Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 14 May 2024

The political right is in an illiberal trap of its own making, which offers their opponents opportunities


A new CPS report 'Taking Back Control’, co-written by the relatively sensible and numerate among Conservative MPs Neil O’Brien, proposes a national commitment to return net migration to the historical norm of the tens of thousands. The last government to do such a thing was of course the Cameron coalition, and their failure to meet these targets was a key factor behind the rise of UKIP and Brexit.

Others are more qualified to discuss the report in detail. Instead I want to set it within a much broader political economy framework, mainly focused on the UK but with references to the US where there are obvious parallels or differences. I will begin by describing how the political right of Thatcher and Reagan, which came to be associated with the emergence and then dominance of neoliberalism, ended up becoming an authoritarian party proposing limits on immigration, trade, and human rights. As I have discussed this in more detail in earlier posts I will be more brief here.

If you tend to describe everything that came from Thatcher and Reagan as neoliberal, let me emphasise why there is a huge contradiction between neoliberalism and controls on immigration and trade. If you like to think of neoliberalism as an ideology that favours free markets, then erecting trade barriers or telling firms what labour they can hire is not promoting free markets but instead state interference in markets. [1] I tend to think about neoliberalism as a collection of ideas that helps existing capital in general (e.g. reducing union power), or at least some parts of capital without harming others (privatisation). If you like, under neoliberalism the executive is at least in part “a committee for managing the common affairs of the whole bourgeoisie”. In technical terms they represent ideas that are Pareto improvements for capital. Yet immigration controls or trade barriers harm large sections of capital, so how can politicians that enact them be categorised as neoliberal?

Of course neoliberal ideology remains a core part of how most right wing politicians think, and it remains a pervasive influence on society more generally. Yet while it is obvious to describe the Thatcher and Reagan governments as neoliberal, it is much harder to use that label for politicians that erect rather than lower barriers to trade, and politicians who attempt to stop firms hiring workers from overseas.

Party membership on the right has always been pretty socially conservative. Yet this hasn’t been true of right wing politicians in the UK at least. As this study by Bale et al shows, most Conservative MPs tend to be as socially liberal as the average voter (and therefore much more liberal than Conservative party members), but much more right wing on economics. (I don’t know if similar data exists for the US.)

This suggests that for these politicians, the focus on attracting socially conservative voters was at least initially a political tactic rather than anything based on personal conviction. In a sense this is not surprising. Arguing for yet more tax cuts for the rich, or for less regulations in the labour market, may be consistent with neoliberalism but is not likely to attract that many voters. In addition, the UK voting system (as in the US) favours social conservative over socially liberal voters. As I argue here, the initial popularity of Thatcherism was time limited, as the failure of the privatised water industry clearly shows.

The problem with using immigration as an insincere tactic is that it has led, on both sides of the Atlantic, to the dominance of social conservatism on the political right. In the US the Republican’s Southern Strategy broadened out into culture wars, was followed by the Tea Party and then by Donald Trump. In the UK the failure of the Cameron coalition to meet its immigration targets, because Cameron and Osborne knew that trying to do so would harm the economy, led to the UKIP insurgency and Cameron’s Brexit referendum pledge. The rest, as they say, is painful history that everyone in the UK knows all too well.

While the mechanisms that led to Trump and Brexit are rather different, reflecting constitutional differences between the two countries, [2] there are also some common elements. Two in particular are the role of money from rich individuals, and the role of the media (in particular Fox News in the US and the right wing press in the UK). Both signal the growing importance of plutocracy in both countries, which I started writing about back in 2017, and is now becoming more mainstream in the UK (for example see Martin Wolf’s latest book “The Crisis of Democratic Capitalism” (interesting review here)).

At the time many focused on the populist nature of Brexit and Trump. It is tempting to argue that this aspect, though real enough (enemies of the people and all that), is an inevitable consequence of the triumph of social conservatism over both social liberalism and neoliberal economics. A label often used for social conservatism is authoritarian, because social conservative and authoritarian views tend to go together. Social conservatives prefer dominant, uncompromising leaders. [3] While social conservatism may naturally go together with authoritarianism and populist leaders, in my view it is social conservatism rather than populism that provides the driving force here.

The key factor that led to Brexit in the UK, and which continues to haunt the Conservative party, is the party’s vulnerability to electoral challenge from insurgent parties that can promise stronger action on immigration. This alone will ensure immigration continues to be perhaps the central policy of a Conservative opposition: hence the CPS report noted in the introduction. In truth a Conservative opposition also has little choice as long as a Labour government avoids obviously left wing economic policies and providing that it provides considerable support for public services. If the economy does better than it has over the last fourteen years (and it would be unlucky not to), then a focus by a Conservative opposition on socially conservative issues is inevitable.

The other key factor behind Brexit was the strong support from the right wing press, and for the foreseeable future this will ensure the Conservatives remain a pro-Brexit party, even though this is likely to be unpopular among a majority of voters. In addition, the readership of the right wing press tends to be older and therefore more socially conservative, so this force will help maintain the dominance of social conservatism among Conservative politicians.

Ironically, and in contrast to the US, I believe the composition of party members has been much less important in the UK than insurgency from the right, the right wing press and the influence of wealthy political donors. Although these members do get to choose the party leader, their choice is limited by MPs, and these MPs can ensure that members never get the choice of electing the likes of Suella Braverman. However party members do get to choose new MPs, so their influence via this route will be important over the longer run.

