Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 24 February 2017

The NAIRU: a response to critics

When I wrote my piece on NAIRU bashing, I mainly had in mind a few newspaper articles I had read which said we cannot reliably estimate it so why not junk the concept. What I had forgotten, however, is that for heterodox economists of a certain hue, the NAIRU is a trigger word, a bit like methodology is for mainstream economists. It conjures up lots of bad associations.

As a result, I got comments on my blog that were almost unbelievable. The most colourful was “NAIRU is the economic equivalent of "Muslim ban"”. At least two wanted to hold me directly responsible for any unemployment at the NAIRU. For example: “So according to you a fraction of the workforce needs to be kept unemployed.” Which is a bit like saying to doctors: “So according to you some people have to be allowed to die as a result of cancer.”

I have to say straight away that not everyone responded in that way. Some were much more thoughtful and constructive (like Jo Michell, for example). But the less thoughtful reactions are interesting in a way too.

I need to recap what the NAIRU is, particularly because heterodox economists seem to imagine it is many things it is not. Let’s take a very simple Phillips curve

Inflation this period = expected inflation next period - aU +b

where ‘a’ is a parameter and U is a measure of excess supply/demand in the economy. Unemployment will be one measure of that excess supply, but it is far from a perfect measure. (That my previous post was about excess supply, rather than actual unemployment, was obvious from what I wrote.) ‘b’ stands for a collection of slow moving variables. These could include a measure of union power, or how mobile labour was, or the degree of monopoly in the goods market. The NAIRU is defined as

NAIRU = b/a

If U is less than the NAIRU over a sustained period then inflation will rise, which will increase inflation expectations, which increases inflation further etc.

The concept is of interest to policymakers involved in demand management. They have to decide how much they can push demand before inflation starts rising. If they are independent central banks, they have to accept the world as it is. The NAIRU is a description of how the economy works: nothing more or less. This is why complaints that economists who use or estimate the concept are somehow responsible for those left unemployed are so dumb.

Of course you can criticise the concept of the NAIRU, but logically that has to involve criticism of the Phillips curve from where it comes. It is also reasonable to argue that the concept is fine, but the NAIRU is so difficult to measure that it would be better not to try and estimate it or let it guide policy. I have a lot of sympathy with that view at the moment, which is why I argue that, in the US right now, policy makers should find the NAIRU by allowing inflation to rise above target. But that point of view was irrelevant in my previous post, which was about the concept of the NAIRU, not its measurement.

As far as the concept is concerned, I think the strongest attacks come from thinking about hysteresis, as Jo Michell suggests. But even here, we add a complication to the NAIRU analysis, rather than overturn that analysis altogether. What hysteresis does is to make periods where unemployment is above the NAIRU extremely costly. It also means that periods of being slightly below the current NAIRU might be justified if they reduce the NAIRU itself.

I want to end by adding two reflections. The first relates to modelling the NAIRU. There once was, following the work of Layard and Nickell, an empirical literature that attempted to model for OECD countries a time series for the NAIRU, using proxy variables for things like union power, the benefit regime and geographical mismatch. With the dominance of the microfoundations methodology that work appears to have decreased, although to some extent it is still there in work based on matching models. I would be very interested to know if that time series analysis, now potentially enriched by matching models and flow data, has continued in any way.

The second relates to the sharp reactions to my original post I noted at the start, and the hostility displayed by some heterodox economists (I stress some) to the concept. I have been trying to decide what annoys me about this so much. I think it is this. The concept of the NAIRU, or equivalently the Phillips curve, is very basic to macroeconomics. It is hard to teach about inflation, unemployment and demand management without it. Those trying to set interest rates in independent central banks are, for the most part, doing what they can to find the optimal balance between inflation and unemployment.

Accepting the concept of the NAIRU does not mean you have to agree with their judgements. But if you want to argue that they could be doing something better, you need to use the language of macroeconomics. You can say, as many besides myself have done, that the NAIRU is either a lot lower than central bank estimates, or is currently so uncertain that these estimates should not influence policy. But if you say that the NAIRU has to be Bashed, Smashed, And Trashed, you will not get anywhere.

I also get very annoyed when I hear refutation by reference (as here for example). It would be so easy to write my blog posts that way. Instead I generally try to explain or present an argument that I hope is understandable. Economics is usually not so hard that this is impossible, although finding the right words is never easy. Economics is certainly not a religion, where all you have to do is choose which sect you belong to and then follow great works.     

