Austerity, crowding out, and Peston.

In response to blogs by Robert Peston, Simon Wren Lewis, and Jonathan Portes.

In Peston’s blog, he says ‘I am simply pointing out that there is a debate here’, after suggesting earlier that ‘maybe the lesson of the last Parliament… is that if you cut deep and early you create room for the private sector to expand.’

Peston is right to say that there is a debate, and that some advocate the view that if you shrink government spending to close the deficit, that you reverse ‘crowding out’ and will see ‘expansionary austerity’.  [those quotes not Peston’s].

But, he gives the impression that the debate is between tribes with equal numbers of members, or who make their points with equal empirical backing.

As Simon responds in his blog, the consensus view is that, at least in normal ranges, cutting G is not expansionary.

Moreover, at the zero bound, the case for deficit reduction not ‘making room’ is even stronger, since it’s much less proven that there can be compensating monetary policy stimulus.

The reason the ‘making room’ argument is false, in my view, and articulated many times over by others, is that it falsely holds national income constant, which is then to be hypothetically to be divided between bad G (government spending) and good the rest (private spending).  In the macro model that has most support in the data this doesn’t hold.  That model is the RBC model with sticky prices, often called ‘New Keynesian’, but whose pretty conservative origins are forgotten in the further shorthand ‘Keynesian’ which Robert uses in his blog.  In that model the initial lowering of aggregate demand puts downward pressure on prices, which subsequently raises real rates, causing aggregate demand from the private sector to fall further.

I said ‘most support from the data’ and by that I mean things like:  if you shock an empirical time series model of the economy with a monetary policy contraction, that has effects on real variables (hard to rationalise without sticky prices).  Or ‘if you look at prices, they tend to spend significant periods not changing’ (!).

Peston scolds Krugman/Wren-Lewis/Portes for the ‘patronising’ view that voters failed to grasp that there is no crowding out at the zero bound.  But the argument is quite subtle.  Lots of students struggle with it.  I find I have to re-learn it all the time, and discover new things each time I do.  Many of my old policymaker customers didn’t get it.  Getting it depends on grasping a lot of mathematical and intuitive machinery and then working out whether you want to buy its logic or not.

I don’t think view got a fair hearing during the election, because all parties judged that it’s too tricky and nerdy to base an electoral pitch on.  Most media outlets probably thought that it was too dry to retain the attention of their readers.  Hence, it’s not patronising at all to question what voters understood.  I take Robert’s branding of the Keynesians as ‘patronising’ to be a somewhat commercially-motivated piece of currying favour with Peston’s large audience.  It probably would not do to infuriate a large number of British reader/license payers with the suggestion that they don’t grasp optimal fiscal and monetary policy at the zero bound.

Jonathan Portes writes interestingly about the natural experiment afforded by the shock result of a Conservative majority.  This is to be interpreted as a broadside against Peston too, who previously invoked the spectre of ‘Mr Markets’, who will run from government bonds if fiscal policy is not adequately austerian.  Jonathan notes that there was no jump up in bond yields once the Conservative majority was made clear.

That is certainly refutation of the argument that any change in future debt trajectory will be manifest in risk premia.  However, theory of sovereign default and bond pricing would suggest that the relation between forecast debt trajectories and such premia would be highly nonlinear.  It might be perfectly reasonable to see moderate changes in forecast debt trajectories affect premia not at all, and for these effects only to be come apparent when debt trajectories are forecast to approach forecast points of maximum sustainable debt.  [I say ‘points’ somewhat simplistically, since such ‘points’ would depend on a forecast distribution of bond prices/implied interest rates themselves.]

Regardless, I don’t disagree with one of the thrusts of Jonathan’s blog.  Since that is: markets did not presume there to be any risk of default catastrophe from choosing a forecast Labour-SNP-LibDem coalition deficit reduction plan versus a Conservative one.  Of course, one has to note too that markets also did not view the Tory plan as leading to self-defeating financial catastrophe either.  Ie markets did not think that Conservative cuts would lead us to look more ‘like Greece’.

One of the other details in Jonathan’s blog, which he and Simon have mentioned before, is that what provides concrete escape from public finance problems is having an independent currency.  I don’t buy that.  As I have said before, since inflation imposes social costs, we have an inflation target, and will always put some weight on its adherence, and markets will expect that.  At some point, plugging a hole in public finances with seigniorage becomes too socially costly because of the resultant inflation that it will not be undertaken, default being a better option, and is what will be expected.  This mechanism is alive and well in the theory, and there are examples of defaults by independent currency governments in the past.  I accept that how much this helps adjudicate debates we have had about alternative proposed fiscal policies in the UK is moot.

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Peter Pan’s quantitative flying

The FT carried reports of the oddest central bank Governor speech I have ever encountered.  Koruda likened the BoJ’s recent quantitative easing policy to a confidence trick.  One that would fail as soon as people stopped believing, just like Peter Pan warned that he would crash if he stopped believing he could fly.

