The Recovery: What I got wrong & what I’ve learned
2013 is coming to an end and the economy is firmly into recovery stage. The recovery that we have is not the one we wanted – it comes two and half years later than expected, it is unbalanced and (crucially) it is not feeding through into median income growth. But, all these important caveats aside, it would be churlish in the extreme not to admit that my central view of what was likely to happen (in terms of GDP growth) in 2013 has been proved wrong.
And having admitted that, it is worth looking to see what the source of that error was and what I can learn from that.
I think, for reasons I’ll outline below, that my big mistake was to underestimate the potential power of monetary policy and how it can impact on the wider economy. I think lessons can be drawn from this which say important things about rebalancing, the sustainability of growth and the kind of policies which the UK needs in order to build a better functioning economy.
I also think, for what it is worth, that the type of recovery we are ‘enjoying’ points towards Larry Summers being right on the really big question in current macro – that of ‘secular stagnation’.
Having gotten the confessional, ‘I was wrong’ out of the way, I think I’ve bought myself the right to say, ‘but I wasn’t completely in the wrong ball park’. Back in October last year I wrote a long post entitled ‘why I expect a weak recovery’, which to both provided an expected direction of travel for how I saw the UK economy developing in the future and also (and perhaps more importantly) set out how I think about the economy.
That post concluded:
I foresee three possible scenarios for the UK economy in the next three or four years (in the absence of rapid rebalancing towards a net trade or investment led recovery and in the absence of a change in fiscal or monetary policy):
- First, and most preferable but most unlikely, we get strong growth in real incomes as inflation falls back towards 2% and wage growth increases. If that happens then consumption growth will be stronger and the economy will grow at a decent pace.
- Second, and what I think is the most likely outcome – my central ‘forecast’ if you will – household income growth will be weak and the savings ratio will not drop by much. The result will be weak consumption growth and an economy that is growing, but growing slowly – in the order of 1-1.5% a year. In historical terms of recovery from recession this is pretty much a disaster.
- Third, it is possible that we still get weak income growth but that the savings ratio drops rapidly. In this scenario we’d see faster consumption growth and hence faster overall growth. This however would be accompanied by a big increase in household debt. It might give us 3 – 4 years of decent growth, but at the risk of increasing the financial imbalances that got us into trouble in the first place.
I hope for the first outcome, expect the second and worry about the third.
I expected the second, we got the third. I always thought the third was possible but I did not, in all honesty, think it the most likely outcome. In my defence – policy did change.
My third scenario from 14 months has the benefit of fitting the UK data – consumption is the biggest driver of growth, consumption is rising faster than household incomes and the household savings ratio has fallen. More importantly, the most recent OBR forecasts expect these trends to continue into the future.
The really important question then, if I am going to learn from this episode, is ‘why is the economy recovering now?’
I think two of the most common explanations –lower inflation and an easing of the Eurozone crisis – don’t fully stack up.
Whilst it is certainly true that inflation has fallen over 2013, this misses the crucial fact that wage growth has also slowed. So whilst RPI and CPI fell from 2.9% and 2.5% last summer (August) to 2.6% and 2.1% this November, average weekly earnings growth fell from 1.6% to 0.9% over the same period.
Since the summer of 2012, which is roughly when the current recovery can be dated to, wage growth has fallen by more than inflation. In other words the squeeze on real wages has intensified.
It also true that the Eurocrisis seems (in aggregate and on some measures anyway) to have eased since last summer. But I fail to see the transmission mechanism from this to a stronger UK outturn. The most direct, and obvious, channel would be increased exports. But this certainly hasn’t materialised. The trade deficit has widened rather than closed over the last year.
Some point to better conditions in Europe leading to an increase in business confidence – well, this may be the case but I can’t see any evidence in either business investment data or pay settlements that increased confidence has led to higher activity from the corporate sector in aggregate.
Other would argue that there is a link between better news from the Continent and increased consumer spending. The fact that people are hearing less about the potential break-up of the single currency is encouraging them to go and spend. This feels, to me anyway, like a bit of a stretch – ‘have you heard that Italian bond yields are now well below 7%? I think I’ll go and buy a new dishwasher’.
Where the Eurocrisis easing may have had a bigger impact is on the cost of credit – but I suspect that a bigger factor can be found in domestic monetary policy.
In today’s FT Chris Giles has an interesting column on the role of consumption in growth (and yes, he is right that consumption is ultimately the point of growth, but I think he underplays the need for a rebalancing of the UK economy). He writes that:
Is it more likely that households reached for their wallets again because they were gripped by a sudden collective insanity that duped them into spending against their best interests? Or is it more probable that lower unemployment and falling inflation has eased the squeeze on incomes, encouraging people to believe their future incomes might be better than feared? I plump for the latter – and welcome it.
I think he is missing a third possibility. Alongside the dichotomy between collective insanity and increased confidence, is it not possible that the cost of borrowing dropped making it more attractive to consumers?
This is certainly what the ONS seems to think has happened. As the October Economic Review noted:
…households deleveraged between 2008 and 2011, reducing their exposure to non-credit card unsecured debt. However, from mid-2012 onwards this trend has reversed. During the year to July, households increased their unsecured borrowing by almost £5.4bn.
