Wednesday, 1 October 2014

Why uncosted tax cuts are apparently a problem for Labour

Just a short addition to today’s post. I had assumed that the Conservatives’ macroeconomic pitch for the next election was going to be based on prudence and ‘responsibility’. Only we will achieve a budget surplus by 2020, because only we recognise how dangerously high the current level of government debt is. We will achieve this, because unlike the other parties we do not go around making unfunded spending commitments. Of course the Conservatives would plan targeted tax breaks for the (very) well off, like the one on pensions announced earlier this week and well described by the Economist here, but these would be sufficiently specialised that they would not dent the public image.

I was wrong, as Cameron revealed today with commitments to large tax cuts mainly for middle and high income earners by 2020 whatever. These commitments are totally unfunded, in the sense that we are not told how they would be paid for (except that it will not be by additional borrowing). So the pretence that government spending had to be cut to get debt down has gone - we now have lower government spending (which, given existing commitments, has to mean additional money from the working poor and disabled) in order to cut taxes.

I mentioned last week the drubbing the supposedly left leaning Channel 4 news gave Ed Miliband because he forgot to mention the deficit. As anticipated, John Snow’s interview with Cameron was an altogether more friendly affair. But today their economics editor Paul Mason, whose journalism can be very good, was forced to acknowledge that this unfunded tax give away broke from the recent tradition where particular fiscal pledges were fully costed. But no fear, even Mr. Mason lives in mediamacro land. His final thought on this unfunded tax pledge - it puts Labour in a very difficult position!?! Unbelievable.


How many UK elections can a nasty party win?

This last month I wrote my most widely read post in this blog’s nearly three years existence. Over 20,000 read this on Scottish independence. Yet I wrote that post with some regret, because I was acting as the typical economist killjoy. I had a lot of sympathy behind much of the support for the Yes campaign, which was to avoid being governed by a fairly extreme right wing party. I hope no one ever writes that the No vote was a victory for David Cameron’s Conservatives, because that would be a truly Orwellian distortion of reality. One of the most telling contrasts for me was Gordon Brown’s impassioned speech for the union compared to Cameron’s opportunistic attempt to appease his own MPs the morning after the result.

A post I have no regrets writing is this about Theresa May’s one time concern about the Conservative party being seen as the ‘nasty party’. Everything in the months since I wrote it, including the current party conference, confirms that this image no longer worries the leadership. The puzzle I raised in that post is why as late as 2010 Cameron was still keen to foster the idea of a more compassionate conservatism. What has changed so completely in just four years?

One answer is UKIP. Yet trying to prevent losses to another party of the right should not alter the traditional logic that a party needs to occupy the centre to win an election. Another answer is the recession, which has perhaps led to a hardening of attitudes among the electorate as a whole. The hypothesis is that in a recession people are more inclined to believe those on welfare are scroungers, and that immigrants steal their jobs. This hardening should reverse as the economy recovers, but we also know that real wages are still likely to be lower in 2015 compared to 2010.

That was where I ended that previous post. I wrote “although nastiness might accord with voter sentiments today, at some point in the future voters in more generous times will have no problem forgetting this, and just remembering the Conservatives as the nasty party.” But in writing this I might have been both unfair to the British electorate and to the strategy of the Conservative party.

To see why, take a temporary detour from welfare to macro. Chris Dillow rightly questioned the “groupthink bubble” that sees George Osborne’s stewardship of the economy as the Conservative’s strongest card. Yet those in the bubble could respond that they were simply reflecting what the public appear to be saying in the polls. The problem here is establishing cause and effect. What I call mediamacro believes that the last Labour government seriously mismanaged the public finances, when in reality its sins were relatively minor. Mediamacro thinks that the deficit somehow helped cause the recession, whereas in reality the causality goes the other way. Mediamacro thinks that the deficit is the most important problem of today, and largely ignores the stagnation of productivity. Mediamacro celebrates the 2013 recovery as vindicating austerity, which is an argument only the most politically committed academic economist would endorse.

So why do those answering polls think the Conservatives are more competent at managing the economy? It can hardly be because of their own experience, with real wages falling since 2010 compared to steady increases before then. While they might think that Labour allowed excessive leverage by UK banks which helped cause the recession, they are unlikely to also believe that the Conservatives were urging much greater caution at the time! Or could it be that their answers about competence are influenced by what mediamacro itself believes?

