A message for all our readers in the United Kingdom

From Scott Sumner, but endorsed by me in full:

Take the current situation in the UK.  If I’m not mistaken, the British political system is different from that in America.  British governments are basically elected dictatorships, with no checks and balances.  Even though the Bank of England is independent, the government can give it whatever mandate it likes.  If I’m right then both fiscal and monetary policy are technically under the control of the Cameron government.

So I read the UK austerity critics as saying:

“Because you guys are too stupid to raise your inflation target to 3%, or to switch over to NGDP targeting, fiscal austerity will fail.  We believe the solution is not to be less stupid about monetary policy, but rather to run up every larger public debts.”

Is that right?  Is that what critics are doing?

Some will argue that my views are naive, that Cameron would be savagely attacked for a desperate attempt to print money as a way of overcoming the failures of his coalition government.  Yes, but by whom?  Would this criticism come from Ed Balls?  Perhaps, but in that case he would essentially be saying:

“It’s outrageous that the Cameron government is trying to use monetary stimulus to raise inflation from 2% to 3%, whereas they should be using fiscal stimulus to raise inflation from 2% to 3%.”

I’m sorry to have to repeat this over and over again, but what 99% of pundits on both sides of the Atlantic are treating as a debate about “stimulus” and “austerity” is actually a debate about stupidity.  I’m not saying the pundits are stupid (Krugman certainly understands what I’m saying) but rather they are addressing their audience as if the audience was stupid.

Don’t talk down to Cameron and Osborne!  Don’t say “austerity will fail.”  Say “austerity will work, but only if the BOE becomes much more aggressive, otherwise it will fail.”  That sort of advice would be USEFUL.  Instead we are getting a bunch of pundits getting ego boosts because they can say “I told you so.”

Scream it from the rooftops!


Staying up a wee bit late tonight? It's 1:15 here in Clarendon.

In fairness, some people will object that monetary policy doesn't work at the zero interest rate boundary. Personally, I find that opinion unfathomable-- it's saying that a central bank with a fiat currency cannot increase the money supply, which is only true if they limit their tools. But it is a consistent position.

The position that I find nonsense is the one that seems to think that QE works, agrees (and is relieved) that Bernanke can do more if he wishes if things get worse, but opposes further monetary stimulus right now while calling for more fiscal stimulus right now-- but still saying that we need to have medium-term austerity/reducing deficits. It's a confusing mish-mash of policies.

Personally, I favor the Sumner policy solution. Reduce the deficit, offset it with explicit additional monetary stimulus. Drop it from helicopters if need be.

"it’s saying that a central bank with a fiat currency cannot increase the money supply, which is only true if they limit their tools. But it is a consistent position"

No it is not. It is to say that an increase in the fiat curency will not cause inflation (unless you simply give people money - maybe as a compensation for digging holes, maybe through tax cuts, etc.)

"maybe as a compensation for digging holes, maybe through tax cuts"
What about helicopter drops?

Volcker is not a fan of this idea:

So now we are beginning to hear murmurings about the possible invigorating effects of “just a little inflation.” Perhaps 4 or 5 percent a year would be just the thing to deal with the overhang of debt and encourage the “animal spirits” of business, or so the argument goes.

It’s not yet a full-throated chorus. But remarkably, at least one member of the Fed’s policy making committee recently departed from the price-stability script.

The siren song is both alluring and predictable. Economic circumstances and the limitations on orthodox policies are indeed frustrating. After all, if 1 or 2 percent inflation is O.K. and has not raised inflationary expectations — as the Fed and most central banks believe — why not 3 or 4 or even more? Let’s try to get business to jump the gun and invest now in the expectation of higher prices later, and raise housing prices (presumably commodities and gold, too) and maybe wages will follow. If the dollar is weakened, that’s a good thing; it might even help close the trade deficit. And of course, as soon as the economy expands sufficiently, we will promptly return to price stability.

Well, good luck.

Some mathematical models spawned in academic seminars might support this scenario. But all of our economic history says it won’t work that way. I thought we learned that lesson in the 1970s. That’s when the word stagflation was invented to describe a truly ugly combination of rising inflation and stunted growth.

