Myths: a reply to Tony Yates

Source:  Myths: a reply to Tony Yates    Tag:  dqe
In this post Tony was responding to both my mediamacro series and Paul Krugman’s Guardian article, but I’m going to focus on the former. That is because I think Tony only really has a problem with the first in the series, which was about the 2010 ‘crisis’. So his ‘third way’ is really 7/8th my way! He also argues that 2010 austerity was not a major problem because of developments in consumer price inflation, but that is an argument that I did not cover in the myth series, because it is not part of the narrative I was criticising. I will address it here.

First the 2010 crisis. Tony agrees that there were no signs of a crisis in the markets, but he rightly says that a crisis could have subsequently happened. If I wanted to be pedantic, I would say that this means he agrees with my criticism of the mediamacro narrative, which at the very least allows politicians to pretend that there was an actual crisis. There is rather a big difference between “we saved the economy from a firestorm”, and “we took prudent action because bad things might have happened”. So maybe 15/16th my way.

As there was no actual crisis, what were the chances of one happening? Eric Lonergan has written a very good response to Tony on this, but he makes an additional point which I have made in the past but which I can too easily forget. Because austerity damages the real economy, it increases domestic credit risks. To the extent that governments stand behind those extending the credit (banks), then austerity can actually increase government default risk. So austerity as a precautionary policy can actually make the outcome you are trying to prevent more likely.

I also think I take a different view to Tony on what might have happened if markets had suddenly taken fright on the deficit and stopped buying UK debt. We agree that the Bank could have just bought the debt - as it was doing anyway under QE. But could it control inflation at the same time? At first sight it seems obvious that printing more money to buy government debt would compromise the inflation target. But that will not be true if you are at the Zero Lower Bound (ZLB), and austerity is only a problem at the ZLB. Paul Krugman has written a paper on this, but it becomes irrelevant because of our second disagreement.

This is that although the lack of recovery from 2010 to 2012 was regrettable, it was also inevitable given that inflation was way above target. Tony sees the MPC as trying - and largely succeeding - in getting the optimal balance between inflation being too high and output being too low. If that is the case, the ZLB was not actually a constraint during that period - interest rates combined with QE were doing just what the MPC would have wanted. This view is also a position that I think most MPC members hold.

Here I think we need to take a step back and think about what good policymaking is. A good policy is one that allows for what might happen, and not just what eventually did happen. In a sense this is a trivial observation: we do not want policies that are OK 51% of the time, but really screw up 49% of the time. However I think, after the event when we know how the world did turn out, it is so easy to forget this key point. We do not want to take taxis that generally get us there a bit quicker by taking risks, but occasionally crash. If we are unlikely enough to take such a taxi, and we do not crash, we do not say to ourselves ‘good choice’.

As Paul emphasises in his reply to Tony, you wait until you are well clear of the Zero Lower Bound (ZLB) before embarking on fiscal tightening. You are about to hit the economy hard, so you want to be pretty sure that someone else will be able to make sure it can absorb that blow. In the case of Osborne in June 2010, we do not know if he even understood the risk, because his keynote speech on macroeconomic policy ignores the ZLB issue. But if he did, he certainly did not think to himself that inflation was going to rise to 5% in 2011 so austerity is OK. (The OBR forecast for inflation was below 3%.)

While on that subject, Martin Sandbu says that as Danish and Swiss rates are now negative, 0.5% was not the ZLB anyway. This is completely beside the point. It was absolutely clear in 2010 that the Bank regarded 0.5% as the lower bound, so they were not going to cut rates further. The Bank was independent, so the Chancellor had to work around what the Bank was actually going to do (and not what five years later we might wonder what it might have done). 

What this all means is that Tony’s argument about inflation is not an excuse for austerity, but an argument about how much in practice it cost. I addressed this argument in detail here. I will not repeat what I said, because I do not want to detract from the more fundamental point above, but the upshot is that the £4000 per household figure that I often quote for the cost of austerity already incorporates some monetary policy reaction to fiscal decisions, so could well include any raising of rates in 2011 if austerity had not happened. But whatever the cost, 2010 austerity was a first order policy mistake, because it took unnecessary and large risks with the economy.