Wednesday, 22 February 2017

The academic consensus on austerity solidifies, but policymakers go their own sweet way

With yet another study showing how damaging austerity can be, you would think that at some point some politicians would eventually get it. This tepid economic recovery has been a huge vindication of Keynesian economics, which also happens to be mainstream economics. The textbooks and state of the art macroeconomics said cutting public spending while interest rates were stuck at their lower bound was a very bad idea. And sure enough pretty well every ex post analysis of this period finds that it was. It is particularly ironic that at a time when countless articles have appeared about the ‘crisis in economics’, a massive experiment by policymakers has seen an important part of it vindicated.

There were three countries or areas that adopted austerity in spades: the US, the UK and the Eurozone. Are any of these likely to recognise the error of their austerity ways anytime soon? The conventional wisdom is that this will happen in the US, but this is to confuse actions and the reasoning behind them. Any fiscal expansion in the US would not be for Keynesian reasons. This is partly for the obvious reason that interest rates are rising, and the central bank has shown no clear sign that they would not meet any further expansion with additional increases. There remains a clear and rather urgent need for a large increase in public investment financed by borrowing, but that seems unlikely to happen. What we are sure to get is tax cuts, particularly for the rich, because that is nowadays the main goal of Republican economic policy. Among Republicans, Keynesian economics remains the work of the devil.

In the UK there is also a desperate need for public investment. In addition, the NHS is crying out for a substantial tax financed fiscal expansion, which would help get interest rates off their lower bound. But UK policy makers only have one thing on their minds at the moment. It is Brexit at any cost. We know that because they show no interest in any other options. Right now God could reveal to climbers on Ben Nevis that Brexit would cost the average UK household 20% of their income, and policy would not change. [0] While some in the government may be tempted by fiscal expansion as a way to hide those costs, the Treasury seems to be keeping an iron grip on the purse strings. Never has the UK government seemed so politically secure, and never has it been further from sensible economics.

Not all of the Eurozone’s problems are due to a failure to recognise Keynesian macro. As Martin Sandbu argues here, what has been done and continues to be done to Greece is the age old story of the creditor refusing to admit that they have made bad loans, and therefore squeezing the debtor for every last drop and not realising that doing so only makes things worse. But even here a failure to understand Keynesian economics contributes to this lack of understanding. A country that is allowed to recover from a demand led recession will be far more able to find resources to pay back debt.

However if you look very hard there are signs that things might be improving in the Eurozone. Fiscal austerity at the aggregate level seems to have come to an end. Some key actors, even in EC institutions and governments, are beginning to see how austerity policies may only encourage the rise of the populist right. But that is a long way from the key reform that is required, which is replacing the existing fiscal architecture with something more Keynesian that recognises the mistakes of the past.

If anything is going to happen at all, I doubt if it will be the abandonment of the stability pact and fiscal compact, desirable though that would be. What seems more likely is a gradual adaptation of the mess that all these rules already are. The adaptation does not even need to look like Keynesian policy. National fiscal and macroprudential policies need to focus on inflation differentials between the individual country and the Eurozone average. This focus could be embodied in a rule, which still allowed debt or the deficit to be guided by a target when inflation was at the zone average. This rule has to be symmetric in inflation differentials, prescribing fiscal expansion if a country’s inflation is lower than average.

Equally disappointing has been the complacency of independent central banks. We have had the most prolonged recovery from recession, with lasting damage to long run supply, but you might be forgiven for thinking that we were still in the Great Moderation. Central banks should be busy comparing the four main ways of avoiding another Zero Lower Bound episode: a higher inflation target, negative nominal rates, nominal GDP targets or helicopter money. They also have to stop being so discreet about fiscal policy. Keeping quiet itself makes another ZLB episode more dangerous.

Occasionally people ask why my blogs seem to be as much about politics as economics these days. I agree, there has been a change since 2015. Before that, I would have greeted a new paper on fiscal multipliers by comparing it to the existing literature, and examining its strengths and weaknesses. These days there just seems so little point. I do hope all this knowledge will one day see the light of day among policymakers, but right now I wonder if there is an equally good chance that policy makers will stop paying for knowledge they have no intention of using. [1] Sometimes writing about the finer details of estimated multipliers can seem like rearranging the deckchairs on the Titanic.


