The great Brexit devaluation mystery

A James Alexander post

Simon Wren-Lewis has an interesting post, Brexit harm denial and the exchange rate, where he discusses some popular notions about the great British devaluation after the Brexit vote.

I have already discussed it here and explained that part is a pessimistic reading of the future trade deals that the UK might strike. If you are pessimistic then fair enough. But this is not really about economics but futurology.

For a more optimistic, but very realistic understanding of the issues involved in trade deals Dr Richard North and his colleagues at EUReferendum have an excellent blog and series of monographs on Brexit, or Flexcit as they call it.

Wren-Lewis who, as far as I can tell, has never written a blog post on the economics of wealth creation out of the hundreds that he has posted, is not a great guide to the workings of the market – even if, to his credit, he is occasionally sympathetic to NGDP Targeting. Wealth creation is mysterious to him, a grubby business at best, full of overpaid CEOs, neoliberalism at worst. Perhaps it just happens by chance? According to him “99% of economics is about market failure” [in a reply on his blog to a comment of mine]: the modern dismal science epitomised, and his flirtations with Corbyn explained.

What caused the price change?

While it is utterly wrong to argue from a price change, it is very right to try and understand what caused the price change. Why did holders of Sterling sell? Political uncertainty was a factor, but that was relatively quickly sorted out and Sterling remains at the lows. Have other factors like US Dollar strength taken over, preventing a Sterling rally. Maybe.

Perhaps it was expectations that Mark Carney would dramatically ease monetary policy? In which case, the devaluation was not caused by Brexit but by the BoE’s expected stance. Although Carney had campaigned for Remain he made it clear he was ready to act if Remain lost. And he did act decisively, both on the day with interviews and somewhat grudgingly followed up with actions.

A relaxed monetary policy is quite a big step for a BoE that had been tightening all through 2015, if not quite a much as the US. In that sense, Brexit got Carney off the hook of having to make a more obvious u-turn. Carney had heavily overestimated UK economic strength during 2015 and early 2016 and was going to have ease in 2016 anyway.

Perhaps Sterling fell because market participants expected the UK economy to be smaller years ahead. Maybe, but it’s hard to see, practically speaking why they sold Sterling now on such an uncertain outcome, years ahead. Safe-haven buying of UK government bonds pushed down yields, which rather goes against this argument.

At the end of the day, the depreciation was only 10%, not that big in longer run historical contexts. Sterling fell 25% vs the US Dollar during both the 2008 financial crisis and after the ERM exit. It often moves on unexpected political news. The mild shock of a Tory victory in May 2015 drove it up 4%.

On Wren-Lewis’ specific four points:

  1. 1. “Depreciation has a good side, because it gives a boost to our exporters”

Well, he admits this is true. There will be a short term boost to exports thanks to the depreciation. And this will be good for the economy as the costs of Brexit, when it happens, will only come later. He says that “we are poorer because of Brexit”, but only because the markets expect us to be poorer and hence drove down the currency. He may be right in his interpretation, but those markets could turn out to be wrong about that piece of futurology. It is still very encouraging that Wren-Lewis recognises that market expectations can have real effects, just like market expectations about nominal growth.

He also claims that “markets believe Brexit will cause an economic downturn in the UK, implying lower levels of UK interest rates. (In this they have been proved correct).” One hates to disagree with such an eminent economist in his interpretations of market moves, but the Bank of England was very confident that Brexit would cause a rise in gilt yields due to fear about the UK economy and its credit rating. Remainers like Wren-Lewis and the BoE seem like they want to be right about the negative consequences of Brexit whatever gilt yields did.

What Wren-Lewis specifically fails to mention is the benefit to domestic demand of a depreciation, nicely expressed by Britmouse at Uneconomical back in January this year. Currency devaluation is a way of boosting AD, by forcing consumers to switch from overseas goods and services to domestic goods and services. This is the classic benefit of devaluation, not that it is good for exporters. The overall impact on the balance of trade is hard to tell given the inelasticity of much import demand. What tends to happen on a devaluation is that the value (in the devaluing currency) of both exports and imports rises, thus raising AD. If the devaluation was due to Carney’s expected reaction, then good.

  1. “Sterling was overvalued anyway”

While it is “ludicrous” to suggest that the problem of overvaluation, if it existed, was overcome by the Brexit devaluation, it isn’t ludicrous to suggest that devaluation will offset some of the pain. See 1.