Analogy:  imagine the head of a retail bank giving an interview from a swanky office: ‘know what?  there’s hardly any of your money actually left in the bank!  We’ve loaned it all out to people!   And we don’t know if we are going to get it back!  We just have to hope that not too many of you come at once to get your cash, because if you do, we are sunk!’

Other central banks have been much more circumspect.   They understand the game the BoJ are playing.  If expected future inflation rises, real rates fall, which encourages spending and the inflation today that will validate the increase in forecast inflation.  But they have also conducted event and time series studies of the impact of QE;  and poured money into conferences investigating its possible mechanisms.  They stress that there is an underlying process that will generate stimulus, and know that it is dangerous to call forth expectations of success if there is nothing behind it all.

I think it would be fair to say that the median central bank has taken a more confident line on the effectiveness of these policies than would an expert with no vested interest.

Bernanke joked that QE is a policy that ‘works in practice, but it doesn’t work in theory’, downplaying doubts that he would have had with his academic hat on about what can be read into ‘working in practice’ without a convincing story [‘theory’].

The BoE, as I have written before, on many occasions put an over-confident gloss on their view of the effectiveness of QE.  Draghi, seeking to convince markets to stop believing that Spain, Portugal and even Italy might leave the Euro, and have their debts redenominated, said that they would ‘do whatever it takes’, in the form of literally unlimited purchases of short-term debt.  He could not have meant what he said, because there was surely no support for exposing EU tax-payers to unlimited corresponding losses.  [See old blog].

But imagine what would have happened if he’d said ‘please, let’s just hope that the Euro stays together.  Let’s just hope that someone does whatever it takes, whatever that might be.’

Koruda might be right.  He might even think that he might be right.  But if he does, he should keep it to himself, and keep polishing the emerging narratives about how QE might work, and putting aside some of the associated seigniorage for those research conferences.

Greece vs the Troika and the trouble with democracies

The Greek crisis being a spectacle of financial warfare between creditors and debtor, rather than an exercise in benign social planning, it’s instructive to think about the difficulties posed by Greek democracy in reaching an agreement, through the jaundiced eyes of the creditors.

Before the Troika allow release of the remaining 7.2bn euros of the second bailout fund, or think about a further agreement involving debt structuring or write-downs, they want something in return.

That something is structural reform.  An unfortunate term for a rag-bag of regulations to make Greek welfare, public sector procurement and hiring, minimum wage laws, product markets and tax collection conform to norms in the rest of Europe.

These things are wanted partly for the debatable reason that if they are enacted this will make further Greek bailouts less likely;  partly out of a conception of what is fair; and because it is easier to sell the gift of debt forgiveness if the Greeks are made to concede something they would rather not.

All that said, whatever the current Greek government agree to on structural reform, they can’t bind the hands of their successors.

The creditors know that if they offer debt forgiveness, once that is pocketed a future Greek government a few years down the road can simply turn undo their good work.  Indeed, they might have to promise to renege to command electoral support.

Few electorates, let alone that of the current traumatised Greek polity, can be counted on to express choices that are much elevated above wanting ones cake and eating it.  So one can hardly expect an electorate to encourage Syriza’s successor cabinet to worry about the tricky issue of sustaining reputational equilibria in a bargaining game with the Eurozone creditors.  Or to think that the Eurozone creditors would think this.

Hence, there is probably more than simple political symbolism behind a reluctance to write down debt completely.  If the burden of debt is relieved by temporary, but adjustable deductions to market interest rates, and/or putting back the date when it has to be paid back, creditors have some hold over governments that follow Syriza and would otherwise have their own political imperatives.

This safeguard, presuming it’s kept, will not be without its consequences.

It no doubt risks a drawing out of the uncertainty around Greek finances, dampening activity.  And it will probably entail a prolonging of the political as well as the economic agony, giving energy to the anti-Eurozone, even the anti-capitalist strains in the Greek popular reaction to the calamity they have lived through.

But, of course, with their own political futures to look out for, the creditors can’t help themselves either.

 

Feldstein, money, inflation and the zero bound

I just came across this by Marty Feldstein, circulated by Matt O Brien on Twitter.  And it’s mighty confusing.  The premise of the article is the puzzle that the rapid expansion of the monetary base since the onset of the financial crisis was not accompanied by the historically normal corresponding increase in prices. But why should this be such a puzzle?  Standard models of money demand predict that as the cost of holding real money balances [that’s money divided by prices] falls, the demand for them rises.  This requires assuming that real balances have some use, and for sure many are still justly pondering just what that is, but I doubt that Feldstein would depart from the holding answers we have developed thus far. So during any period when nominal interest rates fall sharply, we would not expect money and prices to move one for one because real balances will increase.

Moreover, notice that what has happened is that base money has expanded while interest rates have been at, approximately, the zero bound.  The same standard model supposes that the market for real balances clears.  And that interest rates at the zero bound implies that the amount of usefulness yielded by the last increment in real balances has also fallen to zero or thereabouts.  Implying, given how we normally assume that this increment falls as real balances increases, but by less each time, that real balances are tending to infinity.  Taking the model literally, there’s no reason to expect the price level to move at all with the expansion of money.  [This is a crude version of the story told by Krugman and later Eggertson and Woodford].