[0] Here are some man-made estimates
[1] U.S. U.K.


Friday, 17 February 2017

NAIRU bashing

The NAIRU is the level of unemployment at which inflation is stable. Ever since economists invented the concept people have poked fun at how difficult to measure and elusive the NAIRU appears to be, and these articles often end with the proclamation that it is time we ditched the concept. Even good journalists can do it. But few of these attempts to trash the NAIRU answer a very simple and obvious question - how else do we link the real economy to inflation?

One exception are those that attempt to suggest that all we need to effectively control the economy is a nominal anchor, like the money supply or the exchange rate. But to cut a long story short, attempts to put this into practice have never worked out too well. The most recent attempt has been the Euro: just adopt a common currency, and inflation in individual countries will be forced to follow the average. This didn’t prove to be true for either Germany or the periphery, with disastrous results.

The NAIRU is one of those economic concepts which is essential to understand the economy but is extremely difficult to measure. Let’s start with the reasons for difficulty. First, unemployment is not perfectly measured (with people giving up looking for work who start looking again when the economy grows strongly), and may not capture the idea it is meant to represent, which is excess supply or demand in the labour market. Second, it looks at only the labour market, whereas inflation may also have something to do with excess demand in the goods market. Third, even if neither of these problems existed, the way unemployment interacts with inflation is still not clear.

The way economists have thought about the relationship between unemployment and inflation over the last 50 years is the Phillips curve. That says that inflation depends on expected inflation and unemployment. The importance of expected inflation means that simply drawing unemployment against inflation will always produce a mess. I remember from one of the earlier editions of Mankiw’s textbook he had a lovely plot of this for the US, that contradicted what I just said: it displayed clear ‘Phillips curve loops’. But it was always messier for other countries and it got messier for the US once we had inflation targeting (as it should with rational expectations). See this post for details.

The ubiquity of the New Keynesian Phillips Curve (NKPC) in current macroeconomics should not fool anyone that we finally have the true model of inflation. Its frequency of use reflects the obsession with microfoundations methodology and the consequent downgrading of empirical analysis. We know that workers and employers don’t like nominal wage cuts, but that aversion is not in the NKPC. If monetary policy is stuck at the Zero Lower Bound the NKPC says that inflation should become rather volatile, but that did not appear to happen, a point John Cochrane has stressed.

I could go on and on, and write my own NAIRU bashing piece. But here is the rub. If we really think there is no relationship between unemployment and inflation, why on earth are we not trying to get unemployment below 4%? We know that the government could, by spending more, raise demand and reduce unemployment. And why would we ever raise interest rates above their lower bound?

I’ve been there, done that. While we should not be obsessed by the 1970s, we should not wipe it from our minds either. Then policy makers did in effect ditch the NAIRU, and we got uncomfortably high inflation. In 1980 in the US and UK policy changed and increased unemployment, and inflation fell. There is a relationship between inflation and unemployment, but it is just very difficult to pin down. For most macroeconomists, the concept of the NAIRU really just stands for that basic macroeconomic truth.

A more subtle critique of the NAIRU would be to acknowledge that truth, but say that because the relationship is difficult to measure, we should stop using unemployment as a guide to setting monetary policy. Let’s just focus on the objective, inflation, and move rates according to what actually happens to inflation. In other words forget forecasting, and let monetary policy operate like a thermostat, raising rates when inflation is above target and vice versa.

That could lead to large oscillations in inflation, but there is a more serious problem. This tends to be forgotten, but inflation is not the only goal of monetary policy. Take what is currently happening in the UK. Inflation is rising, and is expected to soon exceed its target, but the central bank has cut interest rates because it is more concerned about the impact of Brexit on the real economy. That shows quite clearly that policy makers in reality target some measure of the output gap as well as inflation. And they are quite right to, because why create a recession just to smooth inflation.

OK, so just target some weighted average of inflation and unemployment like a thermostat. But what level of unemployment? There is a danger that would always mean we would tolerate high inflation if unemployment is low. We know that is not a good idea, because inflation would just go on rising. So why not target the difference between unemployment and some level which is consistent with stable inflation. We could call that level X, but we should try to be more descriptive. Any suggestions?

