Home > Fiscal Policy, Monetary Policy > Austerity Forever or 4% Inflation: Your Choice, Britain

Austerity Forever or 4% Inflation: Your Choice, Britain

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.

  1. ChrisA
    September 25, 2014 at 08:18

    Well said. But just thinking about this a bit more, how much wage growth can be expected in the UK if the Eurozone is in recession? Even if there was no recession in Europe whenever I visit London for business I am amazed by the amount of people from Europe working in almost every business. This time it is really different – people from all over Europe can move to the UK very easily, they are usually nowadays good English speakers, there is little prejudice in the UK against foreigners, the internet makes knowing about and applying for jobs very easy, there is usually an established community that can help in the early stages. And of course London is gradually becoming the capital city of Europe in finance and business head offices, so it is the place to go to advance your career. So the Euro recession is just going to exacerbate this trend of forcing down wages in the UK, especially for the higher skill areas. NGDP rising per capita potential worker is whats needed to restore wage growth which will restore the tax base. But can the UK really reflate the whole Euro economy on its own?

    • September 25, 2014 at 14:07

      The idea of a positive labour supply shock from the Eurozone is certainly attractive. The “buts”:

      1. Net migration is around 250K according to the surveys. That is really tiny to the size of workforce. Are the surveys wrong?

      2. Which way does that composition effect go? You mention London: I would presume that migration to London should drag average wages UP not down, because London wages tend to be above the rest of the country already.

      That second question applies for productivity as much as for nominal wages.

      • ChrisA
        September 26, 2014 at 01:48

        Well I suspect that the numbers are larger than the official figures for all sorts of reasons but even if they are not, what we are talking about is a marginal effect. Especially on the higher skilled labour that is most easy to move. Just the presence of a “reserve army of labour” in Europe can put pressure on wages in the UK. It makes the cost of supply curve very flat./

        On your second point, high London wages are already in the average, so new London jobs at lower wages than the existing ones will drag down the overall average would it not? Even if those jobs are higher paid than the average. Flipchartrick had a good recent post on this; http://flipchartfairytales.wordpress.com/2014/09/24/a-high-skill-low-wage-recovery

        Let imagine that Osborne kidnaps Carney’s hamster and demands an ultra-loose monetary policy as a ransom in a last ditch attempt to win the election. Carney goes out and starts buying every asset in sight, the UK moves to boom times a-la the Barber boom, the Lawson boom and so on. Meanwhile the ECB notes some incipient inflation in Calais due to all the British shoppers and raises interest rates for the Eurozone to 10% as a precaution. Labour will surely be attracted away from the Eurozone and to the UK. Inflation in the UK will certainly increase in many sectors, but wages will likely lag the overall inflation.

  2. September 25, 2014 at 18:32

    London employment up 10% since 2009. I had no idea it was this strong – no wonder house prices are soaring! http://www.ons.gov.uk/ons/dcp171778_378478.pdf

    • ChrisA
      September 26, 2014 at 01:54

      Yes looks like most of the new jobs since 2009 in London and the rest in the South East, This is not surprising, this is basically the history of the world, increasing urbanization since forever. And the bigger the city the bigger it grows. I guess the UK is lucky that it is getting what looks like Europe’s capital city inside its borders.

  3. jamesxinxlondon
    September 26, 2014 at 07:24

    Looking forward to a revisionist critique by a Market Monetarist of the “Barber Boom”. Was it so bad? Are you listening Marcus?

  4. ChrisA
    September 26, 2014 at 08:21

    Nice chart from Ben Chu to illustrate the original post by BM;

    Tax receipts for consumption (including houses in consumption) rising, while those related to wages stagnating.

    • james in london
      September 26, 2014 at 14:49

      The rise in “consumption” taxes for housing is mainly related to stamp duty, and not showing evidence of a very fast rise in actual consumption. House purchase is more of an investment. But see Scott Sumner for best discussions on this issue.

    • jamesxinxlondon
      September 26, 2014 at 21:46

      VAT revenues need to somehow be adjusted for the rapid changes in rates, it’s not just the economic cycle. The rate dropped from 17.5% to 15% for 13 months from 1 Dec 2008; then back to 17.5% on 1 Jan 2010; then up to 20% from 4 Jan 2011 – a 33% increase from the 2009 lows. And then there is potentially tighter collections regime as the economy has recovered. Maybe 3% compound? Good chart though.

