Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 30 August 2013

The New Keynesian model in grad school macro teaching

Despite appearances to the contrary, I do not think Krugman and DeLong actually disagree with me on the dominance or otherwise of the New Keynesian business cycle model in academia. I wrote:

“Yet in many who were part of the New Classical revolution, or who were taught by its leaders, there remains a deep antagonism to Keynesian ideas…. As a result, in certain places NK theory was tolerated rather than embraced, or was quietly marginalised.”

That was a key point of the post, although I admit I did take rather a long time getting there.

So I do not think there is any qualitative disagreement. The New Keynesian model is the dominant model of business cycles in central banks. In academia it is not dominant. Is it still the framework of first choice for the majority, as I suspect, or only about half of academics, as DeLong suggests? Impressions gained from non-random contacts or gatherings are not good evidence, so I was relying more on this survey, but that is just one particular sample. And it would be interesting to know results for other countries besides the US - particularly those that have chosen to embrace austerity or advocate it for others.

I did find some evidence from a survey of grad students undertaken by David Colander in 2005. This only covered the major US schools, but from Table 5 you will find that 22% of students from Chicago believed price rigidities were unimportant, while the equivalent number for Harvard was zero. 13% of Chicago students and 20% from Stanford disagreed that ‘fiscal policy can be an effective stabilizer’ (Table 6). But perhaps more revealing are some of the observations Colander makes in the text. Here is one.

“The students told me that the differences in policy views on macro that showed up in the survey did not reflect what they were taught about policy in macro, since they were taught almost nothing about macro policy, but reflected their undergraduate training. When asked about survey results showing that students at his school had changed their views on policy, one student stated, “I think that in the macro course we never talked about monetary or fiscal policy, although it might have been slipped in as a variable in one particular model, but that wasn’t the focus, so it didn’t come from the courses.” Another stated, “Monetary and fiscal policy are not abstract enough to be a question that would be answered in a macro course.”

I guess it might be possible to teach the NK model as if you were not talking about policy, but it would be an odd thing to do. 

For me this reaffirms Paul Krugman comment that, “It would be interesting to know how many graduate departments were in fact teaching New Keynesian macro in 2008”. Even if records on this are not immediately available, memories should still be reasonably fresh. And knowing what is taught in 2013 should at least give us a lower bound. A good indicator of academics’ views is what they teach or what they were taught. I don’t think this information has been collected by anyone, and I think it would be a valuable thing to do if anyone has the time. [1] What I am pretty sure about is that, in twenty years time, some people will write about this, and it would be nice for them to have some more concrete evidence: the time to collect it is now.

[1] I think the key number here should be the proportion of a core masters macro course that is devoted to New Keynesian analysis (i.e. any DSGE model with sticky prices, and policy analysis using that model). Obviously zero would be a very interesting finding, but one week out of twenty is also somewhat suggestive. Measurement is tricky of course, but my quick estimate of this number for the current Oxford MPhil, which would also apply to 2008, is around 20-30%.
Information on current teaching should either be available from the web, or available on request from the departments. However it would be interesting to try and collect information from recent students as a cross check. As one academic once told me: “I intended to cover NK economics but I just ran out of time”.    

Wednesday, 28 August 2013

Macro workers and macro wars

A long post I’m afraid, even with extensive use of footnotes. But I really think it is much more productive to try and understand someone’s opposing point of view than just be rude about it.

Most academic macroeconomists are just trying to advance the discipline by getting their papers published, and are certainly not consciously trying to defend some ideological viewpoint. As a result, there are lots of macroeconomists producing high quality work in a wide variety of diverse areas. There are many interesting new ideas being explored. Furthermore this work can be appreciated by most fellow researchers. Unlike the 60s and 70s, where members of different schools of thought talked across each other, we now have a shared language as a result of the microfoundation of macro. My own view is that as a result macro today is much more interesting than macro was back then. Furthermore, this work can be useful to policymakers, as Paul Krugman outlines in the case of monetary policy here.

Ahh - that may have made you pause for thought. Isn’t that the same Paul Krugman who says there is something “deeply wrong with economics”. Who talks about how ideology and politics distort the advice that economists - and perhaps particularly macroeconomists - give to policymakers. And who suggests that in many cases policymakers would be better off thinking about good old IS-LM than any of this more modern stuff.

One of the problems when Paul Krugman does this is that it gets on the nerves of many academic macroeconomists, who would much rather identify with the sentiments I express in my first paragraph. Economists like Tony Yates, for example. I suspect they see Paul Krugman’s attacks on the state of macroeconomics as akin to a personal attack on their own and colleagues work, and as a result they can go way over the top in reaction. I think this is understandable, but it is wrong.

As I see it both points of view are correct. As Stephen Williamson argues, in one sense macroeconomics is flourishing. Take the example of financial frictions. There is now a wealth of papers out there exploring different types of friction, in large part responding to events of just the last five years. This is hardly the response of a moribund, out of touch discipline. And as Krugman says, sometimes this work can be useful to policymakers. But that is not the acid test for the integrity of a supposedly scientific discipline. In days of old, policymakers made much use of astrology. The acid test is when the discipline tells policymakers something they do not want to hear, and unites behind this implication of its models and the data.

Nearly fifteen years ago I began working with DSGE models looking at monetary and fiscal interactions. [1] Doing this work taught me a lot about how fiscal policy worked in New Keynesian models. I understood more clearly why monetary policy was the stabilisation tool of choice in those models, but also why fiscal policy - appropriately designed - was also quite effective in that role if monetary policy was absent (individual countries in the Eurozone) or impaired (the ZLB). Why New Keynesian models? Because if you were interested in business cycle stabilisation, that is the framework that most involved in that area (academics and policymakers) were using. So when we hit the ZLB, the reaction of policymakers in using fiscal stimulus seemed logical, entirely appropriate and fully in line with current theory.

I also found that in these models the basics of Barro’s tax smoothing hypothesis continues to apply, so if you needed to reduce debt, you should do so as gradually as possible. This also seemed like as robust a result as one can get in macro.

The acid test for macro came in 2010. Policymakers, for a variety of reasons, went into reverse with fiscal policy. Austerity replaced stimulus around the world. If academic macroeconomists had been true to their discipline, they would have been united in saying that our standard models tell us this will reduce output and raise unemployment. They would have said that if markets allow, the time to reduce debt is when the ZLB comes to an end, and then it should be done gradually. Many did say that, but many did not. This division at least encouraged policymakers to continue with austerity.

So macroeconomists as a collective failed this test, repeating errors made in the 1930s. But unlike the 1930s, it did not have ignorance as an excuse. 

