Monday, 27 April 2015

Received wisdom in macroeconomics

For both non-economists and economists

There has been some talk recently about what is wrong with macroeconomics. (Jérémie Cohen-Setton has a good summary, although non-economists are allowed to do a bit of skipping. And yes, I am a little late on this - cannot think why.) Of course there is always talk of this kind - it just ebbs and flows. But I think this recent upsurge has missed an important point (which, as is often the case, is an elaboration of a point already made by Paul Krugman). .

Many of the complaints about macro are along the lines that it needs more models involving X. Now X can be many things: a financial sector, nonlinearities, multiple equilibria etc. Yet as anyone who is involved in modern macro knows, pretty well whatever X is, there are models that have those things. If you want chapter and verse on this, see Tony Yates (as in here). Indeed, one of the characteristics of modern macro, as opposed to the stuff I dimly remember from my youth, is the huge variety of approaches on offer. In that sense, academic macro is flourishing.

Does that mean the critics are wrong? Not necessarily. I think what is missing in this discussion is the concept of a received wisdom which non-academics (including politicians and civil servants) can readily access. There may be plenty of models which allow for recessions to persist indefinitely, for example, but the received wisdom might still be that recessions are temporary affairs caused by price stickiness and therefore the economy always ‘self-corrects’. So the criticism should not be that there is no analysis of X, but that X is not part of the received wisdom.

A related point can be made about the financial crisis. It is not the case that we need a whole new set of economic tools to understand financial crises: it turns out we had most of the tools already. (Most, not all - see for example the reference here to the Bank of England’s work on networks). The problem was more the received wisdom, which was that the problems that the financial system had shown in the past had been solved, and so we could just ignore them. Once that received wisdom was shattered, there were plenty of tools in the toolbox to analyse what had gone wrong.

So where exactly is this received wisdom of which I speak? An obvious place to look is the textbooks we use. However the pace at which the subject moves (often propelled by events) means they are far from a perfect source, and they are not that accessible for non-economists. In the sciences the received wisdom is normally common knowledge among academics; in macroeconomics less so. One place you will clearly find it is in institutions that have to use that knowledge to do their job. So there is clearly a received wisdom about monetary policy, and you will find it among the economists in central banks.

That is why I’m happy to talk about the New Keynesian model being the consensus model as far as business cycles are concerned, because that is the case in central banks. Others have disagreed with this consensus label, but often because they are thinking about the lack of consensus among the wider academic community. Sometimes you can go further still, and argue that the received wisdom in an institution can be found quite precisely in the model that they use to forecast and do policy analysis.

I think this way of thinking can help us understand one reason why governments across the globe have so easily failed by implementing premature austerity. In the past, and perhaps if they did not have an independent central bank, they would probably have had in house capacity (and perhaps a model) to know what damage austerity would cause. But with the widespread adoption of independent central banks, that capacity has faded. Finance ministries have lost that expertise, and become much more about expenditure control. Independent central banks had the knowledge to know that fiscal austerity would be damaging, but for a variety of reasons typically chose not to express it.

Without a clear sense of received wisdom, policymakers are at the mercy of policy entrepreneurs or ideology-based think tanks, and may be unaware that the line they are being sold might be viewed as rubbish by many academics. That of course is putting it very charitably: the problem may be that the policymaker is fully aware of what they are doing, but know they can get away with it because the media is unaware of any received wisdom, or may find it difficult to express. Whichever it is, it suggests one particular route by which independent central banks are part of the reason for the persistence of the Great Recession. By locating the received wisdom about fiscal policy in an institution that was unwilling to express this wisdom, that wisdom was effectively lost.     

Mediamacro myth 7: the strong recovery

It was perhaps inevitable that when output did start growing again in 2013, everyone would breathe a huge sigh of relief, and extol what was happening. But that time has passed, and yet mediamacro - with few exceptions - has not told people the truth about the recovery. What they have not said is that the recovery does not really deserve that name. This picture tells you why.

The first point is to stop talking about GDP, and start talking about GDP per head. An economy that grows because it has more people in it is not obviously a good or bad thing, and from the government’s point of view - given its (missed) net migration target - it represents a failure. It is GDP per head that determines living standards, which is what matters.

Now if you were on a journey, and in one part of your journey you were delayed by 10 minutes because of a traffic jam, you would be relieved when that jam came to an end, but would you call moving again a recovery? Surely you would only talk about a recovery if you made up for some of that lost time. As the chart shows, we have failed as yet to make up for any of the ground lost not just in the 2009 recession, but also ground lost as a result of fiscal austerity in 2010 and 2011.

