Wednesday, 1 April 2015

Economists vs. Business Leaders?

Today illustrated very clearly why the monthly CFM survey of mainly academic, mostly macro UK economists was such a good idea. (And something that I should have included in this discussion.) I have often written that I thought austerity was only supported by a small minority of UK macroeconomists, but my evidence for this has been much thinner than I would like. Today CFM published their latest survey which asked: “Do you agree that the austerity policies of the coalition government have had a positive effect on aggregate economic activity (employment and GDP) in the UK?”

The response was clear: 15% agreed, 18% neither agreed nor disagreed, and 66% disagreed. As CFM reported: “Ignoring those who sat on the fence, 19% agree and 81% disagree with the proposition. This ratio is unaffected by confidence weighting.”

That was welcome confirmation of my prior, but what was much more important is that the survey came out on the same day as the Daily Telegraph published a letter from 100 business leaders saying exactly the opposite. To quote: “We believe this Conservative-led Government has been good for business and has pursued policies which have supported investment and job creation.” Now of course a letter (organised by whom?) is not a survey, and it is hardly news that Labour has policies that are unpopular with business leaders. Yet the letter was nevertheless the lead item on BBC news today.

However in at least some of the reports I heard that led on the letter ‘news’, the CFM survey was also mentioned. I myself participated in Radio 4’s World at One (about 11 minutes in) as a direct result of the survey. Robert Peston went as far as to ask: “Who to trust - business leaders or economists?” I liked the way he introduced his post:

“Neither business leaders nor economists have a monopoly of wisdom on what's good for Britain or are free from political bias. But it is perhaps therefore all the more important to remember that those paid to think about how best an economy should be run don't necessarily agree with those paid to run companies.”

He might have also added that, probably without exception, we are paid a lot less than business leaders, so the danger that our opinions might be influenced by Labour policies like reintroducing the 50p income tax rate or introducing a mansion tax is perhaps also smaller!

Tuesday, 31 March 2015

A quick note on two recoveries


Along with revised GDP numbers, we now have GDP per head for 2014 as a whole. (I have used estimates for the fourth quarter up until now.) Growth in 2014 was 2.17%. That is certainly an improvement on previous years: 2013 1.03%, 2012 -0.01%, 2011 0.80%, 2010 1.10%. However it is no more than the average growth rate between 1955 and 2010 of 2.1%.

As charts that I have posted earlier clearly show, this average of around 2.1% really does reflect what looks like a pretty constant trend over the past. We have had recessions before, but they were followed by above average growth: in 1983 GDP per head grew by 4.2%, and in 1994 by 3.8%. So as recoveries go, this one has been terrible.


There are signs that the Eurozone recovery may also be beginning. If this turns out to be the case, you are sure to read a great deal about how this is all down to the ECB finally adopting Quantitative Easing. I suspect you will read rather less about another explanation, which is that fiscal contraction began to ease off last year, and that this will continue into 2015. The chart below is from the March 2015 OECD Economic Outlook, so the 2014 numbers should be fairly reliable estimates.

Government underlying primary balances: OECD Economic Outlook March 2015

The message in both cases is simple. Fiscal austerity reduces growth. When fiscal austerity stops, growth can resume. It’s a message that rather a lot of people who were responsible for the fiscal tightening would rather you didn’t hear.

Monday, 30 March 2015

Greece and other benefit scroungers

Whenever I write a post critical of German views on Eurozone policy, I get comments which can be paraphrased in the following way. Greece (and maybe other Eurozone countries) are incapable of governing themselves properly, and when they get into difficulties Germany has to bail them out, so it is only reasonable that as a price for this Germany should insist on imposing changes to the way these countries do things.

To say such an attitude is inherently wrong (wrong in any possible circumstances) seems to be too strong. The IMF, after all, has played a very similar role many times. Many may criticise the kinds of reforms that the IMF has demanded as part of its conditionality, but to suggest that conditions are never made as part of such a loan package seems unrealistic.

