The OBR, productivity and policy failures

Chris Giles had an article in the FT yesterday about the UK’s continuing dreadful productivity performance, and the implications this might have for forecasts of the public finances. It has the following chart comparing successive OBR forecasts and actual data.

I want to make two points about this. The first is about the OBR’s forecast. [1] It is easy to say looking at this chart that the OBR has for a long time been foolishly optimistic about UK productivity growth. Too often growth was expected to return to its long run trend shortly after the forecast was published but it failed to do so. Expect lots of articles about how hopeless macro forecasts are in general, or perhaps how hopeless OBR forecasts are in particular. It was obvious, these articles might say, that trend productivity growth in the UK has taken a permanent hit following the financial crisis.

Anyone saying this is ignoring the history of the UK economy for the 50 years before the GFC. After each downturn or recession, labour productivity growth has initially fallen, but it has within a few years recovered to return to its underlying trend of around 2.25% per annum. This means not just returning to growth of 2.25%, but initially exceeding it as productivity caught up with the ground lost in the recession. In a boom sometimes growth exceeded this trend line, but it soon fell back towards it.

This made sense. Productivity growth reflects technical progress and innovation, and they tend to continue despite recessions. A firm may not be able to implement innovations during a recession, but once the recession is over experience suggests they make up for lost ground in terms of putting innovations into practice.

Given this experience, OBR forecasts have always been pretty pessimistic. They have assumed a return to trend growth, but no catch up to make up for lost ground. If they had also forecast, in 2014 say, that given recent experience they expected productivity growth to be almost flat for the next five years that would have been regarded as extreme at the time. Why would UK firms continue to ignore productivity enhancing innovations when the macroeconomic outlook looked reasonable?

And of course in 2014 UK productivity growth was positive. This brings me to my second point, which follows from this quote from the FT article:

“In the Budget, both the OBR and Mr Hammond are likely to stress that the downgraded forecasts do not reflect a new assessment of the damage to the UK economy from Brexit, but a reassessment of likely productivity growth after so many recent disappointments.”

Chris may be right that they will say this, but is it remotely plausible? As my recent post tried to suggest, UK productivity growth can be seen as suffering from three large shocks: the recession following the GFC, the absence of a normal recovery as a result of austerity, and then Brexit. The first two of those shocks led to a period of intense uncertainty, causing UK firms to put on hold any plans to innovate. Just as they thought things had returned to a subdued version of normal they were hit by the third, Brexit. During periods of intense uncertainty, productivity stalls or may even decline a little, as firms meet any increase in demand by increasing employment but not investing in new techniques. [2]

This story involving uncertainty seems to fit the data. Once the recovery (of sorts) finally began in 2013, productivity growth picked up. That sustained growth came to a halt when the Conservatives won the 2015 election, and the possibility of Brexit began to be an important factor for firms. [3]

These two points are related in the following way. The experience of the 50 years before the GFC suggested that you could hit the economy with pretty large hammers, but it would eventually bounce back. However that may have been contingent on a belief by firms that if policymakers were wielding the hammer (using high interest rates for example) they would take it away fairly soon, and replace it by stimulus. That belief was shattered in the UK by the GFC and austerity, where policymakers decided to keep using the hammer. What little confidence remained was destroyed by Brexit.

Discoveries are still be being made in universities around the world, and we know innovations are still being implemented by leading UK firms. It seems completely far fetched to imagine the GFC is still having some mysterious impact on the remainder of UK firms such that they refuse to adopt these innovations. A much more plausible story is that we are seeing what happens when most firms lose confidence in the ability of policymakers to manage the economy.

[1] I am on the OBR’s advisory panel, but as our job when we meet once a year is to be critical of OBR assumptions, and as we have no role in producing their forecasts, I think what I say here can be completely objective.

[2] Productivity can initially fall because new employees are not as productive as those who have been working in the firms for some time, for example.

[3] An alternative story is that the UK has settled into a new slow growth ‘equilibrium’, where the majority of firms are so pessimistic they hardly innovate at all.      

Why is MMT so popular?

I think, as a result of earlier posts, that I can be pretty confident that I can answer this question. But first some background. Although MMT has been around for some time, it recently held its first international conference and has in the last few years attracted a devoted band of followers online. According to this article, it has ‘rock star appeal’. In this post I just want to concentrate on the core of MMT which involves fiscal policy, and not talk about other ideas like job guarantees.

