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Austerity Forever or 4% Inflation: Your Choice, Britain

September 24, 2014 25 comments

Serious people talk about the public finances facing a dilemma of higher taxes and/or cuts to public services.  When I read those discussions all I can think about is nominal GDP.  As a non-serious blogger, I reside happily in what Flip Chart Rick calls “Fiscal La La Land”, with my simple solution for fiscal salvation: the 4% solution, raising the inflation target.

Raising the inflation target would raise tax revenues, raise the denominator in debt/GDP, and allows cuts to real wages in the public sector without renegotiating (or reneging on) contracts made in nominal terms, and/or mass redundancies, both of which naturally provoke outrage from public sector workers and many consumers of those services.

Of course, we don’t really need higher “inflation”.  And Serious People can’t talk like that, because “inflating away the debt” is unthinkable, it is not virtuous.  The virtuous idea of “deflating up the debt” is curiously absent from modern debate, but that is exactly what the British government has managed to achieve in driving nominal GDP 20% below trend since 2008.

Here is the OBR explaining clearly what really matters – my emphasis applied, and read closely: 

1.14.  If the ballooning of the budget deficit simply reflected the fact that nominal GDP and asset markets had fallen a long way below the paths anticipated for them prior to the crisis – and that in time they could be expected to return to those paths – then there would be no compelling case for a large-scale fiscal consolidation to return the budget deficit to its pre-crisis level, although debt interest costs could be higher for a significant period.

1.15. The case for the consolidation – accepted by both the previous and current Governments, albeit with disagreement about its size and pace – is that the potential level of GDP that the economy can sustain, consistent with meeting the inflation target, is likely to be permanently lower than people thought prior to the crisis. Our latest forecast assumes that potential GDP was around 12 1⁄2 per cent lower than the Budget 2008 forecast by 2012-13 and that it will be 16 per cent below an extrapolation of that forecast by 2018-19. Even the most optimistic external assessments lie well below an extrapolation of the Budget 2008 forecast.

Market monetarists are often perceived as being pseudo-austerians in our opposition to “using fiscal policy”.  I think this is backwards.  I see “fiscal austerity” as a necessary by-product of the failed macro policy regime called inflation targeting, and nominal GDP level targeting is the best way to avoid “fiscal austerity”.

That is exactly what the OBR is saying above.  If NGDP was expected to return to trend there is no case for fiscal consolidation.  A difficult fiscal consolidation is required under inflation targeting when there is a permanent fall in the level of potential GDP.  The current fiscal consolidation is going to continue being “difficult” as long as productivity growth continues to disappoint.  If you want to know how Britain can end up having public finances like Japan, keep watching the productivity figures.

(If this is not intuitive consider what is held constant: if you hold the inflation rate constant, nominal GDP, nominal wages, nominal tax revenues etc must track the path of productivity.  If you hold the path of nominal GDP constant changes to inflation rate reflect changes to productivity growth.)

Right-wingers find this message uncomfortable, but are often the first to champion the idea that “falling prices should reflect rising productivity.”  That’s right.  Specifically, below-trend inflation should reflect above-trend productivity growth, and above-trend inflation should reflect below-trend productivity growth.  That symmetrical outcome is what NGDP targeting aims to provide.  Right now we have below-trend inflation and below-trend productivity growth.  You can’t ignore one half of the equation when it suits you.

The real “austerians” are not the crazy, obsessive monetarists who don’t want to talk about fiscal policy, but the 95% of economists who have a crazy, obsessive belief that 2% inflation targeting approximates optimal macro policy.

The Creditable Dullness of Being Mark Carney

September 12, 2014 17 comments

UK macro is really quite boring at the moment, and I cannot be happier to report that news.  Of course boring events do not get reported as “news”, but that’s why we have blogs.  Sure, there is a lot of debate about Scotland and so on which is related to macroeconomics – but UK macro events are not really capturing the headlines.  UK GDP updates, labour market news… well, there’s a war on… let’s talk about Putin.

Contrast with the Eurozone.  Mario Draghi is exciting!  He is doing things.  Pulling levers!  Fiddling with interest rates.  Easing credit conditions, improving financial conditions.  Trying to get that CPI rate up… maybe.  Oh, and allowing inflation expectations to collapse.  That’s news.

Mark Carney expressed a worthy ambition in his statement to the Treasury Select Committee in 2013, that he “would like to achieve an exit in 2018 that is less newsworthy than my entrance”.  I think he is well on the way to achieving that.  This is how it should be.  Central banking should be boring – nominal stability should be boring.  If the nominal economy is stable, all the “news” will be “real”, in the sense of being supply-side.

For the first time in years I could not be bothered to watch the Inflation Report live last month, but skipping through the recording, the Broadbent, Carney and Shafik show is delightfully dull.  Carney even takes pleasure from his own boringness:

What we’re putting emphasis on, and I know it’s boring and repetitive and it doesn’t clip into a new headline, we’re focusing on the path, the likely path of rates, the limited and gradual adjustment in those rates over the medium term, because of the headwinds that are facing this economy.

And again…

First and foremost it’s about the path for rate increases. I know it’s dull, I know it’s repetitive, but that’s the problem with consistency, it’s dull and repetitive.

Bravo Dr. C, bravo.  And the annoying cricket metaphors are gone too.

This is what short-term inflation expectations (from gilt yields) looked like when UK macro events were newsworthy:

UK Inflation Expectations.  Source: Bank of England

UK RPI Inflation Expectations. Source: Bank of England

Quite the roller-coaster.  I use the 3.5 year measure because it’s the most complete time series.  Note this is RPI not CPI, and RPI at 3% is roughly equivalent to CPI at 2%.

Here is the last year and a bit:

UK Inflation Expectations.  Source: Bank of England

UK RPI Inflation Expectations. Source: Bank of England

What a dull, dull graph.  Carney and the rest of the MPC deserve the highest praise for making macro policy boring.