Wednesday, 15 February 2017

Brexit and Trump are fundamentally a failure of the political right

Of course globalisation and inequality are important in explaining the proximate causes of Brexit and Trump. But neither event is an aberration: a moment of madness in an otherwise sea of rationality and evidence based policy making. And after each of these events, you do not find those from the political right doing all they can to return to political sanity. History is often as much about those who let things pass as about those who made them happen.

Only one Conservative MP voted against triggering Article 50, even though probably a majority of Tory MPs support remaining in the EU. Forget having to respect the ‘will of the people’. These MPs were not just agreeing to leave the EU, they were also agreeing to a hard Brexit which meant leaving the Single Market and giving up any say in how we leave the EU. None of that was on the ballot paper in the referendum. If they had wanted to, they could have joined with Labour in voting for amendments that put some limits on the power of the executive. An executive that has openly speculated about going for the hardest Brexit possible. But almost all chose not to. It is also no accident that the only Conservative MP to stand up to the Brexit bandwagon and vote against triggering Article 50 was Ken Clarke, a Conservative of bygone days.

In the US, once Trump had been elected, the Republican party largely rallied round ‘their man’. This might be normal behaviour, but Trump was no normal candidate. If ever there was a man temperamentally ill-suited for the office and totally unprepared for it, this was Trump. Yet their attitude before the election and in his few weeks in power seems to be that as long as he passes substantial tax cuts for the rich and deregulates banks, they are prepared to keep their fingers crossed that he does not do anything stupid like start a war with Iran or China.

The acceptance of Trump and Brexit by the political right is not surprising because they have laid so much of the groundwork for these events. The reason why nearly all Republicans could never bring themselves to say to voters that Trump was too dangerous and that they should vote for Clinton was because of what that party had become over the last few decades. It has been the Republican party that has steadily abused the machinery of government to get their own way, whether it involves nominees to the supreme and other courts or refusing to extend the deficit limit (but only when a democrat is in the White House, of course). It is they that have started acting as a unified bloc in Congress, with the only aim of stopping a democratic president doing anything. Thus a health care regime original put together by Republican Mitt Romney became evil when Obama essentially adopted it. A party that had done nothing to limit the power of a propaganda machine that they helped create, a machine which would eventually become a cheerleader for the outsider the party did not want. A party that started post-truth or alternative facts by backing climate change deniers, among other things.

The drift of the Republican party from being liberal to illiberal, from being secular to Christian, from being environmentally aware to climate change deniers, from supporting minorities to attacking ‘welfare queens’, did not happen all at once but has been a steady process. Of course there were key moments in that process, such as Nixon’s ‘southern strategy’, Reagan’s adoption of tax cuts for the rich that would ‘pay for themselves’ and neoliberalism more generally, to the Tea Party most recently. But the process has been all one way with few attempts to stop it.

The same is true for the UK, except perhaps less obviously so because the UK media too often hype the rhetoric and not the consequences of actions. We typically think of Margaret Thatcher as representing a clear break from more traditional conservatism. But this is not the whole story. For a start, although Thatcher changed the way Prime Ministers started talking about the EU, Thatcher in office was no Eurosceptic, and helped create the single market and the expansion to the east. Second, Thatcher did not lead a party of Thatcherites. Her successor, John Major, was a compromise candidate between the Thatcherite and more traditionally conservative factions. Major was a committed European, who would never have offered the Eurosceptics a referendum even though they plagued his time as PM. I doubt very much that he would have been prepared to lead his party out of the EU, yet nowadays it goes almost unremarked that Theresa May would take the country on a course that she earlier said would do it harm, just for the sake of power and the party. May whose flagship policy is to undo the work of Thatcher and replace comprehensive schools with the 11+, and who admirers compare to Enoch Powell. Not to mention Boris Johnson, who so obviously led the Brexit campaign he didn’t believe in only so he could become PM. From a Prime Minister whose father owned a couple of grocery shops and became first a chemist and then a conviction politician, to another Bullingdon boy born to wealth who will say whatever gets him power. We have moved well beyond Thatcher.

