Ken Rogoff is back in the news with a FT piece that defends the Cameron government’s fiscal policy. Here’s something that caught my attention:
According to the debt panglossians, UK leaders watched as the economy stagnated, rationing stimulus out of a baseless concern over credit risks. Even though the UK ran one of the largest deficits of any advanced country, the panglossians say it should have borrowed more. Perhaps, but their logic is based on a shallow reading of the evidence –and on amnesia about recent risks to eurozone stability.
I believe the size of the UK deficits is an underreported story. I did a number of posts on this last year, beginning in January 2012. At the time, here were the three biggest budget deficits in the world (in 2011, of those countries covered by The Economist):
- Egypt 10% of GDP
- Greece: 9.5% of GDP
- Britain: 8.8% of GDP
Here are the 5 largest deficits for 2013:
- Egypt 13.0% of GDP
- Pakistan 8.8% of GDP
- Venezuela 8.6% of GDP
- Japan 8.3% of GDP
- Britain 7.6% of GDP
BTW, the US is 4% and the eurozone is 3.3%. Britain really does have a huge deficit.
Even at the time I knew the reply would be that the budget was actually quite contractionary on a cyclically adjusted basis. I suspected that excuse was weak, but now we know with almost 100% certainty that it is flat out wrong. And that’s because the Keynesians totally misjudged the nature of the UK recession.
Even by the beginning of 2013 the UK was hitting record employment levels, month after month, while the US lagged 3 or 4 million below the peak. So why did the Keynesians think the UK was so depressed? (Matthew Klein say “Many economists” (guess who he linked to) say it’s worse than the Great Depression.)
They were wrong because they looked at real GDP. But that’s the wrong variable!!!! And the reason is simple:
NEVER REASON FROM A QUANTITY CHANGE.
They were trying to figure out the size of the demand shortfall, and instead of looking at NGDP growth they looked at RGDP. But RGDP is affected by both demand and supply shocks. The method used by the Keynesians would make it a 100% tautology that all recessions are 100% demand-side. No wonder they are so dismissive of the RBC people.
Britain does face a demand shortfall, but it’s nothing at all unusual. They have an unemployment rate that is perhaps 2% above the natural rate, and an output level that is perhaps 4% below the natural rate (less in my view.) That means the huge gap between actual RGDP and a trend line drawn through 2008 is very misleading.
If you want to understand what’s wrong with Britain read all of Tyler Cowen’s post on the US. He’s maybe 65% right about the US. But if you applied his arguments to the UK, he’d be virtually 100% right.
So if Britain’s output gap is nothing special, which is now abundantly clear, then it is fair to compare the UK budget deficit to those of other countries. And that means it’s clear that Britain’s fiscal policy has been, and still is, far more expansionary than in other developed countries, excluding Japan.
The Keynesians are wrong about Britain for a multitude of reasons:
- The output shortfall is at least 75% productivity, and at most 25% demand-side.
- They have not been doing austerity.
- Even if they had been doing austerity, it would not have reduced British AD because of monetary offset.
- Even if you argue that monetary offset would not have occurred, there would be no reason for the Conservatives to avoid fiscal austerity for reasons on non-monetary offset, because they give the BoE its mandate. The BoE will only adopt an excessively contractionary monetary policy if Osborne orders them to do so.
The huge deficits in the UK result from Gordon Brown’s reckless decision to greatly increase the size of the British state in the good years (2000-07), combined with a decision to double down on an even bigger British state in the bad years (after 2007.) Government spending rose from 37% of GDP to 50% of GDP. Then productivity plunged. That’s the mess the Tories inherited. They really didn’t have any good options. Yes, monetary policy should have been somewhat more expansionary. But if it had been then inflation would have been even higher, and Ed Balls would still be hammering them for a failed policy. He’d talk about falling real wages from the higher inflation. And he’d still complain about a demand shortfall even if the actual shortfall was 100% supply-side.
PS. Some austerians can be blamed for also opposing monetary stimulus. But not Rogoff, he’s advocated a 4% inflation target.