A James Alexander post
One of Scott Sumner’s great contributions to economics (blogging) has been his oft-repeated mantra of “not reasoning from a price change”. Probably its most familiar usage is related to the oil price, although there are many, many more.
The oil price case
The 2014 collapse in oil prices was heralded by many financial types and economists as a great boon to wealth creation, a sort of hidden tax cut. What Scott tirelessly pointed out is that if the oil price drop was as a result of a drop in demand then the cut in price would not herald a rise in wealth, but was more a consequence of a fall in wealth.
While many thought the fall in price was related to supply it did also coincide with the great monetary tightening that followed on from the end of QE3 and the rise and rise of the USD further confirmed this thesis. There were no wild consumer celebrations of the oil price fall, things carried on pretty much as usual: the dull, low growth environment.
Similarly, earlier rises in the price of oil, often dramatic ones, should not have heralded real economy shocks as they are most often associated with an increase in demand. Real economy shocks have only been the consequence of oil price shocks when central banks have mistakenly decided that the short term CPI impacts are long term inflationary impacts – which they never are and never can be unless they are a trigger for excessive monetary tightening by those same central banks.
Sometimes the OPEC oil cartel has managed to raise prices dramatically, but economic crashes following such actions should only occur if monetary policy overreacts.
All in all, positive and negative oil price shocks are really just another instance of central banks being the real shockers, and not real shocks, just like Brexit. Bernanke himself wrote a paper in 1997 which concludes:
Substantively, our results suggest that an important part of the effect of oil price shocks on the economy results not from the change in oil prices, per se, but from the resulting tightening of monetary policy. This finding may help to explain the apparently large effects of oil price changes found by Hamilton and many others.
Currency devaluation not like any commodity price move
On Brexit I have been criticised for reasoning from a price change when celebrating the fall in the value of the pound. Surely it has fallen because of Brexit, and thus cannot also ameliorate the impact of Brexit?
Macroeconomists have struggled to make clear exactly the nature of the potential Brexit shock. Is it an Aggregate Supply or an Aggregate Demand shock? Or both?
Supply shock offset partly by devaluation
A “supply shock” is one that shifts the Aggregate Supply curve to the left, less is supplied at each and every price level along the curve. Such a shock would be inflationary as less output is available for the same amount of money around.
The tricky wrinkle is that the shock is, potentially, to the supplying of overseas markets only, not UK ones. Brexit is firstly a threat to UK exports. This would be expected to impact the currency not the UK economy per se. This shock would mean less GBP demand and the consequent drop in the currency.
The drop in the currency would then partially offset the impact as cheaper UK production would tempt other foreigners, even EU ones, to buy UK goods and services, shifting the AD curve to the right. How much so depends on the elasticity of overseas demand, an unknown, especially in advance.
The potential supply shock from Brexit will also depend on the deal with the EU and the deals with the RoW now negotiated independently of the EU. These are huge uncertainties but uncertainty is normal. Businesses live with it all the time.
The theory that the EU will want to “punish” the UK is interesting but self-interest will win out. Assuming the worst case seems like scaremongering. This piece “Long Day’s Journey Into Night” by the Centre for European Reform being typical:
Economic developments in Britain since the referendum suggest that a recession is coming. And the politics of the negotiation with the EU suggest the country will suffer a prolonged period of weak economic growth … It is clearly in the EU’s interest to be inflexible. The EU wants the UK to understand the trade-off between single market access and free movement, and to come to a decision about what is more important to Britain. If people elsewhere in Europe see mounting economic problems in Britain, they might be less likely to support anti-EU parties, for example in France.
Many countries thrive outside the EU, why not the UK? Many countries inside the EU are in dire straits.The almost wide-eyed optimism that the EU is the best for the UK, or even many countries left in it, is sadly unimaginative.
This optimism could be envisaged as the AS curve shifting right in the short-term. In the longer run the AS curve is usually considered more vertical, so Brexit may not really alter the level of RGDP but would have raised the price level. Insofar as the EU was holding back UK productivity the AS curve may indeed shift to the right, lowering the price level and increasing RGDP.
Demand shock may occur too, entirely offset’able by monetary policy
The “pure” shock of Brexit was on UK politics. Spending decisions may well be put off. A surprise change in leadership of government is undoubtedly unsettling. Especially to non-Brits used to British stability. Part of the UK devaluation was this pure negative shock. And insofar as it was pure shock the impact will dissipate as politics settles down again, and the GBP will rally – as it has partly been doing so already.
It is even possible UK political economy will improve, and thus turn into a positive demand shock. Cameron was an average PM, more style than substance. More importantly, Osborne was over-focused on the deficit and under-focused on NGDP growth – even if he did recognise the worsening of the problem he did nothing about it. And the Labour Party may implode, which is usually good for UK economic confidence – though not always. The Blair years with Brown at the Treasury were mostly good ones for the UK economy.
The furious ignorance about monetary policy in this piece from the UK’s Centre for Policy Studies is quite encouraging – in that they fear a loosening of monetary policy from the new government:
Plans to relax the UK’s deficit reduction programme open up the risk of monetary policy
being used to deal with UK debt by inflation.
- The UK has already been through unprecedentedly loose monetary policy with record low
interest rates for 83 consecutive months and a £375bn QE programme.
- Risks of persistent loose monetary policy are clear. Asset price inflation, increasing
consumer debt, rising inflation and sustaining zombie firms are major risks.
- Government borrowing costs have fallen since Brexit, but counter-intuitively costs to insure
against government defaults have increased. Additional risk of investor flight if holders of
0.38 per cent yielding debt may soon face a 2.5 to 3 per cent inflation environment (as
- Abandonment of deficit targets, political instability and inappropriate monetary policy
response could lead to potential recession risk.
It is hard to know where to start putting these people right except to point out that low rates are a sign of tight monetary policy not loose or even ultra-loose, that 2.5-3.0% inflation is absolutely nothing to fear, and that only strong nominal growth can deal with “excessive” debt.
Sometimes it feels like the UK is sailing between the Scylla of EU wrath for requesting a divorce and the Charybdis of tight monetary policy. I expect that like with most divorce proceedings, even the sometimes bloody ones, life moves on sooner rather than later. And I hope that now Osborne has left the Treasury the blockages to a more flexible monetary policy will dissolve.