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.
Keynesians love to say that the deficit will come down with growth. This is 50% wrong, because when Keynesians talk about “growth” we know they mean real GDP growth 100% of the time. But it is nominal GDP growth which determines the course of the public finances; tax revenue follows nominal GDP and NGDP is the denominator in debt/GDP. (When we talk about “debt/GDP” it is the only time that “nominal” is implicit!)
Japan had positive real GDP growth for some of its “lost decade”; but it never had any nominal GDP growth. That is why Japan’s public sector debt/GDP went off the charts; not merely because Japan had insufficient real growth (though that is probably also true).
Keynesians are also 50% right, because under inflation targeting real GDP growth “determines” nominal GDP growth. This assumption is embedded in many macro models; we read that improving productivity will improve the public finances, which is true because higher productivity ⇒ higher real GDP growth ⇒ higher nominal GDP growth – if inflation is always held constant.
Maybe I’m beating a dead horse here, but Keynesians should be more open about the insane implications of macro models which embed the assumption of price stability. For example, such models tell us that it is roughly true that the collapse in productivity since 2007 has caused the collapse in the public finances.
I started wondering about Switzerland.
Consider what would happen if Swiss productivity falls 50% tomorrow. What would happen to the level of Swiss output? Well, we know that Switzerland is at the ZLB, and so Swiss real GDP is determined by Swiss fiscal policy… right? Therefore, absent any change in Swiss fiscal policy, Swiss real GDP would stay the same, and the 50% fall in productivity implies that Swiss workers would immediately double their number of hours worked, so they could retain the same level of real income (output). That logic is unassailable. There is no other possible way that the Swiss could keep real GDP the same except by a doubling in employment, defined in terms of hours worked.
Obviously that argument is totally bonkers. Who really believes that the level of Swiss output is unrelated to the level of Swiss productivity? Now read the argument repeated endlessly by the likes of Martin Wolf (H/T Mr. Portes), writing today on the Autumn Statement:
Unfortunately, this heartwarming performance on employment is a mirror image of the dismal performance on productivity. Ultimately, real wages have fallen because output per hour has fallen. That has softened job losses. The OBR assumes the past productivity losses, relative to the trend, will not be recouped. Yet it hopes growth of output per hour will recover to close to 2 per cent by 2015.
“output per hour has fallen. That has softened job losses.”
Falling productivity is the mirror image of rising employment… because we know that UK output is demand-determined – is determined by George Osborne’s fiscal austerity.
I don’t see why that argument is any less bonkers. Does Martin Wolf really believe that the level of UK output is unrelated to the level of productivity? That is exactly what he argues.
The OBR’s March 2011 forecast appears to be the first time they published a forecast for total hours worked. I’ve graphed below the change in the level of UK real GDP since 2011 Q1 in three different ways:
1) The OBR forecast,
2) What the current ONS data say actually happened,
3) A supply-side counterfactual derived from:
a) The expected path of UK productivity (output/hour) from the OBR forecast, and
b) The actual observed path of UK total hours worked from the current ONS data.
This simple 5-minute counterfactual implies that the productivity collapse more than explains the entire shortfall of output (vs expected) since 2011. By 2013 Q3, hours worked is 3% higher than expected, and productivity is 7% lower.
Now consider the “fiscalist” claims that the weakness of UK real GDP since 2010 is evidence that the “fiscal multiplier” is real and large. That works perfectly, but not as a demand-side argument; as a supply-side argument it fits the data extremely well.
2.198 A garden bridge for London – The government will provide a £30 million contribution to support the construction of a new Garden Bridge across the River Thames in London. This will supplement funding from Transport for London and private donations.
These aren’t the supply-side reforms we were looking for,
Here is Winston Churchill discussing the “cost of living” in Parliamant, as recorded in Hansard in 1925 (via a paper by Susan Wolcott via Bob Hetzel), attacking the ideas of one Professor Keynes:
The hon. Member for Keighley was deploring a fall in prices, but what does a rise in prices mean? It means a rise in the cost of living, and what does that mean? It means a diminution, in exact mathematical ratio, of the real wages which are received by the working classes.
