Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday 21 September 2015

What do macroeconomists know anyway?

In an article in the Independent today I argue that what goes for a ‘credible’ economic policy among politicians and the media is often very different from what an academic economist might describe as credible. Which invites the obvious response: who cares, what do academic economists know anyway? So I look at what I regard as the three major macroeconomic policy disasters in the UK over the last 35 years, and one success.

The success was the decision not to join the Euro in 2003. It is pretty clear that this was the right decision, and it was made after what may have been the most extensive academic consultation ever undertaken by the Treasury, coupled with substantial macro analysis. (I talk more about this here.) The Prime Minister Tony Blair was initially in favour of joining, but the analysis helped persuade him otherwise.

The first failure was Mrs. Thatcher’s monetarism, which was famously opposed by 364 economists. Those on the right have tried to spin this as a failure by the economists, but the actual policy framework of money supply targets was a complete disaster and was quickly abandoned, never to be tried again. (Here is a discussion, and here is an account from one of the two movers behind the letter.)

Current austerity we all know about: if not, read this.

The third disaster was the UK’s entry into the European Exchange Rate Mechanism (ERM) in 1990 at an overvalued exchange rate, and the subsequent recession and forced exit in 1992. My argument that this went against macroeconomic analysis needs some justification. At the time I was in charge of macroeconomic research at the National Institute (NIESR) in London, and I undertook with colleagues what was easily the most extensive analysis of the consequence of entry into the ERM at different exchange rates. This was subsequently published in 1991, but all the material was first presented before we entered the ERM.

We concluded that the UK’s actual entry rate was 10-15% above the equilibrium rate. The implication was unavoidable: either we would be forced out, or trying to stay would lead to a recession as part of an ‘internal devaluation’. I remember Sam Brittan, one of the main writers at the FT at the time, saying that he thought we had won the intellectual argument, but that his instinct was still that we should enter at a high rate.

After entry into the ERM the UK entered a recession, and we were then forced out just two years later. Our analysis was vindicated. It is true that the whole system eventually collapsed as a consequence of the tight monetary policy that followed German unification, but it is no accident that the UK was the first to go (Black Wednesday). On leaving the ERM sterling depreciated by 10%, and the UK recovered quickly from recession.

There is no doubt that had the Treasury taken our advice and entered at a lower rate, less jobs would have been needlessly lost. I have often wondered if I could have done things differently to make a more persuasive case. But honestly I doubt it: the almost macho appeal of entering at a ‘strong’ rate was too great, together with the idea that the market knew best. As I say in The Independent, macroeconomists are far from perfect, but the UK evidence suggests that you ignore their advice at your peril.


  1. "The Prime Minister Tony Blair was initially in favour of joining, but the analysis helped persuade him otherwise."

    Source for this claim please.

    The more generally held view (or perhaps it is a myth?) is that Blair was in favour, Brown against, and Brown blocked him.

    1. Labour's 1997 manifesto promised a referendum as a pre-condition of joining the euro. At no stage could any such referendum have been won. Blair knew this better than anyone.

      I think the highest that can be claimed for the academic consultation is that it meant that Blair couldn't start on a campaign to try and sell euro entry as he wished to do. (This is what he says in A Journey.)

    2. I think that is encompassed by the term 'persuaded'. And I do not think it makes any difference to the point I'm making.

    3. I think it does.

      The dispute was a political one between Brown and Blair. Blair wanted in. Brown didn't. The academics were drafted in to provide Brown with ammunition in this dispute and to stop Blair from starting on his campaign of persuasion.

      The picture you painted was one of high minded ministers persuaded by the evidence presented by the academics and deferring to them. That wasn't the truth. The truth was that the decision was political all the way down: the obstacles of the promised referendum and an obdurate and powerful Chancellor were too great. The advice was just ammunition in a fight to which you were not party.

      I was and am a fan of the Blair government, but I don't believe its decision making is accurately characterised in the way you do here (see Blair's memoir, unless he is lying).

    4. The picture I paint ... No, the picture you imagined I painted. I wrote: the analysis helped persuade him otherwise. That is quite compatible with a Prime Minister who has a political view, and is prevented from pursuing it by the weight of economic evidence.

      So you have read Blair's memoir. I was actually there, with access to many of the main actors involved. The economic evidence mattered. If it had come out clearly supporting entry, we would probably have joined. So it is a clear example of economics winning out over economics. They do not happen often, which is why I cherish events when it does.