The cause of this switch is unclear, but one factor is likely to be recent falls in the interest rates on personal loans. While the rates for personal loans of up to £10,000 have been on a broadly downward trend since late 2009, the rate for smaller loans fell quite sharply at the end of 2012…
I increasingly think if we want to understand what turned the stagnation of late 2010 to mid-2012 into the growing economy of mid-2012 onwards then we should be looking at unconventional monetary policy.
From mid 2009 or so onwards I have tended to think monetary policy could play only a limited role in generating a sustainable recovery. Rates had already hit rock bottom, QE (at least when pursused in the typical Bank of England ‘buy gilts’ manner) seemed to able to prevent a slide into depression but not to ensure a robust recovery and a still damaged banking system was unable to lend.
What I have learned since mid-2012 is that monetary policy, even at the lower bound (i.e. when rates can’t be cut further), can still be very powerful.
I would point to the Funding for Lending Scheme, now modified, as the biggest catalyst for a falling household savings ratio and growing consumption. This has now be given by a further fillip by the second part of the Help-to-Buy Scheme – which is run from the Treasury, but I’d have thought that guaranteeing mortgage debts was more akin to monetary policy in its impact.
I think, taken together, the FLS, Help to Buy and an pick up in the housing market explain the falling household savings ratio. And that the falling household savings ratio explains the bulk of the upturn in growth.
As Jonathan Portes has pointed out , the OBR thinks fiscal policy has been reducing growth by around 1-1.5%. The IMF last Autumn re-evaluated its own estimates of the fiscal multipliers (the extent to which changes in fiscal policy impact on the wider economy) and announced they may be substantially higher than the OBR assumes. As I noted at the time, I think they are right.
I think fiscal policy has been an even greater drag on economic performance than the OBR suspect and yet we are faced with a stronger recovery (in terms of GDP) than expected. This leads me to think that monetary policy has been especially powerful – both directly and in terms of raising confidence.
So, does this mean the Chancellor was right along? The policy mix of ‘tight fiscal and easy money’ does, after all, seem to be generating growth at long last.
I don’t believe it does.
Monetary and fiscal policy, as I’m fond of pointing out, are not exact substitutes – they impact different sectors of the economy in different ways.
At a time when real interest rates were negative for government borrowing there was far, far more that could have (and should have) been done by fiscal policy. As for the argument that any fiscal expansion would have been offset by a monetary tightening, I’m afraid I find this unconvincing. I simply don’t think the Bank of England would have reacted to faster growth in 2011 and 2012 by tightening rapidly. And if had done, then their mandate is not set in stone and could have been changed by the government.
On a wider level though, the bigger problem with the ‘tight fiscal, easy money’ mix is that it failed to engage when the changing dynamics of the UK economy. In particular it missed two of what I call the new stylised facts of growth.
Firstly that “rising GDP growth does not necessarily feed through to rising standards of living for households in the middle and below” and secondly that “household borrowing is more responsive to low interest rates than corporate borrowing”.
The first says a lot about our current recovery (output up, employment up, inflation down, unemployment down but real wages still falling) and the second is important for monetary (and fiscal) policy makers to grasp.
Over the last 30 years or more corporate decision making has become increasingly short term. Andrew Smithers in particular has chronicled this trend (and tied it convincingly to executive remuneration practices).
If corporate decision making is indeed working over a shorter time horizon, then firms are less likely to respond to cheap borrowing by investing. Add into the mix a British banking system which is far more comfortable with the straight forward business of lending against property and issuing credit cards than it is with SME lending and you have a rather gloomy picture.
Low rates (and inventive monetary policy) are more likely to boost consumption and house prices than they are to increase business investment.
This is the recovery we got.
So what policy lessons can be learned from all this? I’d suggest three.
First, given the current dynamics of the British economy then fiscal policy would have better suited to shaping a sustainable, rebalanced recovery than monetary policy. None of the developments over the past 18 months have led me to change my view on this.
Second, monetary policy can be very powerful indeed but if we want to see a real rebalancing (more business investment, better export growth, etc) then we won’t get that from monetary policy alone. Indeed whilst monetary or fiscal policy is capable of addressing an immediate demand shortage (and a year or so ago I thought only fiscal policy could), addressing the longer term challenges of short termism, weak investment and squeezed living standards requires wider ranging economic reform rather than conventional economic policy. The kind of thing I was blogging about earlier this week.
Finally, there maybe a tension in the Bank of England’s many current roles. If monetary policy is most likely to impact on the household sector’s consumption (and the transmission mechanism may involve increasing personal debt levels and house prices) then there will be difficult issues in the future between the Monetary Policy Committee (charged with hitting an inflation target and then supporting the wider economy) and the Financial Policy Committee (charged with ensuring financial stability) of the Bank.
All of these lessons point back in broadly the same direction – which shouldn’t just think of ‘economic policy’ as pulling on a series of fiscal or monetary levers. Instead we need to think about the role of institutions in the economy, from how the labour market sets pays to how corporations govern themselves to how the banking system actually works. Generating a sustainable recovery that actually lifts median living standards means more than fiscal stimulus or monetary easing alone.