The Labour party echoes those words by choosing to campaign in 2013… on… wait for it… rising prices and falling real wages, the “cost of living crisis“. Somebody in the Labour party should read Nick Rowe, if not Keynes on the economic consequences of (thinking like) Mr. Churchill.
Simon says I should hold Osborne responsible for the UK’s macro policy failure. Did Keynes hold Churchill responsible for returning the UK to gold at a level which required a great deflation? Keynes wrote, on Churchill’s decision:
Why did he do such a silly thing?
Partly, perhaps, because he has no instinctive judgment to prevent him from making mistakes; partly because, lacking this instinctive judgment, he was deafened by the clamorous voices of conventional finance; and, most of all, because he was gravely misled by his experts.
My emphasis. That perfectly captures how I feel about Osborne: yes, failing to change the MPC remit is awful and stupid, but is not terribly surprising given the advice he’s had.
The Bank of England has mounted a lobbying campaign to keep the 2% inflation target over the last nine months. Mervyn King’s choice of words for those who consider a departure from 2% CPI was downright vicious; “unrealistic”, “painful experience”, “illusion”, “terrible price”, “wishful thinking”, “the dreamers”. And that’s before I start on Spencer Dale or Martin Weale. If I were to summarize the MPC consensus it would be that they could target anything other than 2% CPI but it would be a very, very bad idea.
Macroeconomists outside the Bank are broadly split into two groups. The “fiscalists” think our demand-side [edit: problems] can only be solved using fiscal policy, because monetary policy is interest rates and we ran out of interest rates. And there’s the supply-siders who think our problems are mostly supply-side because of the CPI data (or political bias, take your pick).
There are others (like Simon) who cannot be so narrowly categorized, and have more nuanced views. But why should HM Treasury listen to Simon Wren-Lewis and Scott Sumner and ignore Mervyn King and Charles Goodhart (who is cited twice in the remit review discussion of NGDP targeting)? It is not credible to crucify Osborne on a cross marked “ignorant of basic economics“, when he is following the advice of experts like King and Goodhart.
I think Osborne went somewhat beyond the consensus view of modern-day “experts” in asking the Bank to do forward guidance, and he deserves quiet applause for that. I believe a range of policy options was available to the MPC under the guise of “forward guidance” and MPC members should be held to account both for the policy choices they make, and for the policy advice they give HM Treasury.
I also think the Labour party are also being “gravely misled” by today’s experts who have convinced them that UK demand-side problems are purely fiscal “because ZLB”. That is not what New Keynesians should say about optimal macro policy at the ZLB. Here’s New Keynesian Lars Svensson in 2006:
Japan has certainly tried an expansionary ﬁscal policy. This has not led to an escape from the liquidity trap, but it has certainly led to a dramatic deterioration of Japan’s public ﬁnances.
That is the kind of thing the Labour party should be hearing from macro experts. Oh, and drop the “cost of living” nonsense.
Now I’m forced to defend Cameron against the Keynesians… it’s a joyless task being a monetarist blogger this week.
Simon says that Cameron’s comments yesterday were rather… audacious. I wouldn’t disagree with the thrust of the argument, that Cameron is taking liberties in claiming explicit support from Carney. A defence of Cameron would be Carney’s specific choice of wording in the press conference in response to a question from Philip Aldrick:
“There’s also obviously the rebalancing that’s necessary on the fiscal side, which is in train.”
He did not say “The government’s foolish, reckless, and unnecessary fiscal consolidation.” He did not go the Bernanke route and openly call for more fiscal stimulus, or perhaps just less fiscal austerity. Instead, he said “the rebalancing that’s necessary on the fiscal side.” – my emphasis, but his choice of words.
Now we have the transcript, I can also quote Carney’s response to Bill Keegan, which is most interesting on this topic.
William Keegan, The Observer: Mr Carney, the MPC is responsible for monetary policy. To what extent do you think the government’s fiscal policy is inhibiting the reduction in unemployment that you so clearly seek?
Carney: Well, a couple of things. First, what we seek is price stability as defined by the 2% inflation target. And the challenge for the MPC is to chart the best path back to that 2% inflation target, given the weakness in activity, given the slack in the labour market and given the initial conditions – given that we’re starting with inflation at 2.9%. And we fully recognise that there has been a prolonged period where inflation has been above target.
