Friday, 24 October 2014

Redistribution between generations

I ought to start a series on common macroeconomic misunderstandings. (I do not watch zombie films.) One would be that the central bank’s balance sheet normally matters, although this nice comment on my last post does the job pretty well. Here is one that crops up fairly regularly - that government debt does not involve redistribution between generations. The misunderstanding here is obvious once you see that generations overlap.

Take a really simple example. Suppose the amount of goods produced each period in the economy is always 100. Now if each period was the life of a generation, and generations did not overlap, then obviously each generation gets 100, and there can be no redistribution between them. But in real life generations do overlap.

So instead let each period involve two generations: the old and young. Suppose each produced 50 goods. But in one period, call it period T, the government decides that the young should pay 10 goods into a pension scheme, and the old should get that pension at T, even though they contributed nothing when young. In other words, the young pay the old. A fanciful idea? No, it is called an unfunded pension scheme, and it is how the state pension works in the UK. As a result of the scheme, the old at T get 60 goods, and the young only 40, of the 100 produced in period T. The old at T are clear winners. Who loses? Not the young at T if the scheme continues, because they get 60 when old (and assume for simplicity that people do not care when they get goods). The losers are the generation who are old in the period the scheme stops. Say that is period T+10, when the young get to keep their 50, but the old who only got 40 when young only get 50 when old. So we have a clear redistribution from the old in period T+10 to the old in period T. Yet output in period T and T+10 is unchanged at 100.

That example did not involve any debt, but I started with it because it shows so clearly how you can have redistribution between generations even if output is unchanged. To bring in debt, suppose government taxes both the old and young by 10 each period, and transforms this 20 into public goods. So each generation has a lifetime consumption of 80 of private goods.

Now in period T the government says that the young need pay no taxes, but will instead give 10 goods in exchange for a paper asset - government debt - that can be redeemed next period for 10 goods. In period T nothing changes, except that the young now have this asset. In period T+1 this allows them (the now old) to consume 50 private goods rather than 40: the 40 it produces less tax and the 10 it now gets from the government by selling the debt. Their total consumption of private goods has increased from 80 to 90. How does the government obtain these 10 to give the now old? It says to the young: either you pay 20 rather than 10 in taxes, or you can buy this government debt for 10. As people only care about their total consumption, the young obviously buy the debt. They now consume 30 in private goods in T+1, but 50 in T+2 when they sell their debt, which gets us back to the original 80 in total lifetime consumption.

This process continues until period T+10, say, when the government refuses to give the young the choice of buying debt, and just raises an extra 10 in taxes on the young. So the debt disappears, but the young are worse off, as they only have 30 of private goods to consume this period. Their total lifetime consumption of private goods is 70. We have a clear redistribution of 10 from the young in period T+10 to the young in period T enacted by the government issuing debt in period T.

If you are thinking that these redistributions need not occur if the debt is never repaid or the pension scheme never wound up, then we need to get a bit more realistic and bring in interest rates and growth (and the famous r<>g relationship), which these posts of mine (and these at least as good posts from Nick Rowe) discuss. But the idea with this post is to get across in a very simple way how redistribution between generations can work because generations overlap.

Nick Rowe

The burden of the (bad monetary policy) on future generations

Wednesday, 22 October 2014

Helicopter money

Periodically articles appear advocating, or discussing, helicopter money. Here is a simple guide to this strange sounding concept. I go in descending order of importance, covering the essential ground in points 1-7, and dealing with more esoteric matters after that.

