Mediamacro myths. The third way.

Simon Wren Lewis has a string of posts explaining what he describes as several ‘myths’ of ‘mediamacro’, and contrasting that with how he sees the true narrative of the financial crisis and the different governments’ conduct during it.

I want to recap on a few points where I depart from his narrative, compelling and persuasive though it is in large part.

I do think in broad terms the initial drive to austerity was warranted.  [Though this is enough to embrace either the path the Coalition chose, or the one that Labour were proposing at the 2010 election].

And on two grounds.

At that time, there was a real sense that our own banking system could have been engulfed by a second financial crisis, and that this would have stretched our sovereign’s ability to pay.  Simon has pointed out, persuasively, that spreads on UK debt were not blowing up at the time, and so this casts doubt on those worries.  That said, there’s lots about measured market views about things that is puzzling, all the time.  For instance, I find it perplexing [though I haven’t to my knowledge been joined in this view] that markets believed the ‘do whatever it takes’ promise behind the ECB’s OMTs [Outright Monetary Transactions]. Which to my mind seem nothing more than a successful bluff.  It’s also worth pointing out that just as there can be bad self-fulfilling prophecies in sovereign markets, there can also be good ones.  Just perhaps this explains the apparent success of the ECB and the UK case too.   I’d also note that markets don’t know everything.  There’s a lot that the BoE/PRA know/knew about the state of bank finances and exposures that markets don’t/didn’t.

I also don’t buy that having your own currency frees you from sovereign debt problems.  Though it’s true that the issuer of an independent currency can always print it to meet any financing obligations, it can’t do that AND hit other macroeconomic, particularly inflation objectives.  And it’s perfectly possible to conceive of a situation where default is a better option than a hyperinflation needed to plug a large hole in government finances.  If it comes via expected inflation, you need a lot of seigniorage to finance goverment, and can wreak catastrophe on the un-indexed [read poor] and on future credibility.

These worries did not come to pass, but I found them persuasive at the time, and the fact that these risks did not materialise doesn’t negate that they were part of the distribution of plausible events.  We should remember too that it’s not as though monetary or fiscal policy was drastically tilted to cater for these worries, and rightly so, in my view, since, even for me, they were tail events.

A second reason why the initial push to austerity seemed ok to me was that inflation was well above target.  At that point, therefore, it seemed plausible to view very weak levels of activity as in large part a problem of the financial crisis having throttled the supply side.  Something which it was worth fighting against with fiscal and monetary policy, but which high inflation indicated that as much was being done on both fronts as was warranted.

Someone arguing from Simon’s perspective might counter at this point and ask:  isn’t the fact that inflation has been protractedly below target vindication of the Krugman-Wren-Lewis position?  That’s certainly arguable.  It’s conceivable that the supply-side factors pushing up on inflation in the early phase of the crisis should have been seen as temporary things masking the overriding weakness in demand, and something monetary and fiscal policy needed to look through.  However, even accepting that, there was the offsetting concern of being prepared for the Eurozone related implosion of the remainder of UK banks, already referred to.  And, regardless, one can put the weakness of inflation down to a failure of fiscal policy to switch modes quickly or far enough once it became clear that our own sovereign-banking nexus was going to be ok.  Indeed, even such relaxation as was allowed by Osborne was accompanied by disastrous expectations management in the form of an attempt to deny that there had been any change of plan.

The rest of Simon’s narrative I buy, pretty much.  And right now wish that parties postpone deficit reduction until the recovery has got to the point where interest rates could be lifted clear off the zero bound, and have enough room therefore to compensate for any fiscal contraction.  [And regret that the BoE as repeatedly implied that it has the tools to do whatever it takes to meet the inflation target under current envisaged future fiscal policies].

Once accommodation with monetary policy was possible, I’d be in favour of switching to a fairly hawkish fiscal policy, to facilitate paying down the debt so that in the not too distant future we could run it up by another 40 percentage points again to alleviate the burden of the next major economic crisis that comes along.

I am also not sure about the inference that ‘mediamacro’ is conspiratorial in any sense.  Note that Simon does not claim this.(1)  But in case anyone extrapolates to take mediamacro as that, I’m not willing to go so far.  I’ve met a few of the protagonists, and they seem to be very clever and opinionated and fiercely independent.  They probably also know that their personal brands would implode if they were sniffed out as peddling something that they did not themselves believe.

I’d finish with a classic bit of academic fuzziness too.  Even though there are lots of holes in the Coalition narrative SWL and PK identify – and I concur with them on a lot – we have to be mindful of the fact that ‘macromacro’ [the antidote to medicamacro] itself is a rag-bag of work in progress.

If I knew the New-Keynesian plus financial frictions model of money, macro and unemployment to be true, I could trash to pieces most of what the Coalition say.  However, this body of knowledge begs lots of questions itself.  We could turn this very uncertainty back on the Coalition, of course.  At many steps they were saying ‘this is how it is, and this is what we should do about it’.  And the reply would have been.  ‘Well, actually, things are a lot more nuanced than that, and the weight of evidence points in this direction.’  But in doing this, we have to concede that there is no cast-iron account of the causes of and conduct during the crisis with which we can beat the Lib-Dem-Tory policymakers.  In previous posts on the New Keynesian model Simon actually points out some of its flaws.  He doesn’t buy its strictures that such high weight be placed on deviations of nominal things from target [which under some circumstances would have meant worrying a lot about the initial large deviation of inflation from target in the crisis].  And sees [rightly] many of its foundations in micro as dubious.

For me, the logical corrollary of that scepticism is that our distribution over possible explanations of and prescriptions for what we saw has to be somewhat diffuse, and no complete rhetorical victory is possible.  There probably is something in mediamacro.  I don’t believe in it myself.  [More precisely I put a low weight on it being true].  But we can’t discount it entirely.

(1) In the first version of this post I wrote that I could not remember whether Simon had or had not claimed a conspiracy of mediamacro.  Simon put me right and pointed out that he had not.  Apologies, Simon!