So we’re balancing the need to get inflation back, and our primary responsibility of getting inflation back to the 2% target, with due consideration for output and employment. So, just to be absolutely clear, this is about us fulfilling our primary objective, which is inflation, and given the circumstances, doing it in a balanced way.
Carney continues talking about thresholds after that. Eagle-eyed readers might pick up on which macro variable (hint: starts with “2%”, ends in “inflation”) Carney wants to talk about in response to a question about fiscal policy.
This clearly support’s Simon’s argument that fiscal policy has made monetary policy “difficult” insofar as fiscal policy changes have pushed up the CPI. But I really, really dislike that framing. The whole reason we have nine uber-smart macroeconomists running UK monetary policy is that they are supposed to make “difficult but correct” decisions about UK monetary policy. “Politically unpopular” decisions, if you like.
We did not have Gordon Brown, Alistair Darling and George Osborne running UK monetary policy for the last fifteen years because economists thought that people like Gordon Brown, Alistair Darling and George Osborne would make “easy and incorrect” decisions about UK monetary policy, and politicians were co-opted into that view.
So I am wholly unsympathetic to seeing economists criticise politicians for making life “difficult” for the MPC. (As an aside, Mervyn King was clearly sensitive to this issue. That is why he sat through the 2011 Inflation Report press conferences with a smug look on his face, facing down the press time and time again as they implored him to raise rates and get inflation down. He knew that in 2011 he had an acid test of the MPC’s ability to make “difficult but correct” decisions.)
Simon is clearly right when he says:
In the UK, however, it appears that it is inflation rather than (maybe?) the (perceived?) inadequacy of monetary policy instruments which is restraining further monetary stimulus.
But this does not go far enough. We have had an absolutely clear opportunity for the MPC to decide the extent to which inflation restrains further monetary stimulus. I do not expect they will get such an opportunity again for a long time. And the economists on the MPC have decided that it is absolutely correct to place low inflation above all else in steering a course for UK aggregate demand. That is the “difficult decision” our uber-smart macroeconomists have taken, and the rest of us must now suffer from.
I’ve seen quite a bit of discussion recently from various quarters about how a return to UK growth was inevitable regardless of what Osborne did with UK macro policy.
The benchmark here is Japan. Japan did see a recovery in real GDP after 1991 as prices and wages adjusted to slower nominal GDP growth. But they have never seen a recovery in nominal GDP – Japan’s nominal GDP in 2013 is lower than in 1991. That is basically the critique Bernanke and others applied, to show that Japan’s macro policy was a failure; slow nominal wage growth, slow nominal GDP growth, slow or negative price inflation.
So I think it is still absolutely vital to distinguish between real and nominal GDP growth today in the UK. What we saw in the July PMIs was one month of particularly good growth in a real indicator. If the real indicators continue to indicate fast output growth and we continue to get moderate levels of price inflation I think that is a reasonable sign that we have a nominal GDP recovery. Such a recovery does not happen “naturally”; it must be attributed to a change in macro policy.
(One note of caution here is that measures of output price inflation have been well below consumer price inflation, and the CPI is distorted by things like tuition fees, so it is hard to know exactly what is happening with the nominal economy.)
Market monetarists will point to the “long and variable leads” associated with an anticipated change in UK monetary policy since Carney’s speech on NGDPLT last December. Evidence of a significant easing in monetary conditions since last year is the rise in inflation expectations, fall in Sterling, and rise in UK equity and other Sterling asset prices (yes, house prices too.) It is also reasonable to say that changes in Japanese or US monetary policy have eased UK monetary conditions.
Fiscalists might want to offer a different explanation. Did George Osborne end the “balance sheet recession” by goosing up the housing market, thereby providing a massive helicopter drop of net wealth to the credit-constrained private sector? (I’ve seen estimates that Help 2 Buy will boost house prices by 30%.) Somebody should make that argument, if so. The path of UK private sector balance sheets is completely different to that seen in Japan since 1991, where nominal asset prices have collapsed by 50% or more over twenty plus years.
But either way I think it is important we must judge the success of macro policy in short-run stabilisation by looking at nominal outcomes not by concentrating on real indicators.