I’ve gotten a lot of really smart pushback on my claims about the UK economy, and I think I have significantly underestimated what I already believed to be a substantial aggregate demand shortfall. First, here is a comparison of UK NGDP at *basic* prices (to eliminate the VAT distortion, h/t to the most excellent Britmouse) compared to the US:
The NGDP shortfall in the UK is significantly higher than the US. Furthermore, it is worth noting we had no less than *5* consecutive quarters where NGDP feel at an annualised rate of greater than 1%, and the recovery was slower. Essentially, our NGDP collapse was much more drawn out (although in the US it was a little sharper, but my gut that more drawn out is worse, e.g. it’s harder to hoard labour for longer). Given that we are now about 5% further below trend compared to the US, when using this (probably better) measure of UK NGDP, is it really so surprising things are this bad compared to the States? Think of it this way – if nominal spending was relatively lower, is there any reason to think (ceteris paribus) the real GDP/inflation mix would be more favourable? I don’t think there is, and so I put the lower bound of the output gap relative to the US at about 2%. The total output gap is likely substantially larger.
The second thing that has made me change my mind is I see pretty much no plausible explanation in the data for why we would have had a large productivity shock. At least, it’s not anything remotely near as important as getting more NGDP, pronto.
This is really important. The idea that the output gap is small in the UK is going to make our monetary policy decisions even worse (including how the central bank would react to changes in fiscal policy, given the inflation mandate). Could there be a supply side issue? There could be a small one. But when we look at the NGDP (and inflation) correctly, I think it should be very clear where our priorities lie. And fiscal policy would have its effect highly diminished by the central banks reaction function (which is biased towards low inflation) if it believes the output gap is small. I think it may be time to start making some noise on this.
Also, I said in my previous post that I didn’t buy the post-Keynesian debt story because NGDP was so similar, and there hasn’t obviously been more deleveraging than the US and it couldn’t explain the discrepancy. So, in order to preserve consistency, given this change to my beliefs about relative NGDP, I have moved my subjective probability estimates somewhat in the direction of that explanation. I currently put sticky wages pretty low on my list. I do think sticky prices are the problem (prices clear markets, after all) but I’m now somewhat more agnostic as to which price that is. Which is all the more reason to plump for NGDP (level) targeting.
1) Be very, very careful with inflation and NGDP data, in both choosing the correct dataset and how to interpret it
2) Be very, very careful which base years you use for indices
3) Other people are smarter than you are. Listen to them.
A commenter, ‘david’, says
If you want to contend that there was a real shock, identifying one is not difficult: the economy of the City is heavily involved in finance.
So, if this is right, we’d expect London to be worse affected by the rest of the country, and finance to be especially badly affected. But this does not appear to be the case, based on the ONS’ “Gross Value Added at current basic prices” stats at a regional and industry level (I used the ‘workplace-based’ figures):
Now, Andrew Haldane thinks measuring GVA in the financial sector is problematic. Maybe the data is all wrong. Here’s contributions to GDP growth for 2006-10:
What this seems to suggest was that ‘Business services & finance’ was *incredibly* important to UK growth before 2008, but the reduction in the GDP was slightly more shared around. Here’s the growth in output year-on-year by those sectors:
There are lots of things one could say here. Construction is obviously important. Extraction is not surprising (think ever falling North Sea oil production). But I look at this and see stagnation in manufacturing, utilities, agriculture and (yes) government/other since well before the recession and these sectors took proportionally larger hits in 2009. I think there may be a bigger story, here.
And if I can find a better breakdown for ‘business services and finance’, that may shed a lot of light. But that’s enough from me, for now.
[Update: I added in some missing labels from the first GVA chart. The ever so slight discrepancy between the London total between the two graphs is because the first is 'Headline' GVA and the other is just 'GVA'. In the notes to the stats, it says "The headline regional GVA series for this publication have been calculated using a five-period moving average."]
A commenter ‘Alex’ over at Interfluidity directs me towards Paul Krugman, debunking the idea that the UK inflation has been worse than the US when you take into account the change in VAT. Here is the graph Krugman shows:
What you have to remember is we initially cut VAT before we increased it (and had stimulus before we had austerity). And so you can see my point about how to interpret the recession as a whole. Many thanks to all those who have made comments and provided links about debt dynamics. I will read, ponder and get back to you. But for now I’m sticking to my contention that (given tracking NGDP with the US) the UK experienced a real as well as a nominal shock. As Steve Waldman has pointed out in the comments
below at my previous post, the effect this would have on real wages would exacerbate the problems caused by a desire to deleverage on the part of UK households, and of course these two stories are not mutually exclusive.
*File under: Department of Yikes
Compare the following two charts, again from the Debt and Deleveraging report by the McKinsey Global Institute:
And I remind you again of UK and US Nominal GDP:
I look at these charts and think: “Sorry, which economy is supposed to be experiencing stagflation, and which one is supposed to be in recovery?”
