Despite the hysteria from some right-wing bloggers over the size of the deficit, few seem to have even an elementary grasp of basic macroeconomics or recent economic history. One blogger, for example, suggests that: 1) I have “little grasp on inflationary pressures”; 2) we “are undergoing an expansionary fiscal contraction”; and 3) “Obama’s Keynesian stimulus has failed”. These are similar arguments to those made by Spectator editor Fraser Nelson that I rebutted in full in an earlier blog. Fraser had no response, of course. Right-wing bloggers, it seems, want to push the UK economy into a second Great Depression.
So let’s look at their claims. First, there is little evidence of domestically driven inflationary pressures in the UK, as various members of the MPC have made clear. For example, in his written testimony to the Treasury select committee yesterday, the MPC member David Miles argued that more than 100 per cent of the current measured inflation in the UK was due to the temporary factors of a VAT increase, oil and commodity price increases and the depreciation of the currency. The MPC member Paul Fisher and the Bank of England governor, Mervyn King, have made similar arguments in recent speeches. The majority of the MPC does not believe that there are significant inflationary pressures two years down the road, which is what monetary policy can impact today. It also seems unlikely that interest rates were too low in 2009.
In its latest forecast, the MPC has made it clear that it needs to look through the current high levels of CPI inflation, as at the forecast horizon inflation will return to target. The MPC member Adam Posen has stressed that there remains a risk of deflation and I agree with him; the recent decline in oil price and slowing growth pushes us in that direction. This week, Posen said that the Bank for International Settlement’s argument that the Bank of England should raise rates because of non-existent inflation was “nonsense” and he is right. Inflation is likely to plummet as the temporary factors drop out. If the MPC were to raise rates, that would increase unemployment and lower growth.
Inflating the debt away looks attractive, especially where there have been large declines in house prices as there have been in the US, Ireland, Spain and the UK. At some point, interest rates need to rise to normal levels, so that when the next shock arrives, they can be cut. Assuming house prices fall another 15 per cent or so — which seems plausible — then that would leave three million households in negative equity, which they can’t walk away from. If we assume approximately £50,000 of negative equity for each household, that would amount to £150 billion in losses that would fall on banks’ balance sheets. Inflation looks like a better option than that. The problem is trying to create some inflation, given the strong deflationary pressures at work. The right-wing blogosphere’s solution to the problem of negative housing equity is what, precisely?
Interest rates should not be increased right now, which is one of the few things that George Osborne, Lord Lamont, Vince Cable, King and I apparently all agree on. Just think what interest rises would do to homeowners on variable-rate mortgages. Raising rates now would hurt house prices and reduce consumer spending and lower even further the already anaemic growth the UK economy is experiencing — more on that below. Interestingly, the financial markets don’t believe the bloggers, as they are now predicting that the first interest rate rise will not happen until the middle of 2012. Indeed, now the yield curve, which is derived from what is being traded, implies that rates will be 1 per cent or lower for the next five years. The minutes of the latest MPC meeting suggests that the possibility of further quantitative easing — meaning monetary loosening, not tightening — is now back on the table, due to the worry of deflation rather than inflation.
Second, the whole idea of an “expansionary fiscal contraction” is a contradiction in terms. That is clear from what has been happening in Greece, Ireland and Portugal, countries that have involuntarily had to impose austerity measures because they were stuck in monetary union and unable to depreciate their exchange rate. The coalition government decided to voluntarily and unnecessarily impose austerity too deep and too fast, even though the markets were not demanding it.
Contrary to the false claims of Cameron, Osborne and Clegg, the UK economy was never close to bankruptcy and the previous Labour government was not responsible for the global financial crisis. As I have made clear many times, the UK is not Greece, Botswana or Paraguay. This utterly false and dangerous talk caused consumer confidence to collapse even before austerity hits, and I lay the blame for that squarely at senior members of the ConDem government’s door. The collapse in consumer confidence predates and predicts the collapse in consumer spending that is now devastating the high street: the value of goods sold in the high street fell by 1.4 per cent in May, which isn’t surprising, given that real disposable income fell 0.8 per cent in Q1 2011, after a fall of 0.9 per cent in the previous quarter. Over the past few days, Jane Norman, Homeform, Habitat and TJ Hughes have filed for administration while HMV, Carpetright and Thorntons all declared profit warnings. Marks and Spencers started its sale two weeks early with heavy discounting. Without the consumer, the recovery is in doubt.
