An important fortnight in the macroeconomic debate


this is an extract from our Growth Bulletin for 19th October 2012. To read the full article and sign up to receive it straight to your inbox, click here

This week saw more positive news on the employment front. The UK’s employment rate for 16-64 year olds rose 0.5 percentage points to 71.3% for June-August 2012 compared with the previous quarter. And overall there were 212,000 more people in work and 50,000 fewer unemployed than in the last three months.

This all means the UK’s productivity puzzle continues to baffle. How can employment have been rising so strongly yet overall output growth be non-existent? This week the ONS published their analysis which outlined a combination of factors. But the most interesting explanation out there appeared in a recent speech from the Monetary Policy Committee’s Ben Broadbent.

In his speech, Broadbent outlined how both inflation and employment had been out of kilter with output in recent years. At two extremes this suggests two different hypotheses: the ‘demand deficient’ one – that firms are hoarding labour, and waiting for an upturn. If this doesn’t come then we would expect employment and inflation to fall in time. The other is that productivity has fallen because of some supply-side shock as a result of the financial crisis.

Broadbent concludes that the strength of new hires and evidence on spare capacity suggests the demand thesis is not able to explain our position. Instead, he examines how the financial crisis has affected capital markets to see if there’s an evident supply-side explanation. Higher costs of capital might be one factor – these lead to lower capital formation and over time capital intensity, and thus falling productivity. But investment hasn’t fallen anywhere near enough to explain the fall in productivity we’ve seen.

The missing explanation, according to Broadbent, is the allocation of resources across the economy. The financial crisis and the commodity price shocks have hit certain sectors harder and led to changing demand patterns across sectors. Aggregate productivity will only be insulated from this if resources can be reallocated quickly to take account of these. Whilst labour markets have reacted quickly, the same cannot be said of capital. Though there has been some movement, it has not been enough to make much of a dent in the spread of rates of return seen since the crisis. Firms in high potential industries that are capital constrained are therefore forced to hire more employees to meet demand.

He concludes:

“The longer they [divergences in output and inflation/employment] go on, the harder it is to believe that there hasn’t also been a genuine hit to the economy’s effective supply capacity. There needn’t have been any “technical regress” for this to have occurred. A combination of uneven demand (across sectors) and an impaired financial system, one that is unable to reallocates capital resources sufficiently quickly to respond to such shocks, is enough to reduce aggregate output per employee.”

The positive here is that it suggests once the financial system returns to health we could see a return to above trend productivity growth, and as Broadbent suggests, it means macroeconomic policy makers should be more concerned about the direction of travel for employment than output.

It’ll be interesting to see whether this interesting thesis is proved correct as events unfold.


There’s been lots of excitement among the anti-austerity crowd about the most recent IMF World Economic Outlook report, which sought to reassess fiscal multipliers (i.e. how much fiscal consolidation would affect growth in the short-run). They revised up their estimates after carrying out regression analysis examining how fiscal consolidation affected the forecast error on growth. They concluded that multipliers are likely to be higher than they first thought (when they used historical estimates) because a) many countries are trying to cut spending together b) many countries are at or near the zero lower bound for interest rates. Thus, the multiplier is actually more like somewhere between 0.9 and 1.7 compared to the previous 0.5 estimate, meaning spending cuts and tax rises are likely to have a bigger short-term effect on growth than we originally thought.

Several commentators have run with this to suggest that this should have implications for UK government policy and that the OBR should re-examine its assumed multipliers in its analysis to maintain credibility. But, when examining the methodology of the work the IMF has undertaken, it’s unclear that we can take the conclusion of their work as a reason to change course.