3. “Sterling is only back to where it was …”

Wren-Lewis makes an obscure argument by analogy, something about having your basic pay cut but the boss promises it won’t be that bad as bonuses will be higher. The UK may be 10% poorer in $ terms but is it really relevant when Britons are paid in Sterling and wages in Sterling didn’t move at all. The UK is a massive holder of overseas investments, was the UK richer after the devaluation also?

And, yes, Sterling in Euro terms (the purple line) really only was “back to where it was”. In US Dollar terms (the blue line) it has been falling for a long while, mostly due to much more US monetary tightening versus the UK. To be fair, it does depend where one starts to draw the line, but then an argument about that issue doesn’t really lead very far as more and more “noise” enters the discussion.

JA Brexit Devaluation

  1. It is just a temporary problem before things become clearer”

Wren-Lewis now lays his cards on the table (I think) and assumes there will be a short term economic downturn until the UK accepts the single market and free movement, at which point “the economy then recovers, interest rates rise, and sterling appreciates”. Brexiteers can then be blamed “for all this uncertainty and the temporary damage”.

Again, Wren-Lewis engages in a lot of futurology. Who knows if there will be much of a significant economic downturn from Brexit. Were we due one anyway given the weak NGDP growth over the last 15 months? A fact that Wren-Lewis and other macro-economists have been awfully silent over.

Who is to say what “free movement” means once it is up for negotiation? Does it mean exactly what we have now, with full access to UK welfare benefits for all and any EU citizens who move to the UK? Once we have agreed the trade deal with the EU will the EU prevent us negotiating deals with third party countries and blocs that the EU has so signally failed to do itself? Would this be bad for the UK?

The answers to these questions and many more will inevitably colour the macro-economic outcome, but these are political questions and macro-economists (and the Bank of England) would do well to make clear their political judgements on these issues before sounding off with such certainty about the economic outcomes.

What does and does not make sense?

In “Explaining the last 10 years”, Simon Wren-Lewis starts off:

The Great Recession was larger than any previous post WWII recession. But that is not what it will be mainly remembered for. Unlike previous recessions, it appears to have led to, or coincided with, a permanent reduction in the productive potential of the economy relative to previous trends.

According to measures of potential output put out by the CBO, the coincidence is clear, with a marked kink in the level of potential output occurring concomitant with the “Great Recession”. If that´s true, as the chart shows the economy has essentially closed the “gap”.

Greater Depression_1

However, according to a deterministic trend, estimated from 1955 to 1997 and projected forward, the “gap” has been rising given that real output growth, after dropping hard during the “GR” has never “bothered” to grow sufficiently to close the “gap”.

Greater Depression_2

The first case indicates that the apostles of the “Great Stagnation” thesis have a point. The second view says that the economy is, in the words of Brad Delong from almost 2 years ago, in a “Greater Depression”:

First it was the 2007 financial crisis. Then it became the 2008 financial crisis. Next it was the downturn of 2008-2009. Finally, in mid-2009, it was dubbed the “Great Recession.” And, with the business cycle’s shift onto an upward trajectory in late 2009, the world breathed a collective a sigh of relief. We would not, it was believed, have to move on to the next label, which would inevitably contain the dreaded D-word.

But the sense of relief was premature. Contrary to the claims of politicians and their senior aides that the “summer of recovery” had arrived, the United States did not experience a V-shaped pattern of economic revival, as it did after the recessions of the late 1970s and early 1980s. And the US economy remained far below its previous growth trend.


A year and a half ago, those who expected a return by 2017 to the path of potential output – whatever that would be – estimated that the Great Recession would ultimately cost the North Atlantic economy about 80% of one year’s GDP, or $13 trillion, in lost production. If such a five-year recovery began now – a highly optimistic scenario – it would mean losses of about $20 trillion. If, as seems more likely, the economy performs over the next five years as it has for the last two, then takes another five years to recover, a massive $35 trillion worth of wealth would be lost.

When do we admit that it is time to call what is happening by its true name?

Simon Wren Lewis goes on to indicate that:

If we stick to the more plausible idea that this is all somehow the result of the financial crisis and recession, we can again split explanations into two types: those that focus on the financial crisis and argue that crises of this type (rather than other types of recession) impact on potential output, and those that look at the impact of the recession itself. The distinction is important in understanding the impact of austerity. If the length and depth of the recession has permanently hit potential output, as Fatas and Summers suggest, then the cost of austerity is much greater than we could have imagined.

But I believe that´s the wrong focus. The charts show that the economy was “suffocated” not by austerity, but from a highly inadequate monetary policy, as indicated by the behavior of aggregate spending or NGDP.