But while conditionality of any kind cannot be ruled out, it can also go far too far. It should never become imperialism, and the choices of a sovereign people should be respected and accommodated, not ignored.

It is clear that the Greek government ran up unsustainable debts, and tried to hide these. As a result, it was bound to default on those debts. As doing so would exclude it from the markets for a time, it was also reasonable to lend (not give) Greece money to enable it to gradually rather than immediately achieve primary balance. Some conditionality to correct any underlying weaknesses in the openness and accountability of the budgetary process would seem reasonable in such circumstances.

Contrast that with what actually happened. First the Eurozone resisted default, and then it was only partial, which meant providing far larger official loans than were needed. The beneficiaries of this were mainly the financial institutions (e.g. Eurozone banks) who would have otherwise lost money. Second, ridiculously severe austerity was imposed, which crashed the economy and made it much more difficult for Greece to adjust. Third, conditionality far in excess of what was required is being imposed.

I have argued before, based on very rough and ready calculations that the fall in Greek GDP since 2010 could be entirely accounted for by fiscal austerity. This conclusion has now been backed up by rather more rigorous analysis in a new paper by Sebastian Gechert and Ansgar Rannenberg. As we both acknowledge, some GDP loss was inevitable because the deficit had to be reduced (and Greece does not have an independent monetary policy which could offset the impact of deficit reduction). However, as always, timing is everything. The paper argues that “most of the costs of fiscal consolidation could have been avoided by postponing and gradually implementing it after the recovery of the Greek economy, due to the lower expenditure multipliers during normal times.”

The delay in default, its partial nature and a degree of austerity that Gechert and Rannenberg describe as ‘biblical’ and which did such damage are all acutely embarrassing for the Troika. But instead of criticism being directed at these governments, we see a narrative that tries to blame what happened from 2010 onwards on Greece itself, and the Greek people in particular. The economy has crashed because the Greek people do not work hard, austerity has not worked because it has not really happened, and there have not been enough reforms. None of this is true, but the narrative seems largely impervious to facts. (On reforms, for example, see here.)

All this reminds me strongly of how certain attitudes to beneficiaries of the welfare state have been encouraged by the UK coalition government. Rather than admit that unemployment benefits had risen because of the recession and the absence of a recovery (itself a result of austerity), the focus became on the personal failings of the unemployed themselves. The media (TV as well as the tabloids) are still full of examples of supposed ‘welfare cheats’, but they rarely put such examples into context: how tax evasion is a bigger problem that benefit fraud, for example.

People do hate the idea of ‘their taxes’ allowing ‘other people’ to get ‘something for nothing’. In contrast tax evasion does not sound too different from tax avoidance, which many people do as much of as they can. Condemning one and ignoring the other may be human nature. What is clearly wrong is politicians playing on these feelings to misdirect anger away from their own mistakes, or undertaking unnecessary or even harmful policies to play to the gallery. A clear case of the latter is the recent increase in benefit sanctions, which are being applied in an excessive and unfair way, greatly increasing the use of foodbanks as a result. That a committee of MPs where the government is in a majority have expressed grave concerns about the policy just before an election gives an indication of the scale of the injustice that has been taking place.

When politicians do this, it is a sign of chronic political weakness: a desperate attempt to cover up past mistakes. There is a strong danger that the same dynamic may occur in the continuing standoff between Greece and the Eurozone. Having encouraged a rhetoric where a virtuous Eurozone has shown nothing but generosity to a feckless Greece, politicians feel compelled to live up to that false narrative by acting tough in negotiations, which does no one any good to put it mildly. When Putin behaves recklessly to boost his popularity and succeeds, we can blame the lack of press freedom. When political leaders in the UK or Germany play the same trick, do we blame the media for playing along or the people for falling for it?

Friday, 27 March 2015

Protecting the public from policy entrepreneurs

One of Paul Krugman’s first books, Peddling Prosperity, made a distinction between academic economists and people he called "policy entrepreneurs". These are individuals who promote particular intellectual positions and ideological policy prescriptions which have little or no academic support, but which may appeal to certain politicians.

