David Demery

I am a Research Fellow in the School of Economics, Finance and Management at the University of Bristol.  My main academic research is in macroeconomics but I am also interested in the measurement of poverty and income inequality.

My work in macroeconomics has been somewhat eclectic covering monetary economics, consumption, modelling expectations and business cycle analysis. My current research is in new-Keynesian economics.

The links on the left give a flavour of my recent work in theoretical and applied macroeconomics, and in the measurement of poverty and income inequality. The Research link gives details of my current research activity.

There are (at least) two noteworthy features of the latest GDP figures. The first has been widely publicized: this is the first ‘double-dip’ recession since 1975, when Margaret Thatcher was elected leader of the opposition Conservative Party and the film ‘Jaws’ was first released. The latest figures are provisional and the revised figure may well see a mild improvement. Andrew Goodwin of Ernst & Young’s economic forecasting unit, the Item Club “would be very surprised if these figures were not revised upwards.” And as the Financial Times has pointed out, ‘the contraction hinged on data about construction activity, and this is notoriously volatile. Without them, growth in the first quarter would have been static.’

Double-dip recession or a stagnant economy at best – hardly a vindication of the Coalition’s approach to macroeconomic management.

Secondly the current recession is worse than that of the 1930s (see the ONS chart). You would think that those responsible for macroeconomic policy would begin to wonder about the wisdom of austerity. But it would be political suicide for Cameron and Osborne to change direction and both maintain (in public at least) their belief that austerity will eventually succeed. As we will see they are not alone in this forlorn hope.

How have the serious right-wing press reacted? According to the Telegraph ‘the austerity programme does command the confidence of the markets, and that remains crucial. It is this that allows the Government to borrow at attractive rates, which in turn gives the Bank of England the freedom to keep the cost of borrowing low. It would be madness to jeopardise that during such a hesitant recovery.’ So the Telegraph believes that the bond vigilantes are still worried about sovereign debt default and a little more public-sector borrowing will drive UK bond rates to Greek levels. What is the current rate on 10-year UK government bonds? It’s 2%. Looks like a good time to borrow and help the stagnant economy. When will apparently intelligent commentators appreciate that the UK is not like Greece, Ireland, Spain or Portugal? It is not in the Euro area. It has its own independent monetary policy and its currency is not locked into the euro.

The Financial Times is also keen that the UK Coalition stick to austerity. ‘There is no guarantee that under a more expansionary fiscal policy the British economy would be doing significantly better. And set against this is the risk that the UK’s low borrowing cost might rise.’ Also worried about the circling bond vigilantes, the FT sees little to gain from a fiscal expansion. Where does this view come from? Certainly not the scientific evidence.

Former Chair of the Council of Economic Advisers in the Obama administration Christina Romer has an excellent survey on the empirical evidence and it does not support the FT position. Her concluding comments are illuminating:

The one thing that has disillusioned me is the discussion of fiscal policy. Policymakers and far too many economists seem to be arguing from ideology rather than evidence. … The evidence is stronger than it has ever been that fiscal policy matters—that fiscal stimulus helps the economy add jobs, and that reducing the budget deficit lowers growth at least in the near term. And yet, this evidence does not seem to be getting through to the legislative process.

And neither does it seem to be getting through to the leaders of our Coalition government or the editors of the right-wing press in the UK.

Krugman has recently pointed out that the US administration is not that different from our own, at least as evidenced by its behaviour over the past two years, a period over which real government spending on goods and services has been substantially reduced. Despite the rhetoric,  Obama has been beguiled by the British and European obsession with public sector austerity. Krugman’s concluding remark in today’s New York Times op-ed says it all:

So we’re now living in a world of zombie economic policies — policies that should have been killed by the evidence that all of their premises are wrong, but which keep shambling along nonetheless. And it’s anyone’s guess when this reign of error will end.

In a recent Guardian piece, Harvard economist Kenneth Rogoff admits to being confused by the public disdain of excessive salaries paid to top-earners in business and finance when the high earnings of sports stars does not attract similar outrage. Why should talent on the sports field be acceptable but talent in business and finance not?

Typically highly-paid sports men and women can only have achieved their success by their own talent and effort. There are only self-made sports stars. The same cannot be said of success in business and finance, where privilege and accident of birth play major roles.