Greater Depression_3

Greater Depression_4

And that wrong-headed monetary policy remains in place today!

How a myth is born

Bernanke HeroFirst, you get a “The Hero” magazine cover


Bernanke Person of the YearThen you get to be Person of the Year

Bernanke Hero1

And finally, you write a memoir titled “The Courage to Act”



and voilá, the myth is born!

The latest invocation comes from Simon Wren-Lewis:

Here is an extract from an interview with Ben Bernanke by George Eaton in the New Statesman:

Though a depression was averted in 2008, the recovery in the US and the UK has been slow. Bernanke partly blames the imposition of fiscal austerity (spending cuts and tax rises), which limited the effectiveness of monetary stimulus. “All the major industrial countries – US, UK, eurozone – ran too quickly to budget-cutting, given the severity of the recession and the level of unemployment.”

Partly thanks to Bernanke’s leadership (and knowledge), the Great Recession was not as bad as the Great Depression of the 1930s. Monetary policy reacted much more quickly, and financial institutions were (nearly all) bailed out. In 2009 we also enacted fiscal stimulus, but in 2010 we reverted to the policies of the early 1930s with fiscal austerity. That mistake was partly the result of panic following events in the Eurozone (see the IMF analysis discussed here), but it also reflected political opportunism on the right.

However, as Scott Sumner concludes in a recent post:

That’s why it’s so important to get the facts right. Just as the Abe government showed the BOJ was not out of ammo in the early 2000s, a close examination of what the Fed did and didn’t do, and a cross country comparison of monetary policy during the Great Recession and recovery, shows that monetary policy is always and everywhere highly effective.

What are the facts?

The chart shows that during the first few months of the Great Depression (GD) and the Great Recession (GR), the behaviour of NGDP was similar.


After that, things were very different. What Bernanke´s knowledge did was to apply the results from his “made my name” 1983 article “Nonmonetary effects of the financial crisis in the propagation of the Great Depression”, by going on a bank bail-out spree, thus avoiding the propagation factors that were very “active” in 1931/32.

The charts from the Great Depression indicate what Bernanke avoided. They also show that to get the economy to “turn around” and take a path back to the previous trend, monetary policy has to be really expansionary. That was true even with interest rates at the ZLB, as happened when FDR made a significant change in the monetary regime, cutting the link to gold in March 1933, almost four years after the start of the depression! NGDP growth went up by enough to put the economy on the path back to trend.


The next charts show what happened now. Notice that in the early 2000s, Greenspan also allowed NGDP to drop below trend, but that mistake was fully offset, and by the time Bernanke took the Fed´s helm. NGDP was back on trend.

Without going in to all the details, the fact is that Bernanke allowed NGDP to fall in “Great Depression style”. As mentioned, he avoided a second “GD” by bailing-out the financial system. In addition, by introducing QE in March 2009, monetary policy reacted much more quickly than in the “GD”.


However, notice the difference. In Bernanke´s case, monetary policy was just sufficient to put the economy on a growing trend along a lower level path. It never tried, as happened after March 1933, to get back to the original trend path. Thus, the economy is stuck in a “lesser depression” a.k.a. “Great Stagnation”.

And that really has nothing to do with fiscal policy.

UK Socialists show interest in NGDP Targeting, BoE proxy moans

A James Alexander post

Scott Sumner is both warming up to Bernie Sanders and getting excited by growing signs of acceptance for Market Monetarism. In the UK we seem to be getting both things in the one package.

Writing in the Financial Times our new, “hard-left socialist”, senior opposition spokesman on finance, Shadow Chancellor of the Exchequer John McDonnell, has said he is interested in NGDP Targeting.

McDonnell has created a group of leading, if left-leaning. macro-economists to advise him on macro-economic policy. Their first job is to lead a review of the Inflation Targeting mandate of the Bank of England. The group includes many names familiar to Market Monetarists like Adam Posen, David Blanchflower and Simon Wren-Lewis. We know them because of their willingness to debate about NGDP Targeting and even broadly accept it as at least partially useful – though they all prefer active fiscal policy at the ZLB over what they consider to be unconventional monetary policy.

“The last time the Treasury tweaked the MPC’s remit was in 2013, when George Osborne, chancellor, clarified that the committee need not force inflation back to the target by the fastest possible route if a slower one would be better for growth. We will consider whether such trade-offs should be formalised. And we will look at more radical ideas, such as introducing a target for nominal gross domestic product — a suggestion Mr Carney broached in 2012.”

This is great news.

The diehards at the Bank of England won’t like it. An initial response from one of the leading UK economist who often represents mainstream BoE views was distinctly lukewarm.