  1. Helicopter money is a form of fiscal stimulus. The original Friedman thought experiment involved the central bank distributing money by helicopter, but the real world counterpart to that is a tax cut of some form.
  2. What makes helicopter money different from a conventional tax cut is that helicopter money is paid for by the central bank printing money, rather than the government issuing debt.
  3. The central bank printing money is nothing new: Quantitative Easing (QE) involves the central bank creating reserves and using them to buy financial assets - mainly government debt. As a result, helicopter money is actually the combination of two very familiar policies: QE coupled with a tax cut. Another way of thinking about it: instead of using money to buy assets (QE alone), the central bank gives it away to people. If you think intuitively that this would be a better use of the money as a means of stimulating the economy, I think you are right.
  4. Is it exactly the same as a conventional tax cut plus QE? A conventional tax cut would involve the government creating more debt, which the central bank would then buy under QE. With helicopter money no additional government debt would be created. But is government debt held by the central bank, where the central bank pays back to the Treasury the interest it receives on this debt, really government debt in anything more than name only? The answer would appear to be yes, because the central bank could decide to sell the debt, in which case it would revert back to being normal government debt.
  5. However at this point we have to ask what the aim of the central bank is. Suppose the central bank has an inflation target. It achieves that target by changing interest rates, which it can either control (at the short end) or influence (at the long end) by buying or selling assets of various kinds. So central bank decisions about buying and selling government debt are determined by the need to hit the inflation target. Given this, whether money is created by buying government debt (through QE) which finances the tax cut or by financing the tax cut directly seems immaterial, because decisions about how much money gets created in the long run are determined by the need to hit the inflation target.
  6. There is a general principle here that should always be born in mind when thinking about helicopter money. The central bank cannot independently control inflation and control money creation - the two are linked in the long run (although the short run may be much more unpredictable). Now it could be that advocates of helicopter money really want higher inflation targets, but do not want to be explicit about this, just as they may not want to call helicopter money a fiscal stimulus. The problem with this is that central bankers do understand the macroeconomics, so there seems little point trying to be deceptive. If helicopter money does not mean higher inflation targets, then this policy is just fiscal stimulus plus QE. (I elaborate on this point here, and discuss but largely discount possible differences here. A less technical discussion is here.)
  7. Saying that helicopter money is 'just' fiscal stimulus plus QE is not meant to be dismissive. Mark Blyth and Eric Lonergan make the quite legitimate point that our institutional separation between monetary and fiscal policy may not be appropriate to a world where the liquidity trap may be a frequent problem. Many years ago I suggested in a FT piece that the central bank might be given a limited ability to temporarily change a small number of fiscal instruments to enhance its control over the economy. The more recent proposal outlined by Jonathan Portes and myself has some similarities with this idea.
  8. Turning to the tax cut, would this work in stimulating consumption? A familiar objection to a bond financed tax cut is Ricardian Equivalence: people just save the tax cut because they know taxes will increase in the future to pay the interest on the new debt. Now we know that for very good reasons Ricardian Equivalence does not hold in the real world, so we are entering the territory of angels and pins here, and as a result you may want to stop reading now. If not, the question is: if Ricardian Equivalence did hold, would a tax cut financed by printing money be subject to the same problem? Here we come to the issue of whether central bank money is 'irredeemable'. The next point explains.
  9. Ricardian Equivalence works because, to avoid having to reduce future consumption when taxes rise to pay the interest on the government debt created by the original tax cut, consumers are forced to invest all of the tax cut. If a £100 tax cut implies taxes are higher by £5 each subsequent year to pay a 5% interest rate, then if the rate of interest consumers can receive is also 5%, to generate an extra £5 each year to pay those higher taxes they have to invest all £100 of the tax cut. Now suppose the tax cut is financed by printing money. There is now no interest to pay. So if the central bank never wanted to undo its money creation, there is no reason why private agents who hold this money should not regard it as wealth and at some point spend it. This is what is meant by money being irredeemable.
  10. However we need to recall that the central bank may have an inflation target. For that reason, it may want to undo its money creation. If people expect that to happen, they will not regard their money holding as wealth. The logic of Ricardian Equivalence does apply. (The central bank may not be able to reduce money by raising taxes, but it can sell its government debt instead. Now the government has to pay interest on its debt, so taxes will rise.) This is why Willem Buiter stresses that it is expected future money, not current money, that is regarded as wealth.
  11. Tony Yates has a recent post on this. He argues that if the central bank assumes money is irredeemable, and starts printing a lot of it, people may stop wanting to use it. If they do that, it will no longer be seen as wealth. This is real angels and pins stuff that can come from taking microfoundations too seriously. Just ask yourself what you would do if you received a cheque in the post from the central bank. As Nick Rowe points out in this post, we can cut through all this by noting the link between money creation and inflation targets. The money required to sustain an inflation target will not be redeemed, so it can be regarded as wealth.
  12. Suppose central banks do stick to their inflation targets, but are having trouble achieving them because inflation is too low and we are in a liquidity trap. Without helicopter money, the inflation target will be undershot. That is the context of the current discussion. Might agents save the tax cut, because they will anticipate higher prices and recognise that they will need the additional money as a medium of exchange? As I discuss here, this is not a problem because the increase in prices will reduce real interest rates, which will stimulate the economy that way. As Willem Buiter says, "there always exists a combined monetary and fiscal policy action that boosts private demand".