  5. W. Peden
    September 26, 2014 at 13:30

    James in London,

    Interesting question. I’m sure Marcus Nunes could do a better job, but a few revisionary observations-

    (1) Not a MARKET monetarist point, but it’s a myth that narrow money aggregates weren’t a good indicator of inflation in the early 1970s. As Edward Nelson pointed out, M0 and M1 have greater interest-rate elasticities than broader aggregates like £M3 and M4, due to their lack of interest-bearing components, and so you’d expect them to grow more slowly during an inflation. Also, there was a major cut to reserve requirements in the early 1970s that reduced the bank demand to hold M0. Both the narrow aggregates were good indicators of UK NGDP and inflation during the 1970s, and unlike £M3 their demand-functions stayed stable over the decade.

    (2) Now for NGDP. To set the scene for the Barber Boom: the quarterly data I have (from the “Money Creation in a Modern Economy”) suggest that UK economic policy was very good from Q2 1965 to Q4 1967, when there was a halving of NGDP growth from over 10% to about 5%. NGDP growth then picked up following devaluation, and by the end of the (perhaps overrated) Roy Jenkins chancellorship was running at about 10% again.

    Looking at NGDP, the “recession” during the early stages of the Heath government was clearly a supply shock. NGDP growth was above trend and stable from Q3 1970 to Q1 1972, but during this period unemployment rose dramatically and RGDP slowed right down (and IIRC fell in some quarters) presumably due to the collapse of incomes policies and the reversion of unemployment to its underlying natural rate, which had risen as a result of the major expansion of the welfare state during the Wilson government.

    In terms of NGDP, the Barber Boom was very short. From Q2 1972 to Q1 1973, NGDP growth accelerated drastically from about 11% to over 20% as the government desperately tried to get unemployment down and RGDP growth up to 5%. Looking at the quarterly RGDP data from Trading Economics, NON-ANNUALIZED RGDP growth reached 5.3% in Q1 1973. In other words, even by the standards of their own incorrect estimates of the output gap, the UK macroeconomic authorities expanded RGDP by more than their ANNUAL target in a single quarter.

    By this time, all the money supply (then M0, M1, M2, £M3, and M3) and expectations indicators (e.g. money market nominal interest rates and the exchange rate) were screaming that monetary policy was too loose. Asset prices were going mental. However, the NIESR was saying as late as June 1973 that there was no reason why the boom need end, or should be ended. Since unemployment was still above-trend, it was thought that there must have been a lot of extra capacity.

    However, the boom was ended. NGDP growth was brought down even more rapidly than it was raised, falling to under 5% by Q1 1974. I have mixed feelings about this disinflation. On the one hand, a mid-term government practicing a statutory incomes policy probably has the best excuse and tools for a “shock therapy” approach, and unemployment continued to fall, presumably due to a temporary shift in the natural rate of unemployment resulting from the incomes policy. Nevertheless, a recession began in Q1 1974, partly supply-driven (the oil crisis and the miners’ strike) and partly driven by the sharp fall in NGDP growth.

    Probably the main revisionist note I shall sound is this: by the end of Anthony Barber’s chancellorship in March 1973, there was absolutely no reason why the UK needed to have >20% inflation. The monetary overhang could have been handled by a good market monetarist chancellor. Even taking Q1 1974 as a bit of an outlier, NGDP growth was coming back under control (relatively speaking) by the end of 1973, nearing 10%. Even with very pessimistic estimates of potential output in 1974-1975, inflation need not have risen very far beyond 10% in that period. And this means that the REAL inflationary boom was under Denis Healey from Q2 1974 to Q4 1975, during which NGDP and inflation accelerated far above 20%.

    So Barber still turns out to be roughly the worst chancellor in 20th century UK history, but moreso because of the instability of his period rather than the overall rise in the price level (which was still awful). He can’t be blamed for the full extent of the inflation that occured in 1975. Healey looks even worse than his reputation and Jenkins doesn’t seem like he fully deserves his extraordinary reputation. This seems like a partisan analysis, but the Heath government was about as far from my political views as Roy Jenkins was, and I think that Healey was an admirable chancellor given his socialist views and the wreckage of UK economic theory that took place in the 1970s.