I remember it as a great book, and unfortunately one of the main subjects - the idea that tax cuts pay for themselves - is still current in the US. It remains the case that this idea has virtually zero academic support, but for whatever reason - the activities of policy entrepreneurs being one - it still has a tight hold on the Republican Party.

I also remember being dissatisfied with the concept of the policy entrepreneur. It seemed to me that the book failed to situate them in a more general framework of how different interests influenced policy. Why were policy entrepreneurs particularly prevalent in economics? Could academics also be policy entrepreneurs? But that was the social scientist in me speaking. It was clear that such people existed, and that their influence could be far from benign.

I was reminded of all this when someone referred me to Andrew Sentance’s latest piece where he advocates moving to a zero inflation target. Coupled with George Osborne and David Cameron proclaiming zero inflation as a great success, a horrible thought occurred. If these guys were re-elected, might they find the arguments of Andrew Sentance appealing, and actually go for zero inflation? (In the UK, the Chancellor sets the inflation target.) Getting rid of inflation completely - sounds like a vote winner!

Why is it a horrible thought? Because all the academic discussion has been going in the opposite direction, for a very good reason. The Great Recession has highlighted the problems caused by the lower bound for nominal interest rates. That problem will not go away if that lower bound turns out to be -1% rather than zero. The discussion of secular stagnation has highlighted how the ‘underlying’ level of real interest rates has steadily fallen over the last few decades. Put the two together, and you see that a 2% inflation target may mean that we hit the interest rate lower bound far too frequently for comfort. A higher inflation target is one way, although not the only way, of reducing this problem.

Given this, calling for a zero inflation target seems perverse. In response, Andrew Sentance says this: “And the fact that a target of zero inflation may not allow central banks to easily impose negative real interest rates may actually be a good thing – protecting savers, who have suffered heavily as a result of very low interest rates since the financial crisis.” This is just the kind of thing a policy entrepreneur would say: identify your target interest group, and appeal to their interests over the common good. A politician who wants to appeal to savers might think that sounds like a good idea, and before you know it the policy is in place.

I suspect things have moved on a little since Peddling Prosperity was published. The role of think tanks is probably greater. The good ones are a means of channelling academic research, as in this very recent discussion of how to enhance real wage growth from the Resolution Foundation (which I would call excellent if it didn’t have a contribution from me). But they are matched by others that are effectively the institutional equivalent of policy entrepreneurs.

One answer to this problem is delegation. If you delegate an issue to a non-political body, that institution is going to be less swayed by the policy entrepreneur, and more influenced by knowledge and evidence. The independent central bank is an obvious example. It is interesting that one of the contributions to the Resolution Foundation volume, from John Van Reenen, calls for a “permanent infrastructure strategy board”, to improve the level and quality of national infrastructure. Of course with delegation comes the danger of power without accountability, and one particular central bank is a good example of that.  

Is delegation the only way we have of protecting ourselves from the policy entrepreneur? I have one final thought. (The idea comes from Chris Dillow, but he said it on my blog first!). Policy entrepreneurs exist in part because of sectional interests. The problem arises if sectional interests drown out evidence based policy. Society as a whole clearly has an interest in evidence based policy, but one institution that is well placed to protect society’s interest here is academia. Although - in the UK at least - academia encourages the dissemination of research, most academics are always going to value their research above its dissemination, because that is how internal incentives work. So maybe the academic sector needs to create a few policy entrepreneurs of its own, whose mission is to disseminate not their own research, but research in a whole field. One of two examples already exist - maybe we should have more of them.  

Thursday, 26 March 2015

Rollercoasters and rules

Chris Giles says today that “there is a gap [between Labour and Conservatives plans] of more than £30bn a year in public spending by the end of the decade, at least 1.4 per cent of national income. This is a bigger political divide seen in any election since the days of Margaret Thatcher.” Chris is absolutely right to focus on this fact, and it is really important that other journalists (including those on the political side) do the same. The reason is that neither Labour nor the Conservatives want to admit this. Labour wants to appear as if they are being ‘tough on the deficit’ and the Conservatives want to turn this into a ‘Labour would put up taxes’ election. With all the noise that these phoney debates throw up, it is important that someone tells people what the consequences of their vote will be.