All this means that, barring economic misfortune, the UK political battleground will remain centred on the social conservative/liberal divide. The replacement of class by age as the key division in mainstream politics will persist. I suspect the same is true in the US [4], although it is hard to see past the chaos that even a Trump defeat will bring. In electoral terms this is bad news for the Conservatives. Brexit is likely to become more unpopular over time, if only for demographic reasons. In addition, as John Burn-Murdoch observes, in anglophone countries younger voters tend to be more tolerant of immigration than older voters. The more the right focuses on socially conservative issues, the less likely it is that younger voters will naturally transition to the right for economic reasons as they age.

This in turn will give a Labour government more freedom to adopt more socially liberal policies. They will need that freedom, because just as the Conservatives have had to worry in government about insurgent parties on the right, so a Labour government after an initial honeymoon period will need to worry about losing votes to parties that are either more liberal and/or left wing. This is hard to imagine today, where Labour are trading off government failure to court Conservative voters, and where (as the local elections showed) Conservative unpopularity means that the efforts of Labour, the Liberals and Greens are largely complementary.

Once Labour has become established in government that situation will change. As it seems increasingly likely that Labour will be cautious on using higher taxes to improve public services (i.e. will not follow the approach I suggested here), and the mess the current government has left things in is so great, dissatisfaction with the slow speed of progress is bound to grow. That is much more likely to see the polls shifting towards the Greens and Liberal Democrats than the Conservatives, whose record on public services will persist in voter memories for some time.

That dissatisfaction will only intensify if Labour attempts to fight the Conservatives on their socially Conservative territory. In addition, controlling immigration rather than tackling the causes of immigration does economic damage which Labour cannot afford. The same is true if Labour are too cautious on Europe, and I suspect the Lib Dems will be quick to return to trying to outflank Labour on this issue. (I discussed the importance of a tipping point in public attitudes to Brexit here.) A Labour government will find, if it tries, that trying to follow the Conservatives down their socially conservative rabbit hole will cause way more electoral problems than it solves. [5] Instead they should see that the hole the Conservatives have dug for themselves (and Braverman wants them to continue to dig) is an opportunity for a fresh, more liberal approach.

[1] John Elledge suggested an way in which Brexit could still be described as favouring free markets, if you see ‘free’ as the absence of any government involvement in trade. (Free from rather than free to trade.) While I thought this ingenious at the time, I now suspect that this is an ex-post rationalisation rather than any fundamental division within neoliberalism. After all, there is nothing within neoliberalism that objects to the state making life easier for business, and that is what the international harmonisation of regulations within the Single Market essentially is.

[2] The existence of primary elections in the US allowed those who wanted to elect politicians who would place a greater weight on socially conservative policies in government a direct route of achieving their ends. Money and media influence could be employed to support more socially conservative politicians in elections for Congress and, ultimately, for the White House. That is much more difficult in the UK for individual MPs.

[3] There is more to it than that of course. While right wing economic views are often justified on the basis that they work for everyone (trickle down, efficiency of the private sector etc), with the social conservative liberal divide it is much more clearly a matter of personal preference. In addition, it is clear that over the last fifty years or so social liberalism has been winning. So it suits the social conservative to believe not only in the myth of the silent majority, but also to be attracted by the idea that their views are the ‘will of the people’.

[4] The importance of the Christian right in the US, a force largely absent in the more secular UK, is an additional factor.

[5] Just as the Conservatives in government are prevented from locating their policy positions near the centre of the social conservative/liberal divide because of an insurgent party to their right, so Labour in government will find it dangerous to stay close to that centre because voters will move to a more socially liberal party.

Wednesday 8 May 2024

When are large and persistent increases in debt to GDP justified?


In this post I showed a chart of UK government debt to GDP since 1900. It starts off at below 50%, then rises sharply to 200% during WWI. It rose to 250% during WWII, but then fell steadily during the post war golden age, going below 50% by the mid-1970s. The next sharp rise is after the Global Financial Crisis, followed by a smaller rise during the pandemic, getting to current levels of around 100% of GDP.

This brief chronology suggests that debt to GDP (and more recently also central bank issued reserves to GDP) rise sharply in extreme crises. But climate change is an extreme crisis facing every country, so why are most governments (maybe US excluded) resisting the idea that they should be running large deficits to pay for measures to reduce the extent of climate change? Is there a clear way of deciding when it is OK to allow large and persistent government deficits and when it is not?

In this post I set out why there is. To make things simple, I will assume the case for higher spending is overwhelming, so the issue is only how it should be paid for. The obvious alternative to allowing this additional spending to generate persistently large deficits is to substantially increase taxes. There is a standard economic proposition called ‘tax smoothing’, which states that it is better to smooth taxes over time than have erratic increases or decreases. In economic terms most taxes have distortionary costs, where the costs associated with a unit increase in taxes are likely to increase with the level of taxes, so it is less costly to smooth taxes over time. It is also intuitive: if a government offered people the chance of paying no tax for 5 years followed by the certainty of paying double normal tax for the next five, then most people would reject this offer.

A key point is that while there are clear benefits from keeping taxes smooth rather than allowing their path to be dictated by erratic movements in government spending, and occasionally periods of very high spending, there are no costs to erratic movements in government deficits, government debt or bank reserves. So it makes perfect sense to try and smooth taxes, letting government deficits take the strain of both erratic and sometimes high levels of government spending.

It is tax smoothing that justifies allowing debt or reserves to rise substantially during periods of unusually high spending. However note that the higher government spending that justifies a high deficit is temporary. If it was permanent, tax smoothing would not apply, and taxes would need to rise in line with government spending, with no increase in the deficit. Even if the expenditure has long lasting benefits, such as better education for example, that doesn’t imply it should be funded by borrowing or money creation if that higher spending is permanent. (This abstracts from Keynesian arguments, which we consider below.)

