Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 22 February 2017

The academic consensus on austerity solidifies, but policymakers go their own sweet way

With yet another study showing how damaging austerity can be, you would think that at some point some politicians would eventually get it. This tepid economic recovery has been a huge vindication of Keynesian economics, which also happens to be mainstream economics. The textbooks and state of the art macroeconomics said cutting public spending while interest rates were stuck at their lower bound was a very bad idea. And sure enough pretty well every ex post analysis of this period finds that it was. It is particularly ironic that at a time when countless articles have appeared about the ‘crisis in economics’, a massive experiment by policymakers has seen an important part of it vindicated.

There were three countries or areas that adopted austerity in spades: the US, the UK and the Eurozone. Are any of these likely to recognise the error of their austerity ways anytime soon? The conventional wisdom is that this will happen in the US, but this is to confuse actions and the reasoning behind them. Any fiscal expansion in the US would not be for Keynesian reasons. This is partly for the obvious reason that interest rates are rising, and the central bank has shown no clear sign that they would not meet any further expansion with additional increases. There remains a clear and rather urgent need for a large increase in public investment financed by borrowing, but that seems unlikely to happen. What we are sure to get is tax cuts, particularly for the rich, because that is nowadays the main goal of Republican economic policy. Among Republicans, Keynesian economics remains the work of the devil.

In the UK there is also a desperate need for public investment. In addition, the NHS is crying out for a substantial tax financed fiscal expansion, which would help get interest rates off their lower bound. But UK policy makers only have one thing on their minds at the moment. It is Brexit at any cost. We know that because they show no interest in any other options. Right now God could reveal to climbers on Ben Nevis that Brexit would cost the average UK household 20% of their income, and policy would not change. [0] While some in the government may be tempted by fiscal expansion as a way to hide those costs, the Treasury seems to be keeping an iron grip on the purse strings. Never has the UK government seemed so politically secure, and never has it been further from sensible economics.

Not all of the Eurozone’s problems are due to a failure to recognise Keynesian macro. As Martin Sandbu argues here, what has been done and continues to be done to Greece is the age old story of the creditor refusing to admit that they have made bad loans, and therefore squeezing the debtor for every last drop and not realising that doing so only makes things worse. But even here a failure to understand Keynesian economics contributes to this lack of understanding. A country that is allowed to recover from a demand led recession will be far more able to find resources to pay back debt.

However if you look very hard there are signs that things might be improving in the Eurozone. Fiscal austerity at the aggregate level seems to have come to an end. Some key actors, even in EC institutions and governments, are beginning to see how austerity policies may only encourage the rise of the populist right. But that is a long way from the key reform that is required, which is replacing the existing fiscal architecture with something more Keynesian that recognises the mistakes of the past.

If anything is going to happen at all, I doubt if it will be the abandonment of the stability pact and fiscal compact, desirable though that would be. What seems more likely is a gradual adaptation of the mess that all these rules already are. The adaptation does not even need to look like Keynesian policy. National fiscal and macroprudential policies need to focus on inflation differentials between the individual country and the Eurozone average. This focus could be embodied in a rule, which still allowed debt or the deficit to be guided by a target when inflation was at the zone average. This rule has to be symmetric in inflation differentials, prescribing fiscal expansion if a country’s inflation is lower than average.

Equally disappointing has been the complacency of independent central banks. We have had the most prolonged recovery from recession, with lasting damage to long run supply, but you might be forgiven for thinking that we were still in the Great Moderation. Central banks should be busy comparing the four main ways of avoiding another Zero Lower Bound episode: a higher inflation target, negative nominal rates, nominal GDP targets or helicopter money. They also have to stop being so discreet about fiscal policy. Keeping quiet itself makes another ZLB episode more dangerous.