Tony Yates even addressed himself to the NGDP Targeting idea:

“I’ve blogged a lot about this before, and haven’t the heart to repeat it here.  Very briefly.  Growth targets would not make a whole lot of difference.  Levels targets rely on being a rational expectations nutcase, and even then would probably be incredible.”

The attack on Rational Expectations is the oddest thing. It’s not clear what his problem with RE really is. It’s very hard to figure out. Yates is clearly a clever guy, but like most central bankers and their supporters, they distrust markets and prefer discretion. Yates seems to think that elite central bankers sitting around a table with lots of different models, lots of data and super-smart intuition is better than clear rules. We only need to ask how that worked out in 2008 to see what was wrong: internal politics, confusion and hopeless or downright counter-productive signalling. To recognise that central bankers were the prime cause of the recession is a step too far for the self-same central bankers and their proxies.

From an earlier anti-NGDP Targeting piece Yates demonstrates clearly the knots he ends up tying himself in when thinking about RE:

“Policymakers at the BoE used an RE model, but when they thought it was relevant, would often adjust forecast profiles by hand afterwards to try to offset what they thought were the effects of rational expectations.  (Highly unscientific and hopelessly imprecise in doing it this way, but well-intended).  However, whether central banks assume RE or not, it’s not a good defence of a regime that it works well in a false world those central banks happen to believe in.”

Who’s the nutcase?

Update. Excellent blog from Ben Southwood at the Adam Smith Institute.

Simon says: monetary policy is better, when possible

Simon Wren-Lewis writes:

There are practical reasons for preferring interest rate changes (when possible) to changes in government spending as the stabilisation tool of choice, although the extent to which these are inevitable or just conditional on current institutional arrangements is an interesting question. Here I want to give an economic reason for this preference.


The government could prevent waste in two ways. It could persuade consumers to hold less money and buy more goods, which we can call monetary policy. Or it could buy up all the surplus production and produce more public goods, which we could call fiscal policy. Both solutions eliminate waste, but monetary policy is preferable to fiscal policy because the public/private good mix remains optimal.

Three comments on this reason for preferring monetary policy. First, if for some reason monetary policy cannot do this job, clearly using fiscal policy is better than doing nothing. It is better to produce something useful with goods rather than letting them rot…

He would have naturally come to the “solution” if he freed himself from the “monetary policy=interest rate policy” constraint and thought of monetary policy as providing a stable nominal background with, for example, a nominal spending (NGDP) target.

Osborne needs to learn some Market Monetarism

A James Alexander post

Keynesians, especially left-wing ones, are hyper-quick to attack George Osborne, the U.K. Chancellor of the Exchequer (aka the Finance Minister or Treasury Secretary) for the smallest attempts at controlling the budget deficit and howl him down whenever he is so economically illiterate to think there is the smallest problem with Britain’s 80% debt to GDP ratio.

Perhaps on the day when Osborne’s deficit reduction plans went a bit astray they were all too busy cracking open the prosecco that they failed to spot significantly worrying remarks about monetary policy.

The Times reported thus , while Osborne was tripping through ChIna:

Mr Osborne hinted earlier yesterday that interest rates were going to rise, clearly siding with Mark Carney, the Bank of England governor, against Andy Haldane, its chief economist, who recently suggested that rates might have to stay low for longer because of problems in the Chinese economy, or may even need to fall.

Mr Osborne appeared to play down last week’s decision by the US Federal Reserve to hold rates rather than put them up, saying it had been dictated by the circumstances at the time.

Then he added, in what was close to a departure from the traditional reluctance of chancellors to interfere with the independence of the Bank, that the signals of rate rises in recent weeks reflected the growth in the American and British economies and that the “general signal coming from the Bank and the Federal Reserve is that the exit from very loose monetary policy is going to come”.

For starters, I thought this might trigger a debate about Central Bank Independence. (CBI) which has been filling then UK macro blogs like here and here since the Corbynomics debate exploded. Personally, I am CBA about CBI, the policy is the key, and often central bankers can’t be trusted to make good policy, but governments can, eg Japan. Of course, we see things often the other way around, too, but it is a sterile debate about means rather than ends.

The bigger issue is why Osborne thinks monetary policy is very loose. To be fair mainstream macro and “mediamacro” (HT Simon Wren-Lewis for the term) make the common mistake all the time of confusing interest rate levels and the amount of QE with the stance of monetary policy. The stance of monetary policy can only be measured by looking at whether demand for money is outstripping supply of money, and that can only be seen by looking at where nominal growth (aka Aggregate Demand) is headed. If on a downward trend money is tight, if on an upward trend money is loose. If in trend monetary policy is just right.