I’m not saying that deleveraging doesn’t matter, I’m saying that it isn’t obvious to me how it is supposed to explain the discrepancy.
From the comments section over at Modeled Behavior:
I’m with you up to “something is wrong with prices,” but where did we get the premise that the price that has something wrong with it must be the real wage. I would suggest the possibility that real wages are a side show and that the price that is out of whack is the real interest rate. Inflation targeting sets a floor on the real interest rate, so if the natural interest rate goes below the negative of the inflation rate, the central bank will (and rightly so, because the cure would be worse than the disease) strongly resist any movement toward equilibrium via adjustments in current prices relative to expected future prices. In theory maybe you could work around this problem by having a huge decline in the real wage, but that would throw other things out of whack. The underlying problem is excessive patience.
If you don’t already, you should follow him on Twitter. Here’s a post from him back in November, making the same point. Here is Karl Smith on the logistical difficulties of saving, my favourite post of the year.
Steve Waldman (of the indispensable Interfluidity blog) has answered my plea for an explanation of the UK’s economic woes, offering a ‘Post-Keynesian’ description of the crisis. I highly recommend you go and read the whole thing before reading the rest of this post.
I am not convinced by the Post-Keynesian story. Waldman discussed the fact that the UK has not stabilised the path of nominal income, and this is true. However, here is a comparison of Nominal GDP for the UK and the USA:
Now, it is true that debt levels are much higher here, but (at least according to the recent ‘Debt and Deleveraging’ report from the McKinsey Global Institute) the country currently undergoing deleveraging is the US:
I grant that if the Post-Keynesian story is correct, it seems plausible we should expect the country with the higher debt to have larger (real) problems given equal deviation from the trend in nominal income. The flip side of this (as we are holding NGDP constant) is that inflation must be higher. But I’m not sure how to tie this whole story together with the fact that the US is deleveraging and we, apparently, have not even started (as of Q2 2011). So, you can colour me confused on this one.
I really hope Waldman is wrong, because I put the probability of nominal income returning to trend as basically zero. NGDP-level targeting may make for economic equilibrium, but I seriously doubt that it is a political one too.
So, I thought I would pen (or, rather, dictate as I am using the latest Dragon NaturallySpeaking voice recognition software, which is excellent by the way) a quick follow up to an email I sent to Tyler Cowen, which he then posted (with my permission) on Marginal Revolution.
First, I would like to make clear I am not ‘pro-austerity’ – not in the UK and certainly not in Europe. But we control our own monetary policy here and that makes all the difference. If you have a problem with the level of aggregate demand in the UK, please take it up with Mervyn King, or with our monetary policy objective which is much more heavily biased towards stable prices than full employment.
Second, there are an enormous number of people in the world who are suffering right now due to deficient aggregate demand. I am one of those people who has a problem with Mervyn King and our monetary policy objective. More aggregate demand, please.
However, I am becoming steadily less convinced that this is the whole story, at least for the UK. Back in November, Karl Smith made the clearest statement I have ever read of the New Keynesian explanation of a recession:
I can’t hammer this home enough. A recession is not when something bad happens. A recession is not when people are poor.
A recession is when markets fail to clear. We have workers without factories and factories without workers. We have cars without drivers and drivers without cars. We have homes without families and families without their own home.
Prices clear markets. If there is a recession, something is wrong with prices.
Right now, unemployment remains at over 8% in the UK while real wages are lower than they were 7 years ago and are continuing to fall. Yes, you read that correctly. Which immediately leads one to ask: on this explanation of a recession as expounded by Karl, how much further do real wages have to fall to eliminate disequilibrium unemployment?
I am not a political person, I’m trying to ask an intellectual question here. As an interested observer of (and, I stress, not remotely an expert on) the economy, I am finding the aggregate demand narrative an increasingly unsatisfying explanation of all that is happening in the British economy. Supply-side suffering is suffering too, and I think we need to take very seriously the chance that it is happening.
(Just a quick one, on a topic I am still highly uncertain and confused about. So be nice.)
I’ve been taught no less than three times that the interest rate is the price of money: once at school, once at college and once again at CFA class. And that doesn’t seem right to me.
First, consider a world without money. I offer you one sheep in exchange for two this time next year. The interest rate is 100%. It expresses the rate at which consumption can be shifted through time.
Second, consider a world where everyone adhered to Polonius’ admonition to neither a borrower nor a lender be. There is still money in this world. It is traded for goods and services. The price of money is the rate at which it is traded for goods and services. That is to say, it is what we normally call ‘the price level’.
So money is not essential to the existence of interest rates, and interest rates are not essential to the existence of money. As the medium of exchange, the price of everything is expressed in terms of money. There is no more a case for the price of future consumption being “the” price of money than the price of kumquats. A price is nothing more and nothing less than the rate at which things are exchanged, and money can be exchanged for anything. Considering this, I find it hard to see why setting an interest rate is the ‘essence’ of monetary policy, because it’s just one price among many. That we do it this way just seems like a historical accident.