This is a crucial point that many on both sides tend to ignore. In 2010, the standard business cycle model was the New Keynesian model, and the implications of that model for the efficacy of appropriately designed fiscal policy are clear. So to blame the failure of 2010 on the current dominant macro model is just wrong. You may not like that model, but it cannot be blamed for the widespread adoption of austerity, or the ambivalent attitude of many macroeconomists towards that policy change.

So in my view macroeconomists, not the dominant macroeconomic model, failed. Why? The easy answer is to say that macroeconomists were too influenced by ideology, but I think for most (not all) it is the wrong answer, as I said in my opening paragraph. I think for most (not all) it is not simple politics, so in that respect I agree with Stephen Williamson. [2] So what is it?

Here is one possible answer. First I have to appeal to macroeconomists who learnt their trade after the New Classical revolution to consider where the now dominant methodology in macro came from. If you start your history of macro thought in 1980, then everything can seem nicely progressive. First there were RBC models, applying basic micro to macro. The data showed that this framework could not explain how monetary policy appeared to work, so to resolve this puzzle New Keynesian theory was developed.

But it was not like that at all. [3]

Macro started well before 1980. Its theoretical basis may have been shaky, but it was a scientific discipline in the Popperian sense. The New Classical revolution attempted to kill off Keynesian ideas, and deny the importance of aggregate demand. In that respect it now seems clear, because of the dominance of New Keynesian theory, that this was regressive rather than progressive. 
 
Yet in many who were part of the New Classical revolution, or who were taught by its leaders, there remains a deep antagonism to Keynesian ideas. This was not enough to prevent the emergence of New Keynesian theory, but the NK model built upon rather than challenged the RBC framework, and it could always be dismissed with an assertion about price flexibility. As a result, in certain places NK theory was tolerated rather than embraced, or was quietly marginalised.

This attitude was facilitated by another aspect of the revolution. Although it failed to kill Keynesian economics, it did succeed in changing how macro was done. Microfoundations macro did not just become an important way of explaining the economy, it became the only acceptable way. Now we can debate the wisdom of that. But I think it is very difficult to deny that this methodological revolution reduced the discipline that data can provide on model proliferation. It becomes far too easy to say ‘but in this model something different happens’, even if there is compelling empirical evidence that said model is not applicable. [4] [5]

I think this may help explain why a good proportion of macroeconomists failed to advocate fiscal stimulus in 2009 and call the consequences of subsequent austerity. [6] Now you may disagree with my view that this represented a failure for macroeconomists as a whole. What I want to convince you of here is that my view that it did, and perhaps similar views of others, does not amount to an assertion that modern macro is fundamentally flawed, and that those working within it are wasting their time. While the New Classical revolution may have moved macro many steps forward, in condemning Keynesian ideas it took one large step backwards, and the consequences of that mistake are still with us.



[1] In part this was a reaction to a different policy decision. The work of various economists before the formation of the Euro had suggested that countercyclical fiscal policy should be a key stabilisation tool for individual Eurozone members. That work was ignored by policymakers, and they were backed up by a significant number of macroeconomists, in part using other models that focused on free rider problems and fiscal dominance. How this all turned out is another story, but once again the collective of academic macroeconomists hardly covered itself in glory.

[2] Personally, I do not think the actions of some eminent economists who ignore their economics when batting for their favoured politicians is critical here, regrettable though it is. Nor on its own were the comments of other eminent macroeconomists who appeared not to have kept up with the literature, although as I suggest here I think this was indicative. Both could have been isolated examples, quickly brushed aside. More revealing is this survey, where although 46% of economists agreed that the US stimulus was a good policy, a large 40% were uncertain or did not answer. That is just one survey, but it reflects a similar division amongst the macroeconomists I know, and the views you find on the web. See, for example, the quote from Tom Sargent in Stephen Williamson’s post. Now I think some of this 40% are equivocal about fiscal stimulus (and therefore not too worried about austerity) because of a deep distrust of government intervention or the state. Whatever the merits of this mistrust, this is exactly the ideology and politics that Paul Krugman and I complain about. I think some others of this 40% take a view that monetary policy is still up to the job, even at the ZLB. I have talked about this most recently here. This post provides a third possible explanation, although I am sure there are others. (I tried to be comprehensive here.) 

[3] Getting the history of macro thought right is important for other reasons as well. As I suggested here, the structure of NK models may owe as much to the need to work with rather than against the then dominant RBC paradigm, as to any intrinsic empirical merits of that structure.

[4] I have tried to argue that economists working in central banks take more notice of the data, which helps explain why the NK model is dominant there, but Stephen Williamson disagrees.

[5] Another arguable consequence is that modelbuilding became too conformist. The charge that some element of a model is ad hoc and lacks microfoundations hangs like a Sword of Damocles over modelbuilders. Probably too much intolerance of alternative methodologies came with this revolution as well. I think this is part of any explanation of why so little work was done on financial frictions before 2008, as Mark Thoma suggests. Again I am not arguing that the methodology is wrong, but instead that it may have certain perhaps unintended and unfortunate consequences. In my own experience if you talk to many microeconomists about DSGE in macro they can be quite critical: for example about how narrow the micro used is, or how obsessed with technicalities the analysis can become. Sometimes they can be downright dismissive

[6] You could argue that ideology lay behind the New Classical revolution’s attempt to kill off Keynesian economics, and I do not really know enough to agree or disagree. What I do think is that most of those involved in the revolution thought that they were just exposing deficient theory, which in many cases they were.

  

Monday, 26 August 2013

Banks, economists and politicians: just follow the money

Economics rightly comes in for a lot of stick for failing to appreciate the possibility of a financial crash before 2007/8. However it is important to ask whether things would have been very different if it had. What has happened to financial regulation after the crash is a clear indication that it would have made very little difference.

There is one simple and straightforward measure that would go a long way to avoiding another global financial crisis, and that is to substantially increase the proportion of bank equity that banks are obliged to hold. This point is put forcibly, and in plain language, in a recent book by Admati and Hellwig: The Bankers New Clothes. (Here is a short NYT piece by Admati.) Admati and Hellwig suggest the proportion of the balance sheet that is backed by equity should be something like 25%, and other estimates for the optimal amount of bank equity come up with similar numbers. The numbers that regulators are intending to impose post-crisis are tiny in comparison.

It is worth quoting the first paragraph of a FT review by Martin Wolf of their book:

“The UK’s Independent Commission on Banking, of which I was a member, made a modest proposal: the proportion of the balance sheet of UK retail banks that has to be funded by equity, instead of debt, should be raised to 4 per cent. This would be just a percentage point above the figure suggested by the Basel Committee on Banking Supervision. The government rejected this, because of lobbying by the banks.”