If there is this huge disconnect between reality and media portrayal for the macroeconomy, could the same thing be happening with attitudes to welfare? There is no doubt that the representation of disability in the print media has changed substantially over the last decade or so. Television has, after a lag, followed this trend. There is scant evidence that this reflects any significant change in the degree of benefit fraud. It could reflect a ‘hardening of attitudes’ as a result of the recession, but causality could also run the other way. Do people vastly overestimate the amount of benefit fraud because they want to do so, or because of the information they get through the media? Is this overestimation a reflection of a recession induced hardening of attitudes, or a cause of it?

This is crucial to answering the question posed in the title to this post. If squeezing the poor and disabled is a policy that reflects a recession induced change in public attitudes, then the party that follows this change may be vulnerable when the recession ends (although perhaps not before 2015). If it reflects misinformation provided by the media, then the relevant question is whether this misinformation might continue well beyond the economic recovery. If it does, the Conservative party may have a much more durable election strategy. 

Friday, 26 September 2014

The entirely predictable recession

Sometimes when I write about the Eurozone, I get comments about how inappropriate it is to apply ‘an anglo-saxon model’ of how that economy works. I think the best translation of ‘anglo-saxon’ is Keynesian. In an important sense this is rubbish. All I am doing is using the framework that is used by most applied macromodellers everywhere. That framework says that if you have a large fiscal contraction like this

Underlying Government Primary Balances: source OECD Economic Outlook
without a large compensating relaxation in monetary policy, then you will get the stagnation in output that I showed at the top of this post, and a substantial increase in unemployment.

Can this scale of fiscal contraction in itself fully account for the second Eurozone recession? There are various ways of answering this question: see, for example, this work by Jordà and Taylor, or the analysis by Holland and Portes that uses a structural econometric model. A very recent paper (available here) by Ansgar Rannenberg, Christian Schoder and Jan Strasky does something different. It uses modified versions of three different DSGE models to analyse the impact of the Eurozone fiscal contraction from 2011 to 2013. One of these models is QUEST III at the European Commission, which Jan in‘t Veld used in analysis I described here. The other two are FiMod, developed by staff of the Deutsche Bundesbank and the Banco de Espana, and NAWM, the ECB’s New Area Wide Model. All very ‘anglo-saxon’!

The modifications the authors make to the models, and the details of their analysis, would probably only be of interest to inveterate macromodellers like me, so those who want to know more should read the paper. Here I will just quote the key conclusions:

“We find that fiscal consolidation caused a cumulative GDP loss of between 14% and 20% of annual baseline GDP over the 2011 to 2013 period in the Euro Area [EA], implying a cumulative multiplier between 1.5 and 2.2.” and “As a result, the simulated GDP effects of the EA’s fiscal consolidation are large, and would be more than sufficient to explain the recent recession in the EA.”

The idea that a large fiscal contraction shortly after a huge financial crisis would lead to a second recession is not the wild imagining of a group of ‘anglo-saxon’ economists, or a particular macroeconomic ‘school of thought’. It is just mainstream macroeconomics. And we must never forget that this is not the unfortunate cost of having to get debt down in a few periphery countries: as the chart above shows, this fiscal contraction occurred everywhere in the Eurozone. As the simulations described in this link (pdf) show, using the Belgian NIME model, these costs could have been largely avoided if the fiscal consolidation had been delayed until monetary policy was in a position to offset them. It is not just a predictable recession; it is a recession made by policymakers without good cause and therefore an entirely avoidable recession.

Thursday, 25 September 2014

More mediamacro

What was the most important point about Ed Miliband’s speech to the last Labour party conference before the election? The UK media had no doubt. It was that he forgot to mention the deficit. No matter that Ed Balls had spent much of his previous day’s speech laying out their policy on the deficit, which has been intelligently discussed by the IFS and others. Miliband had in his speech forgotten the paragraph where he says how important the deficit is, and he was going to be taken to the cleaners for it.