Although the 2010 Conservatives posed as ‘not the nasty party’, in reality they took policy even further to the right than Thatcher had done. Cameron may have hugged a husky, but his policies told a different story, and he even appointed a climate change denier as Environment minister. The 2010 government embarked on needless austerity, taking resources from everyone and causing acute harm among the poor. It was a Conservative chancellor who encouraged viewing benefit claimants as lazy skivers. It was a Conservative minister and Brexit supporter that imposed a sanctions regime and other welfare reforms that caused suffering previous Conservative ministers would have thought shameful. They tried to deflect blame for all this by hyping the evils of immigration, setting targets they had no intention of keeping because it would cause too much damage to UK business to do so. But these targets were maintained to appease the hard right, embarrass Labour and deflect criticism of austerity. The effects of starving the NHS could be blamed on the health tourist. Imagine what more they would have done if they hadn’t been in coalition. And above all else (as far as Brexit was concerned) they continued to court newspaper owners despite their obvious hatred for the EU.

In the UK the demonisation of the immigrant was not just the work of the Tory tabloids, but also given the stamp of official approval by a Conservative government. Cameron couldn’t warn of the dangers of cutting back EU immigration during the referendum when a large cut in immigration was government policy. The scarring of whole parts of the country was something this increasingly right wing party had done nothing about. Both were critical in allowing Brexit.

We can say, in both the US and UK, that this is about neoliberalism, implying this has replaced the principles of traditional conservatism. However I suspect in many cases that creed is simply a cover to disguise a far simpler motive of protecting and increasing the wealth of the rich. What we have seen is the steady replacement of principles with policies solely designed to gain votes and power to achieve that end. The decline of principled politics and the rise of politics for the rich is not unique to the right, but it is much more obvious there. It was not the Democrats who gave Trump a path to power, and it was not Labour who offered a referendum, or are leading the UK out of the EU.

All this does not go unnoticed by the electorate. They become justifiably cynical about Washington or Westminster. This lays the groundwork for either outsiders who seem to have so much of their own wealth that they are incorruptible, or a protest vote led by a politician whose main virtue is that he makes people laugh. It leads to MPs so desperate for power that they would leave their liberal principles at home and support what is bound to lead to an isolated Britain at the coattails of Donald Trump. A country that seems to be effectively run by a group of 59 MPs whose hatred of Europe dominates all else. And Republicans who stand back while their President cosies up to Russia, threatens trade wars and undoes years of hard work by trying to enact what he described as a Muslim ban.

Of course politicians have always compromised principles to some extent to achieve power. But for the politicians on the right who let Brexit or Trump pass unchallenged, it is not clear what principles remain beyond their own career. Why this seems to have happened so completely on the right in the UK and US is not clear. Is it, as Roy Hattersley suggests, the availability of instant polls and focus groups which make it so easy just to follow popular opinion in order to get elected. Or is it the growing influence of money. Or perhaps even the gradual death of the empathy for others created by WWII. Whatever it is, it is about time we recognised and lamented the passing of conservative principles and their replacement with whatever policies they can get away with to make the rich richer and to keep power. Unfortunately we are all about to reap what this death has helped sow.


Monday, 13 February 2017

The Kerslake Review of the Treasury

This review, published today, was commissioned by John McDonnell but is entirely independent. Although it is ultimately Lord Kerslake’s review, it is the product of a small panel of which I was a member, and also reflects submitted evidence and meetings of invited experts. I can say that in my area, macroeconomic policy, this external evidence was very influential and let me thank again all those involved. This post just focuses on these macroeconomic aspects of this review of the Treasury. [1]

The obvious place to start is to think how the role of the Treasury has changed in the last two decades. In 1997 setting monetary policy was delegated to the Bank of England. In 2010 the forecasting aspects of fiscal policy were delegated to the OBR. To a government obsessed by cutting the size of the state that might suggest that the Treasury did not need to have a large macroeconomic capacity, But if you think about the major macroeconomic disasters if the last decade, that view is completely misguided.

One way of thinking about these disasters is that they reflect a failure to consider potential risks to the economy, and what might be done to both mitigate those risks and respond to them if they occurred. No one was ever going to predict the exact time and date of the financial crisis, but someone in government should have been thinking about what risks a rapidly expanding banking sector might pose. There were not many who warned about the risks, but enough to warrant a risk analysis. As I have said before, I doubt that this could have avoided a crisis - the banking lobby is too strong - but at least the government would have given some thought about what to do if it happened before it happened.