There are short and simple explainers around (e.g. here), but what these and MMT followers are typically not so good at is in explaining exactly why and how they differ from mainstream macroeconomics. To understand this, we need to go back to the 1960s and 70s. Then there was a debate between two groups in macro over whether it was better to use monetary policy or fiscal policy as an instrument for stabilising the economy. I prefer to call these two groups Monetarists and Fiscalists, because both sides used the same theoretical framework, which was Keynesian.

To cut a long story short the monetarist won that argument, although not quite in the way they intended. Instead of central banks controlling the economy in a hands off way using the money supply, they instead actively used interest rate changes to control output and inflation. Fiscal policy was increasingly seen as about controlling the level of government debt. I have called this the Consensus Assignment, because it became a consensus and because I don’t think there is another name for it.

The one or two decades before the financial crisis were the golden years for the Consensus Assignment, in the sense that monetary policy did seem to be relatively successful at controlling inflation and dampening the business cycle. However many governments were less successful at controlling government debt, and this failure was termed ‘deficit bias’.

MMT is essentially different because it rejects the Consensus Assignment. It regards monetary policy as an unreliable instrument for controlling the economy, and MMT prefers to use fiscal policy instead. They are, to use my previous terminology, fiscalists.

If you are always using government spending or taxes to control the economy, you are right not to worry about the budget deficit: it is whatever it needs to be to get inflation to target. Whether you finance those deficits by creating money or selling bonds is also a secondary concern - it just influences what the interest rate is, which has an uncertain impact on activity. For this reason you do not need to worry about who will buy your debt, because you can create money instead.

The GFC exposed the Achilles Heel in the Consensus Assignment, because interest rates hit their lower bound and could no longer be moved to stimulate demand. Alternative measures like QE really were as unreliable as MMT thinks all monetary policy is. What governments started to do was use fiscal policy instead of monetary policy to support the economy, but then austerity happened in 2010 for all the reasons I explore at length here.

Now we can see why MMT is so popular. Austerity is about governments pretending the Consensus Assignment still works when it does not, because interest rates are at their lower bound. We are in an MMT world, where we should be using fiscal policy and not worrying about the deficit, but policymakers don’t understand that. I think most mainstream macroeconomists do understand this, but we are not often heard. The ground was therefore ripe for MMT.

Policymakers following austerity when they clearly should not annoys me a great deal, and I am very happy to join common cause with MMT on this. By comparison, the things that annoy me about MMT are trivial, like a failure to use equations and their wordplay. You will hear from MMTers that taxes do not finance government spending, or that spending comes first, but you will hardly ever see the government’s budget constraint which makes all such semantics seem silly.

MMT is particularly attractive because it does away with the perennial ‘where is the money going to come from’ question. Instead it replaces this question with another: ‘will this extra spending raise inflation above target’. As long as inflation is below target that does not appear to be a constraint. In the US right now interest rates are no longer at their lower bound, but inflation is below target, so it appears to MMTers that the government should not worry about how extra spending is paid for.

Of course having a fiscal authority following MMT and a central bank following the Consensus Assignment once rates are above their lower bound could be a recipe for confusion, unless you believe what happens to interest rates is unimportant. I personally think we have strong econometric evidence that changes in interest rates do matter, so once we are off the lower bound should we be fiscalists like MMT or should we return to the Consensus Assignment? That is a question for another day.

A Labour run on Sterling?

The news that John McDonnell was looking at a scenario where the election of a Labour government was met with a run on Sterling was all over the news yesterday. The Conservatives, who of course know all about runs on Sterling having created one just a year ago with the Brexit vote, immediately grasped the political gift they had been given.

Paranoia on the left meets prejudice on the right. But what would really happen to Sterling if Labour were to win the next election? Given announced policies, the answer is quite clear: Sterling would appreciate. The main reason is that under Labour there would be a large fiscal expansion: for certain in term of public investment and to a lesser extent with current spending. (I assume by then interest rates will be above their ZLB: if they are not, the fiscal expansion could be even larger.) There would also be a balanced budget fiscal expansion: even if government spending increases are financed by tax increases, this is likely to be expansionary to some extent because some of the tax will come out of savings.