I’m not just talking about the right wing press here. Channel 4 news likes to think of itself as being a little more highbrow than other news programmes, and I’ve no doubt that conservatives would describe it as left wing. So here is a link to John Snow’s interview with Miliband yesterday (skip intro and question on middle east to about 3 minutes in). He asks Miliband what the greatest issue facing the next British government is. Miliband responds that it is getting the country to work for most working people rather than be stuck with a more unequal country. Interesting answer, but inequality is not an issue mediamacro recognises. It was a trick question. Now that is twice that you have forgotten to mention the deficit, responds Snow. How could you not mention paying off this appalling deficit? Snow continues. Surely it is the most important issue of all. It is the essence of our economic crisis. And so on.

Now my point here is not about bias, and how this interview could have been scripted by George Osborne. It is about the banality of it all. If you are going to talk about the deficit, ask some real questions about the differences between Labour and Conservative plans. Ask why Labour thinks that debt should not come down more rapidly. There are lots of meaningful questions you could ask. But trying to make a great issue out of a forgotten part of a speech is just silly. It is gotcha journalism for those who get their economics from listening to political commentators. The implication that the deficit is all important, and linking it in a causal way to the recession, is mediamacro at its worst.

What is the really important thing that has happened in the UK economy over the last six years? It is not that the deficit went up and then has started coming down. It is that UK productivity has stalled, and as a result real wages are lower than when the recession began. That is what really matters. That is not a ‘political judgement’; it is what most economists and most ‘ordinary people’ will tell you. But not in mediamacro land. So when Cameron gives his speech to the Conservative party conference, and does not mention this terrible productivity performance, I doubt if one single journalist will even bother to ask why that was not in his speech. This is journalism at its most pathetic.

Wednesday, 24 September 2014

Where macroeconomics went wrong

In my view, the answer is in the 1970/80s with the New Classical revolution (NCR). However I also think the new ideas that came with that revolution were progressive. I have defended rational expectations, I think intertemporal theory is the right place to start in thinking about consumption, and exploring the implications of time inconsistency is very important to macro policy, as well as many other areas of economics. I also think, along with nearly all macroeconomists, that the microfoundations approach to macro (DSGE models) is a progressive research strategy.

That is why discussion about these issues can become so confused. New Classical economics made academic macroeconomics take a number of big steps forward, but a couple of big steps backward at the same time. The clue to the backward steps comes from the name NCR. The research programme was anti-Keynesian (hence New Classical), and it did not want microfounded macro to be an alternative to the then dominant existing methodology, it wanted to replace it (hence revolution). Because the revolution succeeded (although the victory over Keynesian ideas was temporary), generations of students were taught that Keynesian economics was out of date. They were not taught about the pros and cons of the old and new methodologies, but were taught that the old methodology was simply wrong. And that teaching was/is a problem because it itself is wrong.

There had always been opposition to Keynesian ideas, and much (though not all) was ideological, such as attempts to remove Keynesian textbooks from US universities. However the NCR gave what should more precisely be called ‘aggregate demand denial’ an intellectual respectability that it never deserved. The reasons for believing that shifts in demand move output and employment in the short run and prices are sticky are overwhelming, so to deny both was a seemingly impossible task. It was achieved by adopting a methodological position which could ignore inconvenient evidence.

I do not think it had to be like this. Mainstream macroeconomics did not need a revolution in the 1970s and 1980s. Ideas like rational expectations could have been assimilated into the mainstream methodology, and microfounded models could have been developed alongside more eclectic econometric models (SEMs, not VARs), or aggregate theoretical models that Blanchard and Fischer rightly called ‘useful models’. Microfounded models could have shown the kind of errors that can arise in more empirically based models when theory is ignored or only applied piecemeal, and these empirical models could have highlighted the key areas where additional microfoundations were needed.

I think if this had happened, macroeconomics would have been better prepared when the financial crisis hit. Take just one issue: the role of credit conditions in influencing consumption. This is clearly crucial in understanding how consumption might respond to a credit crunch, yet any mechanism of this kind was absent from most DSGE models in 2008. However a more empirically based model of consumption would have had to address this issue well before 2008, as I argue here. If these types of models had continued to be developed within academia, rather than confined to the dustbin by the microfoundations revolution, then at least policymakers would have had something to work with. If there had been interaction between empirical and microfounded models some of the financial frictions literature that has flourished since 2008 might have appeared earlier.