The centrality of tax smoothing to thinking about deficits and debt is why many papers written on fiscal rules, including my own (see here for example) often start by setting out that idea. Tax smoothing also tells us why balanced budget rules are bad economics. As government spending is inevitably lumpy and/or erratic, balancing the budget would match that with a lumpy, erratic path for taxes. More generally it shows why fiscal rules should, if possible, [1] always take the long view, to avoid ‘shocks’ to government spending being translated into a bumpy path for taxes.

Tax smoothing also implies that in a downturn or recession the ‘automatic stabilisers’ (e.g. lower taxes, more unemployment benefits) should be allowed to operate, but obviously tax smoothing can say nothing about countercyclical fiscal policy, because the argument for such policy comes from Keynesian macroeconomics. For moderate downturns or recessions any deficits that come from either the automatic stabilisers or fiscal stimulus will be matched in later years by boom periods where we get automatic surpluses because taxes are unusually high, and also perhaps because of fiscal contractions to moderate demand. In other words the normal business cycle should not lead to persistently higher debt or reserves.

Unfortunately history tells us that occasionally we get very deep recessions, and these are not matched by very large booms. Not only will the deficits caused by the automatic stabilisers be particularly large in these recessions, but fiscal stimulus is likely to be essential because interest rates will hit their lower bound. This is of course what happened during the Global Financial Crisis.

Tax smoothing implies that large deficits during the GFC, to allow for both the automatic stabilisers and fiscal stimulus, were sensible. Once the recovery from a deep recession is complete, it makes sense to - if required - return any deficits to normal levels using spending or taxes. The great sin of 2010 austerity was starting fiscal consolidation in the middle of the recession rather than when the recovery was complete.

Investment is also a lumpy activity: sometimes you need a lot and sometimes not so much. Tax smoothing implies that it would be a mistake to match annual public investment with taxes, which is why I argue that public investment should be paid for by borrowing or issuing reserves, with taxes only matching some long term average of investment expenditure. That is why it makes sense to exclude public investment from any medium term deficit target, and also why the falling debt to GDP rule is a bad target.

Tax smoothing accounts for and justifies large increases in debt during wars and, together with Keynesian policy, implies persistently higher debt after a very deep recession. What about a global pandemic? The justification at the time for large deficits was that this too created a deep recession. In a recent post I questioned whether the extent of deficits run up in the UK and other European countries was justified, but this is really an argument about the extent of the additional spending on the furlough scheme, not tax smoothing.

How does tax smoothing apply to spending to reduce the extent of climate change? It has become increasingly clear that such spending is temporary, in the sense that green energy is likely to be cheaper once the capacity to produce, store and distribute it is in place. So we are talking about a green transition requiring temporarily higher public and private spending to change how we produce energy. Even if that spending lasts for a decade or so the tax smoothing argument once again applies. Spending to green the economy should not be ‘paid for’ by higher taxes, but instead should see a rise in the ratio of debt or reserves to GDP. [2]

How quickly should debt be brought down after one of these crises? In the stylised smoothing model where people live forever (or care about future generations as if they live forever, by leaving appropriate bequests to children) the answer is debt should never be brought back down. Even in more realistic models the answer is that debt should be brought back down very slowly indeed, as I helped show here. If you think that the current generation is more likely to be selfish than caring about future generations, then how quickly debt is brought down will also depend on how much the original spending helps future generations.

The idea that it is politically responsible to keep government debt to GDP constant or bring it down is deeply ingrained in parts of the population and much of the media. This idea is not entirely baseless, as some politicians have in the past increased deficits for their own political advantages, rather than because it made sense in economic terms. But it is equally important to recognise when it is economically irresponsible not to allow large deficits to fund temporary but essential expenditure, particularly if that expenditure might not happen if it had to be paid for by higher taxes. Spending to green the economy and reduce the extent of climate change is a clear example of that.

Note that the tax smoothing argument applies to public spending to green the economy whether that spending is classed as public investment, day to day public spending or involves tax breaks to incentivise firms or consumers to reduce their carbon footprint. The key reason why this spending should lead to higher deficits rather than higher taxes is that it is temporary as part of a green transition.

How can we be sure that a government that says debt is increasing because of measures to green the economy is not in reality abusing this idea to just avoid having to put up taxes to pay for other areas of permanent spending? Checking this in an economy like the UK is perfectly feasible, but it needs to be done by an independent body that is very familiar with the details of government spending and accounting. This sounds like a worthy task for a fiscal council, like the Office of Budget Responsibility in the UK.

[1] Portes & Wren-Lewis discusses what ‘if possible’ means in this case. The more a government (with the help of a fiscal council) can be trusted to abide by the spirit of the rules, the more long term these rules can be.

[2] A carbon tax alongside green investment and subsidies still makes economic sense, which if other taxes remain unchanged would reduce the size of additional deficits. However the political problems with implementation may mean such taxes remain well below effective levels.

Tuesday 30 April 2024

High on their own supply


There was a point on the BBC’s Question Time last week where the Minister for Policing Chris Philip, who was until recently an immigration minister, asked whether the Congo is a different country from Rwanda. It was sufficiently embarrassing that even the Mail reported it as such, and described the audience gasping and laughing in front of the camera. This may be an extreme example, but it is increasingly difficult for most people, including much of the mainstream media, to take our current government and the Conservative party seriously.

There comes a point for any government that has been around for a long time where it gets tired, in terms of lack of new ideas, policies and people, and as a result voters and the media get bored and yearn for something different. That situation can be delayed for a few years by the government changing leader and acting as if it’s a new administration, as Johnson did, but when it becomes clear that it is either not so new or even worse than what came before public disenchantment re-emerges. In that sense this period is very similar to the Major government before the 1997 election.