Chris may also be right that the rollercoaster for public spending set out in the Budget (sharp cuts followed by increases) will not happen. However I think it would be wrong to expect a smooth ride under the Conservatives either. They will have won an election based on an initial two years of substantial spending cuts (particularly to public investment), followed by later years when the overall pace of fiscal consolidation slowed substantially (in part because of Budget tax cuts). If that wins them this election, they will want to repeat that pattern. [1]

The term rollercoaster was coined by Robert Chote, head of the Office for Budget Responsibility. But if the rollercoaster will never happen, was Robert wrong to use this word? Absolutely not - in using that term he was doing his job in a very effective way.

As Chris explains, the reason why the numbers given to the OBR generate a rollercoaster profile is the revised fiscal rule, which says that there should be (cyclically adjusted) balance within three years. Like the old rule, this is a rolling target (but now for three years ahead rather than five), so it means in effect that governments can keep putting off the date balance is achieved as each year rolls past.

If governments start planning their fiscal actions with this in mind, the rule becomes largely worthless: it means reducing deficits maƱana. As I explained here, rolling targets are a good idea because they allow policy to be flexible in the face of shocks. But rolling targets can also be abused by an irresponsible government to forever put off deficit reduction.

As I argued here, there was no good reason for Osborne to switch from a five to three year rolling target, and good reasons to stick to five years. The move to three years looked like a political ploy to embarrass the opposition. When politicians start messing around with fiscal rules for political ends, and these rules then produce silly results which politicians have no intention of sticking to, it is important that an independent institution with the words ‘budget responsibility’ in their title calls attention to what is going on. Robert Chote did that very effectively by using the term rollercoaster. 

[1] Where I think Chris is wrong is in describing plans to decrease debt slowly as risky. The opposite is the case. With interest rates near their floor, sharp austerity puts the economy at risk from adverse macroeconomic shocks. 

Wednesday, 25 March 2015

Why do central banks use New Keynesian models?

And more on whether price setting is microfounded in RBC models. For macroeconomists.

Why do central banks like using the New Keynesian (NK) model? Stephen Williamson says: “I work for one of these institutions, and I have a hard time answering that question, so it's not clear why Simon wants David [Levine] to answer it. Simon posed the question, so I think he should answer it.” The answer is very simple: the model helps these banks do their job of setting an appropriate interest rate. (I suspect because the answer is very simple this is really a setup for another post Stephen wants to write, but as I always find what Stephen writes interesting I have no problem with that.)

What is a NK model? It is a RBC model plus a microfounded model of price setting, and a nominal interest rate set by the central bank. Every NK model has its inner RBC model. You could reasonably say that these NK models were designed to help tell the central bank what interest rate to set. In the simplest case, this involves setting a nominal rate that achieves, or moves towards, the level of real interest rates that is assumed to occur in the inner RBC model: the natural real rate. These models do not tell us how and why the central bank can set the nominal short rate, and those are interesting questions which occasionally might be important. As Stephen points out, NK models tell us very little about money. Most of the time, however, I think interest rate setters can get by without worrying about these how and why questions.

Why not just use the restricted RBC version of the NK model? Because the central bank sets a nominal rate, so it needs an estimate of what expected inflation is. It could get that from surveys, but it also wants to know how expected inflation will change if it changes its nominal rate. I think a central banker might also add that they are supposed to be achieving an inflation target, so having a model that examines the response of inflation to the rest of the economy and nominal interest rate changes seems like an important thing to do.

The reason why I expect people like David Levine to at least acknowledge the question I have just answered is also simple. David Levine claimed that Keynesian economics is nonsense, and had been shown to be nonsense since the New Classical revolution. With views like that, I would at least expect some acknowledgement that central banks appear to think differently. For him, like Stephen, that must be a puzzle. He may not be able to answer that puzzle, but it is good practice to note the puzzles that your worldview throws up.