Tuesday, 21 October 2014

UK immigration and social attitudes

In a previous post I speculated on how the disaffected voter could be both part of the UKIP story and also a factor behind the decline in the popularity of the LibDems. But what about UKIP’s two key policy areas: leaving Europe and stopping immigration?

As I noted last time, for most UKIP voters Europe itself is no big deal. It is an issue which will sit naturally with disaffected voters: if UK politicians seem remote to their interests, politicians in Europe will seem even more so. It is not an issue that a large number of voters will regard as all important in itself. Immigration is much more interesting. This post looks at what evidence we can get from surveys about voter attitudes towards immigration.

The first point to make is that a large majority of the UK public have always favoured tighter controls on immigration. (Interestingly, given SNP policies for an independent Scotland, a majority of Scottish voters also want less immigration!) What has changed over the last two decades has been the salience of the issue. (The charts in this post come from the three sources listed at the end.)

This chart is a little busy, but the green line is the number of people rating race and immigration as one of the top issues. The issue was nowhere until the end of the 1990s. Within the space of about four years its importance rose dramatically, and it has stayed as a key issue since around 2003.

The temporal link with actual levels of migration cannot be a complete coincidence.

Note that immigration from the EU only took off from 2004. So freedom of movement for labour within the EU, which is discussed so much in the media, is not the key to understanding voter concern about immigration.

Nor does concern about immigration appear to involve class. Any differences between the standard social classifications (A-E) and voter concern seems to be swamped by a common movement, as this chart shows.

There is, however, an understandable difference between income groups when they are asked why they are concerned about immigration. Those with low incomes tend to want to reduce immigration because of the perceived impact on jobs and housing, while those on higher incomes are more concerned about the impact on public services.

There are also two additional class related factors which do distinguish between voters attitudes towards the impact of immigration. The first is whether the voter has a university degree. For those that do, the majority believe that immigration has benefited the country both economically and culturally, while those without a degree think the opposite. Second, there is a clear correlation between concern about immigration and the newspaper people read. In addition, people seriously overestimate the extent of UK immigration, probably because of the impression they get from reading certain newspapers. To some extent this may be inevitable, as sensationalism like this or this may help sell newspapers to those who worry about immigration. However the fact that large sections of the UK press want us to leave the EU may mean that causality runs the other way, as I note below. (I do not see this as a simple right-left issue, as many on the right are against tight immigration controls.)

Location is also important. One widely reported result is that concern about immigration tends to be higher where actual levels of immigration are low. (An exception seems to be where asylum seekers are placed.) Many have noted that UKIP’s first MP is in a constituency where levels of immigration are very low. Chris Dillow mentions one poll that found that while 76% think immigration is a very or fairly big problem for Britain, only 18% think it is in their own area. Furthermore those with migrant friends were far more likely to be positive about the impact of immigration than those without.

So immigration for many is about a fear rather than perceived experience. The fear is fed not by official statistics but stories in the media. In that sense it is like crime. In the case of crime, the general perception is that crime is rising, even though for many years nearly every type of crime has been falling in the UK. This encourages politicians to focus on the appearance of action: most calculate that they are better off talking about 'cracking down' on crime than in celebrating its decline. With immigration, the political benefits of appearing to 'deal with the problem of immigration' are greater than arguing that, in average economic terms at least, immigration may not be a problem at all.  