Moreover it’s not clear to me that there is such a blanket disdain. Rogoff implies that the public was outraged by the salary of the late Steve Jobs. I doubt they were. Without offering any evidence for this I suspect there was a great public respect for the former Apple boss, especially amongst iPad owners! And I doubt that the public is over-concerned by the high salaries of others with real talent, like Jeremy Paxson but not the more lightweight Jonathan Ross. Public reaction is much subtler than Rogoff presumes. When company executives set their own remuneration, or when favours are exchanged in an old-boys’ network or when bonuses are paid on financial-sector (gambling) earnings, then there is public disquiet. This is not blanket disapproval of the top one-percenters. It’s about a deep human belief in fairness.

Way back in January 2009 Paul Krugman used ‘back-of-the-envelope‘ calculations to support his view that the Obama fiscal stimulus was simply too weak a policy response to the developing crisis. It struck me as odd at the time that the Stimulus Act of 2009 was so far short of what was required. It now appears that the President-elect’s economic team was less than fully comprehensive in the advice it offered.

Obama’s economics team included Larry Summers and Christina Romer, the incoming chairman of the Council of Economic Advisers. In a memo to the President-elect the team framed the debate around two basic choices: one of around $600 billion and a second of about $850 billion. It now appears that Romer had, in an earlier draft memo, explained what would be required to eliminate the output gap by 2011-Q1: a stimulus of $1.7 to $1.8 trillion. [This link gives details of Romer's earlier draft and the final memo.] According to Noam Scheiber (writing in the New Republic) Summers agreed that a more expansionary stimulus could be justified on economic grounds but political considerations would make it dead on arrival in Congress. Indeed when the incoming chief of staff Rahm Emmanuel heard of Romer’s more ambitious option he asked ‘What are you smoking?’ Perhaps more reasonably, Summers was also concerned about market reaction, fearing Krugman’s ‘bond vigilantes‘.

It seems odd (to me at least) that advice from economic experts should be moulded by how they feel it might be received rather than by rational argument and economic reality. I would like my doctor to explain fully my treatment choices rather than withhold options that might upset me. Summers has much to answer for.

There has been a fascinating development in the salt-fresh-water spat. A number of Chicago (fresh water) economists seem to be confused over something we normally teach in the first year of an economics degree – possibly even at A-level. And former MIT (salt water) economist Paul Krugman (now at Princeton)  has been prominent in exposing their confusion under the telling blog title ’The Dark Age of macroeconomics‘. The three Econ 101 failures are:  John Cochrane, Robert Lucas and Eugene Fama. They argued that an identity (investment = savings) implies that Obama’s fiscal stimulus would have no effect on aggregate spending – a view known as the widely-discredited  ’Treasury View‘. Krugman’s ‘Dark Age’ link (above) elaborates.

One of the three fresh-water economists, John Cochrane, has retracted. Krugman gloats and refers us to an impartial assessment by Noah Smith. Team-Chicago have not come out well from this spat.

In his retraction, Cochrane argued ‘that one can still argue that our government used the recession to radically increase permanent spending’. In other words the financial crisis has provided a convenient excuse for the Obama administration to expand the size of government. I doubt this is the case, as evidenced by Obama’s more recent flirtation with austerity measures. In the UK case exactly the opposite can be argued. I have in an earlier blog suggested that George Osborne’s obsession with national debt is a convenient pretext to reduce the size of government permanently. Whatever their long-term goals, Obama’s stimulus programme is appropriate for an economy in recession and liquidity trap and Osborne’s austerity measures are simply indefensible – unless you believe in the confidence fairy or the threat of the gathering bond vigilantes.

Olivier Blanchard is currently Chief Economist at the IMF and is one of the world’s most accomplished economists. His perspective on 2011 makes interesting reading.  He draws four lessons from the past year and the third is particularly relevant for us in the UK. I quote it in full:

Financial investors are schizophrenic about fiscal consolidation and growth.

They react positively to news of fiscal consolidation, but then react negatively later, when consolidation leads to lower growth—which it often does. Some preliminary estimates that the IMF is working on suggest that it does not take large multipliers for the joint effects of fiscal consolidation and the implied lower growth to lead in the end to an increase, not a decrease, in risk spreads on government bonds.  To the extent that governments feel they have to respond to markets, they may be induced to consolidate too fast, even from the narrow point of view of debt sustainability.

I should be clear here. Substantial fiscal consolidation is needed, and debt levels must decrease. But it should be, in the words of Angela Merkel, a marathon rather than a sprint. It will take more than two decades to return to prudent levels of debt.  There is a proverb that actually applies here too: “slow and steady wins the race.”

