Wednesday, 17 June 2015

A hard time for Keynesians?

I haven't made any comments on the results of the 2015 UK elections (and by now it's a bit late), even though I'm pleased to say I was correct in predicting its final outcome back in January. I say this with particular pride since none of pollsters got it right. Some 'pundits' even said there was going to be a grand coalition between Conservatives and Labour (see their texts published in the Guardian, Sky, BBC, HuffPost). What a bunch of baloney. 

Anyway, what caught my attention in the economic debates regarding the electoral results was this FT column by economic historian and Harvard professor Niall Ferguson. He makes a compelling case that the main reason why the Conservatives won a landslide election, amid the polls saying it was going to be the closest election in decades, was the economy.

Economic voting

From an economic voting perspective it makes sense. There's a huge literature out there linking electoral results to economic performance of incumbent governments. And the findings are almost unanimous - the economy matters! (Or as Bill Clinton's 1992 campaign slogan would say: "It's the economy, stupid!"). If economic times are good; economic growth is high, unemployment and inflation are low (denouncing the Phillips curve are we?), it is almost certain that the government will be reelected. 

Ever since Kramer's (1971) seminal paper in economic voting where he modeled voter choice from a rational utility maximization perspective (voters comparing expected utilities for different candidates based on their intrinsic well-being - so basically, an application of the Downsian (1957) and/or Hottelling (1929) model), there is a unified consensus among economists and political scientists studying elections. From that point on economists and political scientists started testing the so-called incumbency hypothesis, to see whether or not the voters punish incumbents for poor economic performance, and reward them for good performance. A substantial amount of empirical and theoretical research has developed since then, mostly confirming the incumbency hypothesis, although also finding considerable heterogeneity in voter responses to economic performance, particularly for non-US examples. If you're more interested in the topic I recommend Duch and Stevenson (2008) "The Economic Vote", Cambridge University Press. In it they summarize some of the stylized facts on economic voting arising from the vast, expanding research done on this subject in the past 40 years.  

Back to the UK elections. There are many parallels linking this election to that held in 1992 right after Thatcher was deposed by her own party, and when John Major was running for PM for the Conservatives. At the time the Conservatives were facing a resurgent Labour and a currency-induced crisis, with the election polls also predicting a tight race. With a huge turnout of 77%, the Conservatives secured a landslide victory (they got 14 million votes, more than Thatcher or Blair at their respective peaks). Many have said that Major benefited from the favorable economic consequences of Thatcher's government. However this result is still strange since we know that the UK was facing an economic crisis at the time. Plus there was the issue of the Community charge (poll tax) that the Thatcher government introduced, not a very popular move at the time. And still, despite the tax and despite the lackluster economic environment, the Conservatives secured a landslide victory. How's that for economic voting? 

Has austerity succeeded?

In line with the economic vote arguments Ferguson fires a dart at Krugman pulling out his statement from 2011 where he "denounced the “delusions” of the chancellor whose “experiment in austerity” was “going really, really badly". He continues in saying that Krugman predicted the UK would end up worse than during the Great Depression and that the disastrous austerity policy will cripple the UK economy for some time. This obviously didn't happen:
"The UK had the best performing of the G7 economies last year, with a real gross domestic product growth rate of 2.6 per cent. In 2009, the last full year of Labour government, the figure was minus 4.3 per cent. Moreover, far from being in depression, the UK economy has generated more than 1.9m jobs since May 2010. UK unemployment is now 5.6 per cent, roughly half the rates in Italy and France. Weekly earnings are up by more than 8 per cent; in the private sector, the figure is above 10 per cent. Inflation is below 2 per cent and falling."
Ok, so this is obviously a bit of cherry-picking. It's wrong to say that austerity caused higher GDP growth, or that it caused a re-bounce of employment. To determine that we would have to see what would have happened if it had not been for austerity, if the Keynesian solution was being applied from day one (as it has been in 2008 and 2009 during the Brown government). One can also make the claim that Brown's policies pushed the UK in a recession, or that they prevented an even larger slump (recall the similar debates surrounding the Obama stimulus package in the US in 2009). Ideally this could be done by comparing both scenarios across the same period of time (treatment and control group), but in macro this is impossible. In macro it's hard to determine any causal relationship, Prof Ferguson should know this. However the fact remains that the economy was performing well, even above expectations in the last year and a half. 