First, the robustness of the work has been found wanting by Chris Giles at the FT. The results are highly sensitive to the countries included and driven very much by the inclusion of Greece and Germany. Second, we know from previous analysis that although multipliers are likely to be higher when countries are at the zero lower bound for monetary policy and other countries are also retrenching, that they are much lower  for open countries, in flexible exchange rate regimes and with high debts. Therefore multipliers will tend to differ both between countries and within them (for different types of spending and tax), and the bulk of evidence suggests the UK will be at the low end. Third, the short-term effect on growth of government spending is only one consideration – the rise in debt is no free lunch, and one most also factor in its effects and how the need for even larger consolidation at a later stage will affect growth over the medium term. Fourth, the longer we have moderate inflation and fairly robust employment recovery, coupled with low output growth and so low productivity, the more this looks like a supply-side issue which a demand side solution of more government spending is unable to solve.

The OBR report out this week for now is sticking to the line that growth in consumption has primarily been slow over the past two years due to the moderately high inflation caused by the commodity price spike, and that over the past year the Eurozone crisis has proven a big drag on net trade. The key debate then is over how fiscal consolidation has affected overall investment.

A perhaps bemusing part of this debate is the position of the Labour party – who seem to argue simultaneously that the Coalition government’s austerity programme is responsible for the recent increase in borrowing AND the slow the growth prospects of the past couple of years. Of course, this would only be true if the multipliers on government spending were so high that spending more actually generated more in revenue than the cost of the additional spending itself. But even under the IMF’s most optimistic multiplier (1.7), a £100 increase in government spending would increase GDP by £170. Given our average tax rate is around 40% of GDP, the tax revenue generated by this would therefore be at most £68 – meaning that overall government borrowing has still increased by £32. It’s quite simply untrue to suggest that the Coalition government is borrowing more because of any spending cuts so far.


In last week’s Mansion House speech, Adair Turner (a presumed candidate for the post of Bank of England Governor) gave his insight into what went wrong in the build-up to the financial crisis. He also seemed to suggest that more unconventional monetary policy would be necessary in order to ‘stimulate’ the economy.

It seems from both his previous musings on the subject and some well-briefed articles onRobert Peston’s blog and in Simon Jenkins’ Guardian column that one option he’s considered is essentially cancelling government debt held by the Bank of England. At the moment the Bank of England holds £375 billion of government bonds financed by new money (this is QE), but the difference from directly money printing is that the bank would look to sell the bonds back to the market when monetary policy needs to tighten as the economy recovers and inflation picks up.

Instead, Lord Turner now seems to be suggesting that the Bank of England forgive the Treasury some of its debt – and essentially monetise it. This seems incredibly dangerous. If the debt is forgiven there would be less flexibility for reversing the process. UK inflation has already been pretty stubborn over the past couple of years despite the slow overall growth. If growth and the money multiplier picked up, all of this extra money in the system would likely generate substantial inflation, unless quickly counteracted by a tighter monetary policy (which would most likely be driven by interest rate manipulation). But that’s not the only potential consequence; writing off a large chunk of the public debt would also discourage governments from being responsible with our money – no doubt reasoning that debt is not so much of a problem now there is a much lower stock of it to worry about. It thus risks a huge loss of credibility for central banks.

The worry about QE more generally now is not necessarily immediate inflation, it’s that the Bank of England will continually intervene with QE policies in an attempt to continue to make it cheaper for governments to borrow – leading our government to not worry about continual high deficits. As Stephen King’s note for HSBC explained earlier this year, one of the key reasons for gilt yields being so much lower than other countries’ bond yields is due to the actions of the central bank as a purchaser. Allister Heath this week has shown the extent to which this is true. But the longer this goes on, the more difficult it will be to ever return to normal monetary policy once anything resembling a recovery returns (especially true if the debt has been monetised), the risks of a currency collapse accentuate and with uncertainty over the regulatory environment, banks and other financial institutions, when provided with cheap money, may prefer to buy government bonds than to lend to other parts of the economy.

The CPS will be doing some forthcoming work examining QE and UK bond yields. View the speeches from our event “QE and economic growth – can you have one without the other?” and read George Trefgarne’s CPS publication “Quantitative Easing: Lessons from history“.


this is an extract from our Growth Bulletin for 19th October 2012. To read the full article and sign up to receive it straight to your inbox, click here

Date Added: Saturday 20th October 2012