Why are banks so reluctant to raise more equity capital? One reason is tax breaks that make finance using borrowing cheaper. But non-financial companies, that also have a choice between raising equity and borrowing to finance investment, typically use much more equity capital and less borrowing. If things go wrong, you can reduce dividends, but you still have to pay interest, so companies limit the amount of borrowing they do to reduce the risk of bankruptcy. But large banks are famously too big to fail. So someone else takes care of the bankruptcy risk - you and me. We effectively guarantee the borrowing that banks do. (If this is not clear, read chapter 9 of the book here.  The authors make a nice analogy with a rich aunt who offers to always guarantee your mortgage.)

The state guarantee is a huge, and ongoing, public subsidy to the banking sector. For large banks, it is of the same order of magnitude as the profits they make. We know where a large proportion of the profits go - into bonuses for those who work in those banks. The larger is the amount of equity capital that banks are forced to hold, the more the holders of that equity bear the cost of bank failure, and the less is the public subsidy. Seen in this way it becomes obvious why banks do not want to hold more equity capital - they rather like being subsidised by the state, so that the state can contribute to their bonuses. (Existing equity holders will also resist increasing equity capital, for reasons Carola Binder summarises based on the work of Admati and Hellwig and coauthors.)

This is why the argument is largely a no brainer for economists. [1] Most economists are instinctively against state subsidies, unless there are obvious externalities which they are countering. With banks the subsidy is not just an unwarranted transfer of resources, but it is also distorting the incentives for bankers to take risk, as we found out in 2007/8. Bankers make money when the risk pays off, and get bailed out by governments when it does not.

So why are economists being ignored by politicians? It is hardly because banks are popular with the public. The scale of the banking sector’s misdemeanours is incredible, as John Lanchester sets out here. I suspect many will think that banks are being treated lightly because politicians are concerned about choking off the recovery. Yet the argument that banks often make - holding equity capital represents money that is ‘tied up’ and so cannot be lent to firms and consumers - is simply nonsense. A more respectable argument is that holding much more equity capital would translate into greater costs for bank borrowers, but David Miles suggests the size of this effect would not be large. (See also Simon Johnson here, John Plender here and Thomas Hoenig here.) In any case, public subsidies are bound to be passed on to some extent, but that does not justify them. Politicians are busy trying to phase out public subsidies elsewhere, so why are banks so different?

There is one simple explanation. The power of the banking lobby (and the financial industry more generally) is immense, from campaign contributions to regulatory capture of various kinds. It would be nice to imagine that the UK was less vulnerable than the US in this respect, but there are good reasons to think otherwise. [2] As a result, the power and influence of banks and bankers within government has hardly suffered as a result of the Great Recession that they played a large part in creating.

So to return to my original question, would it really have made much difference if more mainstream economists had been fretting about the position of the financial sector before the crisis? I think they would have been ignored then even more than they are being ignored now. The single most effective way of avoiding another financial crisis is to reduce the political influence of the banking sector.      


[1] The optimum amount of equity is not 100%, in part because some (subsidised) borrowing does increase discipline on bankers. For a good discussion of other measures that might reduce the too big to fail problem, see this speech from Andy Haldane. An alternative to the state picking up the bill is to inflict losses on depositors, but the economic problems with this are pretty obvious. Nicolas Véron discusses the difficulties the Eurozone has got itself into with this following the Cyprus crash: see also Simon Johnson here.


[2] In Europe, we had what Mark Blyth describes as the biggest bait-and-switch operation in modern history, where a banking crisis involving private sector debts was turned into a public sector debt crisis. While I would be the last person to defend the macroeconomics status quo, I also think there is an element of bait and switch in the ‘macroeconomics in crisis’ idea. Macroeconomic theory tells us a lot of useful things about how to get out of the recession, if only politicians would take some notice.  

Saturday, 24 August 2013

Missing the point at the IMF

The IMF have just published a working paper entitled: ‘Assessing the Impact and Phasing of Multi-year
Fiscal Adjustment: A General Framework’. Or to put it more simply: should austerity be front loaded or delayed? A really important topic and one where the views of the IMF are of some importance.

I guess if you call anything a ‘General Framework’ you are taking a risk. But honestly, if you also write this

“our framework does not explicitly model the monetary policy response, which could have an important impact on output”

then you have no business using the word ‘Framework’, let alone ‘General’. [1]

We need to go through the logic one more time. When monetary policy is not constrained (we are not at the Zero Lower Bound), monetary policy can (and to a first approximation should) completely offset the impact of any fiscal consolidation. The multiplier in that case will be approximately zero. [2] However if we are at the ZLB, then within the current monetary policy framework (essentially inflation targeting), and unless you are really optimistic about unconventional policy, the ability of monetary policy to stimulate aggregate demand is severely compromised. As a result, any fiscal multiplier will be substantially greater than zero.

Now consider two periods. In the first, we are at the ZLB. In the following period, we are not. Consider two fiscal consolidation programmes. In the first, everything is front loaded into the first period. In the second, nothing happens in the first period, and all fiscal consolidation takes place in the second. Design the two programmes so that we end up with the same debt to GDP ratio by the end of the second period, so they are neutral in this respect.

What is the overall impact on output of the two programmes? Frontloading hits output in the ZLB period, with possible hysteresis effects in the second. Delaying consolidation until the second period has no impact on output whatsoever, because any impact on output is offset by monetary policy. Simple. So the choice is a no-brainer - you delay fiscal adjustment until the ZLB period has ended.

You would think that with these very dramatic implications for the optimal path for fiscal consolidation, allowing for monetary policy would have to be part of any ‘general framework’. Not the whole of any such framework, of course. You would want to consider the particular situation of countries without their own monetary policy. You would also want to consider countries where credibility was so low that delay would raise interest rates on debt (which the paper does do). And of course many countries are not at the ZLB. However some rather large ones are (like the US or the Eurozone as a whole), so ignoring monetary policy in any ‘general framework’ is just crazy.

What the paper does do is allow the size of the multiplier to vary with the output gap. Now you might think that this does something similar to allowing for a monetary policy response and the ZLB. However the way the paper sets things up it does not, because it fails to allow for the fact that outside the ZLB, monetary policy can offset the impact of fiscal policy. In their simulations the gradual (not front loaded) consolidation paths still involve large output losses, because they assume that without fiscal adjustment the output gap would be zero, so delaying fiscal adjustment creates a large negative output gap, which leads to a large multiplier. So this completely misses the idea that monetary policy could and should offset the impact of fiscal consolidation once we are well clear of the ZLB.

This is by now such an obvious and basic point I can only wonder why it is not incorporated into the analysis. By ignoring this point, what has been done is just inapplicable to some major economies. I do not like being so critical and blunt, but this is no academic debating point. And I would hate to think that this reasoning has been ignored precisely because its implications about the timing of fiscal consolidation are so clear.

