Free Lunch: The assault on austerity

Δημοσιεύθηκε: 1 Μαΐου 2015 - 12:23

The holes in the argument

In a last all-out assault before the UK election, the critics of the outgoing coalition's austerity policies are aiming to get history's verdict on their side. In the Guardian, Paul Krugman writes that the case for spending cuts "was a lie". Simon Wren-Lewis's J'accuse in the London Review of Books is entitled "The Austerity Con". Both pieces are worth reading: the authors are detailed and devastating in the intensity with which they take on the coalition government's policy and rhetoric. (For those who really want their fill, Wren-Lewis has a piece into the New Statesman as well, plus a 10-part epic on his own very readable blog). There are also two big holes in their reasoning.

The Keynesian basis of the overarching argument is well-known and should be uncontroversial: cutting government spending or raising taxes in a recession, all other things being equal, mechanically lowers demand in the economy. Unless other things also change to offset this mechanical effect, growth falls. It is true that even this is disputed by some of the more ideological adherents to austerity. But for those interested in the truth, the debate is over how other things could reasonably be expected to change.

Krugman and Wren-Lewis gamely take on the most obvious other factors. One is monetary policy - as George Osborne explicitly stated from the outset, monetary policy makers should be expected to stabilise the economy. The other is the private sector - if private saving and spending decisions respond to government fiscal policy (beyond the mechanical Keynesian effect), they will reinforce or counteract the policy's direct effects. The crucial question is which - does the response compensate for the fiscal cuts (or even overcompensate), or does it worsen them?

Take monetary policy first. Both critics suggest that in more normal situations, where monetary policy can boost demand, fiscal consolidation would not be a problem. But, they say, after 2008 monetary policy was powerless to do this because of the "zero lower bound" on interest rates. All major central banks had lowered interest rates to close to zero; the Bank of England's bank rate came down to 0.5 per cent. There was nothing more central banks could do to help the economy, say Krugman and Wren-Lewis.

But this is wrong. Denmark's policy rate is now -0.75 per cent. The Swiss National Bank targets a band between -0.25 and -1.25 and is currently achieving a -0.72 overnight market rate. Even if these are as low as one can go (and there is strong reason to think rates can be pushed even lower), they mean that the BoE has had 1.25 percentage point of bank rate ammunition available to it throughout the crisis. That's a huge amount of conventional policy powder to keep dry when the economy is languishing. And, of course, there were other things the BoE could do, and did. It started quantitative easing - buying gilts - in 2009. But here too, it was hardly up against a bound: it could have bought more and faster.

It is curious how quickly Krugman and Wren-Lewis pass over these monetary policy insufficiencies. Both take it as a given that monetary policy had reached a zero lower bound by 2009. Krugman spends only two sentences mentioning the evidence that this was not so, only to summarily dismiss its relevance. Wren-Lewis doesn't mention it at all, though he explains QE. (It's unclear whether he thinks it had much effect and in any case doesn't state the BoE should have done more of it). Yet without the premise that monetary policy makers could not do more, their entire argument becomes very lopsided. If the BoE was voluntarily keeping monetary policy tighter than it could have been, isn't that where the blame is due? The FT, for example, told the BoE again and again that it wasn't doing enough.

Second, the private sector response. Krugman and Wren-Lewis rightly call out the government's overblown rhetoric of comparing the UK with Greece. The similarity between the two countries - the size of the fiscal deficit - was less important than the differences - the much smaller UK public debt and the UK's retention of national money presses. Those arguing for prompt fiscal consolidation in 2010 feared that high deficits would spook the private sector into cutting spending and perhaps even into a bond market panic, with higher interest rates depressing demand even further.

Krugman famously dismissed this worry as a belief in "bond vigilantes" and "confidence fairies". But what, exactly, is his and Wren-Lewis's argument for dismissing them? Surely not an appeal to Keynes, who thought animal spirits could do a lot of irrational things. Instead they both make a claim that a government bond market panic is impossible in a country with its own central bank. Because it can always print money to service its debt, investors will never worry about their money not being paid back.

But of course it's possible. As Wren-Lewis himself recently wrote: "Having your own central bank does not rule out the possibility of default." If money printing comes with a cost - economic or political - then default is conceivable, and if default is conceivable, so is a self-fulfilling run. Wren-Lewis, rightly, thinks that in a depressed economy, money printing is not costly in a direct economic sense - on the contrary it is beneficial because it keeps rates lower than they otherwise would be. (That is why the BoE should have done more of it, but Wren-Lewis prefers training his guns elsewhere.)

What about the political cost, however? Recall that the then-governor of the BoE took no pains to hide his view that deficits were becoming too large for his liking. Without revoking central bank independence, could the government have relied on the BoE doing "whatever it takes" to rule out capital flight from the gilt market? If not (and if revoking independence in order to monetise deficits would be politically intolerable), it was still reasonable to worry about a self-fulfilling run. In the UK, such a run was no doubt unlikely, but here we are in the territory of disagreements about probabilities, not lies about impossible dangers.