind of thing – “yet more excuses”, and they probably have a decent argument to make.  McCafferty lumps energy prices in with “administered” prices, which muddies the discussion.

At least the tuition fee case seems clear-cut, though; pro-market reforms in the higher education sector should be embraced by the (mostly right-wing) supply-side pessimists!  Those reforms involve moving spending from one government budget line (direct grants) to another (student loans); it is meaningless from a macro perspective that the CPI only captures what is happening in the latter.

The chart McCafferty provides is rather striking:

Ignoring the minor issue of why that forecast line is somewhat below 2% on the forecast horizon, McCafferty is happy to admit that a large part of that sub-2% inflation is coming from “administered prices” rather than supply pressure on the market prices.  He explains:

Of course in the long run, inflation is a monetary phenomenon, and relative prices adjust to the monetary stance. But the upward pressures on both administered and food prices place a high burden of adjustment on other categories of the CPI basket, if, on average, prices in aggregate are to rise in line with the 2% target (Chart 17). To achieve this, on current projections, the prices of other components of inflation would need to rise over the next couple of years by no more than 1-11⁄4%, historically low for these components. As such, it is likely to take time for these other prices to make the necessary adjustment.

I got briefly excited when I read that paragraph.  It could be read as a clear admission that UK monetary policy is much too tight, and is constrained by the inflation target.  But then I turned the page, and he stopped there.

Mervyn King referenced the “administered prices” issue in his own speech, and the January MPC minutes show it was discussed in the MPC meeting too.  It might be possible to conclude either that:

a) this is a “cry for help” from at least some elements in the MPC who don’t think targeting 2% inflation is optimal at the moment, though are unable to say so explicitly.  Or,

b) the MPC are preparing to use “administered prices” as an “excuse” to ease policy at some point soon.

Equally, this could be the idle musings of an inflation hawk.  The MPC does not need an “excuse” to ease; when inflation is forecast to be below 2% on the forecast horizon, policy is tight by definition.

Categories: Monetary Policy

The Economist Signs Up

February 2, 2013 2 comments

Via Lars and Marcus, another high-profile endorsement for a switch to targeting nominal GDP, this time from The Economist [edit: fixed link]. I won’t repeat those quotes again here.  Ryan Avent adds more background [edit: fixed link] in a Free Exchange blog post:

In Britain, there have indeed been misses [of a hypothetical nominal GDP level target], as the chart at right shows. As of the third quarter of 2012 nominal output was nearly £300 billion (or 18% of NGDP) short of the trend level immediately pre-crisis. Even assuming that policy immediately prior to the crisis was too loose and that the crisis delivered a structural reduction in Britain’s growth potential, the economy remains well below where it might reasonably have been expected to be at this point, in terms of the cash spent and earned in the economy.

That shortfall reflects the contribution of weak demand to Britain’s economic troubles. The Bank of England has laboured to fix the shortfall through a variety of policy measures, including quantitative easing and a “funding for lending” scheme designed to reduce bank-funding costs. But it is constrained in two key ways. First, its policy interest rate is close to zero. And second, it is operating under a 2% inflation target. At the zero lower bound, central banks can continue to stimulate the economy by raising expectations of future inflation, which reduces the real interest rate and boosts output. But the Bank of England has faced pressure, internal and external, to pay heed to its 2% inflation target. That, in turn, limits the credibility of its stimulus efforts.

(I don’t wish to spoil the party but the way The Economist phrase it, “just get NGDP 10% higher” is not ideal; it looks a bit arbitrary.  Lets target policy along a steady growth path of NGDP, please!)

Categories: Monetary Policy