But when boredom turns to laughter, when voters no longer take their political leaders seriously and ignore what they do or say, then the government is in even more serious trouble. Of course Major was made fun of by others in satire, but today the government seems to make its own satire. [1]

For example, how can you possibly take this government seriously given its policy on asylum. Much has been written, quite rightly, on how cruel this policy is, particularly the proposed flights taking refugees to Rwanda. Most of those who cross the Channel receive asylum in the UK because they come from war-torn areas or have been subject to torture and persecution, so to then bundle them against their will onto planes to a country in Africa is immensely cruel. But it is worth putting that aside to instead just focus on the absurdity of the government’s policy. The government's approach has no objective, while at the same time denying reality and even logic..

The government has always insisted that Rwanda is a safe country to send asylum seekers to. The UK’s supreme court, looking at all the evidence, decided Rwanda was not safe for refugees, and therefore the Rwanda scheme was unlawful. The government’s response was to pass legislation that ruled that Rwanda was a safe country. Does this legislation change anything about the character of the current Rwandan government? Of course not. There is a new treaty that is supposed to address the court’s concerns, but ministers don’t know if or when its contents will be implemented or observed and don’t seem to care. All that matters to the government is that they have passed legislation that Rwanda is safe. It’s like saying black is white or 2+2=5 because parliament says so, and because parliament says so no court can say otherwise.

The constitutional implications of this legislation are very serious. It sets a precedent for the government to overrule the courts on issues of fact whenever it likes. This is not what anyone ever meant by parliamentary sovereignty. But it is also absurd. It is absurd that MPs think they can change a reality that they have no control over by simply passing legislation proclaiming an alternative reality. No sane government would ever contemplate doing such a thing, yet our government just did. How can such a government, and the MPs that voted for this legislation, be taken seriously after doing something like this?

Then there is the cost of the scheme. Figures released to the National Audit Office suggest that it will cost an average of £1.8 million to deport each of the first 300 refugees to Rwanda. This figure is in one sense an exaggeration because it includes set-up costs which - if the scheme continues - will be spread over larger numbers. Ian Dunt calculates the marginal cost of each extra refugee sent to Rwanda at nearly £200,000, compared to a normal cost of processing asylum seekers of around £5,000. Of course if Labour win the election and repeal the scheme then £1.8 million per refugee will be the more accurate figure, assuming 300 people are deported before the election. These figures for costs are absurdly large, and it is hard to take any government seriously that would pursue such an expensive policy just to get rid of so few harmless but desperate people.

The response of the government is that their Rwanda scheme will have a deterrent effect, and ‘stop the boats’. But the deterrent argument fails on simple logic. If Rwanda is a safe country, why is the small chance that you will be sent there a deterrent to people who would be prepared to take the considerable risk of crossing the Channel in a small boat? It makes no sense, so how can you not laugh at a government that makes that argument?

Yet all this is small fry, in terms of numbers and costs, compared to the Illegal Migration Act of 2023, which means any adult now arriving by boat will not have their asylum claim considered at all. Instead the Home Secretary will have a duty to remove them, but to where besides Rwanda is a mystery. The Refugee Council estimates that by the end of this year over 100,000 refugees will be stranded in limbo, costing £6 billion on an annual basis.

To be fair, at some point such a policy will act as a deterrent, if those crossing the Channel get the message that they will never be able to claim asylum and instead will be locked up indefinitely. However no one in government seems to have worried about what to do with all those who arrive here in the meantime. Apart from being cruel and costly, the policy is simply unsustainable. Is the government proposing to detain those refugees for the rest of their lives? The policy is absurd, and no serious government would ever do such a thing.

This government’s policy on asylum is not something minor that somehow escaped the attention of senior politicians. Sunak has taken the lead in pushing this policy through parliament, so he and his cabinet are all implicated by the nonsense that it is. Furthermore it is not an isolated example. Equally silly and unserious is a fiscal policy of tax cuts or addition defence spending based on other spending assumptions that will never be delivered. It is not a serious government that responds to the growing number of people who are too ill to work by talking about a ‘sick note culture’, when the UK public sector spends less on incapacity than most other countries and where sickness benefit is so low that the real problem is people going to work with infections that make others ill. How can the government even think of scrapping a route into teaching in the middle of a chronic teacher shortage? And these examples are just from the past week. The list of ridiculous decisions goes on and on. [3]

Of course I understand why this stupidity happens. The government is trying to attract votes by providing headlines for the party in the media, hoping these voters don’t know enough or will not be told enough to see how crazy what the government is doing or saying is. [2] But you have to wonder, as the polls only get worse for the Conservatives, whether the Tory commentariat’s understanding of what ‘their’ voters want is seriously awry, as John Elledge suggests. Perhaps the Conservative party in the media have got high on their own supply. One of the funniest things to read every morning is the titles of comment pieces in the Telegraph. [4]

Among everyone else who does understand enough to know how daft and pointless this all is, including the non-client media, occasional laughter is just the light relief from a mixture of frustration and despair. When most people don’t know whether to laugh or cry at the stupidity of what government politicians say or do, and just desperately wishes for a government that actually wants to actually govern and improve people’s lives rather than provide headlines for its client media, it really is best to leave the stage sooner rather than later. Hanging on just confirms what most people think, that you and your cheerleaders are completely out of touch with reality and those who live in it, and despair and frustration leads to anger. But much of the Conservative party, including its leadership, has been out of touch with reality for some time, which is why we will unfortunately have to endure many more months of this nonsense

[1] Partly also because the BBC has taken what was left of political satire off the air because it was critical of the government.