[1] The paper says, immediately after the quote I give in the main text: "This is reflected implicitly in the fiscal multiplier assumptions in our framework (which can be allowed to vary with the output gap), but future work would be needed to explicitly integrate the monetary policy response into the picture." I discuss below why the 'reflected implicitly' is misleading, and also how the impact of monetary policy could have been captured quite simply.

[2] Approximately, because policy may be targeting inflation instead of or as well as output, and the inflation/output implications of monetary and fiscal policy may differ. It would be wrong in this case to say that multipliers would still be positive because monetary policy is not perfect (and to use something like a Taylor rule to reflect that). Here we are looking at planned fiscal consolidations, which the monetary authorities will know about well in advance. Of course uncertainty means that monetary policy makers will not exactly offset the impact of expected shocks, but they may over compensate (negative multiplier) as well as under compensate (positive multiplier). 

Friday, 23 August 2013

New Keynesian models and the labour market

Do all those using New Keynesian models have to believe everything in those models? To answer this question, you have to know the history of macroeconomic thought. I think the answer is also relevant to another frequently asked question, which is what the difference is between a ‘New Keynesian’ and an ‘Old Keynesian’?

You cannot understand macro today without going back to the New Classical revolution of the 1970s/80s. I often say that the war between traditional macro (Keynesian or Monetarist) and New Classical macro was won and lost on the battlefield of rational expectations. This was not just because rational expectations was such an innovative and refreshing idea, but also because the main weapon in the traditionalists armoury was so vulnerable to it. Take Friedman’s version of the Phillips curve, and replace adaptive expectations by rational expectations, and the traditional mainstream Keynesian story just fell apart. It really was no contest. (See Roger Farmer here, for example.)

I believe that revolution, and the microfoundations programme that lay behind it, brought huge improvements to macro. But it also led to a near death experience for Keynesian economics. I think it is fairly clear that this was one of the objectives of the revolution, and the winners of wars get to rewrite the rules. So getting Keynesian ideas back into macro was a slow process of attrition. The New Classical view was not overthrown but amended. New Keynesian models were RBC models plus sticky prices (and occasionally sticky wages), where stickiness was now microfounded (sort of). Yet from the New Classical point of view, New Keynesian analysis was not a fundamental threat to the revolution. It built upon their analysis, and could be easily dismissed with an assertion about price flexibility. Specifically NK models retained the labour leisure choice, which was at the heart of RBC analysis. Monetary policymakers were doing the Keynesian thing anyway, so little was being conceded in terms of policy. [1]

So labour supply choice and labour market clearing became part of the core New Keynesian model. Is this because all those who use New Keynesian models believe it is a good approximation to what happens in business cycles? I doubt it very much. However for many purposes allowing perfect labour markets does not matter too much. Sticky prices give you a distortion that monetary policy can attempt to negate by stabilising the business cycle. The position you are trying to stabilise towards is the outcome of an RBC model (natural levels), but in many cases that involves the same sort of stabilisation that would be familiar to more traditional Keynesians.

This is not to suggest that New Keynesians are closet traditionalists. Speaking for myself, I am much happier using rational expectations than anything adaptive, and I find it very difficult to think about consumption decisions without starting with an intertemporally optimising consumer. I also think Old Keynesians could be very confused about the relationship between aggregate supply and demand, whereas I find the New Keynesian approach both coherent and intuitive. However, the idea that labour markets clear in a recession is another matter. It is so obviously wrong (again, see Roger Farmer). So why did New Keynesian analysis not quickly abandon the labour market clearing assumption?

Part of the answer is the standard one: it is a useful simplifying assumption which does not give us misleading answers for some questions. However the reason for my initial excursion into macro history is because I think there was, and still is, another answer. If you want to stay within the mainstream, the less you raise the hackles of those who won the great macro war, the more chance you have of getting your paper published.

There are of course a number of standard ways of complicating the labour market in the baseline New Keynesian model. We can make the labour market imperfectly competitive, which allows involuntary unemployment to exist. We can assume wages are sticky, of course. We can add matching. But I would argue that none of these on its own gets close to realistically modelling unemployment in business cycles. In a recession, I doubt very much if unemployment would disappear if the unemployed spent an infinite amount of time searching. (I have always seen programmes designed to give job search assistance to the unemployed as trying to reduce the scaring effects of long term unemployment, rather than as a way of reducing aggregate unemployment in a recession.) To capture unemployment in the business cycle, we need rationing, as Pascal Michaillat argues here (AER article here). This is not an alternative to these other imperfections: to ‘support’ rationing we need some real wage rigidity, and Michaillat’s model incorporates matching. [2]

I think a rationing model of this type is what many ‘Old Keynesians’ had in mind when thinking about unemployment during a business cycle. If this is true, then in this particular sense I am much more of an Old Keynesian than a New Keynesian. The interesting question then becomes when this matters. When does a rationed labour market make a significant difference? I have two suggestions, one tentative and one less so. I am sure there are others.

The tentative suggestion concerns asymmetries. In the baseline NK model, booms are just the opposite of downturns - there is no fundamental asymmetry. Yet traditional measurement of business cycles, with talk of ‘productive potential’ and ‘capacity’, are implicitly based on a rather different conception of the cycle. A recent paper (Vox) by Antonio Fatás and Ilian Mihov takes a similar approach. (See also Paul Krugman here.) Now there is in fact an asymmetry implicit in the NK model: although imperfect competition means that firms may find it profitable to raise production and keep prices unchanged following ‘small’ increases in demand, at some point additional production is likely to become unprofitable. There is no equivalent point with falling demand. However that potential asymmetry is normally ignored. I suspect that a model of unemployment based on rationing will produce asymmetries which cannot be ignored.

The other area where modelling unemployment matters concerns welfare. As I have noted before, Woodford type derivations of social welfare give a low weight to the output gap relative to inflation. This is because the costs of working a bit less than the efficient level are small: what we lose in output we almost gain back in additional leisure. If we have unemployment because of rationing, those costs will rise just because of convexity. [3]

However I think there is a more subtle reason why models that treat cyclical unemployment as rationing should be more prevalent. It will allow New Keynesian economists to say that this is what they would ideally model, even when for reasons of tractability they can get away with simpler models where the labour market clears. Once you recognise that periods of rationing in the labour market are fairly common because economic downturns are common, and that to be on the wrong end of that rationing is very costly, you can see more clearly why the labour contract between a worker and a firm itself involves important asymmetries - asymmetries that firms would be tempted to exploit during a recession. 

Yet you have to ask, if I am right that this way of modelling unemployment is both more realistic and implicit in quite traditional ways of thinking, why is it so rare in the literature? Are we still in a situation where departures from the RBC paradigm have to be limited and non-threatening to the victors of the New Classical revolution?

