Watch For The Endgame

by: Scott Sumner

I just returned from the UK, where I gave several talks and interviews. The main purpose of my trip was to give the Adam Smith Lecture at the Adam Smith Institute. I was very impressed with the people there, especially Ben Southwood and Sam Bowman. Here is a link with a video of the lecture. I also spoke at the Cambridge Union and to some bankers and Treasury people. I did a BBC radio interview, and an interview on BBC's "Newsnight" TV show, which should be broadcast soon.

Almost from the beginning, I've been more popular in the UK than the US. That's probably because the US has a sharper left/right split. Over here, my views are too right-wing for the left (which is rapidly moving ever further leftward), whereas the right sees me as a redistributive Keynesian inflationist.

I noticed that in the UK, all the talk is of raising interest rates later this year, as their economy is growing fast and the employment population ratio is nearing the previous all-time peaks of 1971 and 2006 (what a contrast with the US!) You may recall that a few years ago, I said that the exit from policies can be very revealing. It can help us to understand the effects of policy (as when tapering had a market reaction in the US) and also the underlying dynamics of the monetary fiscal interaction.

First, a bit of background information. Since 2008, the UK has run extremely large budget deficits, bigger than the US as a share of the GDP. Everyone agrees these are too large and need to be reduced. But Keynesians have argued that austerity should be very gradual, to avoid derailing the recovery. That's a fair argument (although I have doubts due to monetary offset), but the implication is that if the recovery ever becomes so strong that you need to raise rates, then clearly, the first place to tighten is fiscal policy, and policymakers should only raise rates when the budget deficit has returned to the optimal level based on the classical principles of public finance. Britain is obviously far from that point.

A few years back, I was very skeptical of the notion that fiscal stimulus in the US was being done because of a lack of effectiveness of monetary stimulus. I predicted that when the time came for tightening, Keynesians would prefer monetary tightening to fiscal austerity, even though their own model says that fiscal austerity should be done first, as it reduces the (still-too-high) budget deficit.

In my admittedly unscientific survey of the UK press, it seems to me that there is more enthusiasm for monetary tightening than accelerated fiscal austerity, just as I expected. Here is an editorial in The Independent, which doesn't even mention of the option of fiscal tightening. (And here's the Times.)

Just to be clear, I am not criticizing the BoE, which has done a good job under Mark Carney. NGDP is rising at a brisk rate. Given the refusal of fiscal policymakers to speed up the austerity process, the BoE may need to raise rates in 6 months to a year. That's monetary offset, and it is quite appropriate. The real problem in Britain is government spending, which is still too high. (Or if you are a left-winger, the real problem is that taxes are too low.)

P.S.: Obviously I'm pleased that there is a single-minded focus on the BoE as the institution that should and does steer the nominal economy. It's a pity that single-minded focus wasn't there in 2008 and 2009.

HT: Travis, W. Peden