The UK Coalition government set out to eliminate the cyclically-adjusted deficit by 2014-15, largely through spending cuts. If Blanchard is right – and the IMF analysis supports him – the haste with with George Osborne has set about fiscal consolidation may well prolong our macroeconomic distress.

According to the Guardian, ‘Jeff Sachs is one of a handful of academics (think Paul Collier and Amartya Sen) that would receive an audience from most heads of state were he to land in their countries’.  And he filled the University of Bristol’s Great Hall when he gave a most impressive talk, hosted by the Bristol Festival of Ideas.  The occasion helped promote his latest book, The Price of Civilization: Economics and Ethics After the Fall, and many lined up after the lecture for the inevitable book signing.  Along with most of those present, I found myself generally in agreement. Our current economic malaise originated with the financial liberalisation programmes initiated by Reagan and Thatcher in the early 1980s and (less predictably) furthered by the more liberal administrations of Clinton and Blair-Brown. As a result we now live in world more prone to financial crises and characterized by indefensible income inequality.

According to Sachs more government investment is needed in education and infrastructure, financed by raising tax on the rich. In the first chapter of his book Sachs asks: ‘Can we really afford more government activism in an era or huge budget deficits? I’ll show that we can and must.’  And yet he closed his address with an endorsement of the UK Coalition Government’s austerity programme – in order to prevent the UK ‘becoming another Greece’ (his words).  Writing in support of the Cameron-Osborne policies, Sachs argues that ‘both budget cuts and tax increases are needed because you can’t tackle such a large deficit with only one of the two tools’. Sadly he left himself too little time at the close of his Bristol talk to explain how his vision of a larger public sector could be reconciled with the Coalition’s austerity measures.  And I left the Great Hall just a little puzzled by the twist in the tail.

Macroeconomists have for some time considered monetary policy more appropriate than fiscal policy for short-run aggregate demand management. The former is easily implemented (the central bank simply adjusts as appropriate its short-term interest rate) whereas the latter is cumbersome, perhaps requiring legislative procedures that take time. When the bank’s interest rate reaches its lower bound (as it has in the UK and elsewhere), the choice is not so straightforward. For in this case (referred to as ‘liquidity trap’), monetary policy has lost all traction.

In an interesting recent paper, Harvard economists Greg Mankiw and Matthew Weinzierl have attempted to set out a hierarchy of policies for stabilizing an economy with sluggish aggregate demand. Their analysis illustrates how (relatively) simple models can intelligently inform public debate. The full detail of their model needn’t concern us here though in some obvious ways it does not provide the best laboratory for analysing monetary and fiscal policies in the UK today. For example labour markets are assumed to function perfectly and the word ‘unemployment’ appears nowhere other than in their citation of Malinvaud’s imaginative 1977 book. The model is ‘new-Keynesian’ in character, starting with the utility and profit functions of households and firms respectively, and establishing a role for aggregate demand management because firms’ prices are sticky. Their hierarchy of stabilizing policies is quite helpful:

1. When the interest rate is above the zero lower bound, conventional monetary policy is sufficient to restore full employment.
2. When the interest rate hits the lower bound, unconventional monetary policy is sufficient. This requires the central bank to commit to keeping its interest rate at the lower bound into future periods. Credibility is a serious problem with this policy as it is ‘time inconsistent’. Having promised to keep rates low in the future, when the future becomes the present the bank is likely to renege on its commitment. This is especially problematic for those central banks with reputations for inflation aversion (like the ECB and Bank of Japan today). The Bank of England has attempted to make this unconventional approach credible through its quantitative easing (QE) programme – open-market purchases of long-term bonds designed to keep their rates low. As the long-term rate is the average of expected future short-term rates, QE is meant to confirm the Bank’s commitment to low interest rates in the future. The jury is still out on the effectiveness of QE but it likely that this unconventional monetary policy will find the time-inconsistency problem hard to overcome.
3. When conventional and unconventional monetary policies are not available (as is arguably the case in the UK today), Mankiw and Weinzierl suggest that ‘fiscal policy may play a role.’ They favour investment tax credits over changes in government spending because the former can mimic what monetary policy would have achieved had it been feasible.
4. If the conditions of (3) prevail but tax adjustments are not possible, government spending should be used to restore full employment.