My point is not that we are on the edge today of serious inflation, which is unlikely if the Fed remains vigilant. Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.

What we know, or should know, from the past is that once inflation becomes anticipated and ingrained — as it eventually would — then the stimulating effects are lost. Once an independent central bank does not simply tolerate a low level of inflation as consistent with “stability,” but invokes inflation as a policy, it becomes very difficult to eliminate.

More here:


It's simple, but worth repeating... fiscal austerity + recession = worse recession but fiscal austerity + monetary stimulus + recession = not as bad recession as the former case. The issue comes when you think about the limits of monetary policy; for instance you can give banks free money, but if they then turnaround and deposit that cash at the central bank instead of lending it then you don't get much of an impact (aside from a very small flow on impact of higher profit margins at the banks). Point is there are things that monetary policy can do and there are things that fiscal policy can do; and it's best not to confuse the two as they are not interchangeable.

What fiscal austerity? I haven't seen any fiscal austerity.

The UK has had a Supreme Court now for a while, so it's no longer a country without any checks and balances.

Also, it is currently governed by a coalition which brings a system of checks and balances into the government itself.

But nobody has to worry about Ed Balls. He is no taken too seriously: http://andreasmoser.wordpress.com/2011/02/06/now-i-know-whom-ed-balls-reminds-me-of/

What they call austerity in the UK seems to be mostly tax increases. This has caused me to swear off the word "austerity" from now on I will say either "tax increases" or "spending cuts."

There is no austerity in the UK. Spending is continuing to rise, and planned to do so for the duration of this government.

I keep pointing this out but for some reason the left wing blogosphere and moderates like Tyler keep ignoring it!

I think the definition of austerity is "reducing the government deficit" (both "reducing spending" and "increasing taxes" are "austerity")..

Nominal Spending < Inflation + population growth = Real Austerity.


I'm no fan of the pro-stimulus position for the UK - how you can call the current spending position in the UK "austerity" is beyond me.

Having said that, Scott is off the mark. Mervyn King himself thinks that the problem is real, not nominal. Quoting him: “While the Monetary Policy Committee can use Bank Rate or asset purchases to help ease the transition, there is a limit to what monetary policy can achieve when real adjustments are required.”

Moreover, IMO the BoE can do very little to create any further inflation. The first round of QE and rate cuts worked because it dragged real rates in the UK down which led to the currency falling by ~20%. The latest round had barely any impact at all either on currency or inflation. The Bank of England already owns ~30% of the outstanding stock of govt bonds thanks to QE – a much higher proportion than elsewhere. It has repeated many times that it will not buy private sector assets. In my opinion, they could buy up the entire outstanding stock of govt bonds and commit never to sell it back and inflation in the UK will not go up one iota.

They could directly intervene in the currency market, like the Swiss, and either hold the cash or buy foreign bonds or even gold, to create a lot of inflation.
It would be a huge wealth transfer to other countries, of course.

The BoE has already said that it will not buy private sector assets - which is a fair point. Once we get beyond govt bonds, we're talking fiscal and industrial policy, not monetary policy.

Of course they could set a currency peg but if the other side of this peg is also in recession (which would be the case right now), then this is a zero-sum game. Everyone cannot devalue their currency at the same time, despite what some monetarists think.

There is so much innocence in that post - about BoE, about the UK economy, about Westminster style democracy - that it's amusing.

“Because you guys are too stupid to raise your inflation target to 3%"
The target is 2% inflation based upon the CPI

Here is the chart for the last few years , its averaging well over 3%, being over 4% for the last year (the period of Austerity)

So Im not sure what rate Scott would like, certainly needs to be higher than 3 to change the status quo.

My feeling is that a higher temporary target has been accepted for the last year(s) already but just not announced, several bouts of QE while way over the target would show that 2% isnt "an at all costs" goal.

In a situation where surgery is one of two possible options, but would only work accompanied by a blood transfusion, and an individual knows that the surgeon will not countenance a blood transfusion, the correct response is still: "don't cut!"