Occasionally people ask why my blogs seem to be as much about politics as economics these days. I agree, there has been a change since 2015. Before that, I would have greeted a new paper on fiscal multipliers by comparing it to the existing literature, and examining its strengths and weaknesses. These days there just seems so little point. I do hope all this knowledge will one day see the light of day among policymakers, but right now I wonder if there is an equally good chance that policy makers will stop paying for knowledge they have no intention of using. [1] Sometimes writing about the finer details of estimated multipliers can seem like rearranging the deckchairs on the Titanic.


[0] Here are some man-made estimates
[1] U.S. U.K.


19 comments:

  1. Perhaps we need to attack the problem directly? What might the economics profession do to help politicians start doing the right thing?

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  2. I would question some of your assumptions here as they affect policy directly.

    You say for example "In addition, the NHS is crying out for a substantial tax financed fiscal expansion, which would help get interest rates off their lower bound". Presumably this is due to an increase in borrowing but this is just what the authorities want to avoid (being forced off the ZLB), in fact they seem to be terrified of it. There is far too much debt around (especially private) and all but a purely nominal increase in rates is likely to have severe economic consequences. As to the substance of your argument I think you are right about the NHS but clearly this is just one element in the "austerity" context.

    Also your comment that in the EZ there should be rules is I think somewhat naive. The last thing the ECB want are rules because that may force them to tighten when they have no wish to. The BOE do this much better by having such vehicles as FLS or TLS to subsidise rates under the radar whilst keeping the fig leaf of positive rates above it.

    Also your four ways to avoid another ZLB episode are also somewhat questionable. A higher inflation target absent wage increases (very likely) will result in lower real wages which, in an economy driven by debt and with high debt levels, is likely to result in lower aggregate demand rather than the soft default that the authorities may want; this will exacerbate problems not alleviate them. This aspect has been recognised by a speech given recently by the governor of the Australian CB.

    You are right to stress politics but the reason is that policy has put us into a box from which there is no easy escape and the politicians know this full well, as do the BOE.

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  3. “This rule has to be symmetric in inflation differentials, prescribing fiscal expansion if a country’s inflation is lower than average.” Good idea. Though getting Germans to agree might be difficult.

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    1. And why should they? The rule is silly and practically impossible to apply, as the Fed and the ECB have found out, and this is even more true in a single Country.

      Anyway, the Iraq war has tought Germans to be stubborn, and right they are.

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  4. Austerity appears to have worked in Ireland?

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  5. Why won't politicians take your advice? Paul Krugman finally figured out years ago why the Very Special People don't always listen to him: class interests and politics. Why presume anymore that politicians are public servants? It seems that ethos died years ago.

    I appreciate your constant critique of these stupid policies--we need that kind of ammo and "rally the troops" call. But that won't be enough. The kind of town hall meetings the Tea Party unleashed seven years ago, and that liberals and others are doing now, will get the point across more affectively. The elite can ignore a blog or a paper--but not a mob.

    Welcome to political sociology & political science.

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  6. I can see a post-Corbyn Labour Party having to turn on the BoE, forcing it to reveal who said what to whom over the period of excess bank lending in the 2000s, just to stop the Tories from linking the Labour Party to the 2008 crisis.





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  7. Why does this seem not to apply in the case of the Asian Financial Crisis? The IMF was vilified for its imposition of austerity, yet these economies (Thailand, South Korea, Indonesia) have enjoyed high growth since.

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  8. "There were three countries or areas that adopted austerity in spades: the US, the UK and the Eurozone."

    The US: When?

    The UK: That's what the voters wanted - no borrowing.

    The Eurozone: Where? In France, public expenditure rose continually since 2007. The same is true of Germany with rhe exception of one year. In the countries that count, there was no austerity.

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  9. "what has been done and continues to be done to Greece is the age old story of the creditor refusing to admit that they have made bad loans, and therefore squeezing the debtor for every last drop and not realising that doing so only makes things worse."

    Nonsense. The creditors continually lent Greece more money, and the private creditors had to agree to an important haircut, i.e. debt pardon.