This fiscal expansion, together perhaps with other labour market measures, would put upward pressure on inflation, prompting higher interest rates from the Monetary Policy Committee of the Bank of England. It is the prospect of those higher interest rates that would make Sterling appreciate. How much inflation rather than output would rise depends on how pessimistic you are about the supply side. If the MPC were doing their job properly, that increase in interest rates plus the appreciation would stop inflation rising very much. We will finally get the rebalancing between monetary and fiscal policy that we should have had for the last decade.

If we are also in a transition period for Brexit, with the final destination unclear, then Labour being elected would also lead to an appreciation because Labour are softer on Brexit than the Conservatives.

So where does the run on Sterling idea come from? The idea that all those traders in currency will get together and engineer one because they do not like a Labour government is nonsense. They may not like a Labour government, but they dislike losing money even more. Capital flight? You might see the share price of power or rail companies fall, but that is not going to be enough to move a currency like sterling. Any depreciation in sterling would be the equivalent of pound notes waiting to be picked up in the City and Wall Street: with higher expected interest rates and a likely future appreciation, who wouldn’t buy sterling?

The only way I can see that you could get a run on Sterling is if enough traders in the markets came to believe that Labour was going to abolish BoE independence because it wanted to keep interest rates low. In that case you could get significantly higher inflation under Labour, which would justify a nominal Sterling depreciation.

Which, of course, is why McDonnell committed to keeping Bank of England independence as one of the first things he did. And which is also why he was very foolish to say what he said, because it might lead some to speculate that he might renege on that commitment. Something tells me he is missing his Economic Advisory Council.

Uber and the anti-regulations bandwagon

The news that Tfl, the regulatory body for transport in London, had banned Uber because of regulatory failures brought out the usual suspects to support or condemn the move. In addition, the company organised an online petition to reverse the decision, which half a million people have signed. Tyler Cowen declared: “The new Britain appears to be a nationalistic, job-protecting, quasi-mercantilist entity, as evidenced by the desire to preserve the work and pay of London’s traditional cabbies”, and plenty of others took a similar line.

What always strikes me on these occasions is how people can jump to conclusions without any evidence. Now it is certainly true that licensing authorities can be captured by, and therefore favour, incumbents and therefore stifle innovation. They can artificially restrict numbers to drive up prices, although Tfl do not do this. But the fact that this happens sometimes does not mean it is happening every time. Equally companies like Uber can believe that they are so big and popular that they can ignore regulations, regulations which are designed to make the market work. [1]

It is important to note on this occasion that Uber have not complained about the regulations. Instead they initially said they had complied with them. Surely the time to write articles condemning Tfl’s decision is after Tfl lose the appeal brought by Uber in the courts.

However there is public evidence in this case. We do know the that as recently as August, a Metropolitan Police Inspector wrote to TfL about his concern that the company was failing to properly investigate allegations against its drivers. Between May 2015 and May 2016 the police investigated 32 drivers for rape or sexual assault of a passenger. It appears there has been at least one case where the police allege UBER allowed a driver that had been accused of sexual assault to stay on their books, leading to another ‘more serious’ attack on a woman in his car. Here is part of the inspector’s letter:

“My concern is twofold, firstly it seems they are deciding what to report (less serious matters / less damaging to reputation over serious offences) and secondly by not reporting to police promptly they are allowing situations to develop that clearly affect the safety and security of the public.”

Uber’s boss yesterday apologised for the mistakes they had made. Whether these mistakes are serious enough to warrant revoking Uber’s license the appeals process will decide, or most likely Uber will be allowed a new license on condition that they start taking regulations seriously.

What worries me in this case is the lack of any self-awareness of those who piled in to condemn the regulator without any evidence. Ten years ago the world experienced a devastating financial crisis that was due, at least in part, to a failure of regulations and regulators to do their job that was in turn due to political pressure from those who took a similar attitude to regulations as those championing Uber. And just three months ago around 80 people lost their lives in London from a fire that almost certainly was the result of a failure to comply with regulations.