The choice of fiscal instrument (taxes or spending) is more complex than Mankiw and Weinzierl imply, as Gauti Eggertsson’s thoughtful discussion of the paper points out. Using a similar new-Keynesian model, Eggertsson has (with Princeton economist Michael Woodford) analysed fiscal policy options for economies in liquidity trap. They show how selective adjustments to tax rates can be used to stabilize but discuss a number of practical impediments to this approach. Temporary increases in government expenditure will restore full employment, spending levels returning to pre-crisis levels once the recovery is achieved. As Eggertsson points out this policy has, like unconventional monetary policy, to overcome the time inconsistency problem – how can governments credibly commit to cutting spending in the future when they have expanded it today?

These academic issues seem very detached from the stance of UK fiscal policy. Far from considering tax cuts or increases in its spending, the Coalition government talks only of austerity, hoping (more forlornly as the recovery falters) that Krugman’s confidence fairies will step in to assist. George Osborne seeks to cut spending when economic theory requires the reverse.

The issue of time inconsistency is important. How can a government’s promise to cut spending in the future  be taken seriously in financial markets when it increases expenditure today? Long-term interest rates may well rise if the markets thought that public sector deficits were permanent. A credible fiscal policy option would be for the government to bring forward existing future public investment programmes (new school, hospitals, roads etc). Admittedly this is likely to take time to implement, but had it been adopted at the time of the crisis, we would now (four years later) been in far better shape. Because these expenditures involve a re-scheduling, the time inconsistency problem is less problematic. The policy is credible.

The eponymous originator of the Taylor Rule seems to have had a change of mind. In 1993 Stanford economist John Taylor proposed that monetary policy (the rate of interest set by central banks) should be linked directly to the inflation rate and the output gap (the percentage difference between an economy’s output and its full potential). In periods of macroeconomic stability, US monetary policy seemed to have followed the Taylor rule, something Taylor himself observed and others more formally demonstrated (Clarida, Gali and Gertler). And, since 1977,  the Federal Reserve Bank has, broadly speaking, been required to pursue the twin objectives of ‘stable prices’ and ‘maximum employment’. The wording may be a little imprecise (what exactly is ‘maximum’ employment?) but the central idea is clear enough: monetary policy should aim to keep inflation low and the economy close to its full capacity – a dual mandate.

Taylor now proposes that the Fed should aim solely at delivering a stable price level (see also his piece with Paul Ryan). He argues that attempts in the past to lower unemployment using monetary policy raised the inflation rate and this actually raised unemployment, though he does not provide any evidence for this assertion. In fact support for simple inflation targeting has come from an unlikely source. Modern new-Keynesian theory suggests that output will always be at its full capacity if prices are stable – a feature referred to as ‘divine coincidence’ by Jordi Gali and Olivier Blanchard. But recent US and UK experience gives little support to the divine coincidence view. Although inflation is roughly on target in both countries (or at least can be expected to be on target in the near future), output is well below its potential and can be expected to remain so for some time. Strict inflation targeting would call for neutral monetary policies; the dual-mandate view calls for an expansionary monetary policy. Since interest rates in both countries have just about reached their zero limit, expansionary policy means quantitative easing.

Financial crises are known to have long-lasting effects on economic activity and unemployment (Reinhart and Rogoff). Inflation is not our present problem – a depressed economy and high unemployment are. So I find it extraordinary that former Fed-chairman Paul Volcker should write a New Work Times op-ed entitled ‘A Little Inflation Can Be a Dangerous Thing‘. In the UK we have been fortunate to have Adam Posen on the MPC.  In a recent speech he makes the case for expansionary monetary policy (QE and more) and shows that the inflationary consequences over the medium term are likely to be minor. The dual-mandate approach goes further. Inflation marginally higher than the 2% target is a price well worth paying if it raises economic activity and lowers unemployment. And, as a number of economists have argued (including Mankiw and Blanchard), raising the target inflation rate is no bad thing.

Robert Barro‘s contribution to economics has been impressive. In the early 1970s he showed (with Herschel Grossman) how economies can find an equilibrium when prices and wages are fixed – general equilibrium analysis with quantity rationing. Their model was more Keynesian than Keynes’s General Theory, where wages alone were fixed. But Barro’s Keynesian period was all too brief and he subsequently became absorbed with new Classical economics, a school of thought aptly called the ‘Economics of Dr Pangloss’ by my former colleague Willem Buiter. [Dr. Pangloss, a character in Voltaire's satire, Candide, taughthis pupils that they live in 'the best of all possible worlds' that 'all is for the best.'] I had dinner with Barro in the early 1980s and I asked what persuaded him to depart so radically from the Keynesian world view. His response was elusive: ‘the first Barro was my twin brother.’ Barro’s work in new Classical economics has been as imaginative as his early work with Grossman. He has made important contributions to monetary business cycle analysis, Ricardian equivalence and endogenous growth economics. Robert Barro is a smart economist.

