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.