The recent historical economic evidence is that UK NGDP is slowing down, 2Q15 was quite poor. The relevant inflation rate for macro policy, the GDP Deflator was worse than poor. Tax revenue growth on incomes is still not great, just like the more difficult to measure wage growth itself. Looking forward, implied UK NGDP growth forecasts are weakening too, judging by market indicators like Sterling strength, long term bond yields, commodity prices and the stock market.

Despite some interestingly radical thoughts from the BoE Chief Economist Andy Haldane, Governor Carney seems squarely in the Janet Yellen/Philips Curve camp of warning rates must rise soon.

Hopefully, Osborne’s Treasury advisers will get him to see sense, if not things won’t turn out well. They won’t turn out disastrously as markets will force more delays in further monetary tightening. But the guidance on policy from Carney and his boss Osborne (and Yellen) will remain a mess. And the mess will, of itself, crimp NGDP growth.

One small step for supply-siders, a giant leap for Wren-Lewis?

A James Alexander post

Market Monetarists have often been a bit frustrated with Simon Wren-Lewis’ Keynesian over-concern with the obstacle of the Zero Lower Bound. Having flirted  with NGDP Targeting a few years ago he went off the idea. It is great to see him both attacking  the idea of raising rates, in fact suggesting a cut in rates, and also returning to support NGDP Targeting:

“Good policy should not just look at the most likely outcome, but also at risks. At the moment there is a significant risk that we may be losing a huge amount of resources because of a tepid recovery. To cover that risk, we should cut rates now. The worst that can happen if this is done is that rates might have to rise a little more rapidly than otherwise in the future, and inflation might slightly overshoot the 2 per cent target. Inconvenient, but not very costly.

If we fail to cover that risk, there is a non-trivial probability that in three years’ time inflation will still be well below target and we will all be asking why on earth everyone in 2015 was talking about an interest rate increase.”

“If the Bank of England had adopted a NGDP target, as many have recommended, the MPC would be tearing their collective hair out right now trying to stimulate the economy. There would be zero talk of interest rate increases. So there seem to be just two possibilities. Either NGDP targeting is nuts, or monetary policy has slowly gone off the rails by focusing on CPI inflation alone.”

Unfortunately, there is still little room for the UK to cut rates as they are obviously very close to the the ZLB, unless the MPC goes down the negative rate road. Perhaps Wren-Lewis is just paving the way for a reopening of his campaign for more big government fiscal policy – he has never proposed tax cuts as a form of fiscal policy as far as I have read. Is this because his anti-market, anti-supply side, bias blinds him? I don’t know. But this bias needs to be overcome for NGDP Targeting to be really effective.

At or around the ZLB central banks have to be very clear just how far they will go with unconventional monetary policy in order to achieve their targets. But the key issue is how the markets, and thus the wider economy, understand what the central bank is really targeting.

Actual NGDP is a tricky thing to target as the numbers inevitably come out after the event, and accurately many months after the event. It could be too little, too late if central banks only look at incoming data. They must look forward, to set the flight path they want to be on.

Better to work with the market and target the market’s expectations for future NGDP. At the moment these expectations can only be seen indirectly through market implied inflation rates, longer term bond yields, equity markets and exchange rates. Consensus macro forecasts are almost worthless with their constant reversion to mean, usually using the same discredited macro models used by the central bank’s themselves. Market prices are far more reliable as a guide to the future as real money is at stake rather than just the reputations of a lot of rent-a-mouths.

It would be best for central banks to help launch an NGDP Futures market as Scott Sumner has argued. This small but imaginative step by a supply-side macroeconomist brought together Friedman’s classic monetarism with the new insights of rational expectations.

It would be even greater if Wren-Lewis too could make this step and work with rational expectations to achieve successful monetary policy and growth, rather than being so skeptical about the market all the time. For a Keynesian like Wren-Lewis this would be a giant leap, but it is a necessary one.

Failed Fiscalist Forecasts

A Mark Sadowski post

The subject of the United States “fiscal cliff” as a test of monetary policy offset at the zero lower bound in interest rates has recently come up yet again. Russ Roberts brought it up here.

Simon Wren-Lewis responds here.

To which Scott Sumner replies here.

For what it’s worth, here’s my two cents worth. I’ve said some the following before in more than one place, but this time I’ll try and be even more complete and explicit.