Regulation bashing has since the financial crisis become one more example of neoliberal overreach. When the two political parties that brought us neoliberalism have today brought us Brexit and a President who seems to want to start a nuclear war, it is time for neoliberals to be thinking about reform rather than just playing the same old tune. Thinking about all that and the 500,000 who signed the pro-Uber petition brought to mind a song of a well known nobel laureate called Talking WWIII Blues, the last verse of which is

Well, now time passed and now it seems

Everybody’s having them dreams

Everybody sees themselves

Walking around with no one else

Half of the people can be part right all of the time

Some of the people can be all right part of the time

But all of the people can’t be all right all of the time

I think Abraham Lincoln said that

“I’ll let you be in my dreams if I can be in yours”

I said that

[1] There is also the question of why Uber rides are cheap, and whether it is making losses simply to drive out the competition, but that is a different issue. 

The real obstacle for the Brexit negotiations

I’m not going to say anything about the content of yesterday’s speech: I talked about the likelihood of a transition arrangement that involved us staying in the Customs Union and Single Market back in March. My only uncertainty then was whether May could be pushed to a No Deal outcome, but as the government has done absolutely nothing to prepare for that outcome it now seems an empty threat. As for a two year transition period, its an insider joke. You have to have no idea about trade negotiations to imagine it could be done in that time, but as that includes most Brexiteers it serves its purpose.

Instead I want to talk about is what could be the real obstacle to the negotiations moving on to the next stage, and that is the Irish border issue. Many have noted that putting it as a first stage issue seems illogical, because what happens to the Irish border will depend on future trade arrangements between the UK and the EU. There obvious answer to why the Irish border question got put in the first stage is that the EU want to force the UK into staying in the EU’s Customs Union precisely to avoid recreating a border between the two parts of Ireland.*

The UK’s paper on this question makes it clear that there is no realistic compromise on this issue, as Ian Dunt’s discussion makes clear. There is a third way, which is for Northern Ireland to remain part of the Customs Union while the rest of the UK is not, but the DUP will have none of that. This was a major implication of the election result and May’s bribes to obtain a confidence and supply arrangement with the DUP.

A key political question will therefore be whether the Irish government and the EU will play this card that they have dealt themselves. The Irish government would like to, but I suspect (from past experience) that if they came under pressure from the rest of the EU they would back down. But the EU would also like the UK to remain in the Customs Union to resolve the border issue. Indeed everyone would be better off if the UK committed to staying in the Customs Union on a permanent basis. The only obstacle to this are the fantasies of Brexiteers, personified in the department led by Liam Fox.

I said I was not going to talk about it, but perhaps this was one reason why May gave her speech yesterday. By confirming that there could be a transitional deal (which Richard Baldwin might call a pay, obey but no say period), she hopes to dampen the resolve of the Irish government and the EU to make this a sticking point in the negotiations. Will either party think to itself 2 years will become 5, by which time we will have a different government that is likely to make the transitional permanent, or will they use their dominant position in the negotiations to try and force the UK to stay in the Customs Union to avoid creating a border (and perhaps also force the resignation of Fox and others)? At the moment we do not know, but I suspect once again Mrs. May and her cabinet have misjudged the EU side.

*I've added to this sentence and elsewhere compared to the first version of this post, which might have been construed as implying the border was being used as an instrument to achieving an economic goal. I do not think that is the case.     

Productivity and monetary policy

The Bank are warning of imminent rises in interest rates. As Chris Giles points out, we have been here before, and before that, but that shouldn’t mean we should dismiss this talk, because one day it will happen. [1] They (the MPC) certainly sound serious. But why when current growth is so slow are they even contemplating it? Here is a clue from Mark Carney’s latest speech (my italics).

“On the supply side, the process of leaving the EU is beginning to be felt. Brexit-related uncertainties are causing some companies to delay decisions about building capacity and entering new markets. Prolonged low investment will restrain growth in the capital stock and increases in productivity. Indeed, if the MPC’s current forecast comes to pass, the level of investment in 2020 is expected to be 20% below the level which the MPC had projected just before the referendum. Net migration has also fallen by 25% since the Referendum.

As a result of these factors and the general weakness in UK productivity growth since the global financial crisis, the supply capacity of the UK economy is likely to expand at only modest rates in coming years.”

When people, like me, say how can the Bank be thinking of raising rates when demand is so weak, the response from the Bank would be that supply has been at least as weak.

