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A good study and a bad proposal Samuel Brittan: Financial Times 20/06/03 The predictable political fudging surrounding the government's decision not to decide about the euro has detracted attention from the Treasury study of the subject. The 18 or so volumes are actually of a high standard. Indeed, I would gladly hand over these documents to the proverbial nephew wanting to understand mainstream economics without having to do the mathematics or pass exams. Contrary to some anti-intellectual sneers, they are not full of equations. Such equations as are there are can be found mostly in appendices, footnotes and similar places and are in the supporting studies rather than the main report. The documents are best regarded as studies touched off by the proposal that the UK should adopt the euro. For they do not tell us whether the British economy will gain or lose from such a decision. The pro-euro lobby has focussed on the long term trade effects, which the Treasury judges could eventually increase UK trade with the euro area by 5 to 50 pc. If the trade increase is at the upper end of the range, the effect could, according to the Treasury, be an addition of ¼pc to the UK annual growth rate,adding 9 pc to GDP over 30 years. Needless to say the euro lobby does not discuss the implications of the lower end of the range. The opponents of the euro have naturally focussed on other studies which outline the possible destabilisation arising from a "one size fits all" European monetary policy. The Treasury charts suggesting that both growth and inflation would have been more unstable if the UK had joined in 1999 have naturally been cited in eurosceptic circles. It is not good enough to say that there are long term gains but short term costs. Close readers of the Treasury paper will see that the authors are well aware that unnecessary stop-go or periods of unnecessarily high unemployment or inflation can themselves undermine the long term growth potential of the economy. This is what they mean by the horrible word "hysteresis". The reader of the documents is however left to judge for himself or herself the net effect of macroeconomic destabilisation and the hoped for long term increases in trade. This is as it should be. For economic science is not advanced enough to provide the answer and probably never will be. It is thus right and proper to go by hunches on wider issues such as the political gains or otherwise of being inside the euro area or the pros and cons of the UK's floating exchange rate regime. Having heaped all this praise on the Treasury documents, I come to the "but". For buried inside them is one suggestion which is, I believe profoundly mistaken, and has implications for many economies apart from the UK. The fact that this dangerous proposal emanates from one of the more sophisticated and better studies (Fiscal Stabilisation and EMU) makes it all the more worthy of attention. The authors start out from the fact that a country belonging to EMU cannot have its own monetary policy. If there is a shock which affects one country more severely than others - or if the same shock has different effects because of different economic structures - then the worst affected country has either to grin and bear it or to find some other economic instrument. The favoured instrument is the revival of short term discretionary fiscal policy, which has been out of fashion for the last few decades. The Treasury authors faithfully discuss the problems which resulted in the discrediting of fiscal policy - including the lags between diagnosis and implementation and between implementation and the effects on the economy. There are also the more subtle distortions arising from politicians being more willing to provide a fiscal stimulus than to impose fiscal constraints. They correctly come to the conclusion that reversible tax changes are likely to be more effective than public expenditure variations, which are likely to be mistimed and to distort the supply side of the economy. They also favour the use of indirect taxes. But unless I have missed something, they leave out one of the key arguments for this preference. This is that if consumers know that a cut in say VAT is likely to be reversed, they will go out and buy while prices are temporarily lower. And similarly they will refrain from buying in the face of a temporary VAT increase. This is true even if taxpayers are forward-looking and realise that tax changes imposed for economic regulation are liable to be reversed. The same argument cannot be applied to income or other direct taxes. The Treasury authors have also reminded their readers that in the UK case there already exists a "Regulator" power for the Chancellor to vary indirect taxes between Budgets and implemented immediately after the announcement, with retrospective parliamentary approval within 28 days. Vat, for instance could be changed by up to a quarter on either side of the present 17.5 pc rate. The fact that the Regulator power has rarely been rea lise used is not an argument against reviving it in more effective form. So far, so good. But it is the precise form in which the Treasury authors would bring back discretionary policy that worries me. The proposal is that if the "output gap" rises to more than 1 or 1½ per cent of GDP, the Chancellor should either have to take action or explain in a report to Parliament why he has not done so. This is clearly modelled on the provisions by which the Governor of the Bank of England at present has to write a letter of explanation if inflation varies by more than 1 per cent on either side of the official 2½ per cent target. Similar proposals could well surface in other countries; and in relation to monetary as well as fiscal policy. It could be embraced by those in the Federal Reserve who would like more formal rules and could also be taken up by EMU finance ministers who want to go beyond the ECB's preoccupation with price stability. Whether such developments would be good or bad depends on what mean by the output gap and whether it can be measured even roughly. In a sentence, the output gap is the difference between actual output and the sustainable level. If output is above that level inflation will rise and eventually an economic stop