So we have not really seen a recovery. Maybe the pessimists are right, and we will never recover any of that lost output, but still you do not call it a recovery.

I can put it another way. Quarterly growth in GDP per head since the beginning of 2013 has averaged about 2% at an annual rate. That is below the average growth rate since 1955. A recovery from a deep recession would have growth rates well above the long term average.

So current growth is unexceptional, and nothing to write home about. The half-truth here is that growth elsewhere has also been poor, but largely because other countries have also implemented premature fiscal austerity. (In terms of GDP per head, both the US and Japan have done better than the UK since the recession.) But even GDP per head may be giving us an overoptimistic picture about average living standards. I’m going to break my one chart rule for this series to add this from the ONS. It plots GDP per head, and Net National Disposable Income (NNDI). The first measures production per head before depreciation, whereas NNDI measures income per head after depreciation.

NNDI has not increased at all under the coalition government, and the reason is that while overseas agents have been receiving some of the income from UK production, domestic residents’ income from overseas production has not been increasing by as much. This is a key reason why the UK current account deficit has been increasing.

In a nutshell, the prosperity of the average citizen in this country has hardly increased over the period of this coalition government - a result that is totally unprecedented since at least WWII. As recoveries from recessions go, this does not seem like a recovery worthy of the name. Yet we keep being told by mediamacro that the Coalition’s strong card is its economic record!

Previous posts in this series


Sunday, 26 April 2015

Mediamacro myth 6: 2013 recovery vindication

The idea that austerity during the first two years of the coalition government was vindicated by the 2013 recovery is so ludicrous that it is almost embarrassing to have to explain why. The half-truths in this case are so flimsy they do not deserve that label. I can think of two reasons why that claim could have any credibility. The first is that people confuse levels and rates or change. The second is that some critics of austerity might have occasionally overstated their case.

To see the first point, imagine that a government on a whim decided to close down half the economy for a year. That would be a crazy thing to do, and with only half as much produced everyone would be a lot poorer. However a year later when that half of the economy started up again, economic growth would be around 100%. The government could claim that this miraculous recovery vindicated its decision to close half the economy down the year before. That would be absurd, but it is a pretty good analogy with claiming that the 2013 recovery vindicated 2010 austerity.

The second point is that some critics of austerity did on a few occasions allow their rhetoric to get the better of them, and suggested that if austerity continued a recovery would never come. That was always an overstatement. It became particularly inappropriate because, as I noted in my last post, fiscal contraction did pause in 2012. But serious analysis should not be about rhetoric, or as Paul Krugman notes about passing off perception as reality. (Sometimes in my rather British way I think Paul is a little too combative with those he might have a chance to persuade, but I’m in 100% agreement with him here.)

What any knowledgeable and honest media reporting should have done is tear the vindication argument to shreds. It should have asked what contribution fiscal austerity made to the slowest recovery from a recession for centuries. That would be an honest debate. No doubt there are factors behind the delayed recovery that the government were powerless to influence, like a weak banking sector for instance. But if the banking sector is unable to support an expanding private sector, which in a recession isn’t too keen on expanding anyway, you have no business throwing public sector employees out of jobs. [1]

Previous posts in this series

[1] And please, before anyone comments about how fast employment has grown, look at the data for unemployment - it went up in 2011. The deeper problems with the 'didn't we do well on employment' line will be addressed in the penultimate post in this series.

Saturday, 25 April 2015

If the LibDems hold the balance

I’ve been relieved that my earlier analysis of the various post poll options seems to accord within a seat or two with what the experts are now saying. Remember nothing should be taken for granted: (the group the legendary Nate Silver has teamed up with) still thinks there is around a 5% chance that the Conservatives win outright. But if we ignore that possibility, the key numbers will be near these:

Zone M: Lab + SNP > 315 = Miliband is PM. (If SNP=50, critical Labour seat total is >265)

If it is close, do not discount some sort of deal with the LibDems too (under new leadership). In addition, if Labour does well, do not rule out a coalition with the LibDems to exclude the SNP.

Zone C: Lab + SNP < 290 = Cameron is PM. (Assumes the LibDem seat total is around 24)

If the seat count is close to 290, Cameron continues only with the support of a few UKIP MPs and the DUP. (In my view, we should be much more worried about a government dependent on the DUP than a government dependent on the SNP.)

Zone B: In between M and C, where Lab+SNP get between 290 and 315 seats, where it is all down to the Liberal Democrats.