This pessimism about the supply side comes straight from the data. If I hear people talking about the UK being a ‘strong economy’, I know they either have not seen this chart or are just lying.

UK Output per hour, whole economy (ONS)

The red line is a trend that pretty well matches the trend in the data until the end of 2007, with the amount you can produce with an hours worth of labour increasing by 2.2% a year. Since the global financial crisis (GFC) there has been almost no growth at all. If you want to know the main reason real wages have stopped increasing, this is it. [2]

I hear some people say this is just oil and financial services. It is not, as this table from a recent Andy Haldane speech shows.

Start at the bottom: total average growth has been non-existent since the crisis. The rest of the table looks at the contribution of each sector to that total. To see what productivity growth would be excluding financial services, just add that figure to the total: 1.8% 1998-2008, 0.4% 2009-2016. That table makes it clear that the productivity crisis is economy wide.

It is worth looking at aggregate productivity since the GFC period in more detail (same data). I often hear people say the productivity slowdown started before the GFC. From the chart below, it clearly did not. (We have just seen the tenth anniversary of Northern Rock going bust, and the UK productivity slowdown started shortly after that event.)

We could describe this data as five phases. 1) Productivity in the recession fell, as it often does in a recession for various reasons. 2) As the economy begins to grow again, so did productivity growth. 3) As it becomes clear, in 2011, that the ‘recovery’ is going to be very weak because of austerity, productivity growth stops growing. 4) By the end of 2013, with stronger growth under way (although still no catch up to previous trends, so not a true recovery) productivity starts growing again, although rather slowly. 5) Since the 2015 election, with the prospect and then the reality of Brexit, even that modest growth disappears. (My data does not include 2017Q2, which saw a very slight fall.) I could shorten the description as follows: recession, modest optimism, pessimism, even more modest optimism, uncertainty.

That is my gloss on the numbers, but I’ve done it to make a point. Productivity growth invariably requires an investment of some kind. It may not be physical investment, but just training someone up to be able to use some new software. Whether a firm incurs that cost will depend, in part, on their expectations about the future. There is a regrettable tendency in macro (I blame RBC theory) to treat productivity growth as manna from heaven. But the idea that potential improvements in technology stopped after the GFC, and just in the UK, is simply ridiculous. The problem is that firms are not investing in new technology. What I call the ‘innovations gap’ has emerged in the UK because of weak growth and the consequent pessimistic expectations of most firms. [3]

The idea that the economy could get itself in a low growth expectations trap is increasingly being put forward by economists: here is George Evans, for example. The UK has got itself into that trap because on the two occasions that a recovery of sorts appeared to be under way, the economy has been hit with terrible policy errors (austerity and Brexit). But the idea that UK firms are incapable of upgrading their production techniques is nonsense. They will do so initially if they can be confident that the demand for their products will increase, or subsequently when the innovation pays for itself even though demand is flat.

Which is why an increase in interest rates right now would be very bad news. It would confirm the pessimistic expectations of most firms that demand is not going to grow fast enough to make innovation worthwhile. Formally, the job of the MPC is not to worry about productivity but to control inflation. But elsewhere, where the same process may be happening to a lesser extent (the productivity slowdown is worldwide, just most acute in the UK), central banks are puzzled at why inflation just refuses to rise. 

The concept of an innovations gap is one solution to that puzzle. Expanding demand allows firms to invest in more productive techniques, and so there is less incentive to choke of demand by raising prices. I suspect in an alternative world where Brexit had not happened the Bank of England would also be puzzling over why prices were not rising. As a result, if the MPC do finally raise interest rates this year, it would be one more mistake to add to the growing list under the heading Brexit.

[1] On each occasion I also wrote a post saying that they should not raise rates, starting I think at the beginning of 2014.

[2] I discussed in earlier posts why real wages are falling by even more than output per head.

[3] Or perhaps the pessimism of the bank manager lending money to those firms. The Haldane speech shows that productivity growth has remained strong among the top, frontier companies. Why? Because these companies, given their position, will be seeing growth relative to the average, and have got to the frontier through a culture of innovation.