[2] So a week in which Sunak gave a press conference describing his Rwanda scheme as an urgent national priority, talked about a sick note culture and made unfunded spending pledges is described as a good week for him.

[3] Postscript (01/05/24) and on 

[4] I read this from Polly Toynbee just after publishing this post, but it covers similar ground and gives chapter and verse on how most voters are on a different page from the Conservative party. 

Tuesday 23 April 2024

The Bernanke Review of Bank of England Forecasting


My guess is that the world is divided into two groups of people: those who are really interested in the process by which central banks decide on monetary policy, and those who are largely disinterested. If I’m right, and you are part of the second group, it may be wise to skip this blog.

As the job of central banks is to set interest rates to keep inflation close to target, and inflation over the recent past has been well above target, then a typical reaction might be that central banks have slipped up in some way. The Bank of England is a typical central bank in this respect, and it commissioned Ben Bernanke - Nobel prize winner and former US central bank (the Fed) chair - to review their forecasting procedures. His published report is here. This post is informed by that report, but really just represents some of my own personal reactions.

My first point is rather fundamental and crucial. The fact that inflation got way above target last year does not necessarily imply the Monetary Policy Committee (MPC) of the Bank or the forecasters at the Bank made any avoidable mistakes, as Tony Yates has repeatedly pointed out. As we should all know by now, the burst of inflation we saw after the pandemic was led by higher commodity prices (helped by an unforecastable war) and was exacerbated by supply chain problems that were not a reflection of domestic overheating in the major economies, including the UK. To use the jargon, both represented short term supply shocks that would lead to only a temporary increase in inflation. Other things being equal, the best monetary policy reaction to such shocks might well be to do nothing, which is pretty well what central banks in the US, UK and EZ decided to do in 2021.

For those who understand this argument, please skip this paragraph. For those who don’t, imagine if central banks had instead raised rates aggressively through 2021. This would have had only a minor impact on oil and gas prices, or supply side bottlenecks, but might well have severely weakened the major economies as they recovered from the pandemic. In a nutshell an earlier central bank reaction would have had little impact on the upward path of inflation, but might have damaged the real economy at a very sensitive moment. It would have had no impact whatsoever on the cost of living squeeze, because wage inflation would have been lower. In some situations it is best for central bankers to do nothing, and 2021 was one of those situations.

By 2022 it became clear that wage inflation was also rising, reflecting a quite tight labour market, and this could threaten to lead to inflation being above target for more than a couple of years. As a result central banks did begin to increase rates pretty rapidly. Here the jury is still out on whether central banks were too slow, too fast or went too far in doing this, so it would be premature to say that central banks in general, and the Bank of England in particular, had a problem it needed to resolve.

Which all means that Bernanke was not looking for a smoking gun which would reveal why the Bank had got things so wrong over the last few years, because it is not obvious that the Bank (and other central banks) have got anything very wrong. Instead his review should be seen as a useful periodic check by an eminent outsider on what the Bank does. (Here is a short blog post based on an earlier review.) However there is a more subtle sense in which recent events do point to a weakness at the Bank, which I will come to at the end.

There is potentially a great deal to talk about from the Review, so here I want to limit myself to just three issues. The first issue, and one where I have some historical expertise, is the forecasting model the Bank uses. The second is about interest rate assumptions in the forecast, and the third is about openness.

Reading between the lines of the Bernanke Review, it is clear that the Bank’s core macromodel, called Compass, is increasingly unhelpful in producing the Bank’s forecast. Chris Giles asks “how on earth did the BoE’s management and governance arrangements allow its modelling to get into such a bad mess?” I think part of the answer reflects a problem with academic macroeconomics, about which I used to write a lot in this blog many years ago.

The current model, Compass, is a pretty basic DSGE model. For those unfamiliar with what that means, can I suggest my own taxonomy of macromodel types here. DSGE models are dominant within academia, and they put internal theoretical consistency above matching the data. An alternative style of model, which goes by many names and which Barnanke calls ‘semi-structural’, puts more emphasis on matching the past data and as a result sacrifices being certain about internal theoretical consistency.

The predecessor at the Bank to the Compass model, called BEQM, was an intriguing and ambitious attempt to combine a DSGE model with a type of semi-structural model. I was the external advisor on that project. I think it’s fair to say that this attempt failed because it was just too complex for the forecasters and decision makers to use and understand.

The Bank’s reaction, to resort to a simpler DSGE model, was in my view the wrong choice. Instead it should have built a modern semi-structural model. The problem with DSGE models is that they don’t help forecasters very much, and are more difficult to revise to take into account new data and issues, as I explain in detail here. I cannot say why they made the wrong choice, but the view that a lot of academic macroeconomists hold that DSGE models are the only way to do structural modelling may have been decisive. My own view, shared by Olivier Blanchard, is rather different, as I explain here. In short, the Bank needs to build a new semi-structural model to replace its current DSGE model, and ensure it devotes sufficient resources to continuously updating and improving this model.

The second issue is about what interest rate assumptions the Bank should use in its forecast. At present it uses both constant interest rates and market expectations, but both of these are unsatisfactory. It is, to put it simply, just daft that the Bank doesn’t forecast the one variable it actually sets. It should follow best practice elsewhere, as I and others have long advocated. It is a shame Bernanke dodged making this a strong recommendation.

What Bernanke did recommend is ditching fan charts showing forecast uncertainty, and instead look at alternative scenarios to the main forecast. How useful this will be remains to be seen, but I think it points to a more fundamental problem. Chris Giles talks about the need to examine past forecast errors, but I think an equally big gap is the lack of Bank analysis of the impact of monetary policy itself.

