In response to recent posts from Simon Wren-Lewis, Paul Krugman and myself, Tony Yates has expanded on his defence of the principle of tightening fiscal policy in the aftermath of the financial crisis.
He provides two lines of argument. I have already dealt with the first – that there might have been a bond panic. Logic and evidence from global bond markets directly contradicts this hypothesis.
His second line of argument is that the UK had an inflation problem in 2010. If this were the case, large budget deficits and QE would indeed have been a problem. Paul Krugman and I have pointed out that Tony’s position is at odds with the Bank of England. Otherwise, why would they have been doing QE.
Tony is therefore making an argument which no one to my knowledge was making at the time: that fiscal policy should be tightened to constrain inflationary pressures. Here is what he says:
“… although the UK was clearly a depressed economy, inflation was quite a long way above target. So no monetary-financed-induced inflation was actually wanted. There were plausible reasons to think that was a temporary thing [PK mentions, fairly, the delayed pass through from the depreciation of Sterling in the immediate aftermath of Lehman’s]. But there were also reasons to think that actually supply was as ‘depressed’ as demand. This is what, for instance, would have been predicted by a financial frictions modified version of the New Keynesian models central banks were using. Falling bank net worth causes them to constrict finance to firms; falling firm net worth causes their cost of finance to rise independently. Both curtail capital-formation and restrict supply.”
To put this argument in context, it is worth reminding ourselves of the Bank of England’s actual views on inflation at the time. They are laid out quite clearly by Mervyn King in his letter to the Chancellor in August that year:
“Why has inflation moved away from the target? Inflation has been volatile over the past two years or so. In that time, it has moved above 5%, then fallen to 1.1 %, risen again to 3.7%, and has since started to fall back once more. But on average over that period, inflation has been above the target. And the recent strength of inflation has surprised the MPC.
The MPC’s assessment is that much of the current high level of inflation can be attributed to the increase in VAT in January 2010, past rises in oil prices and the continued pass-through of higher import prices following the depreciation of sterling since mid-2007. The MPC’s central judgement remains that these effects will prove to have a temporary impact on inflation, and are masking the downward pressure on inflation from spare capacity within companies and the labour market [italics added].”
Looking forward, Mervyn King continued:
“As the effects of higher VAT, energy price rises and import price increases drop out of the twelve- month comparison, inflation should fall back, probably to below the target, reflecting the influence of spare capacity in the economy. That influence of spare capacity is one of the factors driving the current weakness in wages – regular pay growth has been less than 2%, markedly lower than the average growth rate of pay in the five years prior to the crisis. The MPC’s central view remains that inflation in the medium term is likely to be close to, or a little below, the target. That is consistent with the current low rate of pay increases, little growth in broad money and credit, generally stable inflation expectations and the most likely prospect being a muted recovery in demand that is insufficient to eliminate the margin of spare capacity in the economy. But how fast and how far inflation will fall are both difficult to judge, with substantial risks in both directions relative to the MPC’s central view.”
Frankly, this analysis was very clear at the time, and largely uncontentious. The contribution of the oil price and VAT to inflation is directly measurable. Responding to “spot” headline inflation, when it is this volatile, and inconsistent with underlying trends in wages, would be an absurd basis for policy-making: is Tony really suggesting that the fiscal position should be eased aggressively one year when inflation is close to 1%, tightened the next when it is 4% etc.?
It is also clear that Tony’s concern that headline inflation was elevated because of financial frictions on the supply-side is decidedly eccentric. As the Governor pointed out, wages and broad money were all consistent with significant spare capacity and below-target inflation – which is why monetary policy was so loose. Tony cannot be thinking that oil prices, VAT, and sterling, were caused by an impaired supply-side. But if all other indicators of trend inflation were pointing in the opposite direction, there is nothing to explain. To quote from the May letter:
“The MPC judges that together these factors [oil, VAT, sterling] more than account [italics added] for the deviation of CPI inflation from target and that the temporary effects of these factors are masking the downward pressure on inflation from the substantial margin of spare capacity in the economy.”
As it happens, I think impaired credit channels can cause enduring damage to the supply-side of the economy, although this was not particularly relevant to the inflation picture in 2010. But why would you tighten fiscal policy if you thought capital-impaired banks and weak balance sheets in the corporate sector were constraining supply? An even weaker economy makes both those factors worse. Easing fiscal policy and boosting demand in this model would cause inflation to fall.
Finally, Tony argues that had the Eurocrisis caused a second global financial panic, the UK might have been viewed as ‘like Ireland’. Again, this ignores overwhelming evidence that the dividing line in global bond markets in 2010 was QE.
The way Tony has been describing the risk of a bond panic in the UK is in no way like what happened in Ireland. The bond panic in Ireland was a credit risk event: in other words the market – rightly – thought there was a risk of sovereign default. No one was arguing that bailing out its banks would cause Ireland a future inflation problem. We know this because credit default swaps (CDS) measure default probabilities, and in all of the bouts of bond market panic in the Eurozone, sovereign CDS spreads widened, and market measures of inflation expectations fell.
That is why it is clear that QE was the fault-line. There is no credit risk in QE-country sovereign bond markets. And market concerns – and central bank concerns – about inflation since the crisis have been consistently to the downside.
Tony may be right to point out that the market’s response to “whatever it takes” was unpredictable. I have some sympathy with this, but it is not relevant. The response of CDS spreads to Eurozone QE this year is more relevant: they have fallen everywhere, except in Greece which is not eligible, and despite a rising risk of a Greek default.
So Tony is in fact saying that the UK was vulnerable to a totally unique bond panic, totally unlike Ireland. In this novel form of panic, the market thinks that government deficits are so large that it will have a future inflation problem, despite the fact that the independent central bank thinks that inflation risks are so skewed to the downside that interest rates are close to zero and it is buying back almost as much debt as the government is issuing. This bond panic is triggered by a second banking crisis, when the government is not just the monopoly supplier of bank reserves – which allows it to reduce the stock government bonds – but also the monopoly supplier of the highest-rated assets in the financial system (government bonds), the demand for which has risen sharply in every panic.
In summary, Tony’s perspective on the inflation dynamics in 2010 is odd and inconsistent with prevailing facts at the time. Even if it were true, the appropriate policy response is the opposite to what he prescribes.
Given that the UK was doing QE and could have done a great deal more (after all a 100% reserve requirement is a regulatory option), the UK could not have had a sovereign run ‘like Ireland’. Tony is in fact describing a sovereign panic which we have seen nowhere, and which makes little sense – precisely because at no time since the financial crisis have markets worried about inflation. And if you want to know why, just look at global inflation trends.
 It is important to be clear that Eurozone QE has conditionality, in a way that is not true of outside the Eurozone – as we have seen in the treatment of Greece. Prospectively, if markets were to think there was a material risk that other countries failed to reach agreements or breach EU rules, and this threatens eligibility, a reemergence of sovereign panic in the Eurozone would be logical.