  2. Your definition of "credible" from the Independent: "A natural way to define a credible economic policy is one that accords with what most economists think. "

    Perhaps, but if you just go with the credible policies, you can never have any innovation. So, arguably, the Thatcher monetarist money-supply approach to running an economy was discredited, as was too high an exchange rate for ERM, and so is the austerity approach to running the economy. But all were innovative, a change from previous ways of doing things.

    And, crucially, there will always be an economist who will defend these policies. And politicians will pick them to support their case. Now all 3 of these policies will have had distributive effects. All made the rich even richer. It always increase unemployment, which will reduce wages, as bargaining power shrinks.

    Even Osborne's austerity comes with very crass exceptions, no austerity for the people who had to pay 50% income tax, Osborne made sure they now pay 40% again.

    Or last July he doubled the money people can get tax relief on when paying into a personal pension, from £40,000 to £80,000 (until the end of this tax year). Now, clearly, that is not a policy of austerity, as most people will not even earn £40,000, let alone be able to put anything like that into a pension fund.

    Or selling off Royal Mail to a significant part to Osborne's best man. Where was the austerity there?

    So all these Tory policies helped the top 10% or top 1%.

    So credible economic policies on the whole help to take money away from the 10% or 1%, not the other way around, as that is the ultimate aim of any fiscal policy. Government is there to redistribute.

    Now all these 3 policies (targetting money supply, ERM membership, austerity) are innovations, but so is PQE (or Overt Monetary Financing). The first three re-distribute to the top, the last one takes interest income away from the providers of government finance, so re-distributes to the masses from the top. From that point of view it is an innovative, re-distributive, progressive and therefore credible policy.

    It is time to embrace some of these overt monetary financing mechanisms (PQE, helicopter money) and make them all into credible policies.

    1. "but if you just go with the credible policies, you can never have any innovation" No. Central bank independence in the UK was an innovation which reflected movements in the academic consensus. You may not like it, but it was an innovation.

    2. It's true that there were more innovations though? That doesn't really contradict it.

  3. I have put this on here before, but shall do so again.

    BBC email from their complaints department sent to me 28/11/2013 referring the BBC's Daily Politics programme:

    ‘Please find below the transcript of the link read by Jo Coburn, as requested: “Well, it’s hard enough to get economists to agree on anything, but back in 1981, more than 360 of them concurred that Thatcherite policies would end in financial calamity. Events are generally held to have proved them wrong. A similar debate has been taking place amongst economists in recent years over George Osborne's prescription for the economy. With the flatlining economy, those arguing that his austerity package is similarly flawed had felt vindicated, but have recent signs of promising growth changed the economic weather? Here’s David.” Thanks once again for taking the time to contact us.’

    On the BBC's website you can refer to the article 'Were 364 economists all wrong?' by Stephanie Flanders, then Economics Editor, BBC Newsnight from March, 2006.

    Incidentally, Flanders left the BBC in September 2013 for JP Morgan Asset Management.

  4. So recently I've suggested that CBI independence is problematic because the influence of people in the financial industry creates pressure to undershoot the inflation target. Krugman has more on that today.

    In that vein, I think it's worth considering that the "macho" push to a "strong pound" is not just an issue of testosterone, it has also been a persistent bias in policymaking that has favoured the interests of the financial sector over (for example) manufacturing. That's a long term trend across the Thatcher years and I think the ERM entry level needs to be seen with that taken into account.

  5. Although you're clearly correct about the ERM and the attempts to monitor the money supply in the early 80s, the case against austerity is (at best) unproven. All the attempts thus far (either supporting or against austerity) are very much based on a "post hoc ergo propter hoc" argument, with absolutely no attempt to establish causality.

    1. We will never be able to experiment on an economy the way a chemist can carry out an experiment. However, as far as we can draw any conclusions, austerity doesn't work.

    2. To my knowledge, the case against austerity is at least as well-proven as others, if not more.

      See here for an excellent paper, which aims for an experiment-like approach given data limitations:

      And a more detailed discussion, including the UK experience, in Jorda-Taylor, which has been covered by Simon on this blog.

    3. Yes, I'm fully aware of the Guarjado et al paper (and the final version that was published in 2013 as well). However, the approach in that paper is typical of all others looking into the impact of austerity - they only include a tiny number of short-run lags of growth and the fiscal measure and, as such, do not control for any other differences across countries that could vary over time. As such, any implications drawn from these models cannot be used to infer causality.

    4. Hi Rohan, this is anon from 3:54.

      Are you aware of any studies that do not find a negative impact of austerity, and use a better specification than the ones above, that you so easily dismiss?