    (For close students of UK economic history, there is a tremendous irony in that- prior to the Great Moderation of 1992-2007- the best period of macroeconomic policy looks like being under the Tories from Q4 1951 to Q3 1963, when NGDP growth came down from over 10% to a fairly steady average rate of 6.5% from Q1 1953 to Q3 1963. In fact, Harold Macmillan’s premiership looks like being about the best period of macroeconomic management in our history: NGDP growth averaged 5.35%, staying within a relatively stable band of 2.3-8.4%. From Q4 1962 to Q3 1963, NGDP growth averaged 5.1% – you can’t get much closer to Sumnerite monetary policy than that!

    The irony is that this period was when great alarm about the UK’s economic performance started to develop, and the main thing that many Keynesians of the day (like Christopher Dow) blamed for this failure was… Macroeconomic policy! It was when the Tories took the Keynesians’ advice and had a big boom during the Douglas-Home government (Reginald Maudling’s “Dash For Growth”) that things started to go sour, and the UK’s Great Inflation of 1964-1980 began…

    This isn’t to say that Macmillan was the best PM ever or even to praise his economic policy in general, though it was better than the Labour alternative of the day. The point is that the failures of the Tories during this period were all on the supply-side, and even then they tended to be in terms of deviations from the ideal rather than outright harmfulness. Relative to other post-war governments, it wasn’t even bad on the size of the state: 1957-1960 saw total government spending as a percentage of GDP average a little under 35%, which is the longest it’s been so low since the outbreak of World War II. Only the early 1960s look bad from a more market liberal perspective.

    Harold Macmillan: an unintentional market monetarist?!)

  6. W. Peden
    September 26, 2014 at 13:47

    For the real masochists for detail, the UK monetary definitions in the early 1970s were-

    M0: not published as such at the time, but contemporaneously constructible using statistics on the public’s notes & coin and reserve balances.

    M1: with some name differences (“sight deposits” rather than “demand deposits”) much as the modern American aggregate and similar in its behaviour to the M1A statistics of the day in America. UK M1 was non-interest bearing until the mid-1970s, but due to a lack of market competition rather than direct regulation.

    M2: this had a brief life and was quite different from the contemporary Retail M4 statistic that serves the same function, and even moreso from US M2. Basically it was M1 plus short-term/callable time deposits. To make matters even more confusing, later in the 1980s £M3 was redefined in a way that made it very similar to the discontinued M2 series!

    £M3: M1 plus all UK public and private commercial bank deposits in sterling.

    M3: £M3 plus public and private deposits in foreign currencies. Along with £M3, it was greatly distorted by deregulation (in the early 1970s) and distortionary credit controls (mid-late 1970s).

    Of these series, M0 was probably the best one to watch in the context of the 1970s, and it was the one that at no point was published or paid attention by the government!

  7. W. Peden
    September 26, 2014 at 13:55

    Oh, and great post. I actually have more hopes for market monetarism in the UK than in the US, because I think that the right in this country is less inclined to inflation-phobia than in America. Curiously, I suspect that this fact is partly thanks to the history of the ERM and the Euro, since eurosceptics have had to claim that European monetary policy tends to be too tight. Being only slightly flippant, could say that the Euro has been a disaster for the Eurozone but probably very good for the UK, insofar as it’s dampened down the inflationistas in the UK over the past few years…

  8. W. Peden
    September 26, 2014 at 14:22

    A little phrase to sum up Barber’s chancellorship: not so much the “Barber Boom” as the “Barber Yo-Yo”.

  9. james in london
    September 26, 2014 at 14:55

    Very interesting. Would still like to see the Historinhas chart, though!

  10. jamesxinxlondon
    September 26, 2014 at 21:57

    It is incredible that Tory mismanagement gets remembered more than Labour. The socialists have all the best writers. But you’d really prefer Maudling’s “dash for growth” and Barber or Lawson “booms” than the opposite.

    Even Tony Blair/Gordon Brown/Alastair Darling’s boom wouldn’t have been so tarnished if the monetary authorities had been less independently obsessed by IT and more flexible. Maybe some revisionism is due to the last Labour Government too, just to be fair.