A couple of the points already made are worth reiterating:

1) Nominal government spending is rising and will continue to do so, so most austerity effects are coming from elevated inflation

2) Inflation has consistently exceeded the BOE target during the past five years and despite the BOE's concerns about undershooting the target over the medium term, it's worth remembering that they have consistently underforecast inflation in a way that's starting to look systematic. De facto, the BOE has made it very clear that 2% is not so much a target as a floor to inflation.

3) I would also add that not only is the government a coalition, but each of the major political parties is too. The Liberal Democrats encompass perhaps the broadest range of beliefs, from the conservative end of the social democrat scale to the further reaches of socialist. But the Conservatives aren't homogenous either. In fact, the right wing of the party (much further right than Cameron) is a large minority in parliament and is strongly opposed to inflating away the U.K.'s debt, because its constituents tend to be prudent and holding private pensions.

4) The big issue in the U.K. is how the pain is distributed. So far the young have taken much of it in the form of unemployment (though this is probably as much down to the failures of the state education system and won't be corrected in the near term) and prudent savers. Those who leveraged up to the eyeballs and took extremely speculative positions, mostly in the housing market, are doing best. But because the U.K. has such an enormous debt mountain--McKinsey says that as a society, the U.K. is the most heavily leveraged int he world--the BOE has decided that its primary focus is to defend the interests of those who borrowed too much and so is engaged in a long term transfer of resources from the prudent to the feckless. In other words, it is effectively targeting NGDP and pursuing a course of inflationary adjustment all the while claiming to be sticking to its 2% remit.

"it is effectively targeting NGDP"

It only looks like that because flexible inflation targeting should give results similar to that of NGDP growth rate targeting; a temporary overshoot in inflation is required/allowed to fill the "output gap" of missing real GDP.

The BoE has allowed only about 3% NGDP growth in 2011. If they had targeted 5% NGDP growth they didn't do very well.

The first 4 paragraphs neatly explain the relationship between The BoE and the government...

Sumner should keep it simpler and say what he really means:

The BOE needs to say, "CUT GVT SPENDING and we guarantee we will save the economy"

A naive question: What's the fundamental argument favoring monetary action over fiscal? Doesn't inflation bring its own set of demons? Is monetary policy the preferred tool in merely the British case or everywhere?

google public choice.

Credit risk. An interest rate for a given maturity can be decomposed into three factors - the real or risk free rate, an inflation premium, and credit risk i.e., default probability and loss given default estimate. At some point a fiscal position becomes unsustainable and the credit risk component will soar. Then the government if forced to either (a) default causing a massive financial panic that takes decades to repair, (b) embrace real austerity (like Greece) or (c ) if it is fortunate, monetize its debt away by having the central bank buy it at par and roll it over forever. In the latter case, you wind up with inflation anyway. Monetary expansion avoids both a and b. Neither is perfect. As one commenter above noted, if banks are not lending, either because of pessimism or because of regulation that requires them to rebuild their balance sheets and reduce lending, then monetary policy is weak. But a bad fiscal policy gets you the worst of all possible worlds in the long run.

Thanks! That's the sort of comment I love MR for.

Say “austerity will work, but only if the BOE becomes much more aggressive, otherwise it will fail.”

what reasons to we have to believe this is true?

it depends on what "work" means, but for simplicity's sake let's say we are trying to reduce unemployment. Where is the Marginal Revolution or Money Illusion post that will convince us that a sufficient quantity of QE will get employment back to where we want it?

why is it intelligent to say "cut as many public sector jobs as you like, employment will rise so long as the BoE buys sufficient gilts" and stupid to say "let's just slow down on the public sector job cuts"

why does it make sense to accept "if it's not working, we're not doing enough of it" arguments concerning monetary policy but reject them concerning fiscal policy?

and what's with all the "there is no austerity in the UK" arguments? Surely people are not reasoning from the size of the deficit?

we experienced a massive financial crisis and saw tax revenues collapse, welfare payments rise, and found ourselves with a 10% deficit. What next? If you decide to start cutting government expenditure, that is austerity. Is everybody in the UK simply imagining government departmental budget cuts, public sector job losses etc? It may be that cutting G is does so much damage to the economy that the deficit hardly falls. So a large deficit does not mean no austerity. Those who oppose austerity are not saying "the solution is to accumulate ever more public debt" if they believe that austerity does not (much) help reduce public debt.