If you look at the Bank of England’s website you will find plenty of interesting research papers, many of which look at a particular aspect of the ‘transmission mechanism’ between monetary policy instruments and key economic variables. A few, like this, examine the whole thing. However there is a world of difference between a piece of research using a particular estimation method or theoretical approach and a considered Bank view based on looking at the totality of evidence. It is the latter which is missing.

For example I started this post by suggesting that the Bank couldn’t have done much to prevent recent inflation without harming the economy, but this should be something the Bank itself should address by looking at what the impact of alternative past interest rate profiles might have been, and publishing the results. More generally, the Bank should publish and regularly update its own assessment of how changes in interest rates impact the economy over time. The Bank must do such analysis internally, so why not make this public? Having a core model that it could trust would of course make this much easier.

Tuesday 16 April 2024

Could governments finance deficits by creating money?


MMTers often say that financing government spending less taxes by issuing government debt is a policy choice, because they could instead create reserves (electronic money) at commercial banks. Of course only governments that have their own currency can do this, so this option is not available to Eurozone governments for example. If governments could finance deficits by creating money/reserves, would they want to do so?

The textbook answer (see here for example) is that monetary financing is inflationary, which is why most governments delegate reserve creation to independent central banks. This is not because of any crude monetarism: in mainstream macro the idea that there is a predictable and causal link between money creation and inflation died many decades ago, and today is believed by only a few. Instead the textbook story relies on the idea that governments creating money would undermine the ability of central banks to control the short term interest rate. Money financing would force interest rates to zero, and that would be inflationary.

However textbooks are nearly always out of date, and this explanation for why money financing would be inflationary became largely irrelevant when central banks started paying interest on reserves. Reserves are like electronic money held by commercial banks, the quantity of which is controlled by central banks. Today central banks control short term interest rates by paying that interest rate on reserves. As a result, it is possible to create large amounts of money/reserves without this ending in higher inflation.

We know this because of Quantitative Easing (QE), where central banks created large amounts of reserves in order to buy government debt. When they did this after the Global Financial Crisis (GFC) we didn’t get hyperinflation! The idea that recent inflation is a result of the new QE that took place during the pandemic is just silly. What recent experience shows us is that it is perfectly possible for central banks to control inflation even when there is a lot of money/reserves in the system.

So if central banks can create large quantities of money but still control inflation, why cannot governments finance their deficits by creating money? If interest is paid on that money/reserves, and it is clear that central banks have complete control over setting that interest rate, there is no reason to believe that money financing deficits rather than financing deficits by issuing bonds would be inflationary. This is what MMT means when it says bond financing is a policy choice.

Indeed we could go further and say that QE has been equivalent to the money financing of current and past deficits. The fact that this has happened because central banks wanted to put downward pressure on long term interest rates rather than governments choosing to money finance is just about motive. In practice we have ended up in much the same place as if governments since some past date had financed their deficits by creating reserves.

Of course none of this would matter if governments had no reason to be interested in money financing deficits. The obvious reason why they might be is if this form of financing was cheaper than selling debt to the bond market. Creating money/reserves incurs a cost equal to whatever the central bank sets the short interest rate to. Issuing debt could incur much the same cost if that debt was very short term. However governments have the option, which they normally take, of selling longer term debt. That may or may not be immediately cheaper than creating money/reserves, because long term interest rates may be above or below short rates. After the GFC short rates were below long rates, so money financing would have been cheaper and QE made a profit. Currently long rates are below short rates so bond financing would be cheaper at the moment. However over the long term whether the option of borrowing long is cheaper for governments remains questionable. Ellison and Scott found that the UK, which tends to borrow long, would have been better off if it had borrowed short.

The situation becomes much clearer if central banks only pay interest on reserves at the margin, rather than paying interest on all reserves. This would allow central banks to continue to control short term interest rates, but also to pay substantially less interest on the total stock of reserves. I discussed this possibility in detail here, in the context of reducing current losses from QE. An additional reason to pay interest only on some rather than all reserves is that there is no obvious reason why commercial banks should receive large sums of money for reserves when rates are high and virtually nothing when rates are low

If interest was only paid on marginal reserves, then it does clearly become attractive from a public finance point of view to finance deficits by creating money/reserves rather than issuing debt. So why are governments not exploring this possibility? I could equally well ask why mainstream economists are not talking more about this possibility. Maybe I’m missing something obvious here. If so please let me know.

One possible argument that I think doesn’t hold water is that cheaper financing of deficits would encourage governments to be fiscally profligate. The main deterrent to fiscal profligacy when there is an independent central bank is high interest rates, not high debt interest payments.

I want to end by making two additional points. The first is about markets and default. Money financing may appear attractive to those who believe that debt finance constrains government fiscal decisions. The idea is that bond markets could suddenly stop lending governments money, and this inhibits politicians from optimal fiscal policy choices. If politicians think this way they are mistaken, because as I have explained elsewhere the bond market is highly unlikely to stop lending the government money, and if it ever did the central bank would act as a last resort buyer of government debt. This is what happened as the pandemic hit, and after Truss’s infamous fiscal event. [1]

Because governments can create money they never need to worry about being forced to default as a result of a bond market strike. In addition governments having a magic money tree means that bondholders can always get paid interest and their money back. The only formal default [2] that bond markets need to worry about is when governments choose it, because the political cost of servicing government debt becomes too high. We are way away from such levels today, so the following paragraph is strictly of academic interest only.