Go back a few years, and you will see that Feldstein edited an NBER book of papers explaining the ‘costs of inflation’.  And the fulcrum of this work is the deadweight loss imposed on society when high inflation, and corresponding high nominal interest rates in the steady state [courtesy of the Fisher effect], causes people to cut back on real balances.  Which, since these balances are assumed to be socially useful, is costly.

So the key to Feldstein’s puzzle is in his earlier work on the costs of inflation.  Just reasoning the other way along the demand curve for real balances.

Some Keynes personal history you might not have read yet

This post following exchanges on Twitter this morning.  It’s a link to a piece written by Ariadne Birnberg.

It’s family-unit self-promotion, since Ari is my wife.  But relevant to the general theme of this blog, as it recounts the story of her grandmother, Naomi Bentwich, who typed up ‘The Economic Consequences of the Peace’ for Keynes.

Brief sketch:  While working for him she became convinced he was in love with her.  Was dispensed with after confronting him with this.  And, seemingly, lived on with this delusion, divining messages in his journalism, and driven to write her own autobiography about her and Keynes after being interviewed by Roy Harrod, who was writing his own Keynes biography.

Here’s the article:  Most Beautiful Maynard.
[Link corrected from earlier draft].

 

More tax collection now in Greece isn’t so great!

I just had an email conversation with Greek macroeconomist Evi Pappa who is a Professor at EUI in Florence. 

She made a point about tax collection that I had, for some reason, not grasped, even though it’s blindingly obvious.

Right now, in the throes of an aggregate demand death spiral, cranking up tax collection on the mass of the population is not going to help.  Because it’s an increase in taxes!  [That’s the mental leap I made today!]  And will depress aggregate demand still further.  And, since they are in a single currency, there will be no compensating monetary policy loosening for them.

In the longer term, tax evasion is obviously vital to sort out.  But if that task has to be begun right now, the best thing would be to cut tax rates so that increased tax collection did not mean higher tax revenues.   In fact, in the short-term, cutting tax rates might actually help spread the custom of collecting and paying taxes more widely.  If think of tax evasion as a costly activity, then we might expect that, without changing the costs of tax evasion, cutting tax rates would lower the returns to tax evasion, and, hence increase taxes paid.  [h/t Pontus Rendahl at Cambridge for pointing this second rather basic point out to me].

Of course, a lot of Syriza’s rhetorical focus on this has been about extracting more revenues from the rich and super-rich.  Extracting that money would not depress demand much, because those individuals tend to have very low propensities to consume out of marginal income.  But if that can’t be done without the collateral damage imposed by much wider tax collection on the weight of lower and middle-income individuals, then better to postpone until the trajectory of the economy is more certain.

But try telling this to Greek’s creditors.

And we can make similar arguments about G.  That’s government spending.  The pensions and civil servant salaries that are the focus of so much outrage are the Greeks digging Keynesian holes and filling them.  And whatever the rights and wrongs of those payments six months ago, they are more needed now than before.

There’s an irony in the fact that the way the argument has played out between Syriza and the Eurogroup, which has led to renewed recession in Greece, and flight from Greek banks, has actually taken what is optimal from a politics-free perspective further away from what is politically feasible.

If there were no issues about sovereignty, moral hazard, tit for tat, credibility, etc, the best thing now would be for a much more generous package in the short-term, to counter the recession, relative to the situation last Summer.  However, Syriza’s own tactics, the ‘do what I say or I will blow my own brains out’ strategy, and Eurogroup’s probable increased scepticism about the Greek’s capacity to stick to conditions that would go along with any deal, mean that what they are prepared to offer is probably not more generous than before, and perhaps harsher.

Conserving Keynes

Paul Krugman swats aside my naive plea for a New Keynesian consensus on fiscal policy, suggesting that conservatives have always been opposed to Keynes.  But I stand by it.  I think our Conservatives [UK, big C] were tethered by those views.  Else why be so gentle, 2010-2015 and now?  Not all of them, for sure.  There’s audible commentary complaining that the job was only half-done.  The job being deficit reduction.

And if we go back further in history, say to the post-war period, there was essentially a consensus about Keynesian demand-management.  In my view this was never really ditched, either, in the 1970s and 1980s.  It’s just that we came to understand the inflation process better, how to do monetary policy and fiscal policy together.  There are some notable contradictions to this view, of course, like the March 1981 Geoffrey Howe budget that prompted the 364 economists letter.  But, later on in that period of Tory hegemony, there were Keynesian flavours.  Nigel Lawson, despite believing that low-taxes/small state was good for long-run growth, also knew that cutting taxes was stimulative in the short run, and would help them get elected.

Actually, I think I’ll stop there.  After all – applying one of the lessons of the initial exchange here to myself – I’m not a historian and should stick to economics.