I just got the heads up that the IMF is about to publish a media release that suggests the UK government now has a duty to starting expanding the UK economy. In advance they've released a blog on the issue. This is what that blog by Ajal Chopra says:
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The U.K. economy has been flat for nearly two years. This stagnation has left output per capita a staggering 14 percent below its precrisis trend and 6 percent below its pre-crisis level. Weak growth has kept unemployment high at 8.1 percent, with youth unemployment an alarming 22 percent.
The effects of a persistently weak economy and high long-term unemployment can reverberate through a country's economy long into the future–commonly referred to by economists as hysteresis.
Our analysis of such hysteresis effects shows that the large and sustained output gap, the difference between what an economy could produce and what it is producing, raises the danger that a downturn reduces the economy's productive capacity and permanently depresses potential GDP. Such effects could arise because of the erosion of skills from persistently high long-term unemployment, the scrapping of idle capital, and inadequate investment that erodes the capital stock and hinders innovation and the development of new technologies. This would be an enormous waste.
But policymakers are not powerless; their action can help avoid such bleak outcomes. Notably, policies to bolster demand will help close the output gap faster, reduce the risk of hysteresis, and insure against the predominance of downside risks. So how should demand be stimulated?
Three policy priorities
First, monetary stimulus can be provided with further quantitative easing, which evidence suggests can continue to support demand by lowering long-term interest rates and improving banks' liquidity. In line with recommendations made in our report, the Bank of England's Monetary Policy Committee voted on July 5, 2012 to expand further its quantitative easing program. The committee should also keep under review the merits of cutting the policy rate. The recent sharp flattening of the yield curve may have increased the stimulative effect of this instrument, possibly outweighing potential negative effects on money markets and financial stability.
Second, credit easing measures can boost demand. Credit conditions remain tight because elevated bank funding costs have limited the quantity and maturity of lending to the private sector, despite significant monetary easing. We welcome recently announced efforts to lower private-sector borrowing costs through broader provision of bank funding against collateral with haircuts, including the “funding for lending” program. Depending on the effectiveness of these new programs, further credit easing measures may be needed, including purchases of private-sector assets on secondary markets.
The government is also considering taking advantage of its record-low borrowing costs to provide government guarantees to fund large, privately operated infrastructure projects. It is important, however, that the choice of projects and the modalities of their operation–public versus private, and financing by issuing public debt versus guarantees–is based on using public funds as efficiently as possible. They should also not be affected by attempts to artificially limit government gross debt or near-term expenditure.
Third, slowing the pace of fiscal tightening would be the main policy lever to support demand if growth does not pick up sufficiently even after monetary stimulus and strong credit easing measures have been given time to work. The government's reduction of deficits over the last two years has created the space for recalibrating fiscal policy, if needed.
Delaying fiscal consolidation could yield gains
Our analysis, which extends recent influential work by DeLong and Summers, suggests that delaying fiscal consolidation can generate permanent gains if fiscal tightening has a larger negative effect on output during a period of negative or weak growth.
The absence of growth, even after additional monetary and credit easing measures, would indicate that the ability of monetary policy to mitigate partially the contractionary effects of fiscal tightening is even more constrained than currently assumed, implying higher and more asymmetric multipliers when the economy is weak. This may occur, for example, if heightened uncertainty, including concern about tail risks, deters the private sector from borrowing, even in response to significantly cheaper and more easily available credit.
In a nutshell, the priority for U.K. policymakers is to implement more expansionary economic policies, important elements of which are now in train. Without such policies, they risk weak demand that leads to persistently slow growth and high unemployment, which in turn will affect decisions made by consumers and investors, and permanently damage the long-run capacity of the U.K. economy.
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Here’s a selection of some notes I took on Laurence Ball’s 2008 paper on the concept of ‘hystersis’, which was first put forward and named by Blanchard and Summers in 1986, (and was used about the UK first by the IMF in May 2012). When the late Alec Cairncross said of the rising inflation in the UK in the mid-1980s that ‘old habits die hard’, perhaps something more was at work.
Here’s my notes:
The Fed under Volcker tightened policy to fight inflation, but it is less well known that during this period the Fed also eased policy both times when it saw a recession starting, in 1980 and 1981. In the second recession GDP started falling 1981:4, so the Fed reduced interest rates by three percentage points in that quarter and by four more points in 1982, even though inflation was high 1981:4. Unemployment rose from 7.2% in 1980 to 9.7% in 1982. But the shift to a looser policy mean that unemployment was back to 7.2% in 1985.
In the UK policy tightened in the late 1970s, and output fell 1979:2 to 1981:3. But unlike the Fed, the Tory controlled Bank of England did not respond with easier policy, meaning that short-term interest rates rose during the recession. The Bank of England said this was due to the priority to conquer inflation. Unemployment was 6.8% in 1980, rose to 10.7% in 1982, and with policy remaining tight, it was still 10.4% in 1987.
Hysteresis exists because of the long-term unemployed. While a high level of short-term unemployment puts downward pressure on wage inflation, a high level of long-term unemployment does not. A decrease in aggregate demand initially causes a rise in short-term unemployment, but this turns into long-term unemployment if the slump continues. The initial short-term unemployment causes inflation to fall, but then inflation stabilises, and at that point the NAIRU is higher because of the pool of long-term unemployed. This fits well with the above comparison between the Volcker and Thatcher disinflations. The Thatcher contraction triggered hysteresis by creating the pool of long-term unemployed, whereas the Volcker disinflation led to a temporary rise in the short-term unemployed. And a long duration of unemployment benefits allows the long-term unemployed to become detached from the labour market indefinitely. So long-term unemployment has smaller effects on inflation. More research is needed to see whether NAIRU increases in episodes such as the Thatcher disinflation are tied to shifts from short-term to long-term unemployment.
It is possible to think of central banks facing high unemployment could increase demand, accepting the rise in inflation to reduce the NAIRU. Then they should tighten policy to reduce inflation, but reverse the tightening quickly before a temporary rise in short-term unemployment can push the NAIRU back up. But we would need greater understanding of hysteresis to give this advice.
Many economists think that the 1960s and 1970s have proved that it is dangerous to target employment levels rather than inflation, and hysteresis factors seem like a backward-looking step. But hysteresis clearly exists.