This analysis by Harry Lambert is excellent in detail, but I think the overall gloss that Miliband is now the favourite is misleading if you read the text. Labour needs all the seats in which it is currently favoured, plus a few surprises. Electionforecast currently have the most likely outcome as Lab+SNP=315, which means we are just in Zone B.

My instinct was always that Clegg wanted to go with Cameron, and as each day passes this becomes much clearer. But that does not mean he will get his wish, if Labour plays its cards right and LibDem members have any influence on their party. The reason is that in terms of policy, and party members, the LibDems are nearer Labour than the Conservatives. Clegg would talk to the Conservatives first, and just as last time he will play it such that this coalition appears to be the only option. He can use the following three arguments:

1)    The Conservatives have more seats than Labour (which assumes the SNP do as well as predicted). If Con>Lab+SNP this will carry some weight; if not less so.

2)    Not working in a government dependent on a party that wants to break up the UK. I think this is a highly undemocratic argument, one that can ironically only hasten the break-up of the UK, and it becomes particularly odd if the alternative is a government dependent on the DUP. Incidentally it is also a stance that does the LibDems no favours in trying to keep (or ever win back) their Scottish seats.

3)    Labour are not offering such a good deal.

What Labour can do is try and pre-empt this last argument by (if necessary) making the deal they are prepared to do public, so that the party sees what is on offer. Which means they need to think this through before 7th May.

In the end the LibDems got nothing from their current coalition on voting reform, and Labour could offer them something for sure. Not having to worry about a European referendum would also be attractive to the LibDems, particularly as Cameron could well advocate leaving. Labour could also be flexible about the type of arrangement: it could be a formal coalition, or it could be simply an understanding (that Miliband should be PM), but otherwise the LibDems vote on issues as their manifesto dictates. If they lose a lot of seats, that last option may appear attractive, particularly if the party is strongly divided over continuing with the Conservatives. There is also a strong argument that continuing in coalition with the Conservatives will bring about their eventual demise.

However, despite all this, to go with Labour would involve rejecting their current leadership’s advice (and maybe therefore their current leadership), and I suspect that will be too much for them in the end. Having helped them win a seat in the past, I hope I’m wrong.

Mediamacro myth 5: the long term plan

People should by now know the Orwellian character on this government’s spin enough to suspect that if they keep on asserting something, it is almost certainly not true. So it is with the idea of the ‘long term economic plan’. Here is a chart of the original plan for the deficit, and what has actually happened.
UK current budget deficit: June 2010 plans and outturns (per cent GDP).

The government kept their word on reducing the deficit in financial years 2010-11 and 2011-12, in part through sharp reductions in public investment: cancelling repairs to schools, reducing spending on flood defences etc. But that helped kill the recovery, so they allowed deficit reduction to stall.

The 2010 plan put the pace of deficit reduction at the centre of policy making, and the data make it clear that in 2012 the plan changed. Why did mediamacro not call this for what it was. There are two half-truths here. First, austerity in terms of squeezing lots of government departments continued. Welfare reform continued to cause plenty of misery, and food banks continued to grow. So in that very visible sense, the policy of squeezing the state was not abandoned. Second, the Chancellor’s main fiscal rule allowed him to delay austerity in this way (because the form of the rule, since abandoned, was sensible in that respect), so in that sense there was no dramatic change. However in terms of the deficit numbers, fiscal austerity was put on hold in 2012. 

Not making it clear that the plan had changed was a serious failure. If that call had been made, the Chancellor would have had to account for why he had allowed deficit reduction to stall, and that in turn would have established quite clearly that previous austerity had delayed the recovery. Failure to make that call allowed (and continues to allow) the Chancellor to pretend that the delayed recovery was not his fault, when it so clearly was. (Some journalists also got sidetracked in focusing on OBR forecasts, rather than on the OBR’s assessment of the impact of austerity.) Finally not saying that the plan had changed encouraged the ludicrous claim that the 2013 recovery vindicated austerity, which is tomorrows myth.

So this is why the Chancellor keeps on talking about his ‘long term economic plan’, because to admit he changed his plan (as a sensible reaction to the delayed recovery) would open the door to questions about why the plan had changed, and therefore about the damage that austerity had done. It that sense the ‘long term economic plan’ is a key part of the mediamacro myth. 