Two things make immigration particularly toxic as a political issue. The first is that economic issues (jobs, housing, public services) can so easily be linked to it. However the first chart should warn against a belief that immigration concerns will disappear if real wages begin to rise. The second is the link with EU membership. While it is clear that public concerns about immigration became important long before immigration from the EU rose substantially, it suits those that want us to leave the EU to suggest that EU immigration is critical to public perceptions on this issue. For that reason, it seems unlikely that the political 'problem of immigration' is going to go away as long as the UK remains in the EU. 

If this last statement is true, there is an interesting implication. UKIP can continue to receive strong support by saying that they have the only certain way of 'tackling immigration', and this will be true whatever actually happens to the numbers (immigration is like crime). The question that then arises is whether the Conservative party can live with that. Promising a referendum and then staying in the EU may win the next election but it will not make UKIP go away. Instead the party may calculate that the only way of making the issue of immigration less toxic is to take the UK out of the EU. 

Sources for charts:

Oxford’s Migration Observatory, Ipsos-Mori and the British Social Attitudes survey.

Tuesday, 14 October 2014

The mythical Phillips curve?

Suppose you had just an hour to teach the basics of macroeconomics, what relationship would you be sure to include? My answer would be the Phillips curve. With the Phillips curve you can go a long way to understanding what monetary policy is all about.

My faith in the Phillips curve comes from simple but highly plausible ideas. In a boom, demand is strong relative to the economy’s capacity to produce, so prices and wages tend to rise faster than in an economic downturn. However workers do not normally suffer from money illusion: in a boom they want higher real wages to go with increasing labour supply. Equally firms are interested in profit margins, so if costs rise, so will prices. As firms do not change prices every day, they will think about future as well as current costs. That means that inflation depends on expected inflation as well as some indicator of excess demand, like unemployment.

Microfoundations confirm this logic, but add a crucial point that is not immediately obvious. Inflation today will depend on expectations about inflation in the future, not expectations about current inflation. That is the major contribution of New Keynesian theory to macroeconomics.

This combination of simple and formal theory would be of little interest if it was inconsistent with the data. A few do periodically claim just this: that it is very hard to find a Phillips curve in the data. (For example here is Stephen Williamson talking about Europe - but see also this from László Andor claiming just the opposite - and this from Chris Dillow on the UK.) If this was true, it would mean that monetary policymakers the world over were using the wrong framework in taking their decisions.

So is it true? The problem is that we do not have good data series going back very far on inflation expectations. Results from estimating econometric equations can therefore vary a lot depending how this crucial variable is treated. What I want to do here is just look at the raw data on inflation and unemployment for the US, and see whether it is really true that it is hard to find a Phillips curve.

The first chart plots consumer price inflation (y axis) against unemployment (x axis), where a line joins one year to the next. We start down the bottom right in 1961, when inflation was about 1% and unemployment 6.7%. Over the next few years we get the kind of pattern Phillips originally observed: unemployment falls and inflation rises.

The problem is that with inflation rising to 5.5% in 1969, it made sense for agents to raise their expectations about inflation. (In fact they almost surely started doing this before 1969, which may give the line from 1961 to 1969 its curvature. For given expectations, the line might be quite flat, a point I will come back to later.) So when unemployment started rising again, inflation didn’t go back to 1%, because expected inflation had risen. The pattern we get are called Phillips curve loops: falling unemployment over time is clearly associated with rising inflation, but this short run pattern is overlaid on a trend rise in inflation because inflation expectations are rising. Of course the other thing going on here is that we had two oil price hikes in 1974 and 1979. The chart finishes in 1980.

Most economists agree that things changed in 1980, as Volker used monetary policy aggressively to get inflation down. The next chart plots inflation and unemployment from 1980 to 2000.

Inflation came down from 13.5% in 1980 to 3.2% in 1983 partly because unemployment was high, but also because inflation expectations fell rapidly. (We do have survey evidence showing this happening.) The remaining period is dominated by a large fall in unemployment. So why didn’t this fall in unemployment push inflation back up? In terms of the chart, why isn’t the 2000 point much higher? Again expectations are confusing things. One survey has inflation expectations at around 5% in 1983, falling towards 3% at the end of 1999. So inflation was being held back for that reason. A Phillips curve, and its loops, is still there, but pretty flat.