[1] When, in a liquidity trap, macroeconomists started using these very same models to show that fiscal policy might be effective as a replacement for monetary policy, the response was very different. Countercyclical fiscal policy was something that New Classical economists had thought they had killed off for good.

[2] Some technical remarks.

(a) Indivisibility of labour, reflecting the observation (e.g. Shimer, 2010) that hours per worker are quite acyclical, has been used in RBC models: early examples include Hansen (1985) and Hansen and Wright (1992). Michaillat also assumes constant labour force participation, so the labour supply curve is vertical, and critically some real wage rigidity and diminishing returns.

(b) Consider a deterioration in technology. With flexible wages, we would get no rationing, because real wages would fall until all labour was employed. What if real wages were fixed? If we have constant returns to labour, then if anyone is employed, everyone would be employed, because hiring more workers is always profitable (mpl>w always). What Michaillat does is to allow diminishing returns (and a degree of wage flexibility): some workers will be employed, but after a point hiring becomes unprofitable, so rationing can occur.  

(c) Michaillat adds matching frictions to the model, so as productivity improves, rationing unemployment declines but frictional unemployment increases (as matches become more difficult). Michaillat’s model is not New Keynesian, as there is no price rigidity, but there is no reason why price rigidity could not be added. Blanchard and Gali (2010) is a NK model with matching frictions, but constant returns rules out rationing.

[3] I do not think they will rise enough, because in the standard formulation the unemployed are still ‘enjoying’ their additional leisure. One day macroeconomists will feel able to note that in reality most view the cost of being unemployed as far greater than its pecuniary cost less any benefit they get from their additional leisure time. This may be a result of a rational anticipation of future personal costs (e.g. here or here), or a more ‘behavioural’ status issue, but the evidence that it is there is undeniable. And please do not tell me that microfounding this unhappiness is hard - why should macro be the only place where behavioural economics is not allowed to enter!? (There is a literature on using wellbeing data to make valuations.) Once we have got this bit of reality (back?) into macro, it should be much more difficult for policymakers to give up on the unemployed.

References (some with links in the main text)

Olivier Blanchard & Jordi Galí (2010), Labor Markets and Monetary Policy: A New Keynesian Model with Unemployment,  American Economic Journal: Macroeconomics, vol. 2(2), pages 1-30

Hansen, Gary D (1985) “Indivisible Labour and the Business Cycle” Journal of Monetary Economics 16, 309-327

Hansen, Gary D and Wright, Randall (1992) “The Labour Market in Real Business Cycle Theory” Federal Reserve Bank of Minneapolis Quarterly Review 16, 2-12.

Pascal Michaillat (2012), Do Matching Frictions Explain Unemployment? Not in Bad Times, American Economic Review, vol. 102(4), pages 1721-50.

Shimer, R. ‘Labor Markets and Business Cycles’, Princeton, NJ: Princeton University Press, 2010.




Wednesday, 21 August 2013

Left, Right and Centre: some recent observations

I’m sure many political scientists hate the way descriptions in politics so often amount to a position on a straight line. It is one-dimensional. There is the obvious aggregation problem: should a person or political party, who is left of centre on issue X, and right of centre on issue Y, be described at generally in the middle of the political spectrum? How do we weight the importance of issues X and Y? But there is also a problem about whether positions are relative or absolute. This matters in part because the perception among many is that being near the middle is good (‘moderate’), and being away from the centre is bad (‘extreme’).

Three recent posts made me think about this. The first, by Noah Smith, is part of a current economics blog topic on Milton Friedman. I happen to pretty much agree with everything Noah says, but have absolutely no expertise on this - on matters of who thought what decades ago, I am curious but not interested enough to do any work. (Much better to leave it to David Glasner or Brad DeLong.) However it did strike me as obviously relevant to what has happened to the political centre, at least in the US.

One of Paul Krugman’s frequent complaints is that political commentators define the political centre as being somewhere between the Democrats and Republicans, regardless of the positions that each side take. He argues that the Republicans today are much more right wing than a generation ago, so that under this definition the centre today becomes what was right wing back then. This matters in part because the presumption is that the centre is the place for commentators to be.

Now one reaction might be: well he would say that, wouldn’t he. He is just trying to make his own views, which are ‘obviously’ to the left, sound more centrist than they actually are. But on economics at least, how politicians see Milton Friedman’s views provides some sort of objective yardstick. As Noah points out, some of Friedman’s positions would now be regarded as dangerously left wing by a good part of today’s Republican Party, whereas they were not so regarded 30 years ago.

The second post was my own, and the comments on it. It was about the increase in support for parties away from the centre in the UK and Netherlands, which I thought could be related to the recessions and austerity there, and more particularly to falling real wages. (Incidentally Robert Reich wrote a post on the same day making a similar argument about US politics.) I received many interesting comments on my post, and I want to thank everyone involved. A persistent theme was that I was wrong to call UKIP and the Freedom Party ‘far-right’, and imply any kind of equivalence to fascism.

I deliberately did not use the term fascist. Nor did I intend to imply that UKIP or the Freedom Party was fascist, or indeed that they were comparable - except to the extent that they are to the right of their respective and longer established mainstream right-of-centre parties. I used the term ‘far-right’ to denote this, as commentators often do, but I appreciate that many people read that as short for ‘furthest-right’ rather than the ‘farther-right’ that I had in mind.

I think many of these comments raised important issues. For example, would it make more sense to characterise UKIP and perhaps others not as a point on a left/right spectrum, but instead as specific issue parties? But the comments also revealed how sensitive people are to where the party they may support or sympathise with is placed on the political spectrum, and the obvious reason why. The endpoints of the political spectrum are typically defined by fascism and communism, and therefore the farther away you appear to be from those extremes, the better. Whether that is a deficiency or an advantage of this simple left/right model is an interesting question.

Why this may have a more substantial importance is illustrated by the third post, which involves think thanks in the UK. The right of centre think tank, the Centre for Policy Studies (CPS), had publicised its study into BBC bias, based in part on how the BBC uses different think tanks. [1] Part of their argument is that the BBC often calls left-of-centre think tanks ‘independent’, but mentions the ideological position of right wing think tanks. One of the think tanks it defines as left-of-centre is the Social Market Foundation (SMF). Yet, as this post from SMF complains, the SMF do not think of themselves as left-of-centre, and they provide evidence about why that description is wrong.