Stephen also seems to miss my point about the lack of any microfounded model of price setting in the RBC model. The key variable is the real interest rate, and as he points out the difference between perfect competition and monopolistic competition is not critical here. In a monetary economy the real interest rate is set by both price setters in the goods market and the central bank. The RBC model contains neither. To say that the RBC model assumes that agents set the appropriate market clearing prices describes an outcome, but not the mechanism by which it is achieved.

That may be fine - a perfectly acceptable simplification - if when we do think how price setters and the central bank interact, that is the outcome we generally converge towards. NK models suggest that most of the time that is true. This in turn means that the microfoundations of price setting in RBC models applied to a monetary economy rest on NK foundations. The RBC model assumes the real interest rate clears the goods market, and the NK model shows us why in a monetary economy that can happen (and occasionally why it does not). 

Tuesday, 24 March 2015

Zero UK Inflation

Today it was announced that UK consumer price inflation hit zero in February. The ONS estimate that we have to go back to the 1960s for the last time this happened. More importantly, core inflation fell back 0.2% to 1.2%, after 0.1% increases in the previous two months. As Geoff Tily points out, if you take out the 0.2% contribution from the decision to raise student fees (which are hardly an indicator of excess demand), then the Governor could be writing a letter to the Chancellor based on core inflation, and not just the actual inflation rate.

The Chancellor is in election mode and so does not care: in fact he says zero inflation is good news, and he just hopes no one asks him why he chose to reaffirm a symmetrical 2% target. For the Bank of England it means the key question is now should they cut rates? As I noted here, optimal control exercises on the Bank’s model and forecast say they should, and I discussed here why there is an additional strong prudential case for doing so.

The point I want to make now is about survey evidence on capacity utilisation. I had a number of memorable meetings with various economists and officials at the Treasury, Bank and elsewhere when the Great Recession was at its height, but the one that left me most puzzled was with one of the more academic economists at the Bank of England. It was at about the time that core inflation started rising to above 2%, despite unemployment being very high and very little signs of a recovery. At much the same time survey measures of capacity utilisation were suggesting a strong recovery, completely at variance with the actual output data. The gist of our discussion was: what the hell is going on!? It was particularly puzzling for me, because I had many years before done a lot of work with survey data of this kind, and back then it seemed pretty reliable.

The problem with the 2010 period was that it was exceptional, and so in that sense it was not that surprising to see surprising things going on. My own pet theory at the time was that the financial crisis had made firms much more risk averse, which made them less likely to cut prices in an attempt to gain market share. Move on to today, and things are perhaps a bit less exceptional. What today’s figures emphasise is that the inflation ‘puzzle’ of 2010/11 has gone away. Levels of inflation are now much more consistent with substantial spare capacity in the economy. However the bizarre behaviour of the survey data has not disappeared.

Here is a nice chart from the ONS, comparing various different measures of spare capacity.

What it shows is that labour market indicators suggest an amount of spare capacity well outside the ‘normal’ range from the pre-recession years. In contrast, both hours worked and survey based indicators (the first six measures) suggest the output gap is quite small, and in one case actually positive. As this OBR paper shows, survey measures of capacity utilisation were suggesting a positive output gap as early as 2012.

Faced with this combination of spare capacity in the labour market and firms reporting its absence, a macroeconomist would suggest it could be a consequence of high real wages, encouraging substitution from labour to capital. Firms were fully utilising their capital – hence no spare capacity – but had hired less labour as a result. However a notable characteristic of this recession in the UK has been the high degree of labour market flexibility, with large falls in real wages. One of the more persuasive theories for the UK productivity puzzle, which I outlined here, is that we have seen factor substitution going in the other direction.

Back in 2010, I was reluctant to suggest the survey data were simply wrong, partly because of their past reliability but mainly because inflation was telling a similar story. On the day that inflation hits zero, I think the argument that these survey measures are not measuring what we used to think they measured has become much stronger. But that still leaves an unanswered question - why have they gone wrong, when they worked well in the past?