"If I’m not mistaken, the British political system is different from that in America. British governments are basically elected dictatorships, with no checks and balances".

Unfortunately, he's mistaken. This is just silly. I'll provide one link with a useful summary of supposed differences between presidentialism and parlamentarism:


Being in a position to say I told you so regardless of the course of future events is job one of any pundit.


I agree with Sumner's proposition, but the real problem is that the UK doesn't impose austerity. Sure some cuts have been made in the public sector to maintain a credible investment grade, but overall spending (as part of GDP) is still rising.
In addition to that, a lot of policies announced or enacted by the British government constitute a typical Keynesian solution to the crisis. These include targeting (read: centrally planing) credit (http://im-an-economist.blogspot.com/2012/02/effectiveness-of-credit-targets.html), large infrastructural projects, youth subsidies, housing subsidies, fiscal stimuli to businesses (http://im-an-economist.blogspot.com/2011/12/investment-should-be-left-to-private.html) - the list goes on and on.
They have sent the completely wrong signals to the domestic economy and this is the main reason their policies are failing.


not according to the IFS. According to the IFS, G/GDP rose sharply decade before crisis, but existing government plans are for G/GDP to be back at 2001 levels by 2014, so that's G falling as "part of GDP" from where we found ourselves time of crisis.

[actually the 2014 is from memory, could be later]

that is true, and I did note that the government is making cuts, but the problem is how is it using the money saved from the cuts? And it's using it to apply Keynesian stimuli policies. Now, the total G may be falling due to large public sector cuts, but there is still a big sign of dependency on stimuli in the economy via all sort of subsidies and policies generally considered to be fiscally expansive.

I see the problem in a mixed rhetoric (i.e. advocating austerity on one end but trying to steer private sector incentives on the other) that is sending mixed signals to the economy.

It's always seemed a bit bizarre to me how VAT increases in the UK translate to higher inflation. The result is that "austerity" in raising taxes results in inflation, by definition. Yet monetary policy gets blamed? From http://www.forexlive.com/blog/2012/02/14/uk-analysis-jan-cpi-inflation-falls-due-vat-base-effects/ posted on Feb. 14:

"LONDON (MNI) – Consumer price inflation declined sharply, as expected, in January as the hike in VAT seen last January fell out of the annual comparison, figures from National Statistics showed Tuesday.

Consumer prices fell 0.5% on the month in January causing inflation to fall to 3.6% on the year from 4.2% in December, in line with the median forecast and the lowest since November 2010. Since November inflation as fallen by 1.2 percentage points, the largest two month decline since late 2008, adding weight to to the Bank of England’s view that it will fall sharply back to target or below this year."

So, yes, inflation, even taking into account the VAT has been higher than 2%, but it's falling fast, may drop below 2% without further monetary stimulus, and was primarily caused by a hike in the VAT from 17.5% to 20%. I'm not a monetary theorist, but it seems like the BOE would've had to clamp down pretty hard on the money supply to keep measured CPI to 2% when the price of everything was raised that much by fiscal fiat. I wonder what effect that would've had on the UK economy and the deficit?

love that this is posted on MR immediately after a link to a TED talk about how political irrationality stems from a rational bias toward individual political ignorance.

Scott Sumner is right that pundits believe their audience is stupid.  I suspect that may be the only thing pundits are consistently correct about.

Are advocates of fiscal policy arguing that if monetary policy used, if you put out enough money to jump start the economy:

1. It will be too much to bring back in when inflation starts up resulting in high inflation.
2. Monetary policy does not put enough of the money in poor people's hands so use fiscal policy.

I think that we should try NGDP targeting myself. Even if you use the numbers of Obama administration the coast per job of fiscal policy is way too high.

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