So why didn’t this happen? Why did we have a revolution which overturned an existing methodology and temporarily banished Keynesian theory, rather than an adaptation and augmentation of what was then mainstream? Was the attraction of overturning orthodoxy too strong, as it is for a minority of heterodox economists today? Did an ideological imperative of dismissing Keynesian ideas play a role? To what extent was the hostile reaction of many in the macroeconomic establishment to eminently sensible ideas like rational expectations responsible? Was the attraction of a methodology where at least you could be sure you were consistent too enticing, perhaps encouraged by increasing segmentation between theoretical and empirical macro? I would love to know the answer to these questions. 


Tuesday, 23 September 2014

Let it roll!

Both the IFS and the Resolution Foundation crunch the numbers, and come up with a broadly similar assessment of the different UK political parties fiscal plans post 2015 to the one Giles Wilkes, Steven Toft and I independently arrived at a few months ago. Essentially if for some reason (?) you want to bring debt down quickly and are not worried about a further dose of austerity and possibly repeating the mistake of 2010, vote Conservative.

Are Labour and the LibDems shouting about this really important difference as a way to gain votes? Exactly the opposite is true - they want voters to think that they are as ‘tough’ as the Conservatives on the deficit, but just a little more compassionate in the way they will reduce it. We are in the world of ‘mediamacro’, where ‘responsibility’ is code for fiscal austerity (which, in the real world of the liquidity trap, is of course irresponsible), and ‘credibility’ is code for the policies that business ‘leaders’ and the financial ‘priesthood’ like.

What I want to focus on here is an unusual but welcome piece of forthright opinion in the IFS assessment. To quote:

“.. the current government’s fiscal mandate is explicitly forward looking with a rolling five-year target, while each of the three parties’ proposed new targets for borrowing seem to relate to a fixed date – that is, all of them refer to achieving the objective during the next Parliament. There are strong arguments in favour of forward-looking, rather than fixed date, targets and all the parties would be well advised to consider rephrasing their objectives in this way.”

As I noted here, this is one of the things this government got right, and it would be a shame (and dangerous) to take a step backwards. So the IFS is correct, but the argument appears strange at first, so it may be worth spelling out.

Having a deficit target to be achieved within the next five years, where that five year period remains as time moves on (a rolling target) seems far too easy. There is never a date by which we can unambiguously say that the target has been achieved or not. It would seem much better to have a target for a fixed date e.g. current balance by 2020.

The problem with this logic comes when we approach 2020, and some unexpected shock occurs. Rather than adjusting to that shock gradually over the next five years, adjustment has to be very rapid. This breaks the first rule of fiscal management, which is that the deficit should be a shock absorber, not a rigid target.

In fact we are used to a similar idea from monetary policy. This attempts to achieve the inflation target within the next two years or so. (In the UK this two years used to be set in stone, but less so now.) The reason often given for this is that it takes some time for changes in interest rates to have their full influence on prices, but this is only part of the story. Interest rates have some impact on prices quite quickly, so it would in principle be possible to try and meet an inflation target with a shorter time horizon, but the reason this is not attempted is that it would lead to damaging variability in interest rates and output.

The inflation target that most central banks have is also a rolling target: no central bank says it will aim to achieve its target by 2016. This does not stop central banks being accountable for their actions. If inflation is not on target by 2016, and there were no unexpected shocks over the previous two years, the central bank will come in for plenty of criticism. However if oil prices unexpectedly rose substantially in 2015, we would not want or expect the bank to do everything in its power to keep to its inflation target in 2016.

The same logic applies to fiscal policy. It is true that rolling targets do give the fiscal authority the possibility to cheat, and as Jonathan Portes and I argue (here or here), if the government has in the past always cheated and there is no institutional arrangement to stop this happening, then fixed date targets may be an unfortunate necessity. However we also argue this is not the case in the UK for two reasons. First, in the past UK governments have proved to be quite capable of taking the actions required to meet fiscal rules - what has often derailed them has been unexpected shocks like recessions. Second in the OBR we have an effective fiscal council which in this respect acts as a watchdog.

So let us hope that the fact that current plans are expressed as fixed date targets reflect the desire for easy communication just before an election, and that whoever gets elected reverts back to rolling targets when in government. Let us hope that achieving fiscal targets by 2020 does not become part of what mediamacro thinks is responsible and credible. 