Undergraduate economics teaching moves into 21st century

The CORE economics curriculum, designed to provide an introduction to economics that reflects economics as it is today rather than as it was decades ago, has won justified praise from John Cassidy. I also think it is brilliant, not just for first year undergraduates but also for interested non-economists. To wet your appetite, read this short account by two of the leading lights behind the project.

Rather than spend the rest of this post singing its praises, I want to ask why first year undergraduate textbooks represent a clear example of market failure. The failure I have in mind is the inability to teach economics as it currently is, rather than as it was decades ago. If you look at the standard first year, Econ 101 textbook, it does contain more modern stuff, but normally in later chapters after presenting the basic models/frameworks which have not changed for 30 years or more. As a result, textbooks tend to be both dull, seemingly irrelevant and much too large. (This is a blanket generalisation and I’m sure there some exceptions.)

Here is my theory, which I will try and explain in plain english rather than with economics jargon. Although the ultimate consumers of textbooks are students, they are chosen by teachers who set the course textbook. So why are Econ 101 teachers not demanding textbooks that are less dull and more up to date?

Suppose someone had written something like the Core material, and a publisher (as publishers do) had sent it out to people currently teaching Econ 101 for comments. The reaction they will have got from a good proportion of Econ 101 teachers would have been ‘that is interesting, but can we include at the start some of the stuff I have taught for the last five years’. They, naturally, do not want to completely rewrite their courses, and I fear in a few cases learn material that is new to them.

The publisher reports back to the author: ‘we cannot publish this as it stands, but if you start with the traditional material then maybe’. It is a market failure because publishers are looking at the current set of Econ 101 teachers, and not those who will one day teach it and would love to have something more up to date. Another force for conservatism is that the big names who dominate the market find it much easier to add new stuff on at the end as extra chapters than rewrite their textbook from scratch.

I could add more, but I have been rude to enough of my colleagues already. Let we add two other specific points about CORE. The first is that it is clearly mainstream: this is not the pluralist text that many heterodox economists would like. That I fear is inevitable: economics is mainly a vocational subject, not a liberal arts subject. (Thats upset a few more.) But I was surprised to see MMT people describe this textbook as not for them. I have, after all, argued that MMT is just standard macro without what I have called the Consensus Assignment. [1] So I had a look.

In the section on government finances (14.8) we get

“When there is a budget deficit, this means the government must borrow to cover the gap between its revenue and its expenditure. The government borrows by selling bonds.”

This is not correct, and nor does it follow modern macro. [2] There we write the government budget constraint to include a term in the change in the stock of high powered money. (If money does not appear, it is because the paper explicitly chooses to work in a moneyless world for simplicity.) In short, the government can finance the gap between revenue and expenditure by creating money. Ignoring money in this section is obviously an oversight, as the discussion in section 10 clearly shows. But it is an oversight that should be corrected. [3]

That apart, I was already a fan of the macro approach adopted in CORE, because it is a simplified version of the Carlin and Soskice textbook. I like the consistent claims approach as a way of talking about inflation. It emphasises the elementary point that you need both wage and price inflation to get sustained increases in inflation, something monetary policy makers seem to keep forgetting right now.

I like, as some may remember, abandoning the LM curve and explicitly talking about central bank policy. I also like the way that banks are now incorporated as part of the monetary transmission mechanism. If there was a clear manifestation of how outdated (at best, we could also say just plain misleading) most textbooks are, it is their continued use of LM curves and the money multiplier.

I really hope that CORE continues to be successful. It is time we stopped boring and confusing first year undergraduates, and started inspiring them with an understanding of the economic ideas that allow them to address the countless real world economic issues that they will have to face.

[1] The Consensus Assignment gives monetary policy the goal of macroeconomic stabilisation and fiscal policy the goal of stabilising government debt.

[2] We can go back to the work inspired by Carl Christ together with Blinder and Solow. I should add that CORE is not alone among textbooks in failing to properly set out the government’s budget constraint.

[3] Now we all know (and as MMT also clearly states) that there are limits to money financing: too much of it is inflationary. But this should not be internalised by teachers to the extent that money financing is ignored. In particular it gives the impression that to finance a deficit a government has to find someone to lend them money, an incorrect belief that can have very misleading consequences if the government controls its own currency. It is more complicated with independent central banks, but again they are not an excuse to ignore money financing.