To begin with, the sequester was only a small part of the U.S. fiscal consolidation that took place in 2013. The “sequester” refers to the automatic spending cuts in particular categories of outlays that were initially set to begin on January 1, 2013, as a result of the Budget Control Act (BCA), and were postponed by two months by the American Taxpayer Relief Act of 2012 (ATRA) until March 1. ATRA also addressed the expiration of certain provisions of EGTRRA and JGTRRA (the “Bush Tax Cuts”), the 2-year old cut to payroll taxes (the “Payroll Tax Holiday”) and federal extended unemployment insurance. An increase in income tax rates applicable to high income tax payers, an increase in the payroll tax, and a continuation of federal extended unemployment insurance went into effect on January 1, 2013.

In short, the sequester only refers to the spending cuts that went into effect on March 1, 2013 and does not include the two major tax increases that went into effect on January 1, 2013. Based on the CBO’s November 2012 analysis of the “fiscal cliff”, and adjusting for the late start of the sequester, the tax increases that went into effect constituted  approximately 70% of the budgetary effect of going over the “cliff”. This is why analyses such as these are far less than fully satisfactory.

Furthermore, none of the forecasts concerning the effects of fiscal consolidation, by either the CBO, or the major private forecasters, referred to annual 2013 RGDP growth. They all referred to quarterly RGDP growth in 2013 or to year on year RGDP growth in 2013Q4. This because this is the more reasonable measure when the question is what impact a budgetary change starting at or near the beginning of a given year will have on subsequent growth. The Q4/Q4 measure is approximately the average of the four quarterly growth rates following the budgetary change, whereas the Year/Year annual measure is essentially a weighted average of the previous and current year’s quarterly growth rates. In this particular instance 3/8ths of the weights in the Year/Year measure come from quarters that occurred before even a single act of the federal fiscal consolidation went into effect on January 1, 2013. For more on why the Q4/Q4 measure might be preferred to the Year/Year measure in this case, see this for example.

The CBO’s last full economic forecast of 2012 (which came out just weeks before QE3 was announced) called for 0.5% year on year decrease in RGDP in 2013Q4 assuming all of the projected fiscal tightening went into effect (Table 2-1).

The previously mentioned November 2012 CBO analysis of the effects of the fiscal cliff states that eliminating all of its components would result in year on year RGDP growth in 2013Q4 being 2.9 percentage points higher (Figure 1). This implies that the CBO was forecasting that year on year RGDP growth would be 2.4% in 2013Q4 without any of the components of the fiscal cliff.

A careful reading of the CBO’s estimates from November 2012 indicates that the fiscal consolidation (the 2% payroll tax increase, the high income tax increase and the sequester) should have subtracted 1.4 points from year on year RGDP growth through 2013Q4.

Figure 1 shows that the CBO were estimating that extending the reduction in the payroll tax and extending emergency unemployment benefits would increase year on year RGDP growth by 0.7 points in 2013Q4 (line five). Footnote 15 on page 11 indicates that approximately 80% of the budgetary effect of this component was due to the reduction in the payroll tax. Assuming the fiscal multiplier for the reduction in the payroll tax and emergency unemployment benefits is about the same, the economic effect of not extending the reduction in the payroll tax thus was about 0.56% of RGDP (i.e. 80% of 0.7 points).

Also, Figure 1 suggests that the economic effect of not extending lower tax rates for those with high incomes (the difference between line three and line four) is 0.1% of RGDP. The increase in income tax rates applicable to high income tax payers that went into effect under ATRA was actually somewhat smaller than what the CBO estimates were assuming, but probably not significantly enough to make it worth refining any further.

And lastly, Figure 1 shows that the CBO were estimating that eliminating the defense and nondefense spending reductions (i.e. the “sequester”) would increase year on year RGDP growth by 0.8 points in 2014Q4 (the sum of lines one and two). But the implementation of the sequester was delayed by two months. A crude adjustment to this figure may be obtained by reducing it by one sixth (two out of 12 months) or to about 0.67% of RGDP.

The sum of these three components totals about 1.4% of RGDP. Combining the CBO’s estimated effect of the three components of the fiscal cliff that actually did go into effect, with the CBO’s implied forecast in the absence of any of the components of the fiscal cliff of 2.4% RGDP growth, results in a forecast of 1.0% year on year increase in RGDP in 2013Q4.