Previous posts in this series

Friday, 24 April 2015

Putting party before country

Philip Stephens in the FT says the idea that a Labour-SNP understanding would amount to Labour being held hostage by the SNP is nonsense. He is of course correct. In a vote on any particular issue, 50 odd SNP MPs could hardly impose their will on 600 MPs from other parties. More interesting is what this line tells us about the media, about the current Conservative Party, and about what the future might hold if they remain in power.

First the media. In my continuing series on mediamacro, I stress that myths are best based on half-truths. Half-truths are the grain of truth on which you can erect a huge lie. With the SNP and Labour, the half-truth is that SNP views on an issue could perhaps weigh a little more heavily on Labour than, say, the views of UKIP, because UKIP will always vote to bring down a minority Labour government, but the SNP will not. That fact will never make Labour go where it does not want to go, but at the margin it could nudge it a bit more in one direction. Conceivably, we might get a bit less austerity, we might treat welfare recipients a bit more humanely - that kind of thing. But would we get some policy that was against the interests of the rest of the union? Of course not. Colin Talbot makes it clear how limited the SNP’s power would in practice be here. [1]

With mediamacro, you generally need some expertise, or some knowledge of the data, to see that the half-truth is very far from the myth, knowledge political commentators may not have. In the case of ‘SNP blackmail’, political commentators have the required knowledge more than most. So for me the success of the scaremongering about a minority Labour government will be an interesting test: is lack of economic expertise or knowledge important in explaining mediamacro, or is control of the majority of the UK press sufficient. There are signs that the scaremongering is working.

As Lord Forsyth (former Scottish secretary in a Conservative government) said, his own party is putting electoral tactics above a historic commitment to the defence of the UK union. This can hardly come as a surprise. The Scottish independence referendum was a close run thing, so you might expect a party with the integrity of the nation at heart to tread carefully in the subsequent days and months to heal wounds. Instead, Cameron chose in the morning after the vote to attempt to wrong foot Labour on ‘English votes on English issues’, saying: "We have heard the voice of Scotland and now the millions of voices of England must be heard." It was a gift to the SNP.

What does all this tell us about the Conservative Party? Does it tell us that it secretly wants the SNP to get so strong that it could win a future referendum and break up the union? No, what it tells us is that this is a party that is prepared to take large long term risks for minor short term political advantage. As I have suggested on a number of occasions, that seems to be a common pattern in its macroeconomic policy (premature deficit reduction and Help to Buy being two obvious cases).

One of the clearest examples of this is our relationship with Europe. The decision to hold a referendum was taken to appease the right in his own party and potential UKIP voters, even though the uncertainty it creates will damage the economy and even though there is no chance that Cameron will be able to renegotiate to any significant extent. But large sections of what we might call the Establishment seem unperturbed as long as it helps return a Conservative led government. The assumption seems to be that Cameron will be able to sort things out when the time comes, and it will be business as usual. As Polly Toynbee puts it, the view is that “Cameron is “one of us” so he’ll somehow secure an “in” result for his 2017 referendum”

This ignores all the evidence about party before country. A Cameron recommendation to stay in the EU will split his party: after the election a majority of MPs may favour leaving, and a majority of party members already do. In two years time, all the senior figures in the party will be thinking about the elections for Cameron’s replacement. (This is why Cameron’s announcement that he would step down before 2020 was so significant.) In this situation, what are the chances that Cameron will either be equivocal or recommend exit (leaving his successor to negotiate what they can in the way of trade deals)? In that case, what are the chances of the electorate voting to stay in, when the right wing press that helped win the 2015 election for the Conservatives will be in full cry to leave? I would be foolish to say that exit was a probability, but I would be just as foolish to assume that the risk of leaving was small.

Voting for a political party that repeatedly puts itself before the national interest is not a good call in the best of times. When it could influence our position in Europe and even the Union itself, it becomes a huge mistake. Too many in the UK seem prepared to walk into that minefield, for the sake of avoiding what would be the mild inconvenience for them of a Labour led administration.

[1] I doubt very much that it will make any Labour government give additional preferential treatment to Scotland. The opposition will cry foul on this if that ever happened (and probably sometimes when it does not). As a result, Labour will go out of their way to avoid such an outcome. Would the SNP bring down a Labour government just because they failed to get some minor fiscal advantage? I think that is also highly unlikely. What the SNP will fear most is being seen as the party that brought down a Labour government and helped their opponents into power.