The final chart goes from 2000 to 2013. Note that the inflation axis has changed - it now peaks at 4.5% rather than 16%. The interesting point, which Paul Krugman and others have noted, is that this looks much more like Phillips’s original observation: a simple negative relationship between inflation and unemployment. This could happen if expectations had become much more anchored as a result of credible inflation targeting, and survey data on expectations do suggest this has happened to some extent. There are also important changes in commodity prices happening here too.

While the change in inflation scale allows us to see this more clearly, it hides an important point. Once again the Phillips curve is pretty flat. We go from 4% to 10% unemployment, but inflation changes by at most 4%. However from the previous discussion we can see that this is not necessarily a new phenomenon, once we allow for changing inflation expectations.

Is it this data which makes me believe in the Phillips curve? To be honest, no. Instead it is the basic theory that I discussed at the beginning of this post. It may also be because I’m old enough to remember the 1970s when there were still economists around who denied that lower unemployment would lead to higher inflation, or who thought that the influence of expectations on inflation was weak, or who thought any relationship could be negated by direct controls on wages and prices, with disastrous results. But given how ‘noisy’ macro data normally is, I find the data I have shown here pretty consistent with my beliefs.


Sunday, 12 October 2014


After Thursday’s UK by-elections, we have had a huge amount of ‘Oh God, what will it all mean, will politics ever be the same again’ speculation. As Labour nearly lost one of its safe seats, they as well as the Conservatives are trying hard not to panic. Some writers have optimistically coupled this result with the Scottish referendum turnout to suggest there is a new engagement in politics (but not of the conventional kind) and a search for ‘political identity’. Others have more pessimistically drawn parallels with the rise of fascism. (Are these two contradictory?)

If you see everything in terms of a left-right spectrum, then UKIP’s popularity seems to indicate a dramatic shift to the right. Here is the share of the popular vote gained in elections since 1945, but ending with an average of current polls.

If we place the LibDems as somewhere near the centre of this spectrum, then we have a fairly even balance between parties of the right and left - until now. So has there been a sharp movement to the right among the electorate? UKIP policies are clearly to the right of the Conservatives. But it may be a mistake to confuse the party and its policies with the views of those currently voting for them. Here is Owen Jones noting how UKIP voters tend to want to renationalise the railways and energy companies, increase the minimum wage substantially, and keep the NHS within the public sector.

Perhaps we should see UKIP as an anti-Europe party, something outside the left-right spectrum? Again the party is not the same as its supporters. Only a quarter of UKIP voters in this survey said resolving Britain’s future relations with the European Union is one of the three most important issues currently facing the country. Conservative MPs may be switching to UKIP because of Europe, but it is not clear that UKIP voters are.

Before leaving this chart, we should note that the rise in UKIP is not the only recent dramatic change. The other is the decline of the LibDem vote. In the by-election where Labour only just retained their seat, we actually saw Labour keep its 2010 share of the vote. The gain in UKIP’s share was accounted for by a roughly equal decline in the share of the Conservatives and LibDems. As many Conservatives will have been voting tactically, we once again see an apparent shift from LibDem to UKIP.

Now we know that around half of UKIP voters used to vote Conservative, not LibDem. We also know that a significant number of ex-LibDem voters (about a third?) have moved to Labour, as we might have expected as a result of forming a coalition with the Conservatives. But about 20% of UKIP voters who voted for another party in 2010 are ex-LibDem voters - that is about half a million voters. (The equivalent number for Labour is 15%) Anyone familiar with LibDem policies would be surprised the figure is this high: UKIP wants to leave Europe, but the LibDems have always been the most pro-Europe party. However this may be making the same mistake again: assuming that voters’ views map to party policies.

