Andrew Lilico: Two kinds of recession, and why neither fiscal nor monetary stimulus always works
Household income and expenditure needs can be variable from year to year. Some years income-earners become unemployed or temporarily sick and income is low. Some years there are sudden major expenditure items, such as houses or divorces. We can call these "negative shocks". Some years income-earners get high bonuses or dividends, or inherit money. Some years it turns out costs are lower than expected. We can call these "positive shocks".
If they were unable to save and borrow, the amount households could spend on ordinary consumption needs would vary with these positive and negative shocks. But in fact people tend to prefer a fairly smoothly rising path of consumption to the volatile pattern they would be forced into without saving and borrowing. So they save and borrow in what economists refer to as "consumption smoothing".
However, there is another kind of shock. Sometimes income drops or expenditure rises may not be temporary, but permanent. Income-earners may not simply become temporarily sick but permanently disabled. Costs may rise for some long-term reason, such as the arrival of an unintended extra child. If a shock is permanent, then borrowing will not be a means of keeping consumption going during a temporary downturn, after which all will continue as before. Instead, borrowing, if done at all, will be a means to smooth the transition path down to a lower sustainable level of consumption.
Much the same principles apply to macroeconomic management. If an economy experiences a temporary dip, it may make sense to borrow to keep public spending going along its long-term path. It may even make sense to enact temporary tax cuts to inject extra funds into households, temporarily. Such tactics cannot raise the long-term rate of growth, of course, any more than the household borrowing can raise its long-term consumption, except in extreme cases of irreversibility - e.g. if consumption is so low that an income-earner starves to death and so cannot work in the future; or if a macroeconomic recession is so bad that order breaks down and the country descends into civil war.
There are, of course, those that claim clever reasons why macroeconomic management can raise long-term growth. But the central reason for macroeconomic demand fine-tuning is precisely that I've laid out: smoothing out of the cycle. Why should the economy suffer more than necessary in the short-term if we can borrow a bit of growth from the future to keep things going today?
When the current recession started in 2008, many analysts thought it would be much like the standard smoothing case - as per most recessions in developed economies since the Second World War. We could borrow a bit of growth from the future - some in the form of looser fiscal policy; some in the form of looser monetary policy; but whether fiscal or monetary the principle of demand smoothing was the same. The government maintained that the underlying growth rate of the economy was unaffected.
But just as with a household there can be another kind of shock, the same is true with an economy as a whole. Sometimes it can be subject to shocks that aren't temporary. Part of that might be a permanent loss in output; even worse might be a long-lasting reduction in the rate of growth in output. Right from October 2008, I argued that the financial crisis, and especially the nationalisation of the banks and regulation in response, was associated with a reduction in the sustainable rate of growth in GDP. That was far from the only factor, as I reflected in later analysis. Indeed, early on, though I was more pessimistic on the point than almost anyone else, I now believe I markedly under-estimated how much of the recession was cyclical (i.e. it would go away and smoothing could be a sensible response) and how much was a long-lasting structural change that might even have pre-dated the financial crisis and to which the financial crisis was the response, rather than being the cause.
Nonetheless, I argued from mid-2011 that the sustainable growth rate was probably down to close to 1%, rather than the 2.3% the OBR was then forecasting (let alone the 2.5-2.75% the Treasury stuck to through 2008-10). The OBR has gradually come in line with my figure, and in its latest estimates for recent years is now even lower than me.
If the rate of sustainable growth in the economy is going to be very low for a sufficiently extended period of time that it covers the lifecycle of investment and the period most households would accumulate then service debts, that means standard smoothing techniques are going to fail. GDP Growth cannot then be boosted by any sort of stimulus, monetary or fiscal, in any sustained way.
I emphasize, again, that my point here is not simply about government deficits. It also encompasses interest rates and QE. If the economy has experienced a shock reducing its rate of sustainable growth for an extended period, no kind of stimulus is going to work. To raise growth in that scenario requires raising the sustainable growth rate. I've set out before how to do that here and here, and it remains my view.
The problem in the UK economy is not how to get a quarter or two of extra growth, stimulated temporarily at the expense of some growth later, so that there is not unnecesssary temporary misery through unemployment and stretched household finances. The problem in the UK economy is that the underlying potential rate of output growth has dropped dramatically, and if something is not done to raise it (especially cutting government consumption spending and raising the efficiency of government consumption spending), then unless there is even more inflation, households are going to default on their mortgages and bankrupt the banks, dragging down the UK sovereign. The longer we wait before acting, the bigger the risk we've waited too long. Get those spending cuts going, Mr Osborne! Please don't give up now!