Mediamacro myth 4: The immediate necessity of belt tightening

In previous posts in this series (0, 1, 2, 3) we have established that the large increase in the deficit in 2010 was a consequence of the recession and not Labour profligacy - the Labour government was clearly not profligate - and that this deficit was not causing any panic in the financial markets. But surely it is a good idea for the government to tighten its belt when it runs a large deficit, just as individuals who spend more than they earn need to take action? Mediamacro is fond of drawing this analogy.

The first point to clear out of the way is that individuals do not always try and ‘balance their books’. People generally spend more around Christmas, and make up any deficit through the rest of the year. You can think about deficits and surpluses that are just the result of the normal economic cycle in a similar way.

As the 2010 deficit was a consequence of the recession, can we therefore assume that it will correct itself as the economy recovers? The answer depends on the extent of the recovery. If we returned to the pre-recession trend level of output then roughly yes [1], but not many economists think that is likely. Instead organisations like the OBR assume that much of the impact of the recession on output will be permanent. We can call the additional deficit that arises from this permanent loss of output ‘structural’. The structural deficit will not go away without some government action.

A good rule for an individual with a ‘structural deficit’ is to take action to correct it sooner rather than later, particularly if there are limits to their ability to borrow. Our mediamacro myth is that the same applies to governments: the 'maxing out the national credit card' idea. This is something that every economics student learns is wrong in the first year of their studies. Cutting the government’s deficit reduces aggregate demand, which reduces output. An individual that cuts their spending does not need to worry about the impact their decision will have on the rest of the economy, but the government because it is so large does have to think about this. When the government is free to borrow more at no extra cost (which we have seen that in the UK it was), then it has an important choice about when to start reducing its deficit.

Is there ever a good time to reduce the deficit, if output will always take a hit? There are two reasons why some times are much better than others. First, there is now quite a lot of evidence that cutting deficits in a recession has a larger impact on output than cutting deficits at other times (see here and here). Second, theory tells us that cutting deficits need not in principle harm the economy at all if monetary policy can offset their deflationary impact. If the Bank of England can cut interest rates at the same time as the government cuts its spending, the net effect on the economy could be zero.

This is a crucial point. Indeed it is the half-truth on which the coalition’s policy of immediate austerity seems to have been based. Modern mainstream macroeconomics says that in normal times governments do not need to worry about the impact their fiscal decisions (like austerity) will have on the economy, because monetary policy will offset that impact. In a speech to the RSA in 2009 this was the idea that the future Chancellor put at the centre of his macro strategy.

There was only one problem, which turned out to be extremely serious. Just before he made that speech, UK short term interest rates hit 0.5%, and the Bank of England decided they could be cut no further. They had reached what economists call the ‘Zero Lower Bound’, sometimes described as a liquidity trap. As a result conventional monetary policy was unable to offset the deflationary impact of austerity, and 2010 austerity killed the recovery that seemed to have just started. We had to wait until 2013 for a period of sustained output growth. The Bank did have some unconventional policies that it tried - most notably Quantitative Easing - but as it had no idea how effective these were, they were hardly an adequate substitute for cuts in interest rates.

Was the problem of nominal interest rates hitting a floor and therefore not being able to offset the impact of fiscal austerity on output something economists had not foreseen? Is that why the Chancellor ignored this possibility in his 2009 speech? Far from it! Keynes had dealt with the problem in the Great Depression in the 1930s. More recently, the same problem had arisen in Japan in the 1990s. By 2009 a large number of articles had been written about this problem, which is why economists like Paul Krugman and myself were such strong critics of fiscal austerity the moment it was proposed.   

Most mediamacro myths in this series just need a look at the data and common sense to bust. In those cases it is natural to look at the media itself for the source of the mediamacro problem. In this particular case busting the myth requires some (entirely conventional) macroeconomics. The fact that this macroeconomics has not found its way into political discussion of fiscal policy may reflect other problems in the knowledge transmission mechanism, including the fact that outside the US central banks seem very reluctant to acknowledge the severity of the Zero Lower Bound/liquidity trap problem.

It is difficult to overstate the consequences of this. As we have seen, the prospective Chancellor in a 2009 speech setting out the theoretical framework behind his policy ignored the problem, even though it was in front of his eyes. Each household in this country lost on average at least £4000 as a result. Yet incredibly, the same person proposes to make exactly the same mistake after 2015, and it is largely left to a few academic bloggers to point this out.
Previous posts in this series

[1] Not a complete yes, because although the deficits caused by this kind of recession would be temporary, they will have raised the level of debt, and the interest on that debt will add to future deficits. We can only ignore that if we soon expect a future boom of equal magnitude, which would be an unwise thing to do.