This is also by way of saying that while I understand the zero-lower-bound issue under the current monetary system, the reason why it’s an issue at all is because normal monetary operations revolve around exchanging an asset that, under certain circumstances, becomes highly substitutable with money*.
Maybe we should choose a different one.
*This is also the only way I have been able to understand the ‘QE is just an asset swap’ objection, but that could be as much to do with my feeble brain as the quality of explanation on offer
Yesterday, some guy obviously *pretending* to be me wrote some seriously crazy stuff on my blog. He thought that reserve ratios made no difference to the banking system, and basically bought the MMT line that the only thing that matters is bank capital. But here’s a pretty simple reductio: if reserve requirements are 100%, then deposits finance zero lending. Since banks make money by lending, no bank will (voluntarily) pay interest on deposits. 100% reserve requirements completely divorce lending and deposits. Duh.
How could that guy be so wrong? Well, maybe he thought about it this way. Suppose reserve requirements were increased in such a way that there were no longer enough reserves to sustain the current level of deposits in the economy. In order to prevent a likely deflationary contraction (decrease in V), the central bank creates more reserves (increase in M). As long as no one changes their intertemporal consumption preferences or the balance of their portfolios (a whopping great big howler of an assumption), this *appears* to have no effect at all on the economy or the banking system. The Fed can just create more reserves, whilst managing the marginal cost of loanable funds, and everything seems to go along as normal. But this cannot be right, because if reserve ratios increase then deposits ‘fund’ less lending and banks won’t pay as much to compete for them. The central bank makes up the difference. Interest on deposits fall, and ends up being paid to the central bank instead (as I’m assuming for the moment the Fed funds rate stays the same, and this is supported by repo transactions which earn the Fed interest). Of course, this isn’t even remotely close to an equilibrium, as a reduction in the interest rate on deposits will cause depositors to re-balance their portfolios, affecting both AD and the natural rate of interest (and hence the optimal Fed funds rate under the policy regime).
Basically, an increase in the reserve ratio (under a monetary policy regime like in the US) redistributes seigniorage away from depositors and towards the central bank*. Depositors then take some action to mitigate this by re-balancing their portfolios, with the central bank then counteracting any effects of said re-balancing on the policy target. If any of this re-balancing is towards higher consumption, the Fed funds rate will have to increase (reflecting the change in intertemporal consumption preferences, and hence the natural rate of interest). That being said, as the Fed remits any net income to the Treasury, it’s a little more complicated as less taxation/bonds would be required to finance any given level of government spending.
In conclusion, that guy who took over my blog really should have just spent Sunday morning watching the tennis instead. What an idiot**.
*This, I think, is just another way of making Nick Rowe’s point in the comments on the previous post. I’m seriously considering just outsourcing all my beliefs to him, and being done with this whole ‘having opinions of my own’ thing
**In that guy’s defense, this stuff is (in my view) pretty damn hard. It’s unbelievably easy to make silly mistakes – even if you have a Nobel prize. So be nice… if you happen to see him around
Why do we have fractional reserve banking in a fiat currency world? (speculative, blue-sky thinking, tell me why I’m crazy)
UPDATE: I have a new post here, arguing that this post is wrong.
If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated – David Hume
OK guys, you’re going to have to bear with me on this one because I’m in blue-sky thinking mode – so usual caveats on speculative thinking apply double for this one. What would happen if the central bank just said “We’re implementing a 100% reserve ratio, but don’t worry we’re just going to create all those reserves in your account with us at a click of a button”? I can’t see how anything would happen at all. It wouldn’t be inflationary, because it would make no difference to people’s decisions or ability to use their money to chase goods and services – ‘the coin be locked up in chests’. But it would mean there are no bank runs, because ‘the money is always there’.
So, why can’t we just do this? The central bank can control the money supply as before to maintain a certain policy target, the only difference is there are now tons of new reserves sitting in accounts with the central bank that aren’t allowed to ‘go anywhere’ due to the 100% reserve requirement. The new reserves are created by the central bank as needed, and everything just goes on as before. Except that old-fashioned bank runs would not happen.
Am I crazy? What else would happen to the banking sector if we did this? How would it affect the natural rate of interest? This smacks of WAY-too-good-to-be-true, and I thought the most efficient way for me to find out where I’ve gone wrong here is to open myself up to public humiliation for having missed something totally obvious.
FWIW, the way I ended up at this conclusion was wondering as to what would happen if we increased or decreased reserve requirements, which seemed to me to be precisely nothing – as the central bank (if it was doing it’s job) would just offset the deflationary/inflationary effects caused by a massive reduction/increase of supply in the market for excess reserves. So long as the central bank controls the price in that market, then I can’t see why reserve requirements matter at all. Except that less reserves means more bank runs.
This is by way of saying that I can’t think of any objections to the full-reserve position that are not general objections to the marginal cost of funds being the key instrument of monetary policy, which would apply no matter the regulatory reserve requirement ratio.