When it came to austerity, everything would have been relatively unproblematic if the economy had grown at the pace at first expected in 2010, because monetary policy would still have had control. (Interest rates would have been above their lower bound.) But someone should have been focusing on what happens if things turned out to be less rosy, and making sure ministers had to address these risks. At the very least that analysis would have pinpointed the need to change fiscal policy the moment that more pessimistic outcome came to pass, but perhaps also thinking about this risk might have injected a note of caution into policy before this happened. In a secret Treasury that might not have stopped a determined politician, but if this risk analysis had been made public?

Who in government should have been doing this risk analysis? The obvious institution is not the central bank, which can be far too tentative in the area of fiscal policy and too biased on financial policy, but the Treasury. The Treasury, to use a phrase suggested at one of our evidence gathering meetings, should be “the country’s risk manager of last resort”. The Treasury is uniquely capable of getting information from all the parts of government, including the Bank, and putting it together within a consistent macroeconomic framework.

But this isn’t the only reason why the Treasury still needs a strong macroeconomic capacity. It sets the rules by which fiscal and monetary policy operate, and the danger of not having this capacity is that the rules get determined by political whim, or don’t change through inertia. And it also needs the capability to undertake large pieces of complex analysis very quickly, as we have again seen over the last two decades.

What do I mean by capacity? Above all people: people who have the ability to do and understand state of the art macro analysis. If you compare the number of macroeconomists at the Treasury and the Bank there is a huge imbalance which is not conducive to good policy making. It is absurd to think that you need suites of models to set interest rates, but virtually nothing to set monetary and fiscal policy rules and analyse the impact of potential risks to the economy.

None of this is guaranteed to stop the Treasury become obsessed with the deficit and ignoring macro analysis, but the stronger the macro team is in the Treasury the less likely this is to happen. One other way that is often suggested of combating this danger, and which we considered, involves splitting off from the Treasury key aspects including macro policy into a new Economics ministry. My own view, which is similar to that expressed in the report, is that such a split just runs the danger of institutionalising the dominant role of balancing the budget in policy making.

There is one final benefit of enhancing the macro capacity of the Treasury, and that would be to provide the potential to increase openness. I take it as given that greater openness would be a good thing, and also being an essential way of utilising existing expertise around the country. It is far from clear why risk anaysis has to be secret. To take just two examples, the Bank makes a concerted attempt to find out what is being done in UK universities that might be useful to it, and it publishes a regular blog where their economists can flag interesting data and analysis. It would be good if the Treasury had the capacity to do something similar.


[1] There is a great deal more in the report, both about macro policy and issues around devolution, working with other departments, the overall goals of policy and much more. I also feel I need to note one area where I disagree with how Bob talked about the report yesterday (on Peston’s show and to the Guardian). While I’m sure it is true that the Treasury has lost trust as a result of its incorrect pre-referendum short term forecast, by highlighting this in the context of this report you inevitably give the impression that it did something unprofessional. But both assessments were signed off by Charlie Bean. and the Treasury were hardly alone in expecting negative short term impacts from Brexit. Worse still, it risks suggesting that their long term analysis is suspect.




Thursday, 9 February 2017

How Brexit advocates intend to smear economics

Those who are devoted to Brexit have only faced one real enemy: economics. It is in the DNA of economics that trade is good, and so anything that makes trade more difficult will be costly. On top of this basic insight on which so much of society is built is a host of detailed evidence on the impact of trade agreements and the effect of more trade on the economy. This knowledge had become received wisdom among most MPs, probably as much if not more through their contacts with business.

What Brexit advocates had on their side was the huge advantage of fanatical support from most of the Tabloid press as well as the most widely read broadsheet . It is a schoolboy error to say that because newspaper circulation is declining its influence is also declining. More people may get their news online, but newspapers remain a primary news source online, either directly or indirectly. The broadcast media also tends to take their lead from newspapers. This is why Leave wanted a referendum, because they thought they could win, not because they had any great belief in this form of democracy. [1]

In the referendum itself economists were largely sidelined, and when their arguments did appear via the predictions of organisations like the IMF they were generally accompanied by a matching segment from the tiny band of “economists for Brexit”. For this and other reasons I have discussed at length in earlier posts, the Brexit advocates won, narrowly. But the advocates of Brexit still face a problem. If the news as Brexit happens is all bad, then maybe people will begin to hear about what the overwhelming majority of economists have been saying.

