Why does the UK seem to be doing better?
Here’s how Paul Krugman answers that question (in an interview with Will Hutton):
WH: In Britain, there is now a new consensus forming that the government’s economic forecasts, which were roundly mocked at the time of the April budget for being wildly optimistic, could be right – that is, growth will start to resume in 2010, albeit at a very low rate.
PK: Well, the UK has achieved a lot of monetary traction in the way that no one else has through the depreciation of the pound. In effect, you’ve carried out a successful beggar-my-neighbour devaluation.
WH: So, the United Kingdom might actually get through this in reasonably good shape?
PK: Yeah. That’s why I’ve been watching with an outsider’s slight puzzlement, your bizarre political circus.
WH: Darling and Brown deserve more credit than they’re given?
PK: If the government can hold off having an election until next year, Labour might well be able to run as “we’re the people who brought Britain out of the slump”.
WH: So your advice to the Labour Party is: hold steady.
PK: Probably.
WH: Probably?
PK: I don’t know enough about the other aspects of politics, but I would guess that the option value is quite high that the economy might actually have turned a corner. That’s unique. That’s a uniquely British thing. None of the other G7 countries has anything like that.
WH: And that’s a combination of our big beggar-our-neighbour devaluation, aggressive monetary policy, successfully recapitalising our banks and our fiscal policy.
PK: There hasn’t been very much discretionary fiscal expansion when all’s said and done.
WH: Well, there was a £20bn temporary cut in VAT.
PK: Yeah.
WH: Which is non-trivial.
PK: Non-trivial. But not much [other spending], as I understand.
WH: Well, there was bringing forward £3-4bn of capital spending. Perhaps together in a full year the stimulus was 1.5% GDP. Maybe 2% at the outside.
PK: Monetary policy has been more aggressive – though maybe less than the Fed – and the depreciation of the pound is a nice thing from a UK point of view.
It’s good to hear that the one country that relied on an aggressive monetary policy, rather than fiscal stimulus, is doing better than the others. Of course that’s been my argument all along. I have little to add to Krugman’s comments except two brief points:
1. In a worldwide slump there is no such thing as “beggar-thy-neighbor” policies; only countries pulling their weight, and those that don’t. Britain is one of the few that is (almost) pulling its weight. This comment is not directed at Krugman. He approves of Britain’s policies, and thus I think he is merely using the term ‘beggar-thy-neighbor’ in the traditional sense of a country devaluing in a worldwide slump. I don’t think he opposes their action, rather I believe he thinks the ECB should also try to do more (based on some of his earlier posts that severely criticized the ECB for being too contractionary.)
2. He indicated that the Bank of England might have been less aggressive than the Fed. That might be true in terms of the monetary base, but that indicator is misleading for all the reasons I have endlessly discussed. (Presumably Krugman also understood that policy indicators can be unreliable, which might be why he didn’t simply say they were less aggressive, without the “maybe” qualification.
Given all my disagreements with Krugman over the role of monetary policy, I find it amazing how close our views are on the UK situation. In another post I have planned I will argue that our views have always been very close; it’s just that he interprets the relevant US policy options differently. It is not usual for two economists who differ about policy options in their own country, to have very similar views on policy in another country or at another point in history (such as the Great Depression.)
(BTW, Krugman has argued that spending is more stimulative than tax cuts, which might be one reason why he is not impressed by the temporary VAT tax cut. I have doubts about more government spending, but I do agree that temporary VAT cuts don’t have much impact on AD.)
Update: I should have also mentioned that the depreciation of the pound is not a separate policy, but merely an effect of the aggressively expansionary monetary policy (currect and future expected monetary policy.)
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14. June 2009 at 10:11
Beggar-thy-neighbor is not very accurate. Even beggar-thy-lender is limited when the alternative is default. I cringe whenever I hear not everyone can beggar-thy-neighbor, when everyone beggaring-thy-neighbor is just what is needed, because what is being adjusted is not exchange rates but debt ratios.
14. June 2009 at 11:04
Why do you think that temporary VAT cuts don’t have much impact on AD? The standard argument is that they reduce the after-tax real interest rate, and so increase demand for consumer durables. (It’s not so much the current tax cut, but the expected future tax increase that does this). This is a substitution effect, to be added to any standard income effect of tax cuts (for those who are borrowing-constrained, and for whom current disposable income is what determines consumption demand).
Admittedly, this argument holds the nominal rate of interest constant, and also assumes the before tax rate of inflation is sticky. But that latter argument appears to have some empirical support. I a couple of recent cases where the Canadian government cut VAT (we call it GST), the results on the price level were almost exactly what one would predict from a crude accounting perspective (a 1% cut in VAT causes the price inclusive of tax to fall the same 1%).
14. June 2009 at 12:08
TO BE NOTED: From Knowing And Making:
“VAT cuts work!
