Paul Krugman, Simon Wren-Lewis and Eric Lonergan weighed in on the issue of whether, in 2010, the Coalition’s initial inclination to ‘austerity’ was justified or not. Mark Gregory also made a good point on Twitter which I want to recount.
Responding to some of these…..
Krugman concurs that one cannot always, even in a country with its own currency, independently pursue every separate pair of monetary financing and inflation objectives. But he points out that in a depressed economy, with inflation below target, the expectation of monetary financing of outstanding debt would be welcome. Hence my support for the initial austerian drive of the Coalition, which was to avoid the market forcing the issue, was unfounded. Maybe so.
Two points, however.
First, although in a model world, with an omniscient government-cerntral bank, and one that could commit, one could calibrate the amount of monetary financing that was consistent with hitting ones long-term inflation objectives, I don’t think this is achievable in practice, and it would have been hazardous to try. In John Cochrane’s masterful paper on debt management and the fiscal theory, he explains how with the appropriate tweaking of the maturity structure of nominal debt one can not only hit a particular inflation target, but one can generate any trajectory for the price level one wants. In a replay of the actual world in 2010, however, I think it would have been legitimate to worry that the self-fulfilling amount of monetary financing induced by really going for it on the deficit could have dwarfed what was desirable, and that there were not the institutions to commit such that this financing could be regarded as a choice variable.
Second, although the UK was clearly a depressed economy, inflation was quite a long way above target. So no monetary-financed-induced inflation was actually wanted. There were plausible reasons to think that was a temporary thing [PK mentions, fairly, the delayed pass through from the depreciation of Sterling in the immediate aftermath of Lehman’s]. But there were also reasons to think that actually supply was as ‘depressed’ as demand. This is what, for instance, would have been predicted by a financial frictions modified version of the New Keynesian models central banks were using. Falling bank net worth causes them to constrict finance to firms; falling firm net worth causes their cost of finance to rise independently. Both curtail capital-formation and restrict supply.
PK asks why it was logical to worry especially, in regard to UK fiscal solvency about the financial sector. This question throws me a little. There’s no special insight here. Just that we might have been viewed as ‘like Ireland’, say. A disorderly exit of Greece/Portugal/Spain wasn’t so improbable [PK himself was pessimistic in the early phases of this episode that the Euro would hold together]. The direct exposure of UK banks to this event was not huge (a couple of tens of billions?). But their exposure to other parties who were directly exposed to it was. And a policymaker would have been forgiven for adding onto these figures potential losses from the mysterious contagion fairy. All said, the need to inject capital, and to make explicit a healthy guarantee on UK deposits could quite easily have required £200bn or so of government financing. Perhaps more.
Krugman [and others too] then ask: why not deal with the high inflation with tighter monetary policy, rather than tighter fiscal policy? I don’t feel I have to answer this. All I am claiming is that in the initial phase of the crisis it was plausible to view the demand-side stimulus as having been calibrated roughly right. The surge of inflation above target seemed like a ‘price worth paying’. I think it was one undertaken with some trepidation by the BoE’s Monetary Policy Committee. And there was a fair amount of grumbling from the conservative/market oriented press about the inflation target having been abandoned. But that was rightly ignored. To reprise my original point; fiscal finances were plausibly viewed as imperilled by another financial crisis; credit constraints meant that there was no risk of deflation. Therefore the economy could take some tailing off of the deficit.
Mark Gregory pointed out on Twitter that this may be a way to rationalise what was done. But one can’t claim that that was indeed what was in the Treasury’s mind when it embarked on Plan A in May 2010. True enough. There we should recall Simon’s many interjections drawing attention to the Conservative Party’s determination to use the cover of balance sheet repair to undertake an opportunistic shrinking of the state. And I have to concede that we can’t applaud the Coalition for instrument settings I point out are consistent with a view of the world that they did not hold.
Simon Wren-Lewis points out that we should remember to think as risk managers when devising monetary and fiscal policies [to use the phrase that people thought the fallen God of Greenspan had coined]. In particular, though the MPC-HMT might feel content with themselves that they calibrated the above-inflation-target surge just right with austerity and loose monetary policy, looking back ex-post [and taking a Panglossian view of the subsequent and protracted below target inflation], were they not still reckless in ignoring the risks of trapping the economy at the zero bound ex-ante?
This is a good point and one that is hard to resolve. I’d say only that my argument IS couched in risk-management terms, since it’s about the countervailing risk of exploding the public finances and the monetary framework. Granted, that was not the only risk that had to be contended with.