How close is the UK to potential output?

Paul Krugman draws our attention to this very interesting 98-pp. paper by Bill Martin and Robert Rowthorn (pdf here, also see this Martin Wolf column).  They argue that the current problems of the UK are almost solely demand-based, that the UK’s supposed productivity problem is much overstated and shows up in measurement largely due to labor hoarding, and that observed inflation is due mostly to import price shocks.  There is more, so dare I suggest you read the whole thing?

I have a few points, which I will put under the fold…

1. The authors write: “There is an effective demand failure, high unemployment and, within companies, under‐utilisation of the employed workforce – a form of “labour hoarding”.”  This implies radical deflation for competitive industries (MC = 0), which does not seem to be the case.  Alternatively, it could imply no productivity decline for the more competitive industries, which also does not seem to be the case.

2. Real wages in the UK have been falling, post-recession.  In the pure Keynesian view, how much further must they fall through monetary stimulus to restore full employment ?  Isn’t this ultimately also a pessimistic view about UK productivity?

3. The authors acknowledge that worker productivity has fallen, but they blame this on cheaper labor, and view it as a symptom rather than as a cause.  I doubt if you can fill most of the box that way, as efficiency wage effects are unlikely to be so large.  In any case their mechanisms here are not very clear.  Furthermore wouldn’t the story imply that further stimulus, by lowering real wages, would lower productivity even more?

4. The whole argument rests upon worker willingness to accept lower real wages (and lower nominal wage acceleration) in response to external shocks (see pp.32-33 on how nominal fits into the story and how the authors clearly assume considerable wage flexibility).  Keynesians are otherwise suspicious of this kind of premise, and the real wage decline doesn’t seem to have just come from unseen price inflation.  So why suddenly accept a wage flexibility assumption from these guys?  And if that premise is accepted, why believe in such a big role for demand shocks?  The basic story doesn’t fit together, and it doesn’t fit with Krugman’s own views.

5. Citing “import price shocks” as an explanation for recent UK inflation isn’t actually different from citing “supply side bottlenecks.”

6. This is more speculative: the UK boom of the oughties possibly can be understood as a joint boom of supply and demand, rooted in multiple equilibria.  Investors have since reevaluated which equilibrium the UK “belongs” to.  The “British story” just doesn’t seem so exciting any more, Jubilee or no Jubilee, and the credit rationing from the banks reflects this.  A response to a very large shock can in fact reveal lots of information about future prospects.  The authors don’t give much shrift to forward-looking theories and mechanisms.  (By the way, maybe you don’t like multiple equilibria stories, but as I read the paper the authors also seem to be relying on one for the labor market wage-productivity link, though again I wish they would spell out their story more formally.)

7. Labor hoarding in the U.S. seems to have gone down a great deal, so it is odd to invoke it as the decisive factor to explain the UK data.  It’s declining in popularity as an explanation more generally, and I don’t see what the authors do to resurrect it.

8. There were plenty of new hires after the recession ended; why didn’t firms just reallocate their surplus “overhead” labor that was being hoarded?  The discussion circa p.37 doesn’t convince me, as it doesn’t face this question head on.

9. The effects of the credit bust are both demand-side and supply-side, and also suggest maybe that isn’t the key distinction here for the UK.

Let’s try a few general points:

10. There are admittedly some puzzling features of the recent UK economy, most of all how much real wages have fallen.  But they are puzzles for all major theories, not just the supply side theories.  Since this is a real wage decline, I tend to think supply side stories are going to have a big role here.

11. It is very likely that AD is a problem, but we just don’t know how large the UK output gap is.  Given that, it is fine to call for credible nominal reflation, just don’t get your hopes up too much or oversell it.

12. This paper makes one more agnostic by stressing the unreliability of the data (such as business capacity surveys, which don’t suggest a lot of excess capacity).  It doesn’t have a coherent demand-side story which fits the cited data, much less a demand-side story consistent with Krugman’s arguments and models.

Comments

Was there too much AD in 2012-X?

Good points. I wonder if there's any momentum for some sort of NGDP targeting in the UK? I would really like them to try it first...

Regarding the financial sector salaries... I wonder what would happen if, for instance, Tyler's theory of the disappearing NFL came about overnight and that entire professional sport vanished, or let's even say the NBA as well. I think Krugman is right here that the effect of the salaries themselves is small, but unfortunately per #6 there are other effects here such as credit tightening and pessimism, and the old equilibrium is just not coming back. NGDP targeting might help ease the shock a bit but another debt bubble seems ill-advised.

It's maddening. Who thought the housing bubble was just about too much construction infrastructure. To begin with, didn't there have to be too little construction for housing prices to rocket up? Do I have to go further?

Hey TD, what would be a good name for this argumentation? "Appeal to prior non sequitur"?

The UK has to be a special case. Its financial sector and financial sector debt are enormous by any standard, much less relative to an economy the size of the UK's. This can't help but produce all sorts of odd economic distortions.

I don't think conventional analysis will work unless it explicitly includes the financial sector.

Since the UK is not part of the eurozone, it is a safe haven currency like the Danish krone. OTOH the UK's huge financial sector is caught up in the European bank perfect storm of over-leverage, bad debt, indebted host countries, bad risk assumptions (sovereign debt), bad judgment (derivative trash) and bad timing for Basel III.

Both of these forces are strong, and UK is quite susceptible to them. The financial tail is wagging the economic dog in most of the rest of Europe. I don't see why the UK should be an exception.

There was a story today that money from the EU periphery is flowing into London real estate as a 'safe haven' Perhaps the slack employment can be dealt with by hiring of many new maids and butlers for the rich peripherites (I take full credit for coining this word!) who are relocating.

How does lower wages help repay existing debt which was already too high for the wages?

Lower wages with already unaffordable debt service of private debt leads to default.

Lower wages means lower taxes paid which means less to service public debt.

Wow, I find myself in agreement with mulp.
It can't be an AD problem if there is too much debt, as more AD won't fix the issues at hand.

The problem is low marginal productivity.

Low marginal productivity of the aggregate of workers, think... like an average marginal productivity that includes the unemployed.

The debt is nominal.

UK inflation is more likely the result of cost-push inflation created by the increasing reliance on private credit for transactions. The Arthurian has been discussing this topic recently and how the reliance on credit increases the factor cost of money.

"2. Real wages in the UK have been falling, post-recession. In the pure Keynesian view, how much further must they fall through monetary stimulus to restore full employment ? Isn’t this ultimately also a pessimistic view about UK productivity?"

Alas the pure Keynesian view assumes labour mobility only within the nation state-the vast majority of new jobs created in the south east of England are being taken up by young, enthusiastic workers from elsewhere in the European Union-thus agreeable looking leggy blonde barmaids from riga or krakow are taking the jobs that might otherwise go to orthodontically challenged girls from Blackburn, ditto the sterotyped Polish plumber etc. And there are loads and loads of Greeks turning up and getting jobs.

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