will have to be imposed. If output is below that level inflation will fall - perhaps even to negative levels, depending on where the starting point is. An enormous number of assumptions are buried in that little word "sustainable". For it involves a judgment not of the physical capacity of the economy but of how far output can be pushed without inflationary strain. It is the first cousin of a related idea ,that of the non-accelerating inflation rate of unemployment or NAIRU. The idea here is that if we try to push unemployment down too far by expansionary policies the result would be an ever-increasing inflation. On the other hand if we allow it to rise too high, as in Japan in the last decade, we get a falling rate of inflation ultimately leading to the shock horror of deflation. In my view, the NAIRU is the more fundamental concept. For businesses will eventually adjust capacity to the growth of demand. On the other hand unemployment can remain for a long time at very high levels if the rigidities of the European social model or the antics of the trade union brothers in the UK prevent adjustments to changes in economic conditions. It has to be said that the UK Labour Government has allowed their economists to discuss publicly both the NAIRU and the output gap which they were not allowed to do even under the Thatcher government, for fear of political exploitation of the concepts. Official analysts have more recently tended to focus on the output gap rather than the NAIRU, avowedly for technical reasons, but subconsciously at least aware that it is the less politically explosive concept of the two. It is striking that Milton Friedman, who helped invent the NAIRU, has consistently refused to give any estimate either of its size or that of the output gap and has preferred to keep them as conceptual tools. A sensational vindication of this reluctance has been provided by a little known Bank of England research paper (UK Inflation in the 1970s and 80s: the role of output gap mismeasurement, by E Nelson and K Nikolov, 2001). The authors have made a heroic effort to construct a series for what policymakers thought the output gap was in the 1970s and 80s, compared with what later data has suggested that it actually was. They have to confront the fact that in the 1970s official economists were not encouraged to estimate an output gap or anything similar. Policy at the time rested too much on the vain hope that an official wage and price controls could keep a lid on inflation without excessive unemployment. Nevertheless the authors have been able to estimate what policymakers implicitly believed from statements by ministers and officials and answers to parliamentary inquiries, in which they gave some views on the trend of output and whether the economy was in recession and by how much. The results for the 1970s are shown in the chart. At the time there was thought to be in the mid-1970s a very large output gap indeed. This was the period when post-war full employment disappeared and headline unemployment rates rose from the low hundreds of thousands to the low millions. No wonder then that governments were extremely reluctant to dampen down demand and that it took a sterling crisis and visits from the IMF to make them do so. But if we revisit these years from the perspective of the year 2000 it now seems that there was no output gap at all and that production was as often above as below its sustainable level. The average over-estimation of the negative output gap of about seven per cent of GDP, a truly massive amount, gave all the wrong indications to policymakers. Some earlier studies have suggested that a similar overestimation was responsible for the US inflation of the 1970's. The Bank of England authors try to allocate the UK misestimation between two causes: a 4pc underestimate of where output actually was - which was subsequently corrected by the revision of the national income figures - and a 3pc overestimate of where the trend line was. Perhaps more surprisingly, there was a 5½pc overestimate of the output gap in the Thatcherite 1980s, despite the reduced ideological obstacles to hard-headed analysis. This time the problem was mainly an underestimate of actual GDP. Later revisions to the data suggest that recessionary forces had been eliminated by 1986, when the Government was still being accused of holding back employment by over restrictive demand management. No doubt officials will say that we have now learned better and will make smaller mistakes. But the gap proposal goes in the face of all the lessons of the 1970s and 80s. The true revolution of ideas was the abandonment of the notion that it was possible to fix real variables such as output and employment by demand management, that is monetary and fiscal policy. Money supply targets, exchange rate targets, and later inflation targets, were all attempts to construct a "nominal framework" which gave financial policy its due in combating cycles of inflation and deflation but no more than that. The roots of persistently high unemployment have to be tackled from the labour market side, whether the Thatcherite attack on union power or the concentration under Gordon Brown on work incentives. Attempts to use statistical estimates of the output gap for policy risk jeopardising these hard won gains. It is quite true that the output gap plays a greater part than I would like in the deliberations of the Bank of England's Monetary Policy committee. Nevertheless it occupies there a subordinate role as a forecasting tool and can be amended or put aside when not found helpful in implementing the Bank's statutory duty, which is confined to the inflation rate. The Treasury proposal, on the other hand, would make the output gap a prime policy target. Behind the technical discussion there is a more human point. It is what Friedrich Hayek called in his Nobel Prize Address, "the pretence of knowledge". By pretending we know more about the characteristics of the economy than we really do we actually throw away the more modest improvements which our limited knowledge makes possible. It took us the closing decades of the 20th century to learn this lesson; I hope we do not spend the first few decades of the new century in unlearning it.
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