Sunday, June 14, 2009

I have doubts about more government spending, but I do agree that temporary VAT cuts don’t have much impact on AD

From The Money Illusion:

"Why does the UK seem to be doing better?

Here’s how Paul Krugman answers that question (in an interview with Will Hutton):

WH: In Britain, there is now a new consensus forming that the government’s economic forecasts, which were roundly mocked at the time of the April budget for being wildly optimistic, could be right - that is, growth will start to resume in 2010, albeit at a very low rate.

PK: Well, the UK has achieved a lot of monetary traction in the way that no one else has through the depreciation of the pound. In effect, you’ve carried out a successful beggar-my-neighbour devaluation.

WH: So, the United Kingdom might actually get through this in reasonably good shape?

PK: Yeah. That’s why I’ve been watching with an outsider’s slight puzzlement, your bizarre political circus.

WH: Darling and Brown deserve more credit than they’re given?

PK: If the government can hold off having an election until next year, Labour might well be able to run as “we’re the people who brought Britain out of the slump”.

WH: So your advice to the Labour Party is: hold steady.

PK: Probably.

WH: Probably?

PK: I don’t know enough about the other aspects of politics, but I would guess that the option value is quite high that the economy might actually have turned a corner. That’s unique. That’s a uniquely British thing. None of the other G7 countries has anything like that.

WH: And that’s a combination of our big beggar-our-neighbour devaluation, aggressive monetary policy, successfully recapitalising our banks and our fiscal policy.

PK: There hasn’t been very much discretionary fiscal expansion when all’s said and done.

WH: Well, there was a £20bn temporary cut in VAT.

PK: Yeah.

WH: Which is non-trivial.

PK: Non-trivial. But not much [other spending], as I understand.

WH: Well, there was bringing forward £3-4bn of capital spending. Perhaps together in a full year the stimulus was 1.5% GDP. Maybe 2% at the outside.

PK: Monetary policy has been more aggressive - though maybe less than the Fed - and the depreciation of the pound is a nice thing from a UK point of view.

It’s good to hear that the one country that relied on an aggressive monetary policy, rather than fiscal stimulus, is doing better than the others. Of course that’s been my argument all along. I have little to add to Krugman’s comments except two brief points:

1. In a worldwide slump there is no such thing as “beggar-thy-neighbor” policies; only countries pulling their weight, and those that don’t. Britain is one of the few that is (almost) pulling its weight. This comment is not directed at Krugman. He approves of Britain’s policies, and thus I think he is merely using the term ‘beggar-thy-neighbor’ in the traditional sense of a country devaluing in a worldwide slump. I don’t think he opposes their action, rather I believe he thinks the ECB should also try to do more (based on some of his earlier posts that severely criticized the ECB for being too contractionary.)

2. He indicated that the Bank of England might have been less aggressive than the Fed. That might be true in terms of the monetary base, but that indicator is misleading for all the reasons I have endlessly discussed. (Presumably Krugman also understood that policy indicators can be unreliable, which might be why he didn’t simply say they were less aggressive, without the “maybe” qualification.

Given all my disagreements with Krugman over the role of monetary policy, I find it amazing how close our views are on the UK situation. In another post I have planned I will argue that our views have always been very close; it’s just that he interprets the relevant US policy options differently. It is not usual for two economists who differ about policy options in their own country, to have very similar views on policy in another country or at another point in history (such as the Great Depression.)

(BTW, Krugman has argued that spending is more stimulative than tax cuts, which might be one reason why he is not impressed by the temporary VAT tax cut. I have doubts about more government spending, but I do agree that temporary VAT cuts don’t have much impact on AD.)

Update: I should have also mentioned that the depreciation of the pound is not a separate policy, but merely an effect of the aggressively expansionary monetary policy (currect and future expected monetary policy.)"

  1. Nick Rowe
    14. June 2009 at 11:04

    Why do you think that temporary VAT cuts don’t have much impact on AD? The standard argument is that they reduce the after-tax real interest rate, and so increase demand for consumer durables. (It’s not so much the current tax cut, but the expected future tax increase that does this). This is a substitution effect, to be added to any standard income effect of tax cuts (for those who are borrowing-constrained, and for whom current disposable income is what determines consumption demand).

    Admittedly, this argument holds the nominal rate of interest constant, and also assumes the before tax rate of inflation is sticky. But that latter argument appears to have some empirical support. I a couple of recent cases where the Canadian government cut VAT (we call it GST), the results on the price level were almost exactly what one would predict from a crude accounting perspective (a 1% cut in VAT causes the price inclusive of tax to fall the same 1%).


  1. Don the libertarian Democrat
    14. June 2009 at 12:08

    TO BE NOTED: From Knowing And Making:

    “VAT cuts work!
    According to the CEBR, the government’s VAT cut in December has worked - with retail sales likely to be £8-9 billion higher this year than without it.

    This is contrary to anecdotal evidence from small businesses, but I speak to lots of small businesses and they are not the first people you’d go to for econometric analysis. By their nature, smaller firms find it harder to dissociate the effects of a VAT cut or any other single input from random changes in demand. A number of larger businesses have reported better results from the change, but again they are not in a position to measure the effect across the whole economy.

    The CEBR is independent of the government, although they were calling for the VAT cut before it happened, so they have a vested interest in declaring it successful. Regardless of this, the retail figures are certainly good news and point to an earlier recovery than might have been expected.”

  2. Don the libertarian DemocratYour comment is awaiting moderation.
    14. June 2009 at 12:10

    Here are the links:

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