Optimal Control, Fiscal Austerity, and Monetary Policy
Over at Equitable Growth: I find myself perseverating over the awful macroeconomic policy record of the Conservative-Liberal Democrat government of the past five years in Britain, and the unconvincing excuses of those who claim that the austerity policies it implemented were not a disaster — and that the austerity policies it ran on would not have come close to or actually broken the back of the economy.
Leave to one side the fact that it is ludicrous that a depression that originates in overbuilding in the desert between Los Angeles and Albuquerque and overleverage in New York has a larger impact shock on the UK than on the US:
The steeper decline really ought to have led to a steeper bounceback in our baseline expectations. So I am still looking for an explanation of why a UK that was growing as fast as the US in the 2000s before 2008 has been growing since — other than that the greater fiscal austerity (and less pressure from the government for monetary expansion) actually had the same effects on output in a Britain that was at the ZLB as it has had everywhere else:
The point that elementary optimal-control considerations mandate that the economy be far from the zero lower bound on safe nominal interest rates before you even begin to think about removing rather than increasing fiscal expansion. As long as the nominal interest rates on long term government debt are very low — as long as monetary policy has shot its interest-rate bolt and is expected remain in that posture for a considerable time — there may be benefits to credibly promising future austerity, but undertaking present austerity simply cannot be the best policy.
Yet a great many people in Britain do not seem to understand this. Even the very smart Tony Yates does not seem to understand this:
Simon Wren-Lewis: Reply to Tony Yates: “Tony… has a problem with… [my] first…
…which was about the 2010 ‘crisis’. So his ‘third way’ is really 7/8th my way!… [On] the 2010 crisis. Tony agrees that there were no signs of a crisis in the markets…. [Note] there is rather a big difference between “we saved the economy from a firestorm”, and “we took prudent action because bad things might have happened”. So maybe 15/16th my way. As there was no actual crisis, what were the chances of one happening? Eric Lonergan… makes an additional point… I can too easily forget. Because austerity damages the real economy, it increases domestic credit risks… [and] actually increase government default risk…. Austerity as a precautionary policy can actually make the outcome you are trying to prevent more likely….
If markets had suddenly taken fright on the deficit and stopped buying UK debt… the Bank could have just bought the debt…. Could it control inflation at the same time?… [Yes] if you are at the Zero Lower Bound (ZLB)…. Paul Krugman has written a paper on this, but it becomes irrelevant because of our second disagreement…. Tony sees the MPC as… succeeding… in… balance[ing] between inflation being too high and output being too low. If that is the case, the ZLB was not actually a constraint….
You wait until you are well clear of the Zero Lower Bound (ZLB) before embarking on fiscal tightening. You are about to hit the economy hard, so you want to be pretty sure that someone else will be able to make sure it can absorb that blow. In the case of Osborne in June 2010, we do not know if he even understood the risk…. Tony’s argument about inflation is not an excuse for austerity, but an argument about how much in practice it cost…. 2010 austerity was a first order policy mistake, because it took unnecessary and large risks with the economy…
In retrospect, monetarists — even conservative monetarists — would have been much better off, and all of us would have been much better off, if Social Credit politicians had won in the 1930s, and if “monetary policy” took the form of equal-dollar credits to everyone with a Social Security number, rather than open-market operations aimed at making “bank rate” effective. The Chair of the Federal Reserve or the Governor of the Bank of England could then, every month, announce what the national monthly monetary dividend would be and provide forward guidance as appropriate. And there would be none of this, from Tony Yates: “We cannot use the demand-management tools that would be effective! We need to cut the deficit in a depression and so do first-order harm to the economy because the second-order benefits of not scaring away the Confidence Fairy are surely larger!”
Originally published at www.bradford-delong.com.