Monday, 22 September 2014

Misleading a country

When this happens (taken from a post by Jérémie Cohen-Setton), something has gone very wrong. The Euro was meant to increase growth, not create stagnation. So what, or who, is to blame?

Many outside the Eurozone, and a growing minority within it, will say the Euro itself. But that is not a very helpful response. Given the level of commitment to the Euro, it is the only correct response if there is no version of this currency union that can be made to work better.

Others will say that the only way forward is further political integration through a fiscal union. That seems like the political equivalent of going from the frying pan into the fire. The story of the Euro is as much a political failure as an economic failure. But I also suspect support among many economists for fiscal union is built upon a questionable premise. The premise is that the current difficulties arise because it is inevitable that Germany will put its national interest above the interests of the Eurozone as a whole.

This argument goes as follows. As a result of undercutting other union members, Germany has become too competitive within the Eurozone. This will be reversed. The ECB has an inflation target of almost 2%. Therefore in normal circumstances we would see inflation above 2% in Germany for some period. This is unfortunate for Germany, but those are the macroeconomic rules of the game in a monetary union.

However we are not in normal circumstances, because the interest rate set by the ECB cannot fall any further. As a result, Eurozone inflation is well below 2%. There is an obvious solution to this problem: replace monetary stimulus with fiscal stimulus. However, this is not in Germany’s interests: as a result of becoming too competitive, their economy is relatively healthy, and they do not want above 2% inflation. Therefore we need a fiscal union to impose fiscal stimulus on Germany. (There is a variant of this argument where we focus on the failure of monetary policy and German pressure on the ECB.)

It is natural for economists to reason this way, because we are used to thinking about rational self-interested individuals. But suppose the problem with German public opinion is not that it is being narrowly self-interested, but that it has been encouraged to think about this in the wrong way. There are two aspects to this. First, although Keynesian economics is taught in all universities, in appears taboo in much German public discussion. Under this anti-Keynesian view the chart above has nothing to do with fiscal contraction, so it must be all about the lack of ‘structural reform’ outside Germany. Second, German politicians are in denial about the implications of low German inflation before the crisis. Logically the only way Germany can avoid above 2% inflation is if the Eurozone as a whole goes through a prolonged depression, but as is painfully obvious from the comments on some of my recent posts, the German public is not told about this.

The two deceptions help reinforce each other. Germany says it is doing OK without the need for fiscal stimulus, so why do other countries need it? Of course Germany is doing fine because its period of relatively low inflation allowed it to uncut its Eurozone competitors.

Never underestimate the power of bad ideas, particularly if they have ideological roots. Here we have the two mistakes that led to the Great Depression being repeated. We look back at the 1930s and think if only they had known about Keynesian economics a depression could have been avoided. However the depression was as much about countries attempting to stick with the gold standard, and the problems with that were obvious at the time. Today we do know about Keynesian economics, but both mistakes continue.

It is possible to believe that balanced-budget fundamentalism is somehow hard wired into the German psyche, and I have personally experienced moments like that described in this comment to my earlier post that seem to confirm this. So I do not want to discount such explanations entirely, but I do wonder if a powerful motive behind this is just the same anti-state neoliberalism that you see elsewhere. Those on the right appear to have a greater distrust of economists and their theories. This may be true of popular attitudes (HT Tyler Cowen), but it is also the case of those running the country.

According to Der Spiegel, the three permanent secretaries running the German finance ministry have studied law rather than economics. Among the nine department heads seven are lawyers and just two are economists. While the balance between lawyers and economists has always favoured lawyers, it has apparently become worse under Schäuble (whose doctorate is also in law).

As a result of all this, it is not at all clear to me that the current problems of the Eurozone are all down to German self-interest. The case for additional infrastructure spending in Germany looks strong, as argued by Marcel Fratzscher, head of the German Institute for Economic Research (DIW). It would therefore seem more than possible to get Germany to take part in a Eurozone wide programme of additional public investment, which can be justified on a microeconomic/supply side basis as well as on macroeconomic/demand side grounds. All that stands in the way is the power of bad ideas, and its embodiment in the Eurozone’s fiscal rules.