Wednesday, 3 February 2016

Whatever happened to the General Theory

My paper in the Review of Keynesian Economics is out. It is a special issue on the relevance of the General Theory 80 years after its publication. My paper is about the New Classical Counter Revolution (NCCR). At first this may seem an odd fit, but I think quite the opposite. If we go back 40 years, macroeconomics as it was then practiced could be justifiably described as being a development of that great work. In contrast students today would not see the General Theory as the foundation of macroeconomics. The change in view is the result of the NCCR.

I also think that many heterodox economists, who tend to read this journal, have failed to come to terms with the NCCR. They are critical of course, but often they fail to address the obvious question: why was the NCCR so successful? Revolutions may be plotted by a small number of individuals to whom you can ascribe (fairly or unfairly) ideological motives, but you also need to account for why the revolution succeeds. Do heterodox economists think that generations of PhD students who continue to ignore their arguments are being forced to do so against their will?

My paper is in part an attempt to begin to answer this question. It argues that the success of the NCCR had little to do with external events (stagflation), or with policy, or indeed with the specific innovations the revolution brought. Instead it was about being seduced by a methodology: the methodology of microfounded models. Where I probably depart from most heterodox economists is that I think macroeconomists were right to be attracted to the methodology, which is a progressive research programme, but the problem was the same as with all seductions: to see only the good and not the bad in their new love.

But my paper is not primarily directed at heterodox economists. I make two claims that should worry mainstream economists. The first is that what masters students are taught, which is that pre-NCCR methods are fatally flawed, is simply wrong. Microfoundations simply replaces one set of flaws with others. The mistake of the NCCR was not in developing DSGE models, but in believing that only these models can provide macroeconomic insight. The pre-NCCR methodology was also progressive, and as developments in UK macro in the 1990s showed, the two methodologies could help each other.

My second claim is that the exclusive focus on a microfoundations methodology seriously compromised the ability of the science to understand the Great Recession. Here I am very specific: mainstream macroeconomics ignored a clear property of the time series for aggregate consumption in the UK and US in a way that pre-NCCR methods would not have done. As a direct result, the importance of the financial sector was largely ignored before the global financial crisis. If pre-NCCR methods had not been trashed by mainstream macroeconomics, the discipline would have been in a far better shape to understand what happened during the Great Recession.

I cannot do justice to the arguments in this short post, so please read the paper.

Thursday, 28 January 2016

Sanders, Corbyn and the financial crisis

Shortly after the full extent of the financial crisis had become clear, I remember saying in a meeting that at least now the position of those who took an extreme neoliberal position (markets are always right, the state just gets in the way of progress) would no longer be taken seriously. I could not have been more wrong. But in a way I think that the ‘surprising’ strength of the radical left (by which I mean those who are not the established centre left) in the US, UK and perhaps some European countries reflects exactly this contradiction.

We need only to consider the position of the financial sector to understand this contradiction. That sector was by far the major cause of the largest recession since WWII, and yet it is now in essentially the same position as it was before the crisis. There are no purely economic reasons why this has to be so: economists know that it is perfectly possible to make fundamental changes to this sector that could significantly reduce the chance of another crisis at little cost, but such possibilities are just not on the political agenda. For example, Admati and Helwig have convincingly argued that the problem with banks is very low capital requirements, but actual reforms have been marginal.

The reason is straightforward: the financial sector has political power. Many on the centre left seem too timid or too ignorant to talk about this power publicly,  and are therefore unwilling to challenge it. The political right and it's media machine help divert those who have little interest in politics and economics into believing that their problems are really due to too many migrants or too generous welfare payments. Those who are members or supporters of left wing political parties tend to have a better understanding of what is going on. To put it simply, a sector that caused a great deal of harm and cost us all a great deal has got away largely unscathed such that it could easily do it all again.