If a government with an independent central bank that had financed all of its past deficits through money/reserve creation chose to default, how could it do so? Unlike government debt, reserves don’t have to be paid back at a set date. The only sense in which such a government could default is to instruct its central bank to no longer pay interest on reserves, which means that the central bank is no longer independent and loses control of inflation. In contrast, defaulting on government debt is possible while maintaining an independent central bank, and therefore maintaining control of inflation.

My second point is about safe assets. Because governments of advanced economies who issue debt in their own currency hardly ever choose to default, the debt they issue is far safer than any debt the private sector creates. [3] Such debt is invaluable to the financial sector. It allows pension funds greater certainty that they can pay future pensions, for example. This is a very good reason why governments should continue to issue at least some debt. Does that mean governments should always finance deficits using debt? No, because governments can issue debt to buy assets (through a sovereign wealth fund for example) rather than fund deficits.

[1] Politicians may worry about the impact of fiscal decisions on how the central bank sets interest rates, but it is absolutely right that they should.

[2] Bond markets do need to worry about inflation, which is sometimes considered as a form of default, but that gets reflected in interest rates through the actions of independent central banks and arbitrage.

[3] It can be disastrous when the private sector thinks they have created safe assets when in reality they haven’t, as we found out in the GFC.

Tuesday 9 April 2024

The Anatomy and Reasons for UK relative Economic and Political decline over the last decade and a half


Nothing works anymore, the country is in a mess, worker’s living standards have remained stagnant, public services are at breaking point. Such statements are now commonplace, and are increasingly brought together in articles like this one by Sam Knight in the New Yorker. But is all this the result of 14 years of bad government, or can the blame be laid at the door of one or two specific events like austerity or Brexit?

Economic decline

I want to start with a post I wrote two years ago, where I was already talking about an unprecedented era of UK macroeconomic decline. I focused on comparisons with the US, and here is an updated chart of GDP per head in the two countries.

The divergence between the two countries has grown steadily since around 2010, it has become particularly dramatic since the pandemic. While real GDP per head in the UK has increased by only around 5% over the last 15 years, in the US it has increased by over 20%. As that earlier post showed, this divergence was not a feature of the previous three decades, but instead started around 2010. Between 1980 and 2010 UK GDP per head grew at least as fast as the US.

Comparisons with Europe are less dramatic, but partly for that reason may be more instructive.

If we compare the UK to the EU average (blue and green), the EU recovered more rapidly from the Global Financial Crisis (GFC) recession, but then fell back as the second Eurozone recession began to bite. However from 2016 onwards EU growth exceeded growth in the UK, leaving an 8% gap by 2023. A difference in growth of 8% over less than a decade is a lot. However over the last 15 years growth in France has been similar to the UK, and things have been worse in Italy (not shown above).

GDP per head does not tell the whole story about prosperity, because it doesn’t tell you about the purchasing power of incomes. Here is a comparison of real wage trends over roughly the same period from this source.

In this case the UK ends up well below France, with real wages in 2023 below 2008 levels. Part of the contrast between real wages and GDP per capita is distributional, with the UK government favouring pensioners in particular. However a large part is also about consumers buying many goods from abroad, and these becoming more expensive because sterling has depreciated. Here is the Sterling Euro rate over this period.

We had a large depreciation during the GFC, followed by a gradual appreciation until Brexit, when sterling depreciated again. A depreciation of 20% between 2007 and 2023 will reduce the purchasing power of UK nominal wages by a good few percent.

What does this tell us about why the UK has experienced a decade and a half of economic decline? These comparisons suggest austerity is important. The UK set out plans for large-scale and relentless austerity earlier than the EU, which is why our recovery was relatively slow, but the EU as a whole fell back to UK levels when it embarked on widespread austerity during the 2011-13 period. The US had an excellent recovery from the pandemic because, unlike the UK and Eurozone, it encouraged its recovery with fiscal expansion. As I argued here, deficit obsession, shared by the UK and EU but not (currently at least) by the US, appears to be bad for growth not just in the short term, but continuing into the medium term as well. Evidence also suggests cutting spending in a recession actually increases the debt to GDP ratio.

Brexit also clearly matters. I doubt that it accounts for all of the GDP per head gap that has opened up between the EU as a whole and the UK since 2016, but it almost certainly accounts for a good part. It is also responsible for the 2016 depreciation which reduced the purchasing power of UK incomes. [1]

To conclude, the relative decline of the UK economy since around 2010 is very real and substantial. It is not unique or the worst performance among major European economies thanks to Italy, although it is worth noting that in contrast to the UK Italian growth has been strong since the pandemic. Both austerity and Brexit have played a large part in producing the UK’s relative decline, but other factors (e,g, bad governance generally, poor pandemic management, encouragement of rent seeking from government) may also have played a part. As the New Yorker article notes, austerity itself probably played a key part in ensuring Brexit happened.

Political decline

Of course the current feeling that nothing works anymore isn’t just about a significant relative decline in living standards. It is also about political failure. There is no doubt that this became acute following Brexit. As I have noted many times, support for Brexit sorted those interested in evidence or even common sense from those who were not: some of the former got expelled from the party by Johnson and the latter got to be in his cabinet.

But 2010 austerity was also a failure of evidence based governance, in two crucial respects. First, we had known since WWII that cutting government spending during a recession, where interest rates were stuck at a lower bound, was a crazy idea. The fact that this was also advocated by the Republican party in the US, and a Germany dominated Europe spooked by the Eurozone crisis, should not lend it any respectability. 

Second, substantially shrinking the state without significantly altering thetasks the state is required to perform only makes sense if you believe that there are massive efficiency gains to be had, and again there was plenty of evidence in 2010 that this was untrue. The dire state of most public services today, which is so central to the current national feeling of despair, stems from this fundamental error that began in 2010.