In a recent Wall Street Journal op-ed, Barro distinguished Keynesian economics from ‘regular economics’, claiming that the former lacks the theoretical foundations of the latter. By ‘regular’ Barro means economics based on the twin assumptions of efficient markets and rational expectations. According to Barro, changes in employment and unemployment (as graphed above for the UK) are the result of properly functioning labour markets. Keynesian economists accept that some fluctuations in employment and unemployment, even at business-cycle frequencies, can be explained in equilibrium terms. But when economies are subject to severe adverse shocks (as in 1929 and 2008) it beggars belief to maintain that labour markets remain in equilibrium. The elegant new Classical models have little or nothing to offer. Models that explain the weather on Venus will not help meteorologists forecast the weather on earth. New classical economics is relevant for a world quite unlike the one we inhabit. Their models are elegant and technically accomplished but irrelevant for our present predicament.

New Classical economists struggle to fit recessions into their framework. I notice that in his WSJ piece Barro offers no explanation of his own for falling employment in the US. How is it possible to explain why 8% of the UK labour force and 9% of that in the US are out of work other than in terms of a labour market in disequilibrium. Charles Plosser attributes the rise in unemployment to a mismatch between the skills employers seek and those workers possess. Why this mismatch should have risen so dramatically in 2008 remains a mystery and Plosser’s explanation was easily refuted by Paul Krugman.  My favourite Chicago eccentric, Casey Mulligan, suggested something even more bizarre. ‘This recession comes from a reduced willingness to work, or a labor market distortion, rather than a reduction in demand.’ What caused this unwillingness to work? This is Mulligan’s answer (and I kid you not):  because changes in mortgage repayment rules favoured low income receivers and encouraged individuals to reduce their labour supply. His view of the 2008 recession is remarkably close to Franco Modigliani’s mischievous description of the Great Depression as a bout of ‘contagious laziness’. How a seemingly intelligent Chicago professor can make such a suggestion is unfathomable. He conveniently overlooked the fact the the 2008 recession was world-wide, and the mortgage repayment rules were a parochial US affair.

There is a model that explains the data rather well: the Keynes-Hicks model, widely taught in introductory economics courses throughout the UK and the US. It may not have the theoretical elegance of the new-Classical model or even that of the more acceptable new-Keynesian approach, but, as Paul Krugman has put it, ‘recent events have been a stunning confirmation of the usefulness of hard thinking in general, and the Keynes-Hicks model in particular.’ Read more on Krugman’s assessment of Barro’s WSJ piece.

The defence of the Coalition’s austerity programme is often expressed in these terms: ‘If we, the general public, have to tighten our belts and pay off our debts, then so must the government.’ With echoes of Margaret Thatcher, George Osborne and Nick Clegg have used a household analogy. The argument runs along these lines: ‘like a household we have to balance the books and not live beyond our means as a nation.’ It all sounds so reasonable and morally upright. But it’s dangerous nonsense. Of course in normal circumstances a balanced public-sector budget is desirable. But not in recession, when belt-tightening and balancing the books are precisely the reverse of what is required of government. When monetary policy has lost traction and when households and firms are saving more and spending less, in order to stabilise aggregate spending the government must save less and spend more. Otherwise we are heading for a Japanese-style lost decade.

Coming from the staunchly Presbyterian town of Kirkcaldy, Adam Smith was keen to identify private morality with public duty, as the following illustrates:

Whatever, therefore, we may imagine the real wealth and revenue of a country to consist in, whether in the value of the annual produce of its land and labour, as plain reason seems to dictate; or in the quantity of the precious metals which circulate within it, as vulgar prejudices suppose; in either view of the matter, every prodigal appears to be a public enemy, and every frugal man a public benefactor.  Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations Book II, Chapter III

The lessons of Keynesian economics are just the reverse. Prodigal individuals will, through their excesses, generate employment for others. The frugality of households and firms will deepen and lengthen the recession. The UK now needs a prodigal government.

UPDATE:

Sadly, Barrack Obama takes the government-household parallel as this Krugman post explains.