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Actually, maybe it is the NGDP after all

May 1, 2012 8 comments

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.

Further lessons:

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.

Categories: Economics