A similar thing applies to the major private forecasters. (Sorry, no links, but some of this can probably still be googled.) The effect of the fiscal consolidation (again, the 2% payroll tax increase, the high income tax increase and the sequester) according to Bank of America, IHS Global Insight, Moody’s, Goldman Sachs, Morgan Stanley, Macroeconomic Advisers and Credit Suisse ranged from 1.0% to 2.0% of GDP, with the average estimate being about 1.6%. The baseline forecast (i.e. the RGDP growth without any components of the fiscal cliff) prior to the beginning of 2013 of these same seven private forecasters was for year on year RGDP growth of 2.0% to 3.5% in 2013Q4 with the average forecast being about 2.7%. Thus the average forecasted year on year RGDP growth in 2013Q4 adjusted for fiscal consolidation was about 1.1%. This is almost exactly the same as the CBO forecast that I’ve teased out above.

We now know that year on year RGDP growth in 2013Q4 was 3.1%, or significantly higher than what the CBO was forecasting, and higher than what most of the major private forecasters were estimating would occur without any fiscal consolidation at all.

Or, in plain English, taking into account the monetary policy offset, the fiscal multiplier still appears to be zero, even at the zero lower bound in interest rates.

Will new tools help to “save” the economy?

The BEA has announced the forthcoming release of new analysis tools:

The Bureau of Economic Analysis plans to launch two new statistics that will serve as tools to help businesses, economists, policymakers and the American public better analyze the performance of the U.S. economy. These tools will be available on July 30 and emerge from an annual BEA process where improvements and revisions to GDP data are implemented. BEA created these two new tools in response to demand from our customers.

Average of Gross Domestic Product (GDP) and Gross Domestic Income (GDI)

Final Sales to Private Domestic Purchasers

This new data tool is just one of the ways that BEA is innovating to better measurethe 21st Century economy and provide business and households better tools for understanding that economy. Providing businesses and individuals with new data tools like these is a priority of the Commerce Department’s “Open for Business Agenda.”

Meanwhile the “more government crowd” is strident.

Simon Wren-Lewis:

When we have a recession caused by demand deficiency such that interest rates hit their Zero Lower Bound (ZLB), the obvious response from a macroeconomic point of view is fiscal stimulus. Instead governments have become obsessed by their debt and deficits, and so we have austerity instead.

Brad DeLong:

Arithmetically, the U.S. economy is depressed because residential construction and government purchases are well below previously-expected trend levels

New Tools_1

And governments are not responding to market signals: financial markets are telling them that they have a once-in-a-lifetime opportunity to advantageously pull spending forward from the future into the present and push taxes back from the present into the future. But, because of the ideology of austerity, they are not taking advantage of this opportunity.

Brad calls a spade a spade: “Economy is depressed”, but it´s not because of his GDP components reasons.

Take Final Sales of Domestic Product (FSDP), to remove some of the volatile components of NGDP. The charts below show how it has performed relative to the “Great Moderation” trend. You also see that the 90/91 and 2001 recessions were “overcome” when FSDP growth managed to get FSDP back on trend. Not so following the “Great Recession”, with the result being a depressed economy.

New Tools_2

This predicament is not due to “residual seasonality”, “inappropriate tools for analyses” or “ideology of austerity”. It´s wholly due to the Fed constraining the growth of nominal spending at an inadequate level, one that has persisted for 5 years! It´s beyond belief that “growth stability” for that length of time is just a coincidence!

I´m reminded of the wisdom of James Meade, who in his 1977 Nobel Lecture said:

Earlier I spoke of ‘price stability’ as being one of the components of ‘internal balance’. Yet in the outline which I have just given of a possible distribution of responsibilities no one is directly responsible for price stability. To make price stability itself the objective of demand management would be very dangerous.

If there were an upward pressure on prices because the prices of imports had risen or because indirect taxes had been raised, the maintenance of price stability would require an offsetting absolute reduction in domestic money wage costs; and who knows what levels of depression and unemployment it might be necessary consciously to engineer in order to achieve such a result?

The “price stability” obsession is the reason the economy was “knocked down” in 2008!

His “solution”:

I have told this particular story simply to make the point that the choice between fiscal action and monetary action must often depend upon basic policy issues which should certainly be the responsibility of the government rather than of any independent monetary authority. Perhaps the best compromise is an independent monetary authority charged so to manage the money supply and the market rate of interest as to maintain the growth of total money income on its 5-per-cent-per-annum target path, after taking into account whatever fiscal policies the government may adopt.

Unfortunately, the economy has remained depressed for too long. That has certainly “sapped its strength”. Nevertheless, a higher level of spending is certainly achievable. Maybe, for incomprehensible (to me) reasons, it´s not desired!

Adrift, but with an attitude!