Now I have worried in the past about whether some think tanks are in the business producing propaganda instead of being in the business of thinking. So I cannot resist quoting the end of SMF’s post. “Especially on a significant issue of public debate - ie. public service broadcasting - think tanks owe a duty to follow the evidence. Or are CPS doing something slightly different than the normal work of a think tank? Without more evidence, I won't stick any other name on them for now.” The post is both short and amusing (unless you work for the CPS), so please have a look. [2]

Yet putting the thinking versus propaganda issue aside, this little tiff does illustrate why these issues can have immediate relevance. An organisation like the BBC tries very hard to be balanced. How you achieve balance depends in many cases on a judgement about where positions or organisations are on the left/right spectrum. The spectrum becomes like a balance scale, with the pivot right in the middle. So if you can persuade an organisation like the BBC that the mid-point is not where they thought it was, you can significantly change the content of their reporting and coverage. Or, even more seriously, if you can convince others that the BBC’s judgement is wrong, you can threaten their future.

If you think I’m being alarmist in this respect, here is how the director of the CPS ends his comment on their own research. “The most important [question] is why should everyone in the UK be forced to pay a poll tax to support an institution which has so conspicuously failed for so long to obey its founding principle of impartiality?” A serious charge if true, but is it true? It is clear that governments (of whatever colour) put a lot of pressure on the BBC, although measuring its effect is very difficult (although sometimes the circumstantial evidence is strong).

However some simple things can be measured, like how much coverage different political parties get. Of course coverage always tends to be biased towards the party in power. But, as Justin Lewis of Cardiff University’s School of Journalism notes, one study suggests that whereas in 2007 the margin between the Labour government and Conservative opposition was less than 2 to 1, the margin in 2012 favoured Cameron over Miliband by more than 3 to 1, with a ratio of more than 4 to 1 between Government and Shadow Ministers. So on this count, the people who should be claiming that the BBC is biased is Labour, not the Conservatives or the right. Are we in danger of entering that state of affairs where everyone just ‘knows’ that the BBC is biased to the left, just as everyone ‘knows’ that there is a liberal bias in the US media, without bothering with that annoying stuff called evidence?

Now one response to this emerging state of affairs is to ask why the left does not bang on about media bias the same way as the right does. Although with a coverage ratio of 1 to 4, perhaps they do, but we just do not get to hear about it.


[1] The publicity appeared to predate publication of the report, which seemed like a strange thing to do.


[2] The blog response from the CPS is also worth reading. As far as I can see, their reason for characterising the SMF as left of centre is that their objective is to “champion policy ideas which marry markets with social justice and take a pro-market rather than free-market approach.” So social justice in the context of a pro-market approach is left wing! One rather telling comment on the SMF post suggested that the CPS used transparency of funding sources as their guide to who was left or right wing. 

Tuesday, 20 August 2013

Measuring the cost of austerity

How do we count the cost of fiscal austerity? The most obvious question to ask, at least for a macroeconomist, is how much higher GDP would be without it. This is what Oscar Jorda and Alan Taylor did in some recent research, which I discussed in this post. All I did in my post was translate this percentage into the amount of output lost per household, because I think that kind of number is easier for non-economists to relate to.

Many macroeconomists today might point out that this is an overestimate of the true cost of austerity, because to the extent that we are collectively producing less because we are working less, we should offset this GDP number with the benefit of the extra leisure we are enjoying.

Many other people, including I hope some macroeconomists, might think that was just silly, and gets things the wrong way round. To the extent that this fall in GDP is associated with a rise in unemployment, that increase in unemployment does much more harm than the amount of goods that unemployed person might otherwise have produced. Chris Dillow has a useful post on this, and the evidence is in my view overwhelming. Exactly why macroeconomists continue to get this backwards will have to be the subject of another post.

David Stuckler, who is in the sociology department at Oxford but who I do not think I have ever met, looks more generally at the impact of austerity on health. Together with Sanjay Basu from Stanford, they have written a book called ‘The Body Economic: Why Austerity Kills’. There is a NYT OpEd by them here, a Mark Thoma synopsis here, and for those who like podcasts an interview (with transcript) here. What Stuckler and Basu do is essentially cross examine a large amount of health data across countries and across time, looking at the relationship between recessions and particular austerity measures with health, including deaths. The examples are varied and interesting: for example how improvements in child mortality and reductions in tuberculosis and whooping cough in the 1930s were correlated with the extent to which state governors embraced Roosevelt’s New Deal (will we see the same with Obamacare?), to how HIV has increased and malaria returned to Greece as a result of health cutbacks.

Of course what we are talking about here are particular forms of fiscal tightening: cuts to welfare and health programmes in particular, but more generally measures that hit the vulnerable poor rather than the rich. A programme to reduce government deficits that only involved increasing taxes on the reasonably well off would have a far less serious impact on health. Their book is also about how best to use public money to most effectively improve health outcomes, and how cutting this money in the short term not only has a negative impact on health, but can also raise costs in the longer run.

For this reason, it would be pointless to say that X amount of fiscal contraction leads on average to some Y deterioration in health outcomes. Nevertheless, the frustration the authors clearly feel is self evident. Talking of the UK government’s new regime for disability testing, they say “It was hard for us, as public health researchers, to understand the government’s position. The Department for Work and Pensions, after all, considered cheating a relatively minor issue.” Talking more generally of austerity, David Stuckler says: “These are massive uncontrolled experiments with entire populations. Had austerity been organised like a drug trial, with a board of ethics, it would have been discontinued, given evidence of its deadly side-effects and the failure of its purported economic benefits to accrue.”

Now some might say that because austerity need not necessarily involve measures that have large negative health outcomes, statements like this, and indeed the title of their book, is alarmist. This is similar to the Troika saying that they are quite right to insist on fiscal contraction so that the interest on Greek loans can be repaid, because it is up to the Greek government how it chooses to reduce its deficit. Typically, however, the same people who make that kind of excuse are also those who want to direct austerity to cutting spending rather than raising taxes, and who complain about the ‘burden’ of social programmes.

Let me end by quoting the conclusion of their New York Times article. “One need not be an economic ideologue — we certainly aren’t — to recognize that the price of austerity can be calculated in human lives. We are not exonerating poor policy decisions of the past or calling for universal debt forgiveness. It’s up to policy makers in America and Europe to figure out the right mix of fiscal and monetary policy. What we have found is that austerity — severe, immediate, indiscriminate cuts to social and health spending — is not only self-defeating, but fatal.”


Thursday, 15 August 2013

The wrong sort of recovery

First, I want to admit to a failure of imagination. Although I described this post as perhaps one of my better forecasts, I did get one important detail wrong. I said (in May 2012) that if there was a risk that UK growth would not come good by 2015, the Chancellor would apply additional stimulus measures, and I suggested investment incentives for firms as an example. That was a dumb example. I suggested it because I thought it made macroeconomic sense. Yet it was dumb because I also knew by then that this was not the way George Osborne thinks. I should instead have asked myself what stimulus measure would provide the best political advantage. And the obvious answer is to make it easier for people to buy houses, because this pushes up house prices. Now, as an economist, you might think rising house prices is the last thing we need, with UK house price to earnings ratios still very high (see below). But from a political point of view, if you are trying to get homeowners’ votes, it makes a lot of sense to engineer a short term increase in house prices, particularly if you make it immediately easier for those who want to buy to get ‘onto the ladder’.