I think it is important to recognise that so much of our current political malaise has deep roots of Conservative party strategy since the fall of the Major government, rather than being something that just happened with Brexit. The contrast with Labour in opposition is instructive. Whatever you might think of Labour’s embrace of some aspects of neoliberalism, it showed a party adapting to electoral failure. Where the subsequent Labour government did differ from Thatcher was in increasing spending on public services and particularly the NHS, and this was clearly popular with most of the public.

The Conservative opposition from 1997 to 2010 took none of this on board. Instead they saw themselves as leaving off where Thatcherism had ended, in an ideological rather than evidence based way. She had ignored the economists when raising taxes in the 1981 recession, so they would go further with austerity, not bothering to note that her fiscal contraction during a recession lasted for only one year and was then reversed. She had shrunk the state so they would do the same, but they ignored the fact that Thatcher mainly reduced what the state did through privatisation rather than starving it of money. Whereas some of Thatcher/Major’s economic policies were popular, those of their successors were not.

In simple terms the Conservatives in opposition moved further to the right on economic policy, rather than shifting left on public spending in a way that Blair/Brown had shown was popular. They understood that good public services were popular, but used the GFC as an excuse to cut spending. Conservative MPs today are much more right wing on economic issues than Conservative voters or members. [2]

Sunak’s strategy of focusing on tax cuts and culture war issues, that today seems so out of touch with the concerns of most voters, also stems from Conservative strategy after 1997. Of course Conservative party members have always been socially conservative, but Thatcher argued for her economic policies on their own terms. In opposition the Conservatives, like the Republicans in the US, saw their culture war as a means of winning despite their economic policies. With the help of the party in the media, they focused on immigration as a means of winning support from voters who were socially conservative but left leaning in economic terms, a strategy that was most successful with Brexit and Johnson’s victory in 2019, but which is now seen by many as the sham it always was.

One other feature of politics that we associate with Brexit and Johnson particularly, and which persists today, may also have its origins in the Conservative’s period in opposition from 1997 to 2010. One notable feature of the attitudes of the average Conservative MP (at least in 2020) is that they are slightly more socially liberal than the average voter, and therefore much more liberal than Tory party members. For most of these MPs the focus on social conservatism and culture wars has to represent a degree of deceit to win power rather than an expression of underlying beliefs or values.

For this reason, the tendency to deceive and lie to gain or retain political power, which reached its summit with the Brexit campaign and which continues today on issues like dealing with refugees, may represent the continuation of a trend that began in those opposition years. We don’t know how much of Cameron and Osborne’s rhetoric of deficit reduction they actually believed, but we do know that they started cutting taxes fairly quickly after 2010, which you wouldn’t do if deficit reduction was really your primary goal.

For these reasons I see the political decline of the last fourteen years as deeply rooted in the way the Conservative party developed since the Thatcher and Major years. One of the reasons for the current feeling of political despair is that the Conservatives under Sunak have almost stopped governing, and instead almost everything the government does seems aimed at trying to rescue some votes.

For completeness I would add two final, more minor, points. The first is that part of the current malaise also comes from an uninspiring opposition, but much of that stems from a First Past The Post electoral system where government typically alternates between the two major parties, and past Labour defeats. In most circumstances, including those today, it makes electoral sense for the opposition to appear ever so slightly more to the left in economic and social terms than the government. Labour too are in the business of winning votes, and in addition are inevitably very cautious of doing anything to lose them.

The second point that needs to be made is that the political decline over the last fourteen years in some part reflects a decline in the quality of our mainstream media. Some of this is obvious, such as the right wing press becoming a propaganda vehicle for Brexit, or the influence the Conservative party has had on the BBC. But it is also the case that the broadcast media, and particularly the BBC, has an increasing obsession with balance at the expense of informing viewers about facts or about the consensus of expert opinion. This has been an important factor in facilitating our political decline. It played a crucial part in the 2015 election, in the Brexit referendum and in the election of Johnson and it continues today. [3] More generally it allows particular members of the elite to present themselves as outsiders, championing ordinary people, and allows political deception and lying as a matter of routine.

When the Conservative led Coalition came to power in 2010, it suggested that cutting public spending rather than improving living standards should become the government’s economic priority. Today we are experiencing the inevitable result, a combination of dire public services and fourteen years of relative economic decline. In an attempt to appeal to voters that wanted functioning public services, they pretended immigration was a major problem. As a result we ended up with Brexit, trying to traffic asylum seekers to Rwanda and a government moving further to the right on social as well as economic issues. Today’s economic and political malaise is a direct consequence of a Conservative party strategy that was conceived after 1997 and implemented from 2010.

[1] The depreciation from 2008 to 2010 is generally put down to the fact that the GFC affected the UK more than most, because our banking sector was relatively large. However, having worked on equilibrium exchange rates, I have always found that justification for such a large depreciation unconvincing. In this respect it is also interesting that once the UK started growing again but the EU did not, sterling began appreciating, such that by 2015 it had regained most of the ground it lost during the GFC.

[2] The fact that taxes have increased as a share of GDP over their time in government is because spending on health has been rising as a share of GDP almost everywhere.

[3] On the few occasions the broadcast media ignored impartiality and took a clear side it backed the wrong cause, including its adoption of deficit obsession after 2010 and relentless pursuit of antisemitism within Labour while largely ignoring Tory Islamophobia and Johnson’s unsuitability to be PM. The latter, together with sections of the Labour right who preferred Johnson to Corbyn, helped ensure Brexit happened and led to many thousands of deaths in the subsequent pandemic.