Talking the economy down even before the full effects of fiscal retrenchment have taken effect has caused the UK economy to slow. I have every expectation that the economic growth will fall even more as austerity hits and it looks like growth in Q2 may well be around zero. The biggest worry is what happens to output in Q3 and Q4 of 2011, which may well come in negative. Today, the ONS revised GDP growth for 2010 downwards from 1.8 per cent to 1.6 per cent, even though the OBR and the Bank of England have been predicting that it would be revised upwards.
Obama’s chief economic adviser and ex-president of Harvard, Larry Summers, recently called the whole idea “oxymoronic” as it doesn’t work. The concept depends on the idea that the public sector is crowding out the private sector, so cutting public spending is a bonanza for the private sector that more than fills the gap.
That is the theory but the practice is totally different. First, in the 1930s, similar arguments were used, which resulted in a fiscal tightening in 1937 in the US. This then plunged the economy back into a double-dip recession. Second, previous examples quoted, such as Canada, cut fiscally in the 1990s but also loosened monetary policy and benefitted from the boom going on in the US. There is no credible empirical evidence that fiscal contractions, without monetary loosening accompanying it, are expansionary. Sorry!
Finally, one right-wing blogger claims that “Obama’s Keynesian stimulus didn’t work”. How do they know what might have been? This amounts to an argument about how the economy would have performed without the stimulus — what economists call the counterfactual.
Right-wing blogs have seriously underestimated the scale of the shock that those of us involved in the crisis, including me, observed at first hand. There are a number of authorities on this issue that believe this is a once in 100 years event — a Taleb-style black swan. Ben Bernanke, governor of the Federal Reserve and the world’s most distinguished scholar of the Great Depression, argued recently on 60 Minutes on CBS that without fiscal and monetary stimulus, unemployment would have been 25 per cent and the US would have entered a depression. Mervyn King has used equally apocalyptic language about the severity of the shock the UK faced and I concur.
Last week, at Dartmouth, I attended a speech by Tim Geithner, currently secretary of the Treasury and previously governor of the New York Fed and FOMC member, who argued: “Most of what feels bad about the American economy today is the aftershock of the crisis . . . We were on the edge of a catastrophic collapse . . . We looked into the abyss . . . We were at the cliff edge.”
The ex-deputy chairman of the FOMC Alan Blinder, in a recent paper, estimated that unemployment would have been around 16 per cent rather than 25 per cent but still markedly higher than the 10 per cent it reached. Further, in a recent column in the Wall Street Journal, Blinder argued that he sleeps well at night knowing that there is gridlock on Capitol Hill and consequently fiscal austerity will not be implemented any time soon. It is hard, admittedly, to separate out the effects of monetary and fiscal stimulus as they were implemented together but collectively they prevented the US economy from heading over the cliff. In my view, the same is true of the UK. The reader is faced with the easy choice between the views of Bernanke, King, Geithner and Blinder on one side and some right-wing blogger on the other. Tough choice, I don’t think.
There remains a further worry about contagion from the fast-moving sovereign debt crisis in Europe. Further bailouts will not solve Greece’s deep-rooted problem of lack of competitiveness across product and labour markets alongside widespread tax evasion. The interconnectedness of the international banking system makes it uncertain how much exposure the UK banking system has. Any fallout would also represent a downside risk to economic growth as the first report of the Fiscal Policy Committee made clear last week.
The UK is undergoing a contractionary fiscal contraction. These right-wing bloggers appear to understand economics about as well as my 120lb Bernese mountain dog, Monty.