So that is what the Chancellor did, with his ‘Help to Buy’ scheme, which either provides guarantees for a significant proportion of 95% mortgages, or provided top-up loans for up to 20% of the house price. Frances Coppola is shocked. She writes

“As my regular readers know, I am determinedly politically non-aligned, so what I am going to say now will probably shock a lot of people. Osborne's behaviour both angers and frightens me. He is playing brinkmanship with the UK economy to achieve political ends. Nothing he does makes much sense from an economic point of view - which is why the flagship Help to Buy scheme has been universally panned, even by his own department and by people from his own party. But if you view his actions as entirely determined by his desire to secure a Conservative victory in 2015, it all makes perfect sense. He is dangerous.”

As my regular readers will know, I’m afraid I very much agree. In my ‘final verdict’ on the Chancellor, I wrote “He is a political tactician, who time and again has put party political gain ahead of the economic interests of the economy.” (That should have been ‘of the country’, but you know what I meant.)

However, as I always like to try to think well of this government’s macroeconomic policy, let me put the argument that getting a recovery by making it easier to borrow money to buy houses makes some sense. It goes something like this. An important reason why the recovery so far has been anaemic is that UK banks are broken. So they are being far too cautious in lending for house purchase. In particular, they are worried that house prices could well fall, and they do not want to pick up the tab if this happens. If you think that is a distortion (because you think they are being too risk averse), then Help to Buy just corrects that distortion. In addition, there are good reasons why one of the byproducts of this scheme might be a boost to aggregate demand.

What is wrong with this argument? While the idea that UK banks are being excessively risk averse in their lending to small businesses is quite plausible, the argument applied to housing is not. The chart below is Nationwide’s first time buyer house price to mean gross earnings ratio.



It has fallen as a result of the recession, but remains historically very high. There are two obvious reasons why it is so high: an inability over the last decade or two to increase housing supply in line with demand, and the fact that interest rates are currently very low. It is a clear objective of government policy to remove barriers to increasing supply, and at some point in the not too distant future interest rates are likely to rise. There is therefore a significant chance that in the medium term real house prices will fall. So it is quite reasonable that banks want to transfer that risk on to someone else.

Now you could say why shouldn’t that someone else be the government? What does it matter if at some point in the future taxes are raised or spending cut to pay for the losses the government will incur on these schemes. If it gets us a recovery, that is a cost worth paying. And that is half right. After all, fiscal stimulus involves spending now, but paying for that with higher taxes or lower spending later. Yet this comparison shows how wrong this scheme is. If we borrow now to increase public investment, then when taxes are higher in the future to pay back that borrowing we have something to show for it. If taxes go up in the future to cover the defaults on loans made to house buyers, we have nothing.

So I think Frances is exactly right. The Chancellor is a very skilled political operator, and with schemes like this the UK is in danger of enjoying another five years of bad economic decisions designed to gain party political advantage.


  

Wednesday, 14 August 2013

Why the Pigou Effect does not get you out of a liquidity trap

For macroeconomists

This issue has surfaced again (see Krugman and Rowe). I wrote a post awhile back on this, but it was quite difficult (for me at least!), so here is an attempt to restate the key conclusions more directly. Ashok Rao has a post covering some of the same themes as my earlier post. The key point here is that I am going to follow Nick in saying that money is different from bonds because money is irredeemable, but even then the Pigou effect is not a magic bullet that gets us out of a liquidity trap.

How is the Pigou effect supposed to get you out of a liquidity trap? In a liquidity trap nominal interest rates are at zero (ZLB). However pretty well everyone agrees that if by some means the monetary authority could induce higher inflation expectations, then the ZLB could be overcome, because real interest rates would fall, stimulating demand. That is a real interest rate effect. It is what some people think Friedman had in mind when he was so critical of Fed policy in the Great Depression. (I have no idea if this is true.) It is what Michael Woodford argues the Fed should now promise to mitigate the impact of the ZLB. It is what Paul Krugman recommended Japan do to get out of the lost decade. But none of these things is the Pigou effect.

The Pigou effect is when the authorities keep the current stock of money constant, and falling prices mean that its real value increases. The idea is that at some point people feel sufficiently wealthier that they spend more, which adds to demand. For this to work, we have to assume that the nominal stock of money will remain unchanged, unaffected by falling prices. Now you might say fine, let’s assume that. But if you do, you might also agree that the fall in prices is temporary. Simple neutrality implies that if you hold the money stock constant, falling prices today will mean higher prices tomorrow. But we have already established that in that case you do not need a Pigou effect, because higher inflation tomorrow at the ZLB will mean lower real interest rates, and you get the demand stimulus the good old real interest rate route. Furthermore, if people understand that prices will rise, they are not really wealthier in an intertemporal sense, because their extra real money balances will be inflated away. If you like, they save their extra real money balances today to pay for future inflation taxes. [1]

The alternative case is where future inflation does not increase as current prices fall - as would happen if the monetary authority targeted future inflation for example, and did not raise that target as prices fell. That would imply that the current nominal money stock was not fixed, because to prevent future inflation rising, the monetary authority must at some stage reduce the nominal stock of money - long run neutrality again. How does it do that without raising interest rates? It could raise taxes. But if it did that, then Ricardian consumers would not think of their higher real balances today as wealth, because this would be offset by future tax increases.

The central bank could reduce the money stock by selling some of its government debt. But under the conditions that Ricardian Equivalence holds, that has the same effect. Now the government will have to raise taxes to pay the interest on that debt, whereas before any interest they did pay came straight back via the central bank.

We can sum this up rather neatly, as Willem Buiter did here with the aid of lots of maths, by saying that what matters is the terminal stock of money, not its current value. The government can only make people feel wealthier by printing money if people believe that the increase in its real value is permanent.

We can apply the same reasoning to a helicopter drop. The first issue is whether issuing money to pay for a tax cut is any different from issuing bonds, and in particular does Ricardian Equivalence apply? Now macroeconomists are confused on this (see my earlier post), but here I’m happy to follow Nick and agree that money financing is different, because money is not redeemable. So a permanent helicopter drop of money will tend to increase consumption. To put it another way, the Ricardian Equivalence mechanism does not apply to a helicopter drop.

However there is another, more economy wide mechanism. If long run neutrality holds, and if people understand this, they will realise that their extra wealth will eventually be inflated away, so they are no better off. (Equivalently, their tax gain today will be offset by a higher inflation tax at some point.) But those expectations of higher inflation, if we are stuck in a liquidity trap, will shift consumption to the present, so the helicopter drop increases demand through a real interest rate mechanism.