And sure enough, that has been happening. Sterling crashes the moment markets hear about the vote, and this will gradually reduce consumers’ real incomes. The Bank has to cut rates to their lower bound and restart QE. Forecasts of the public finances deteriorate, most recently here. So they needed some way of smearing all these negative medium term economic predictions. When the Bank of England revised up their forecast of UK GDP growth in 2017 from 0.8% in August to 2% in February (see this post), they saw their chance.

They will now claim that economists are completely discredited because they all thought GDP would collapse as a result of the Brexit vote and it hasn’t. Therefore anything they say about the public finances or growth in the medium term can be discounted. Now of course among those that know anything about economics this is nonsense. But most people do not know much about economics, they do not read the FT or Economist, so this kind of propaganda is effective. Don’t be surprised to hear it from political journalists in the broadcast media before long.

So for the record, before this happens, here is why it is nonsense.
  1. (And most important) Short term unconditional macroeconomic forecasts are extremely unreliable: always have been and I suspect always will be. They are slightly better than guesswork, but for a central bank that slightly better is well worth having. Predictions about the long term impact of Brexit mainly come from the non-macro part of international trade: gravity equations and all that. Their empirical foundation is strong. The idea that lower immigration will hurt the public finances is also common sense once you recognise that immigrants are young, and therefore will pay taxes that finance their use of the NHS and other public services with plenty to spare. This has nothing to do with macro forecasting!

  2. Actually it is not the case that economists universally thought GDP would collapse. Here is the FT survey: most thought it would collapse, but it was not universal. The FT survey focuses on City economists, not academic economists. One prominent academic economists, Paul Krugman, has always been very dubious about talk of a recession. What is true is that economists universally think Brexit will have bad long term effects.

  3. As I wrote here in June last year, the macro impact of Brexit involves counteracting forces. The depreciation is partly in anticipation of the loss in trade Brexit will bring, but in the short term it could boost net trade. Consumers could beat (for now) the increase in the prices of imported goods by buying durables immediately. Most forecasters thought these effects would be counteracted by negative effects, and it was reasonable to do so, but a sharp downturn was never a one way bet. In contrast, there is no upside to making trade more difficult with your nearest neighbour. The only question is how bad will it be.
If you think this is all so obvious that the propaganda about economists being hopelessly discredited will not work, I think you need to get out more. The line 'they all got the immediate impact completely wrong so we cannot take their medium term predictions seriously, and who can forecast until 2030 anyway' will be repeated ad nauseam in the press and by Leave advocates. Most political journalists will not know this line is rubbish and full of elementary confusions, because they do not talk to academic economists either directly or indirectly. The one group who could puncture this bubble is business, but at present its voice has been fragmented and therefore weak.  



[1] For those who still doubt the power of the tabloid media, imagine there is a car market with a single best selling car, call it car R. A new rival is launched, car L. It is independently assessed to perform worse, but this assessment is not widely available. But car L gets a year of pre-launch publicity in 80% of the tabloid press, followed by a period of 6 months non-stop adverts for this car coupled with stories about the failings of car R. All discussion of the technical merits of the two cars in the broadcast media involve debates between advertisers for both cars. Now, honestly, are you going to tell me that under these circumstances car L would not capture a lot, perhaps a majority, of the market?

Tuesday, 7 February 2017

Does the Bank’s latest forecast mean Brexit has had no effect?

The focus of many (not all) journalists on GDP growth was in evidence again in the reporting of the Bank of England’s latest UK forecast.

Bank of England Inflation Report February 2017 and (in italics) my estimates
Growth rates of
2016
2017
2018
2019
Ave 98-07
GDP
2.0
2.0
1.6
1.7
2.9
Household Income
2
0.75
0.25
0.75
3.0
Savings ratio [1]
5.75
4.5
3.75
3.25
8.0
GDP per head
1.25
1.25
1.0
1.0
2.25 [2]
Household Income p.h.
1.25
0
-0.5
0
na
[1] Level [2] Average 1955-2007

The headline news was Brexit didn’t seem to be having much effect on GDP growth, despite earlier pessimism from the Bank. Leavers have never forgiven the Bank for giving their pessimistic views on the immediate impact of Brexit during the campaign. There is also an attempt to suggest that because many macro forecasters have been surprised by the resilience of the economy since the vote that must mean that the near universal view of economists that Brexit will be bad in the medium term is also now very suspect. Anyone who knows about these things knows that an unconditional macro forecast is very different from a conditional forecast based largely on international trade evidence, but as most people do not know these things (including most political journalists) it is an effective bit of propaganda.