Here is an alternative idea that might be part (and only part) of the story. (It is far from original - see Adam Lent for example.) An important underlying trend since perhaps the 1960s is the rise of the disaffected voter. These are voters with no strong ideological affiliations, and with little interest or knowledge of politics. What they do feel strongly about, however, is that politicians in power do not represent their views or interests, and that ‘they are all as bad as each other’. What will attract these voters are politicians who are not part of the ‘Westminster elite’, because they are untainted by government. This is not a peculiar UK phenomenon - not being part ‘of Washington’ is a constant appeal in the US. This, rather than policies, may be the key factor for these voters.

The emergence of this group could explain some part of the rise in the LibDem vote since the 1970s. By joining the coalition after the 2010 election the LibDems not only lost their more left leaning supporters, they also lost the support of the disaffected voter, because they were now part of government. Very quickly their image changed from plucky outsiders to part of the Westminster establishment, and they could no longer be the party of the disaffected voter. But neither could Labour, who not only had been recently in government, but continued to behave as they did in government. The disaffected voter needed somewhere to go, and for some UKIP became their home.

Of course a large part of UKIP’s support is from disgruntled Conservatives. But if that was the complete story, UKIP’s rise would only be a problem for the Conservatives, and Labour would be quietly encouraging UKIP. This is clearly not the case. If this idea of the disaffected voter sounds similar to the old idea of the protest vote, that is partly true, but with an important difference. Protest votes are generally assumed to melt away come general elections, but this will not be true of the disaffected voter. For that reason, expecting UKIP to fade away may be naive. 

By now you are probably screaming: what about immigration! I think immigration is the kind of the issue that the disaffected voter would focus on. But this post is already too long so my thoughts will have to wait, although I think Chris Dillow is on the right track.  

Friday, 10 October 2014

Are DSGE models distorting policy? - a test case

The debate about the current state of academic macroeconomics continues, but it has reached a kind of equilibrium. Heterodox economists, some microeconomists and many others are actively hostile to the currently dominant macro methodology. Regardless, academic macroeconomists in the papers they write carry on using, almost exclusively, microfounded DSGE models. [1] Critics say this methodology was crucial in missing the financial crisis, but academic macroeconomists respond by highlighting all the work currently being done on financial frictions. I personally think missing the crisis was down to failings of a different kind, but that DSGE did hold back our ability to understand the impact of the crisis. However what I want to suggest here is a forward looking test.

Many of the difficult choices in conducting monetary (and sometimes fiscal) policy involve trade-offs between inflation and unemployment. We saw this in the UK particularly after the crisis, with inflation going well above target during the depth of the recession. What you do in those circumstances depends critically on the costs of excess inflation compared to the costs of higher unemployment. Is 1% higher unemployment worth more or less than 1% higher inflation to society as a whole?

What do New Keynesian DSGE models say about this trade-off? They do not normally model unemployment, but they do model the output gap, which we can relate to unemployment. Their answer is that inflation is much the more important variable, by a factor of ten or more. One reason they do this is that they implicitly assume the unemployed enjoy all the extra leisure time at their disposal. I have discussed other reasons here.

Empirical evidence, and frankly common sense, suggests this is the wrong answer. Thanks to the emergence of a literature that looks at empirical measures of wellbeing, we now have clear evidence that unemployment matters more than inflation. Sometimes, as in this study by Blanchflower et al, it matters much more. Another recent study by economists at the CEP shows that “life satisfaction of individuals is between two and eight times more sensitive to periods when the economy is shrinking than at times of growth”, which as well as being related to the unemployment/inflation trade-off raises additional issues around asymmetry.

So the DSGE models appear to be dead wrong. Furthermore the reasons why they are wrong are not deeply mysterious, and certainly not mysterious enough to make us question the evidence. For example prolonged spells of unemployment have well documented scarring effects (in part because employers cannot tell if unemployment was the result of bad luck or bad performance), which may even affect the children of the unemployed. So it is not as if economists cannot understand the empirical evidence.

Does that mean that the DSGE models are deeply flawed? No, it means they are much too simple. Does that mean that the work behind them (deriving social welfare functions from individual utility) is a waste of time? I would again say no. I have done a little work of this kind, and I understood some things much better by doing so. Will these models ever get close to the data? I do not know, but I think we will learn more interesting and useful things in the attempt. The microfoundations methodology is, in my view, a progressive research strategy.