But it gets much worse. The right has succeeded in morphing the financial crisis into an imagined crisis in financing government debt (or, in the Eurozone with the ECB’s help, into an actual crisis) which required a reduction in the size of the state that neoliberals dream about. The financial crisis, far from exposing neoliberal flaws, has led to its triumph. Confronted with this extraordinary turn of events, many of those on the centre left want to concede defeat and accept austerity!

That is all scandalous, and if the left’s established leaders will not recognise this, it is not surprising that party members and supporters will look elsewhere to those who do. Now wise heads may warn that the radical left has in many cases not grasped the nature of the problem and are simply repeating old slogans, and worse still that voting for radical leaders may deny the left the chance for power, but inevitably this can sound just like the appeasement of many on the centre left. What Corbyn’s victory shows Democrats in the US is the power of the contradiction between the global financial crisis and where we are now.

Sunday, 24 January 2016

German exports and the Eurozone

I have argued that the low level of German wage increases before the financial crisis were a significant destabilising influence on the Eurozone, which also indirectly contributed to Germany taking a hard line on austerity. The basic idea is that Germany gained a significant competitive advantage over its Eurozone neighbours, which it has since been unwilling to unwind (through above average German inflation). What this competitiveness gain did was lead to very healthy export growth and a large current account surplus, and that additional demand meant that Germany did not suffer as much as its neighbours from the second Eurozone recession that policy created. Peter Bofinger has made a similar argument.

This argument is often criticised on the grounds that Germany’s healthy export growth was not primarily due to any competitive advantage, but instead was the result of non-price factors like strong demand from China for the type of goods Germany produces. This and other criticisms were recently made in a paper by Servaas Storm. One of the points made by Storm has itself been criticised by Thorsten Hild, and Hild’s point is entirely correct (see also Storm’s reply here). But the issue about what was the primary cause of strong export growth remains.

Trying to disentangle how much of German export growth was due to the competitiveness advantage they gained would require some econometric analysis which unfortunately I do not have time to undertake. But the point I want to make here is that if there has been a permanent positive shift in Germany’s exports (i.e one unrelated to price or cost competitiveness), then this strengthens the argument that I have been making. Before we get there, it is worth going through the basic macroeconomics involved.

Every country will tend towards some long run level of competitiveness. There are many ways of describing why this is: the need to obtain a balance between the production and demand for domestically produced goods, or the need to achieve a sustainable current account deficit. There are many reasons why this long run level of competitiveness could change over time, but in the absence of a plausible story about why that has happened to Germany (or equivalently, why a 7% of GDP current account surplus might be sustainable) it seems reasonable to assume that it has remained unchanged.

So if an economy in a monetary union, like Germany, moderates wages so that it gains competitiveness in the short term (where the short term could last a decade), this gain has to be unwound at some point. Just as the decline in competitiveness in the periphery needs to be reversed by creating below Eurozone average inflation there, the opposite applies to Germany.

Now suppose there has in fact been a permanent upward shift in the overseas demand for German goods. In the long run if nothing changed we would have an imbalance: the demand for German goods would exceed the supply, or the current account surplus would be unsustainable. The way the economy reacts to get rid of that imbalance is through additional German inflation. Not only must past gains in competitiveness be reversed, but competitiveness must decline even further to reduce the demand for German goods.

For those brought up on a mantra of the need to constantly improve competitiveness, this may seem perverse: getting punished for making goods other countries want. But of course it is not punishment at all. A decline in competitiveness is the same thing as an appreciation in the real exchange rate, and this makes consumers better off, because overseas goods become cheaper (in the jargon, there is a terms of trade gain). It is time for Germany to export a bit less, and start enjoying the benefits.

Posting note

For various reasons over the next month the frequency of posts may diminish. Don’t go away - I will be back.  

Thursday, 21 January 2016

The dead hand of austerity; left and right

Those who care to see know the real damage that austerity has had on people’s lives. From those needing care who now get so little, to those waiting longer for hospital treatment, and those whose homes might not have been flooded without the cuts from 2011. There is nothing unusual about the UK in this respect: austerity (cuts in spending that are either mistimed or unnecessary) causes harm, wherever it is imposed. But the political cost has also been huge.