      Re Gujarado et al and Jorda/Taylor: I think a) constructing a good narrative variable with a large number of observations is way more than decent in terms of establishing causality, b) using that narrative variable as an instrument, and complementing with inverse propensity score weighting, as Jorda-Taylor do, is even better. So I don't buy your rejection of causal claims, so far. Yes, it is difficult to establish causality in macro, but as far as things go, the studies of austerity are pretty decent. Surely not much worse than e.g. ERM?

      Regarding your point on controls, even the Gujarado et al study does a number of robustness checks with various controls and lag structure. And Jorda-Taylor further deal with this in their IPSW. So in the end we have a well-identified shock, and a number of controls for bias on observables, which looks pretty good to me.

    5. But "austerity" is a very amply misused word! So there can be cases for and against "austerity" that are both valid, with different meanings of the word.

      The meaning that fits with the original keynesian discussion is more or less "letting domestic demand by the government fall during a recession caused by a fall in total demand to below its sustainable level". That is failing in maintaining effective demand at its best sustainable level when in a "general glut" (the qualifications all matter enormously).

      Some people seem to use it as "smaller government deficits in any circumstance whatsoever"; I have the impression that SimonWL uses it that way, as he rather strangely seemed to think that Greece was in "austerity" in 2010-2014.

      There are cases, like a balance sheet recession (as opposed to a falling demand one), in which some form of austerity properly defined is inevitable, however unpleasant that is, else there would not be the conditions that caused a balance sheet recession, and the sooner the better, because the costs of balance sheet recessions mount rapidly with time.

      But in general the case for anti-austerity, properly defined, policy is overwhelming on both theoretical and empirical grounds.

  6. It seems to me that the public confidence in what 'economists' say is low largely because they believe that academic economists failed to predict the crash in 2008. It's a bit odd that your Ind article has no mention of any instances where most economists were wrong: has this never happened?

    1. I think economists' involvement in financial regulation is pretty minimal. As far as I can see the financial deregulation that allowed this to happen was largely a result of industry lobbying. True, one very well known economists rubbished the idea that a crisis could happen, but he has also said other contentious things in his time. The main point is that financial sector regulation is not mainstream macro. The episodes I mention are.

    2. "I think economists' involvement in financial regulation is pretty minimal. "

      Sadly, even Hyman Minsky would probably be forced to agree.

      However, if "financial sector regulation is not mainstream macro" then the problem is not that macroeconomists know nothing, it is that they don't appear to know enough to run an economy holistically. Compartmentalising economics may make sense from an academic standpoint, but it leads to disjoined policy making from a practical standpoint.

  7. What was the general view among academic economists on the ERM? You mention that the consultation in 2003 was against Euro membership, but as I understand it the general consensus in 1990 was that Thatcher was being intransigent by delaying ERM entry for so long; however, I don't know what academic economists in general thought during that period, other than that those against covered a wide theoretical spectrum.

    I think that there's more than a bit of spin there regarding the letter of the 364. You say-

    "The first failure was Mrs. Thatcher’s monetarism, which was famously opposed by 364 economists. Those on the right have tried to spin this as a failure by the economists, but the actual policy framework of money supply targets was a complete disaster and was quickly abandoned, never to be tried again."

    There's truth there, but not the whole truth. (And it's hardly surprising that Robert Neild takes the view he does!) Let's look at the actual letter-

    "The following statement on economic policy has been signed by 364 university economists in Britain, whose names are given on the attached list:

    We, who are all present or retired members of the economics staffs of British universities, are convinced that:

    (a) there is no basis in economic theory or supporting evidence for the Government's belief that by deflating demand they will bring inflation permanently under control and thereby induce an automatic recovery in output and employment.

    (b) present policies will deepen the depression, erode the industrial base of our economy and threaten its social and political stability.

    (c) there are alternative policies; and

    (d) the time has come to reject monetarist policies and consider urgently which alternative offers the best hope of sustained recovery."

    So the letter had more to say that just rejecting monetarism, which was one sentence of the letter. The reason why the letter fell into disrepute was not spin by the right, but because-

    (i) Early 1981 marked the trough of the UK's early 1980s recession- - and manufacturing output bottomed out around the time of the letter- . As an exercise in macroeconomic prediction, the letter was an embarrassment.

    (ii) The first claim of the letter, (a), makes sense if one remembers that cost-push inflation theory still rode high in the UK. Frank Hahn was making waves by disputing the link between inflation and expansionary monetary policy. It was also written before Volcker brought down US inflation in 1981-1982. I'm fascinated to hear your views on whether or not (a) is true.