According to the CEBR, the government’s VAT cut in December has worked – with retail sales likely to be £8-9 billion higher this year than without it.
This is contrary to anecdotal evidence from small businesses, but I speak to lots of small businesses and they are not the first people you’d go to for econometric analysis. By their nature, smaller firms find it harder to dissociate the effects of a VAT cut or any other single input from random changes in demand. A number of larger businesses have reported better results from the change, but again they are not in a position to measure the effect across the whole economy.
The CEBR is independent of the government, although they were calling for the VAT cut before it happened, so they have a vested interest in declaring it successful. Regardless of this, the retail figures are certainly good news and point to an earlier recovery than might have been expected.”
14. June 2009 at 12:10
Here are the links:
http://www.knowingandmaking.com/2009/04/vat-cuts-work.html
http://news.bbc.co.uk/2/hi/business/7995850.stm
14. June 2009 at 13:45
This week’s issue of The Economist has a report on the euro area, which outlines several institutional reasons why it can’t be as expansionary as, say, the Fed.
It also says money is “a form of government debt,” which implies that it can’t be issued by free market institutions.
For crying out loud, why doesn’t the writer, John Sullivan, crack a few monetary history tomes? White’s Free Banking in Scotland will do.
(The Economist has been sliding down a long hill for quite a while. At least it hasn’t given up on free trade yet, but that’s about all it’s good on.)
As for Krugman on increasing G spending vs. cutting T, of course he’s more for the former, because he’s a socialist.
Before you post a comment saying I’ve lost it re: the definition of a socialist (nationalization of the means of production–but hey, doesn’t that describe a lot of the stimulis?), socialists think that economies can be planned, contra Hayek, so, for example, anyone who is pro-central banking and monetary policy and therefore against free banking, is a monetary/money socialist.
Worse, Krugman naively thinks more G won’t lead to more politicization of the economy, which is plainly absurd.
So lower G and lower T.
What we need is A (anarchy) plus the constable. And I’m going to keep my powder dry in case the constable gets stroppy, as my Brit friends would say.
14. June 2009 at 21:30
One reason for the UK’s resilience which I think is not widely acknowledged is that the UK didn’t have a construction boom in the first place. A housing bubble yes, but a large part of that house price inflation was caused by a lack of supply. Compare to the US, Ireland or to Spain where the bursting of the bubble caused an abrupt collapse in construction and directly onto GDP. In the UK, the effects have been primarily indirect, through the -ve wealth effect. I’m sure the UK’s recovery will go down as a victory of beggar thy neighbour, and the exchange rate collapse last year will definitely help, but the absence of a construction boom to accompany the housing bubble is as important (and also suggests the fall in house prices should be less than in those other housing bubble countries).
14. June 2009 at 21:33
Oh, and on the VAT effect: the rate went fom 17.5% to 15%. Ordinarily you’d expect that to have some sort of effect. But when the high street was filled with 50% off signs, or even 75% off signs, it’s difficult to see how such a small relative change would have made much marginal difference.
14. June 2009 at 23:09
DG: Possibly because the 50% off signs are marketing, and the VAT cut was real!
Without wishing to be too cynical, normal discounts do not really represent a reduction in prices. They are part of the general interplay of competitive forces: one of the mechanisms that keep a downward pressure on prices, and a way for retailers to attract the attention of consumers, but do not indicate a genuine willingness by stores to take losses. The VAT cut reduces the real effective cost of goods to the retailers and competition (more or less) allows that reduction to be passed on.
At the time of the cut there was naturally speculation in the press about whether retailers were keeping it or passing it on. Even if they did keep it, it would increase retailer profits which would still (eventually) provide a demand boost, though admittedly it might not be a timely one.
15. June 2009 at 03:47
A couple of other ideas…
As I said in an earlier thread I think that the recovery in the UK may be connected to Austrian Capital theory.
If a capital good can be used at many stages in the process of production then it will not be affected so much by a crisis. A person who does a finance job may do that for a large bank. If he gets fired he may do something similar for someone else. Though the return on his knowledge possibly won’t be a high.
I think something that may have had an effect too is flexible mortgages. These are very popular in the UK, I have one, an offset mortgage.
http://en.wikipedia.org/wiki/Offset_mortgage
I understand that these have been crushed by regulation in most other parts of the world. They are very useful in financial planning. I doesn’t matter to me, or others with these sorts of mortgage, if my income stream is lumpy over a few years.
15. June 2009 at 04:57
Lord, I agree, and not just debt ratios, but prices of goods and services (which help debts, but also help employment even without any debt problems.)
Nick, That is a good point that I hadn’t thought of. I live in a country w/o a VAT, and am not used to thinking in those terms. I was only thinking of the income effect, which as John Taylor showed in a May 2009 AER article, was very small for the US tax rebate of the spring of 2008. You may be right about the substitution effect. Singapore uses a similar strategy of adjusting their payroll tax during recessions. This tends to offset sticky nominal wages, and keeps real labor costs from rising during recessions.
