"There's no framework anymore that tells them what to do"
TH: We’re looking at what seems to be a pick up in activity across the board in the UK. Now if growth were to continue into 2015 will the government’s commitment to deep budget cuts in the next parliament be tested if they threaten to undermine growth?
JP: There are several different ways you can look at it. One is to say that if we are right about the supply-side pessimists then what we will see as the economy picks up is that not only that output will pick up but potential output will pick up also. Not that anything will really have changed, but the estimates of potential outputs will have increased.
As a consequence the structural deficit will improve because the estimate of what the underlying position is will get better. The actual deficit will also decrease because of the improved cyclical position. That leads to two interesting questions of politics and economics: what should you do in response, and what will the government actually do?
Remember that when the position worsened, George Osborne’s rules effectively said that you don’t respond to a worsening cyclical position by cutting more but you should respond to a worsening structural position by cutting more. But of course the government ignored them and that’s one of the factors which meant that we’re finally getting some sort of recovery. It was the right decision.
Yet the counterbalance of that is of course, if you think that that was the logical and rational thing to do - and certainly I think it was better than the alternative - if things get better, it starts to undermine the need for further consolidation. So if the fiscal position ends up looking significantly better and you’ve already promised to deliver a very significant backload of spending cuts, the question is, will the government in fact deliver those cuts even when in some sense it has more money than it thought it did when those cuts were set out?
There’s no framework anymore that tells them what to do. They’re muddling through and it’s not at all clear how they will make their decisions.
TH: Which presents an interesting situation coming into the next election cycle, both for the government and those who were predicting that austerity could not produce growth…
JP: Yes, it poses some problems for those of those of us who thought the original plans were mistaken, for which we had two arguments. Firstly we agreed that consolidation was needed, but that the timing was wrong. Clearly cuts were needed but they should have been back-loaded, as cuts are less damaging when done in an environment of growth because multipliers are more likely to be zero or closer to zero.
Secondly, we didn’t actually think that the underlying position was that bad and so people like Simon-Wren Lewis and I thought that the right time for fiscal consolidation is when the economy is growing. It’s not that we’re fiscally irresponsible, it’s just that there’s a time and a place for fiscal responsibility.
The logical implication of our position is that if the economy is growing nicely coming into the next election then you may think that the policy is too loose. We’re not there yet, but there’s no reason why we couldn’t be there in two or three years time.
You have to start from where you are and if where we are in two or three years is in a position of strong underlying growth then it may mean we should be making a fiscal adjustment more rapidly.
TH: How much of a curveball has the government’s ‘Help to Buy’ scheme been for those predicting a gloomy outlook for the UK?
JP: I wrote a while ago about the balance between fiscal and monetary policy - though I don’t take an absolutist approach – and in theory there is no demand problem that cannot be solved by monetary policy. But that doesn’t mean it’s optimal because monetary policy is not this wonderful neutral, predictable and carefully calibrated tool that we all know exactly how to use. That is one of the strong arguments for using fiscal policy rather than buying the government’s line that monetary policy will take care of the demand shortfall.
With ‘Help to Buy’ you can tell a perfectly plausible story saying that the government won’t use predictable tried and tested fiscal policy to manage demand, and so they’re using untried and untested monetary policy. Of course, with untested policy the risk is that you overdo it either for the economy as a whole or particular sectors of it. It can risk setting off economic growth that is being driven to an undesirable extent by house price appreciation.
TH: Over the past three years UK workers have suffered persistent falls in real wages. Some commentators are arguing that, even if the government can engineer some form of recovery, it still don’t seem to have an answer to that.
JP: I have some sympathy for the government in that sense. It’s hard enough getting the fiscal and monetary mix right from the overall macro point of view, and it may be asking too much if we expect them to think about real wages as an independently influenced short term macro variable as well.
I think that if you get decent growth that should be the macro remedy to real wages in the short term and then separately there are many other structural issues concerning the distribution of national income between labour and capital along different points of the income distribution that can be addressed over the longer term.
If you want to make changes to the structure of the labour market to boost real wages, or to reduce the income inequality, you should do so because they are the right thing to do from a five to twenty year perspective, not because you think they are going to make much macro difference in the short term.
So I think trying to use macroeconomic policy to address those in the short term is asking too much given how much difficulty we have making macro policy work. But you can imagine though that things like Help to Buy might make it worse, because you’re effectively re-distributing more income away from the relatively low paid and renters, to people who are retired and own houses.
TH: Given the apparent lack of domestic cost pressures couldn’t nominal wage growth form part of the monetary policymaker’s thinking when assessing the timing for raising interest rates?
JP: Yes absolutely, I don’t deny that it’s a useful indicator, and that if I were thinking about how to make monetary policy that I would consider it. So for example forward guidance seems to be an unmitigated failure. If the idea was to put a cap on market expectations of interest rate rises depending on long-term rates it’s not proven very successful so far, but at least Mark Carney is trying something.
They’re new tools and we don’t always understand exactly how they work.