    Several points on the other post of yours that you link to-

    (1) "Inflation came down rapidly, perhaps more rapidly than was intended."

    On the RPI index, inflation was 18% in 1980 (above that of 1979) 11.9% in 1981 and 8.6% in 1982. It was then stable at 4.6% and 5% in 1983 and 1984. While Labour had set a target of 5% inflation by mid-1982 in their 1979 manifesto, the Tories made no comparable commitment. The government's NGDP forecasts seem to have been roughly fulfilled: NGDP growth was aimed to be about 9.6% in 1982-1983, and the outrun was 9.2%; see Burns in "Keynes and Economic Policy: The Relevance of the General Theory after Fifty years". Nelson and Batini (2005) note that the actual path to this level of NGDP growth was marked by OVERSHOOTS, not undershoots.

    1. (2) You mention, as the 1981 letter did not, hysteresis. However, regardless of the general empirical support for hysteresis in other countries, it does not seem to have been an important factor in the 1980s in Britain. The stylized fact of a "jobless recovery" from mid-1981 onwards, in which employment rose but unemployment stayed steady (itself inconsistent with the letter of the 364) was based on measurement problems due fluctuations in the participation rate. Pissardies (2003) corrects for changes in the participation rate. The resulting figures for unemployment rate suggest that unemployment rose from 1979-1983 as inflation fell, and by more than standard figures would suggest, but then fell steadily after 1983, without the plateau that would suggest hysteresis.

      The UK natural rate of unemployment did rise in the 1980s, but hysteresis resulting from the early 1980s recession is not required to account for this fact. Instead, skills-mismatch due to deindustrialisation, regional disparities, and demographic change seem to be better explanations of persistent unemployment during that period than hysteresis, as well as why the trend of the natural rate was increasing even in the 1970s. This isn't dismissing the hysteresis hypothesis, but questioning its effect size in the UK in that period.

      Finally, on a small nitpicking point:

      "the actual policy framework of money supply targets was a complete disaster and was quickly abandoned"

      The first part of this is true, but the latter part isn't quite right under either interpretation that comes to my mind: if you mean that the money supply ceased to play a major role in macroeconomic decisions after April 1981, then that's too late, because as early as July 1980 interest rate decisions can no longer be rationalised in terms of official monetary targets, and it was Jurg Niehans and Alan Walters who seem to have changed Thatcher's views away from £M3 in this period. From "The Downing Street Years" -

      "Professor Niehans' report which I read in early February, though framed in highly technical language, had a clear message. It was that North Sea oil had probably not been a major factor in sterling's appreciation; rather, tight monetary policy had caused the pound to rise so high, imposing such pressure on British industry and deepening the recession. The report argued that we should use the monetary base rather than £M3 as the main monetary measure and suggested that we should allow it to rise in the first half of 1981. In short, Professor Niehans thought monetary policy was too tight and should quickly be loosened. Alan emphatically agreed with him...

      Far from being deflationary, our budget would have the reverse effect: by cutting government borrowing and over time easing the monetary squeeze, it would allow interest rates and the exchange rate to fall, both of which had created severe difficulties for industry..."

      I agree with your view in your other post-

      "Was it right, given hindsight, to switch off the automatic stabilisers in 1981? In very simplistic terms you can argue both ways."

      - but what the 364 did not predict was what would actually happen.

      You also have to be careful about when you are talking about. The NIESR did not cover itself in glory in the early 1970s, but UK macroeconomics has thankfully travelled a long way since those dark days.

    2. There's also the danger of what Wittgenstein called a "one-sided diet of examples". I'm not sure how well UK macroeconomists were warning about excess demand in 1987-1988, which was admittedly a smaller failure than the others you mention. (Assuming, for the sake of argument, that you are correct re: the Coalition's fiscal tightening.)

      I agree with your overall point, but I would put it this way: UK academic economists are not good precise predictors of the future, but since the theoretical revolutions of the 1970s-1990s, they have become much better at giving good general advice. I would add that insofar as academic economists appear partisan, they will tend to find themselves dismissed in the same way that partisan think-tanks tend to be dismissed; this is unfair, because there's no reason why all parties should have equal shares of wisdom and folly, but it's something that we all have to live with, e.g. I'm coming across as partisan in this comment and I'm not surprised if people will dismiss what I say on those grounds.