    But the creditors want reforms, otherwise they can be sure never to get anything back. As the IMF points out in its latest pronouncements, things cannot work in Greece if half the population is exempt from income taxes and pensions are on the level of much richer countries.

    Unfortunately, Greeks consider refusing reforms as a form of national resistance, rather like against the Ottomans, their first king after their independence, who was a Bavarian, or the Italians and Nazis.

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  10. I think our policymakers are doing the best they can in the circumstances. Austerity alone hasn't really worked but Brexit should help. So far we're still well behind Greece, except in one respect, but of course our policymakers have been handicapped by the greater deal of ruin that there is in the UK.

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  11. House et al's paper can be found here:

    http://www-personal.umich.edu/~ltesar/pdf/austerity.pdf


    Henry

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  12. "The NHS is crying out for a substantial tax financed fiscal expansion, which would help get interest rates off their lower bound". Not sure this makes sense. If its fully financed by taxation, how is it a fiscal expansion? Are you assuming that the hit to aggregate demand from higher taxes would be smaller than the boost from higher government spending? And isn't it odd to cite the prospect of higher interest rates (including on government borrowing) as a positive of increased spending on the NHS?

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  13. "What we are sure to get is tax cuts, particularly for the rich, because that is nowadays the main goal of Republican economic policy."

    Nowadays? It's been their "main goal" since at least 1980, the beginning of the Reagan era. I'd also amend "main goal" to tell it like it is: it's an obsession, a fixation, a mania.

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  14. Simon Wren-Lewis's post gives pöliticians an excellent excuse not to take economists seriously. He has no reason to complain.

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  15. How is this paper evidence? Based on the abstract, Its just a general equilibrium model stuffed with paramaters. Why should anyone trust their results?

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  16. http://www.nytimes.com/1998/02/11/business/international-business-imf-concedes-its-conditions-for-thailand-were-too-austere.html
    The IMF removed the austerity.

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  17. Why do people always dance around the real issue facing us, we are suffering from the policies of a global elite transferring power and wealth to themselves without any regard to the impact it has on ordinary people.

    Margaret Thatcher's secret 1982 cabinet papers, "the longer term options" spells out the agenda in detail.

    https://skwalker1964.files.wordpress.com/2016/10/cab-129-215-6.pdf

    Thatcher denied the existence of this document and it was only released under the 30 year rule in 2012.

    I welcome the views of others as to why people are so reticent not see what is actually happening around them and has been ever since Friedman espoused his mad cap ideas in the 1970s.

    This other 1977 document is just as revealing and was a paper instigated by the then Nicholas Ridley who planned the dismantling the nationalised industries, the undermining of the Unions, and to use military and arms of the state, Police etc., against them. The Miners of course were totally unaware that this had all been planned years in advance. This paper can be found in Bodleian Library in Oxford.

    https://en.wikipedia.org/wiki/Ridley_Plan

    https://quod.lib.umich.edu/h/humfig/11217607.0004.106/--thatcher-s-civilising-offensive-the-ridley-plan?rgn=main;view=fulltext

    The level of bile and smears currently being waged against across the mass media, and Neo-Liberal politicians across the political spectrum isn't it obvious that when Bernie Sanders proclaimed "that the 1% per waging war on its own people", that there is nothing but merit in that view point, and isn't it time for all decent human beings to recognise that?













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  18. Alexander Harvey3 March 2017 at 03:12

    The recent story regarding the setting of the Personal Injury Discount Rate down to minus 3/4% based on the real yield of Index Linked Gilts should tell a tale, but the media doesn't seem to have made the leap to see that, in this case at least, the government can borrow for less than nothing, better than free money.

    It may seem a leap from Insurance Payouts to Deficit Deceit but it must surely be worth challenging the idea that the deficit is unaffordable.

    Unfortunately the belief, received wisdom, that the debt and deficits are unsustainable is so embedded in the minds of so many journalists, I doubt the leap is not simply ignored, but completely invisible.

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