So academics are right to carry on working with these models. But many academic macroeconomists go further than this. They argue that only microfounded DSGE models can provide a sound basis for policy advice. If you press them they will say that maybe it is OK for policymakers to use more ‘ad hoc’ models, but there is no place for these in the academic journals. In my view this is absolutely wrong for at least two reasons.

First, models that are clearly still at the early development stage should not be used to guide policy when we can clearly do better. In this particular case we can easily do better just by using ad hoc social welfare functions on top of an existing DSGE model. (The Lucas critique does not apply, which is why I like this example.) Yes these hybrid models will be ‘internally inconsistent’, but they are clearly better! Second, to confine academics to just doing development work on prototype experimental models is stupid: academic economists can have many useful things to say starting with aggregate models (as here, for example), and this is not something that policymakers alone have the resources (or sometimes the inclination) to do. (We also know that academics will give policy advice, whatever models they use!) Analysis using these more ad hoc but realistic models should be scrutinised in high quality academic journals.

Let’s be even more concrete. Take the debate over whether we should have a higher (than 2%) inflation target (or some other kind of target), because of the risks of hitting the zero lower bound. If this debate just involves micofounded DSGE models which clearly overweight inflation relative to unemployment, then these models will be guilty of distorting policy. This is not a matter of running some variants away from microfounded parameters (as in this comprehensive analysis, for example), but adopting realistic parameters as the base case. If this is not done, then microfounded DSGE models will be guilty of distorting this policy discussion.

[1] A few elderly bloggers, who use both DSGE and more ‘ad hoc’ models and think the critics have a point, are regarded by at least some academics as simply past their sell-by date.

Thursday, 9 October 2014

Do we need a crisis to reduce the deficit?

The macroeconomic case for not cutting the deficit straight after a major recession is as watertight as these things get, at least outside of the Eurozone. (It is also true for the Eurozone, but just a bit more complicated, so its easier to just focus on the US and UK in this post.) If you want to bring the government deficit and debt down, you do so when interest rates are free to counter the impact on aggregate demand. As the problems of high government debt are long term there is no urgency for debt reduction, so the problem can wait. The costs of fiscal consolidation in a liquidity trap are large and immediate, as we have experienced to our cost.

Sometimes austerity proponents will admit this basic macroeconomic truth, but say that it ignores the politics. Politics means that it is very difficult for governments to reduce debt during booms, they say. Although it would be nice to wait for interest rates to rise before cutting the deficit, it will not happen if we do, so we have to cut now. Like all good myths, this is based on a half truth: in the 30 years before the recession, debt tended to rise as a share of GDP in most OECD countries. And it always sounds wise to say you cannot trust politicians.

However both the UK and US show that this is not some kind of iron law of politics. In the UK debt came down from over 100% of GDP between the wars to less than 50% of GDP by the mid-1970s, and was lower still before the recession. (Debt was lower before the recession than when Labour came to power in 1997.) US debt also fell sharply after WWII, but rose again under Reagan and Bush, fell under Clinton and then rose again under the other Bush. So the empirical evidence on US and UK debt is not that it is inherently difficult to reduce in booms; it is do not elect Republican presidents.

My reason for returning to this issue was thinking about the post 2015 UK election plans of all three main political parties. As I have outlined before, all involve tight fiscal control - in my opinion tighter than would be prudent from a macroeconomic point of view. This is fully six years after the recession. So it looks like politics is capable of promising fiscal consolidation well after a crisis. Are we meant to believe that if instead of austerity we had had additional fiscal stimulus after the recession, within the framework that Jonathan Portes and I suggest, things would have been quite different by 2015?

[1] It is true that no party is - as yet - telling us exactly how these numbers would be achieved, but this does not mean it will not happen: the Conservatives delivered in 2010, and Labour broadly stuck to its fiscal rules until the recession. The only party to go back on their election promises were the LibDems, who campaigned for less austerity than they ended up delivering.