Can Keynesians Explain Britain?

Tyler Cowen (approvingly) takes us to Scott Sumner on deficits in Britain:

Step 1.  The Economist magazine reports (in the back) that Britain has the third largest budget deficit in the world, significantly bigger than the US as a share of GDP.  So fiscal policy is obviously expansionary using a simplistic metric that doesn’t adjust for the business cycle.

Step 2.  […] Just how far below potential is the UK economy?  The honest truth is that no one has a clue.  But let’s use the sorts of measures that Keynesians would rely on.  The unemployment rate is roughly the same as in the US.  So by that measure the output gap is similar, although a bit smaller in the UK because they have a slightly higher natural rate of unemployment.  But almost all economists think that no single labor market indicator is perfect.  And all the other measures show the UK doing far better than the US, especially total employment, which hits record levels in the UK month after month, while lagging 3 million below early 2008 levels in the US (a country with a faster growing population.)  Here’s the bottom line: The UK has a smaller output gap than the US using any plausible set of labor market metrics.  […]  And yet the US has not experienced the near zero growth of the UK.  Why not?

Sumner’s first assumption is that fiscal policy in Britain is far more expansionary than the United States as measured by its budget deficit. Some (incorrectly) believe that this doesn’t mean Britain’s policies are particularly expansionary, because it’s output gap is larger. I agree with Scott that this isn’t necessarily true, because Britain’s labor market seems pretty healthy.

Yet Sumner is both accepting that (a) Britain has run a more expansionary fiscal policy, and (b) It’s labor market recovery has been stronger. I don’t think labor market statistics are a good indicator of recovery – more on that later – and I think supply-side factors play a role, so I don’t want to infer any causality. But those two sure as hell seem like a strong vindication of Keynesian policy.

He goes on to say:

Step 3.  Then the Keynesians point to the low RGDP growth in Britain, and claim this somehow proves Britain has a massive output gap, and hence fiscal policy is actually quite austere.  I hope everyone can see the problem with this argument.  It makes the Keynesian theory almost impossible to refute.  

For one, we agree that low RGDP growth can’t really mean much about the magnitude of an output gap. But for different reasons: low growth just means the gap is shrinking (relative to something) slowly. However, it doesn’t make sense to reject an argument because “it’s almost impossible to refute”. Natural selection of organisms is incredibly difficult to refute and that cannot inform our belief in its veracity. The fact is, it doesn’t matter whether the cyclicly-adjusted deficit is high or low. If it’s low, we look at the record high unemployment bad growth and realize more stimulus is needed. If it’s high, we realize whatever we’ve done has worked, but we need more to decrease unemployment. 

The latter case really gets to the point of why labor market statistics are not a good measure, of anything. Unemployment rates are an arbitrary concoction. It doesn’t discriminate between a laid-off autoworker and an engineer who can’t find a job. We’re not all economically equal, so n scientists without a job is a far crappier predicament than n barbers without a job. 

We care about unemployment rates, rightly, because sound employment underpins the social contract. But, the output gap is the real measure of recession. It’s very possible, indeed likely, that the recession hurt all income groups somewhat equally at the onset. But we know recovery has been highly unequal, with most growth accruing in a small number of people. That is output gap can fall drastically without unemployment rates showing proportional decline. 

The two factors that engender this are (a) concentration of human capital and (b) falling wage share of GDP. Unemployment rates completely ignore physical capital that’s in disuse due to cyclical downturn. Of course, this is a good way to think how economically absurd the rate of unemployment is. Imagine have ten units of capital, nine screwdrivers and one factory. If the factory is shutdown, it’s inane to talk about a “10% unemployment” rate. Rather, the lost income in the form of an output gap becomes important.

My point is any conclusion about the success or failure of Keynesian policy should be careful not to use the labor market as indicator of anything. And while I don’t suggest that low RGDP growth rates implies anything about the output gap per se, the complete stagnation in Britain compared with the relative recovery in the US is important. Britain interfered to reign in deficits far more aggressively than America did. Also, in Britain government spending is a bigger component of output than in America, which further exacerbated the effects of unexpected cuts. Because total debt-GDP was expected to be higher in Britain, the deviation from the standard path is what signals austerity.

Sumner is is on the dot about supply-side policies playing an important role, but this is why I think aggregate demand is still important. Inflation is far below expectations, but Britain has not experienced deflation, yet. This chart (from Simon Wren-Lewis) clearly implies a fall in AS:

 

But then why hasn’t Britain experienced any real cost-push inflation? The only answer is a proportional fall in AD which hasn’t recovered in any significant level. And I’m not breaking any Keynesian assumption about sticky price levels because wages are (naturally) more rigid than prices.

All said and done, I cannot deduce that Keynesianism has failed from Sumner’s evidence, but it surely reads as an argument for a nominal income target.