Wren-Lewis and Rogoff on UK austerity

A couple of quick points following on from Simon Wren-Lewis’ mainlymacro post in response to Rogoff’s piece about UK austerity.

Simon argues that the insurance against a flight from UK sovereign debt that ‘austerity’ provided (in quotes because, let’s face it, ‘austerity’ still involved a substantial build up in debt) was not needed because we had QE instead.

I think this is a tricky argument.  For two reasons.  One is a counter to an argument not made by Simon, but I’ll make it anyway.  At the outset, there was almost no positive evidence that QE would work.  We had extremely unpromising circumstantial evidence from the long period Japan had already spent at the zero bound, in deflation, trying QE (albeit that there are criticisms to be made about how they went about it there).  We had a few pieces of research on Operation Twist in the 1960s, and on the time-series of debt management, concluding that debt management (essentially the same as QE) doesn’t matter much.  Since then, there has built up a substantial body of evidence that especially the early QE tranches did lower bond yields (though there are reasons to be sceptical about it, as I and others have argued – see here).  But this evidence didn’t exist at the time.  So it would have been highly reckless to rely on QE as insurance.  (And I think it was highly reckless of the Bank to rely on it anyway, regardless).

The insurance benefit that Simon emphasises is the promise or ability to inflate away the debt with QE.  Personally, I don’t see this as much of a benefit.  As an aside, this wasn’t what the Bank was promising.  It stressed at the outset that QE would be reversed, and was in pursuit of, not attempting to subvert the promise to keep inflation at 2 per cent.  So a different policy would have been needed.  But anyway, inflation is default by another means, and would have similar consequences for the cost of subsequent debt finance, and lead to similar constraints in the ability of future governments to do the kind of fiscal stabilisation policy that Simon’s blogging and research argues for.

Although this wasn’t claimed in either of Simon or Ken’s pieces, I also think it unsound to conclude that the insurance motive to be cautious about fiscal stimulus has gone away entirely.  I think the risk that markets simply conclude UK fiscal policy is crackers is non-existent.  But the risk of a euro-area sovereign-banking crisis is still palpable, and conditional on that materialising the risk of our banking system going underwater, given all the exposures to Spain, Italy and peripherals, and to other parties that are, is extremely high.  For that reason, we have to be sufficiently below what might be guessed to be a sustainable debt ratio to handle a further wholesale recapitalisation of our large banks.  That’s why in the past I argued that no more fiscal stimulus was wise, whatever you thought about its desirability on output gap grounds.