This is true in the Eurozone, but in this post I want to focus on the UK. The cost on the left could not be greater. Austerity and the reaction to it were central to Labour losing the election. The Conservatives managed to pin the blame for Osborne’s austerity on Labour, and as the recent Beckett report acknowledges (rather tellingly): “Whether implicitly or explicitly (opinion and evidence differ somewhat), it was decided not to concentrate on countering the myth … ” It was also central in the revolution of the ranks that happened subsequently.

Austerity is a trap for the left as long as they refuse to challenge it. You cannot say that you will spend more doing worthwhile things, and when (inevitably) asked how you will pay for it try and change the subject. Voters may not be experts on economics, but they can sense weakness and vulnerability. If instead you restrict yourself to changes at the margin, you appear to be ‘just the same’.

I think many of those on the centre left still do not see this trap. There are some problems you cannot triangulate around, but have to tackle head on. Here is a recent example from Rachel Reeves. Much of what she proposes, when she talks about securing the necessary investment in flood defences for example, makes total sense, but it also tends to cost money. Rather than confront Osborne’s unnecessary cuts, she talks about a failure “to demonstrate that we understood that dealing with the deficit and controlling public spending are the precondition of effective progressive government.”

The urge to move on, and not talk about the dry subject of the public finances, is quite understandable and not confined to the parliamentary Labour party. Here is Mariana Mazzucato giving a brief summary of her excellent innovation agenda for Labour (or indeed any political party that is not hamstrung by a neoliberal romantic view that technical advance is all down to the entrepreneur and the state just gets in the way, a view completely destroyed by her excellent book). I was struck by the juxtaposition of the following two sentences:

“Likewise, it is time to move on from the debate over austerity to a new conversation about how to build smart, mutually beneficial public-private partnerships to fuel decades of growth.
For starters, we must invest in education, human capital, technology, and research.”

But of course it becomes so difficult to achieve that investment when the dead hand of austerity is demanding cuts from everything it touches.

That dead hand is not just left handed, but touches the reformist right just as it does the left. Some regard David Cameron’s speeches that talk about reducing the causes of poverty and social deprivation as just window dressing, but I agree with Raphael Bahr that these come from a genuine desire on his part to be remembered as a socially reforming prime minister. Yet as a result of austerity such speeches seem ridiculous now, and will only be disregarded by history: meaningless when set aside the reality of the poverty and harm caused by government actions. Here is a self explanatory chart from the IFS.


There were genuine hopes on all sides that Universal Credit (UC) might achieve the aim of simplifying the benefit system, and thereby reduce the number who fail to claim benefits they are entitled to and need. But as a result of austerity, and those cuts to tax credit that the Chancellor was forced to postpone, UC will now be seen as a way of cutting benefits and will be either extremely unpopular and/or be quickly killed. It would be useful to be able to assess what aspects of the health reform brought in by the coalition worked and which did not, but I suspect all that will be lost in the chaos caused by underfunding.

So the dead hand of austerity kills hope of reform from both left and right. The years of austerity will be seen as wasted years, when no new progress was achieved and plenty that had been achieved in the past setback. Recovery from recessions need not be like this, and indeed has not been like this in the past. They can be a time of renewal and reform: if not from a credit squeezed private sector then at least from government. And it could have been like that again, because there was absolutely no necessity to embark on austerity in the depth of a recession.

Those on the right may say well at least we are getting a smaller state. But attempts to force people to in effect spend less on health, education, justice and even a welfare state, are not durable for more than a decade or two. It will be a hollow victory.

In the US and most of Europe the obsession with austerity is coming to an end. It is still killing Greece and holding back Germany, but elsewhere deficit targets are either being achieved through growth or quietly ignored. Yet in the UK that dead hand continues, seen or unseen, to dominate policy and debate. And with its architect set to become Prince Minister and large parts of the opposition still too timid to challenge it, it looks like another five wasted years lie ahead for us.