Economic Recovery: You’re Doing It Wrong

So sayeth the IMF in a consultation with the UK:

The hand-off from public to private demand-led growth has not fully materialized. Much of this underperformance relative to earlier expectations is due to transitory commodity price shocks and heightened uncertainty following the intensification of stress in the euro area.

Translation: Your fear of the confidence fairy has led you down the path of expansionary austerity which, as we now all know, is a fiction.  You cut public demand before ensuring that private demand was in an upward trend.

Hey, this sounds really familiar… Governor Walker, would you like to get in on this?  I mean, you “balanced” the budget by slashing public spending when private demand was in a slump.  The result?  Record jobs losses and the worst job creation performance in the nation.  Would you like to explain to us all how that was supposed to work out?  I’m still looking for that confidence fairy…

But it gets better!  The UK may be poised for a round of deflation.

Inflation has been on a downward trend since peaking in September 2011, as the impact of indirect tax hikes and commodity price shocks have begun to dissipate. This trend will continue as the large output gap exerts disinflationary pressure. Thus inflation is expected to decline below the 2 percent target over the next 18-24 months with an unchanged macroeconomic stance and barring any sustained increase in commodity prices.

Why is deflation bad?  Paul Krugman points out three compelling reasons.

So first of all: when people expect falling prices, they become less willing to spend, and in particular less willing to borrow.


And when that happens, the economy may stay depressed because people expect deflation, and deflation may continue because the economy remains depressed. That’s the deflationary trap we keep worrying about.

A second effect: even aside from expectations of future deflation, falling prices worsen the position of debtors, by increasing the real burden of their debts.


Finally, in a deflationary economy, wages as well as prices often have to fall – and it’s a fact of life that it’s very hard to cut nominal wages — there’s downward nominal wage rigidity. What this means is that in general economies don’t manage to have falling wages unless they also have mass unemployment, so that workers are desperate enough to accept those wage declines.

This was the story of the 1930s.  There was a time right after the banks were bailed out in 2009 that we could have experienced a deflationary round.  Fortunately, through the magic of quantitative easing, that was avoided.  And that’s one of the suggestions the IMF has for the UK.  They advocate QE and increased spending on targeted areas.

This fiscal space could be used to fund higher infrastructure spending, which has a high multiplier and raises potential output. It will also be important to shield the poorest from the impact of consolidation.


In particular, if growth does not build momentum and is significantly below forecasts even after substantial additional monetary stimulus and further credit easing measures, planned fiscal adjustment would need to be reconsidered. Under these circumstances, gains from delaying fiscal consolidation could be larger as multipliers are estimated to move inversely with growth and the effectiveness of monetary policy. To preserve credibility, reconsidering the path of consolidation should be in the context of a multi-year plan focused on further reducing the UK’s large structural fiscal deficit when the economy is stronger and taking into account risks to sovereign borrowing costs. Fiscal easing measures in such a scenario should focus on temporary tax cuts and greater infrastructure spending, as these may be more credibly temporary than increases in current spending.

In other words, you’re doing it wrong.  As are you, Governor Walker.  As are you.



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