Simon Wren-Lewis characterizes the “adrift”:

The third interpretation about why central banks are doing nothing is there is nothing they can do. Quantitative Easing seems to have come to a permanent halt either because it has stopped having a useful effect, or because policy makers fear it is having undesirable consequences. Under this interpretation the inflation target loses credibility not because the private sector no longer believes policy makers’ stated objectives, but because they no longer believe they have the means to achieve them. 

This possibility is the one that should really be worrying central banks right now. It is a scenario that is quite consistent with what is currently happening, and it puts at risk central bank credibility in a most fundamental way. Quite simply, central bank credibility is destroyed because people believe they have lost the ability (rather than the will) to do their job, and there is very little central banks can do to get it back because of the ZLB. This is what should be giving central banks nightmares. Strangely, however, they seem to be sleeping just fine.

To “compensate” they put on an “attitude”. To show they´re “active” the Fed has elected employment/unemployment as the “informant” on the “appropriate monetary policy” (or interest rate juggling). Note that, as late as 2009, with unemployment climbing fast towards 10% and inflation – both headline and core – dropping like a stone, they mostly talked about inflation during the FOMC Meetings. Now that they are “adrift”, they scramble to get “support” from the labor market!

Interestingly, 40 years ago Franco Modigliani with Lucas Papademos invented NAIRU (initially NIRU) – Non Accelerating Inflation Rate of Unemployment (Non Inflationary Rate of Unemployment) to argue from the “opposite extreme”. In their case, unemployment was far above NAIRU, therefore monetary policy could be expansionary without igniting an increase in inflation:

On the basis of these and other considerations, we conclude that a conservative interim unemployment target for mid-1977 is 6 percent. Achieving this target will require a growth of output of at least 17 percent over the next two years. Of this total, more than half should be achieved in the first year, to allow the growth rate to abate as the ultimate target is approached. Taking into account the price implications of this growth path, we conclude that in the first year money income should grow at an annual rate above 15 percent. From this it is argued that even if the primary stimulus to recovery comes from fiscal policy, as seems necessary to ensure an early and vigorous revival, the money supply will have to increase for a while at a rate well above 10 percent. There is wide concern that such a sharp acceleration in the money supply would have an unfavorable effect on the rate of inflation. But we allay this concern by showing that the evidence is clearly inconsistent with any influence of money on inflation outside of its indirect effect through its contribution to the determination of aggregate demand and employment.

How did things pan out? The chart below indicates that unemployment, which was above 8% when Modigliani & Papademos wrote, came down slowly, as did inflation. However, when NGDP growth accelerates, unemployment falls faster towards the 6% “target” but inflation begins to rise long before the “target” is reached.


In early 2012, when the Fed introduced the 2% inflation target, unemployment was, as in 1975, above 8%. Given that inflation was sliding below the 2% target the Fed “stipulated” that 6% unemployment would indicate the time was ripe for rates to begin to rise! What´s this fixation on 6% unemployment (understood to be the NAIRU level)?

Nevertheless, with unemployment falling towards “target” but with inflation continuing to drop, the Fed “reestimated” NAIRU at something between 5% and 5.5%. As of today, we are at the top of the “NAIRU band”, but inflation is still moving slowly down! Note, importantly, that differently from the 1970s, NGDP growth has remained stable (shy of 4%), a rate of spending growth that is consistent with higher than target inflation only if trend (potential) real output growth is below 2%. By insisting on keeping the economy at a “depressed” level of activity, low trend growth may in fact become “reality” (or the “new normal”). The Fed will then feel vindicated in raising rates, while the “New Fisherians” will feel vindicated in seeing higher rates hand in hand with higher inflation!


In the 1970s, “targets” for unemployment got us into inflationary troubles. Now, “targets” for unemployment will get us into “stagnation” troubles. My good friend Benjamin Cole clearly prefers the former!

Update: Krugman has something useful to say on the NAIRU “controversy”:

I very much hope that Fed staff remembers the 1990s. Circa 1994 it was widely believed, based on seemingly solid research, that the NAIRU was around 6 percent; but Greenspan and company decided to wait for actual evidence of rising inflation, and the result was a long run of job growth that brought unemployment below 4 percent without any kind of inflationary explosion. Suppose they had targeted the presumed NAIRU instead; they would have sacrificed trillions in foregone output, plus all the good things that come from a tight labor market.

The chart illustrates:


Here,also, NGDP growth is stable (not at the 4% range but at the 5.5% range). Inflation remains low and even falls (productivity shock) and the 6% NAIRU estimate was completely irrelevant!