Fiscal stabilization was a success in Britain, there's no doubt about it. And there's no doubt that this is precisely what the UK needed. A country facing a 13% deficit to GDP and close to 90% debt-to-GDP, after applying a Keynesian stimulus during 2008 and 2009, couldn't face such unsustainable public finances any more. Britain is not your average small open economy whose bad public finances could affect its borrowing costs (or its credit rating), but still, having such high levels of debt and deficit is surely crippling for growth. 

Needless to say, Ferguson's column received a great deal of criticism, most going in the direction that it was the global recovery itself (read: foreign trade) that led to Britain's boosted growth numbers. Some have even pointed out to OBRs forecasts that the economy would have been performing even better had it not been for austerity. They say GDP in 2014 would have been about 1.5 p.p. higher without austerity.

However just like Ferguson's numbers, this is cherry-picking as well. We have no idea what the situation would have been if the public finances weren't stabilized in 2011/12. It could have been a disaster if the deficit continued to be above 10% to GDP for the past five years, perhaps it could have affected Britain's borrowing costs and its credit ratings. We could only speculate on what could have happened, which is why these types of calculations are a bit naive.

Furthermore in those two years, in 2013 as well, Britain wasn't hailed for its growth performance at all. On the contrary, reports were of a triple-dip recession, and a prolonged Japanese-style recession. I made the same pessimistic projections back then not due to austerity, but due to certain policies that were failing to target the productivity problem in Britain (see here, here, here and here). The same problem is still there, despite the growth numbers. Britain has gone from jobless growth to a productivity-less growth. This is, in my humble opinion, the crucial economic problem the government will face in its next 5-year term. It will be clouded by issues such as immigration, the NHS (always a hot topic in Britain), and most of all the EU in/out referendum (and possibly Scotland again). Some economists will keep writing about the productivity problem, but in the wake of 'good economic performance' too few will care. 

Verdict: when you're a large open economy, you can get away with anything 

Therefore the jury is still out on the success of austerity. Britain has benefited from stable public finances which has evened out expectations, boosted confidence and reduced uncertainty. Just like Germany, Britain was reluctant to use its reinvigorated public finances and historically low interest rates to increase government spending (as many Keynesian economists have been advocating over the years). And just like Germany it has no regrets about this. Rightly so. They took an alternative route and it worked. Growth rates are small (again just like in Germany) but this hardly worries the people, as optimism over the economy has returned. Particularly in the housing market

As for the defeat of Keynesian policies, in Britain this has been declared back in 2009. Usually Keynesian fiscal stimuli are said to work well only in large open economies (see what LARGE means in this case). Otherwise, too much government spending, even as a typical counter-cyclical response to a downturn, can in most small open economies result in fiscal problems and high government bond yields, thus further diluting the government's options for taking on new debt. Running large deficits means taking on more and more debt each year. And if the price of taking this debt is too high, the negative spiral is quickly reinforced as higher interest payments only put more pressure on widening the deficit. Soon the country is in huge fiscal problems.

However this scenario rarely occurs in large open economies like the US, Germany, UK or Japan. In neither of these countries no matter how large the government debt is, they will always be able to borrow at 1% rates, simply because there will always be a huge demand for their debt (particularly when it's denominated in dollars). This happened during the crisis as well; none of these countries had their bond yields go up. However this is not a justification for taking on more debt. Britain and Germany decided to apply one strategy, while the US did a slightly different one. They all worked precisely because these countries are large, open economies. In other words, they are allowed to experiment and try different things (like QE), but this doesn't apply for the rest of us. For the rest of us fiscal prudence is still key, crisis or no crisis.