A major reason for the more optimistic forecast now is that consumers so far have decided to reduce their saving, which the Bank had not expected. One possible reason for this is that a lot of consumers have decided to undertake major purchases like buying a car to beat the coming price rises expected as a result of the depreciation. That alone would imply that the decline in the ratio is temporary, but as we shall see, the Bank is now expecting it to continue.

It is hard to forget a remark made to a fellow economist during the referendum campaign by the member of the audience in a public meeting in the North West. After this economist had talked about the beneficial effects of joining the Euro on GDP growth, they said something like ‘it may have helped your GDP but it hasn’t helped mine’. In that spirit I want to make two points that were generally ignored by the media in their reporting of this forecast.

First (as regular readers will know), GDP is the output of the country, not the output of an average member of that country. Although the ONS now releases estimates of GDP per head (or per capita as it is often known) with its GDP estimates, most journalists seem to have not noticed. One reason for the focus on aggregate GDP is that forecasters like the Bank continue to publish only aggregate figures.

The table above is an attempt to adjust the Bank of England’s forecast for expected growth in the population. I’ve basically just taken the average population growth rate for the last few years and projected it forward. That could be on the high side if immigration from the EU falls off substantially over the next few years, but this would probably only increase the numbers by another 0.25%. Growth of 1% in GDP per head does not sound so good, particularly when you note it is less than half the historic average.

Second, over the following few years even GDP per head is likely to not feel like ‘my GDP’. We can see this from the Bank’s forecast for real household income. These fail to get above 1% growth. The reason is something Leavers do not like to talk about, and which therefore many journalists ignore: the impact of the Brexit depreciation in sterling. As this depreciation gradually leads to inflation not matched by higher nominal wages, real income growth will suffer.

Why is forecast GDP growth so much higher than income growth? The Bank now expects consumers to reduce their savings to unprecedentedly low levels. Why would they do that? The Bank operates a model where consumers base their current consumption on anticipated future income, and where expectations are rational. If, as economists universally expect, Brexit leads to slower income growth in the future, consumers should have reacted to that by cutting current consumption because their future income will grow more slowly relative to pre-Brexit vote expectations. This they clearly have not done, in part because many of them do not believe future income growth will be reduced by Brexit. That is at the heart of the recent forecast revisions. But this leaves the Bank without any guide to how the savings ratio will evolve. If consumers continue to believe everything is OK, despite the short term fall in their income growth, then further falls in the savings ratio are possible.

Of course even these numbers for household income are also inflated by likely household growth. (They measure all income going to households, not the income of an average household.) The final row adjusts for the expected growth in households. The average household size has remained constant over the last decade, and I have assumed that continues. As you can see, the income of the average household is at best going to be flat, and may fall slightly. So to say, as some Leavers have, that this forecast suggests Brexit will have no effect before we leave is completely wrong.

So how is the score in the match going between Leavers and economists, where goals are actual events rather than clever soundbites. The last time we looked the Leavers had let in two goals: the depreciation in sterling immediately after the vote, and then the Bank having to bring rates down to their lower bound again and start another round of QE. Nothing since then suggests those goals were invalid. If I’m feeling generous I’d say having to revise up a forecast could count as a shot on goal, but as it reflects a mixture of policy and consumers saving less I think it is also a miss.

But there has been a new goal scored by the Leavers, but unfortunately in their own goal. It is now clear to those not dependent on Brexit propaganda that as a result of Brexit we are going to be a supplicant to probably the most dangerous and right wing US president ever. Truly awful. Should never have been president. Got 5 million less votes, and that’s not counting those stopped from voting. Complete fluke. Only got the votes he did because of a biased media and fake news. FBI is an absolute disgrace. Everyone agrees. He’s got to go. Some people are saying he is unstable. Others that he is a stooge of the far right. Impeach the guy. Truly awful. (Sorry, couldn’t resist)

Which all means, the score is now
Economists 3 Leavers 0

and we haven’t even reached half-time yet. But there may be a lot more goals to come when the negotiations conclude. If the economists keep scoring, we can avoid extra time, which is desirable because that only ends in 2030!