Having said that, didn’t Brown also announce plans to raise the top MTR from 40% to 50%? If so, that would undo any stimulus from the VAT rebate.
I would also argue that in an open economy like the UK (or Canada) the exchange rate might be more important than a modest change in the VAT rate, especially if the depreciation is large. I also recall, however, that the UK pound has risen recently, after falling sharply last year. Thus I am not as optimistic about the UK as Krugman. But I agree with Krugman’s basic point that the UK has been more aggressive with monetary policy than most other countries, and that that is a good thing.
Don, That may be right (see my previous response to Nick.) But are the amounts large enough to be significant? And how good are the estimates? Do we know what retail sales would be without the VAT cut? Suppose the revenue loss is offset by a 10 point boost in the top MTR, and that reduces business confidence in the future vibrancy of the City of London. Could that hurt investment? My point is that this stuff is really complicated, and we can’t be sure of the magnitudes. BTW, that is also true for my pet monetary ideas, which I acknowledge work best in a closed economy setting. I don’t know the extent to which Britain can swim against the tide, even if they do boost NGDP through monetary easing.
Bill Stepp, It’s true that the ECB is not backstopped by a single national Treasury, but that doesn’t excuse their 4.25% target rate last fall, nor does it excuse the 1% rate right now. Why not zero? And why not level targeting? (which would be a promise to eventually make for any inflation shortfall that is almost certainly coming in the next year.)
It does seem like Krugman’s political view might bleed into his macro views–although I suppose people would say the same about me.
DG, I agree that the VAT effect may be fairly small, but as Nick pointed out it is probably bigger than I first thought.
The key test of your hypothesis about housing would be to look at manufacturing. Germany and Japan had an even smaller housing bubble than Britain. But they are falling faster because of manufacturing. The weaker pound should have helped UK manufacturing relative to Germany and Japan. Did it? I have no idea. But that would be the appropriate test for the Sumner/Krugman hypothesis that monetary stimulus was effective in Britain.
Leigh, You are absolutely right. Again, the question is how important was this compared to the fall in the pound from $2.00 to $1.45. BTW, I saw most of the Krugman video, and found it more disappointing than I expected. I’ll try to get some comments up soon, and I’d be interested in your reaction.
Current, The fact that finance is important in London is also a weakness however. Yes, a financier may be skilled enough to do other jobs, but in the sort run there would be a massive loss in output if a big chunk of bankers had to switch to other professions—they would be nowhere near as productive. And finance is a big part of the London economy.
The mortgage comment is also interesting–I see the appeal of that type of mortgage. But I still think monetary policy is the main driver of NGDP growth.
15. June 2009 at 05:36
ssumner: “The fact that finance is important in London is also a weakness however. Yes, a financier may be skilled enough to do other jobs, but in the sort run there would be a massive loss in output if a big chunk of bankers had to switch to other professions””they would be nowhere near as productive. And finance is a big part of the London economy.”
Well, a lot of banker have been made sacked. See this:
http://www.telegraph.co.uk/finance/financetopics/financialcrisis/3542572/Financial-crisis-UK-job-losses.html
The argument is a relative one though. What sorts of unemployment of people and resources creates the worst problems?
There will always be a real loss when employment changes like this. All our jobs are specialized to the local environment we work in. That could be a very large loss.
But, in other businesses that exists too, and so do other additional losses. As an engineer if I were fired then there would be a loss in my output as I moved jobs. But there would be a large corresponding loss due to the unemployment of capital equipment.
This is the whole problem though with Austrian capital theory. The heterogeneity of capital can’t practically be observed. Even if the physical part could be so much of it is human capital today.
15. June 2009 at 08:19
“Well, a lot of banker have been made sacked.”
I meant to say “a lot of bankers have been made redundant”.
16. June 2009 at 05:40
The key reason the UK is doing well is that monetary policy in the UK acts as fiscal policy. Unlike the US UK mortgages are all floating rate and act as a tax on disposable income when rates go up…and vice versa. This is the overwhelming reason for relative health of uk consumer. Now you know you can watch the BoE screw it up by tightening too quickly!
16. June 2009 at 09:14
Current, Yes the point about capital is a good one. Offices in London can probably be switched to other uses more easily than factories. Although I should say that I don’t really know enough about this to have an intelligent opinion.
16. June 2009 at 10:45
Mark T:
Variable rate mortgages are also used in the Republic of Ireland where I currently live, fixed rate mortgages are unknown. Things here are very bad though. Variable rate mortgages are also used all over Europe.
The US situation where fixed-rate mortgages are the rule is quite exceptional.
18. June 2009 at 07:31
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