  11. W. Peden
    September 26, 2014 at 23:03

    It certainly is as far as monetary policy goes. The asset price inflation of the 1997-2007 period was almost entirely a result of relative price changes, not overall inflation. NGDP growth was just about spot-on during that period, and one could even argue that the Bank of England handled the 2001-2002 period better than the Fed, and so we not only avoided recession but grew at trend during those years.

    Fiscal policy is another matter, but even then people tend to overstate the mismanagement of the 2002-2007 period. It was poor fiscal policy, but it’s not the source of our current woes.

  12. ChrisA
    September 27, 2014 at 01:38

    Incredibly good piece of analysis WP. I guess my main impression of the whole post war period, up to the late 70’s, was the exchange rate fetishism, or the tendency of people to view whether or not the economy was successful through the lens of how the pound was standing up to the dollar. Perhaps this was empire driven, maintaining an strong overseas presence requires a strong currency, PPP GDP does not buy armies. The empire only benefited a small section of the population though, a good example of what’s good for the rulers not necessarily being good for the country. Mrs. Thatcher’s slashing of exchange rate regulations was arguably one of her best policies.

  13. W. Peden
    September 27, 2014 at 11:20


    I agree on exchange rate deregulation. It’s absurd to think that little over a generation ago there were controls on how much money you could take out of the country!

    I’d describe it as a muddle in which the exchange rate played a big role. Sometimes this role was positive (e.g. avoiding devaluation delayed the inflation of the late ’60s) and sometimes it was a negative role (real interest rates fell to nearly -10% in late 1977 in an attempt to keep the pound low against the dollar). To some extent, however, this continued on-and-off until the early 1990s. It’s wasn’t until the late 1990s that I think UK policymakers fully started allowing the exchange rate to go where it would and focus on domestic conditions.

    To some extent, one could say that in the post-war period policymakers muddled between unemployment and the exchange rate, and then in the 1980s they muddled between monetary aggregates and the exchange rate. 1990-1992 was a brief and awful period when the exchange rate assumed full prominence, and then the exchange rate’s importance was gradually but surely replaced by inflation measures in the inflation-targeting period of 1992 and after.

  14. W. Peden
    September 27, 2014 at 11:24

    One correction to my comment: Anthony Barber’s chancellorship ended in March 1974, not March 1973.

  15. ChrisA
    October 1, 2014 at 02:55

    Revisions in on the UK GDP, again Ben Chu has a good summary;

    The UK is basically the 3rd best in the G7 group. The blame for slowest recovery since the war is still being given to UK austerity, but I reckon that the slow recovery and limited rise in wages and productivity has more to do with the depression that is going on in the UK’s biggest trading partner, the ECB countries. Look at the Italy GDP trend – shocking.

  16. W. Peden
    October 1, 2014 at 11:05


    I notice that he doesn’t include the 1930s recovery and focuses on post-WWII recoveries. That’s odd, because IIRC that’s our most impressive recovery for which we have good data, and it was a rapid recovery at a time of austerity when short-term market interest rates were about the ZLB!

  17. jamesxinxlondon
    October 15, 2014 at 23:03

    BOE’s Weale Says More Likely Than Not Pay Pressures Will Pick Up

    Wednesday, October 15, 2014 19:22
    by Scott Hamilton
    Oct. 15 (Bloomberg) — Bank of England policy maker Martin Weale makes comments at event hosted by Hull University Business School today in Hull, England.

    “While wage growth is weak and inflation is weak, what I think is more likely than not with the current progress of the economy is that unemployment will continue to fall rapidly and wage pressures will pick up”
    Indicators show that “labor market pressures are tightening”

    Can he sleep at night? Reminds you of the two stooges on the FOMC, Fisher and Plosser. Weale and McCafferty. Data dependency is pointless, target the forecast! But targeting where you think the forecast will go is astrology. “Wages pressures will pick up”, if only.

    Even the OBR has realised tax revenues are a bit weak, the only true test of rising nominal GDP.

    • October 16, 2014 at 08:54

      What a weasely speech. Awful. He claims to support above-target inflation “in the period after 2008” due to temporary shocks – except he didn’t in 2011, he wanted lower inflation. And that chart showing maybe 4% wage inflation is pure BS. There is no way that is consistent with any other data we have.

  18. October 16, 2014 at 08:55

    Dear Commenters – an excellent stream of comments here, that history lesson from the 1970s is superb, W. Peden. Thank you all!

  1. September 28, 2014 at 03:10

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