The bottom line is that we can forget about the Pigou effect as a way out of the liquidity trap, at least in what is now our baseline macro model. What is important for the liquidity trap is expectations about future monetary policy. If monetary policy allows future inflation to rise, and expectations are rational, we can get out of the trap. If they do not, then we stay in the trap until some other force gets us out. That force will not be the Pigou effect.

[1] What if neutrality does not hold? Neutrality is pretty basic, but for the sake of argument let’s briefly consider this. Consumers are now wealthier, because they have more real money with no future costs to come. However I have the following problem if we stick with intertemporal consumers of the Ricardian type, who only consume the annuity value of any increase in their wealth. When do these agents consume their new found wealth? Any answer except never appears to violate consumption smoothing.


Monday, 12 August 2013

The Centre Cannot Hold?

Everyone knows about the return of extremist politics as a result of austerity in Greece. (Paul Mason’s reporting has been particularly strong over the last few years.) The link between economic depression and far right extremism in the 1930s is also well documented. Yet I suspect there is a tendency to assume that this kind of thing only happens in ‘immature’ democracies.  This assumption is wrong, as both the Netherlands and the UK currently show.

The Netherlands has been run by a parliament since at least 1848. Coalitions are the norm rather than the exception, and there is a general desire to achieve consensus on important political issues. Before the formation of the Euro, the extreme right in the Netherlands could be described (pdf) as marginal, which was not the case in France for example. Yet recent opinion polls suggest that if elections were held now, the far right Freedom Party would become the largest party in parliament. The left wing Socialists have also been taking support away from the centre-left Labour Party. What the two extreme parties have in common compared to the mainstream is opposition to further fiscal austerity.

So far, there has been a depressing consensus among the more centrist political parties in the Netherlands that they need to follow the Eurozone’s fiscal rules.  The economy is in recession: GDP fell by 1% in 2012, and will probably fall by a similar amount this year.  Unemployment is rising: the Chart below shows OECD forecasts and also OECD estimates of the output gap. Of course this has increased the budget deficit, and so we have had a series of austerity measures in an attempt to keep the deficit at 3% of GDP to stay within the Eurozone’s fiscal rules. [1] When the Freedom Party, which was part of a right wing coalition, refused to support these cuts in 2012, they were passed by a coalition of the centre, egged on by the European Commission.

OECD Economic Outlook Estimates for the Netherlands

Of course the Netherlands, unlike Greece or Ireland or Portugal, has no problem funding its budget deficits, so here austerity is very much a political choice. Recent polls suggest the public has had enough, and that as a result support for the Euro itself is suffering. The union movement has been active in its opposition, but more recently prominent business organisations have also begun to question austerity, although predictably their opposition has focused on tax increases rather than cuts to welfare.  Coen Teulings, who departed as head of the highly respected CPB in April, was vocal in his opposition to recent cuts, but the central bank has been much more supportive of austerity.

The UK has also seen the emergence of a politically successful far-right party: UKIP. This is also unusual from a historical perspective: since Oswald Mosley the UK has a proud tradition of resisting parties of the far right. UKIP’s popularity is not normally linked directly to austerity, but instead to widespread hostility to both immigration and the European Union. As a result, the Conservative Party has taken economically damaging positions on both issues in an attempt to reduce UKIP’s appeal. Chris Bertram at Crooked Timber recounts in detail the sorry state of the UK ‘debate’ on immigration. Yet the link between concerns about immigration on the one hand and unemployment and low wages on the other is fairly obvious. Despite all the valiant attempts by Jonathan Portes and others to focus on the evidence, this is one of those cases where the combination of tabloid media hype, partisan political advantage and ‘common sense’ normally wins, and as a result the UK Labour Party seems to spend much of its time trying to ape the Conservatives.

Why has support for the far-right grown in the UK and the Netherlands, while in France for example the far-right did not make a breakthrough in 2012? No doubt a complete answer would be quite complex. However it is worth noting that the UK and the Netherlands have both experienced sharp falls in real wages in the recent past. The OECD expects real compensation per employee to have declined by a total of about 4.5% in the three years 2011-13 in the Netherlands, and by about 5% in the UK. The decline in the Euro area as a whole has been much smaller, at less than 2%. In France real wages have increased a little in all three years. Figures recently calculated by the House of Commons library show a similar picture, with only Greece and Portugal doing as badly as the UK and Netherlands since mid-2010. [2]

In both the UK and the Netherlands we have recession and fiscal austerity, where the recession has been associated with marked falls in real wages as well as increases in unemployment. In both cases I would argue that there has been no effective opposition to fiscal austerity from the political centre, which helps encourage support for the political extremes. But that is probably as far as the similarity goes, because the position of the centre-left Labour Party in the two countries is very different.

In the UK the Labour Party is in opposition. It seems their general tactic on issues like austerity or immigration is not to question the underlying assumptions on which government policy is based. Perhaps the idea is to avoid being branded as irresponsible (austerity) or out of touch (immigration), while hoping to retain the support of those who do strongly oppose government policy. This position has so far been tenable partly because there is no strong party to the left of Labour. We may have to wait until 2015 to see if this strategy is successful.

The position of the Labour Party in the Netherlands is more immediately problematic. It is now part of the coalition enacting cuts.  The Socialist Party, which is to the left of Labour and which does not support austerity, has moved ahead of Labour in the polls. In April there was a ‘social accord’, where the unions and business groups signed up to the budget deal proposed by the government. Further cuts are now required beyond those agreed in April to meet the fiscal rules, and the unions (and perhaps business leaders) are now actively campaigning against austerity.  Yet it will be hard for the centre-right to ask Brussels for a reprieve, as their leader and Prime Minister, Mark Rutte, has followed Germany in taking a hard line on the 3% deficit limit and the Commission’s enforcement of it.  The reasons for Labour to back additional austerity are much less clear.

So in the Netherlands and elsewhere in Europe, on the issue of the stupidity of pro-cyclical fiscal policy, it is only the views of politicians on the far-left or far-right that matches those of the majority of macroeconomists.  Given the social, economic and political consequences of declining real wages and rising unemployment, which fiscal austerity only makes worse, this is both a very sad and rather dangerous state of affairs.

[1] Yes, this is the actual balance. The OECD estimate that the underlying primary deficit was 1.4% of GDP in 2012, will be 0.1% in 2013, and in surplus in 2014. I think those economists who suggested that the new Eurozone Fiscal Compact would be more enlightened than the old rules need to ask themselves why that has not happened. 


[2] Of course Germany has also avoided falls in real wages. In Germany there is a clear consensus among the parties of the centre for imposing austerity on others! While Merkel’s position is well known, Andrew Watt discusses here how the macroeconomic position of the centre-left SPD goes from bad to worse.