      I have been interested, talking to some UK academic macroeconomists, to see who is and isn't prepared to stick to the views that they had a few months ago on central bank independence and monetized fiscal spending. To the credit of almost all of them, they've stuck to their guns and endured the (sometimes very cruel) criticism that came from others in the discussion.

    3. W Peden
      You are very kind to those 364 economists. The only one of their four statements that isn't Krugmanesque in its ultimate ability to mean anything is (b). And the ridiculously alarmist and over the top (b) was proven wrong. Ergo the 364 were proven wrong.

    4. James Alexander,

      I don't think that's quite fair. A key message they had was that the government should abandon £M3 targeting, and they could have know that the government was doing just that. That doesn't mean that monetary targets would be abandoned, though: the monetary base in particular played a role in UK macroeconomic policymaking up until 1985, after which a pickup in base growth from 1986-1988 was largely ignored and things like the DM exchange rate began to be the focus.

      Part of the reason for the vagueness may have been that UK macro was in ferment in the 1980s, so if they said something more specific than "There are alternative policies", then they would have had fewer signatures. As it was, there were UK academics who were approached and turned it down because the letter was hubristic after the failures of forecasting of the 1970s.

    5. Something which is often forgotten when discussing the 1981 budget is that there was a 2% cut in base rate and the exchange rate was allowed to slide in the next few months (20% against the $) the combination of which represented a very considerable loosening in monetary conditions

    6. I'd be wary about judging monetary conditions using the nominal base rate, especially when inflation was falling. Monetary base growth, which fell steadily in 1980, steadied in 1981, and the old reserve requirement was replaced by an ad hoc system of bank's own reserve targeting.

      The modern Keynesian position would be that while these measures more or less offset the contractionary effects of the 1981 budget, they were not available in 2010-2015, and so monetary offset could not apply in this period.

    7. In (a) the uses of the words "permanently" and "automatically" provide lots of wiggle room;
      in (c) there are always "alternative policies";
      in (d) "monetarist policies" can have many varieties.
      It was quite like the recent 90-odd economist attacking George Osborne, that S W-L signed for the general drift and then disowned for any actual content.
      I still get your point, though.

  8. "After entry into the ERM the UK entered a recession, and we were then forced out just two years later. Our analysis was vindicated. It is true that the whole system eventually collapsed as a consequence of the tight monetary policy that followed German unification, but it is no accident that the UK was the first to go (Black Wednesday). On leaving the ERM sterling depreciated by 10%, and the UK recovered quickly from recession."

    Isn't that another argument for Grexit?

    1. A Grexit would be a good idea, but there are a lot of differences between the UK in 1992 and Greece in 2015. For one thing, our government/bank liabilities were denominated in our own currency. The Euro is like Birmingham: once you're in, it's hard to drive out, even if it would be beneficial overall.

  9. Politicians will usually do what suits their underlying objective,even if they dress up the way they are doing it. The underlying objective of the Tories, or at least the Chancellor, is to shrink the state and to put out to private tender a large range of public services. Austerity is a way of achieving this although it is being undertaken 'in the national economic interest'. I fear that evidence based policies and certainly policies based on economic theories will only ever be followed if they feed into the political aims of those in power. I suspect reading Krugman that the same is true the world over.

  10. In a blog post titled "What do macroeconomists know anyway?" I cannot let pass a very recent statement:

    «The first is obviously welfare reducing,»

    The theorem of the second best precludes any statement as to welfare, especially any beginning «obviously», and especially coming from a professor of economic policy who seems to believe in microfounded new keynesian theories.

    More generally the theorem of the second best perhaps should prevent any involvement in economic policy by microfoundationalist new keynesians, but stranger things have happened :-).

  11. Dear Prof. Wren-Lewis,

    Don't you think it is time to write a post in defence of Michael Foot and how much better things would have turned out if he had not lost against That Ghastly Woman?

    After all, a main line of criticism against Jeremy Corbyn will be the claim that he is nothing but Foot's reincarnation and that that is enough to condemn him.

    1. I've tried very hard, but I cannot see how this relates to this post, or indeed any post I have ever written.

    2. Anon,

    3. Dear Prof. Wren-Lewis,

      In your "Independent" article, your first sentence predicts criricisms of Corbyn's economic policy based on credibility.

      In my comment, I pointed out another line of coming criticisms.

      It seems to me that they require a similar refutation, and time is of the essence.

      Don't you agree?

  12. «in defence of Michael Foot and how much better things would have turned out»

    Dear Jeremy :-) thanks for commenting anonymously here, the problem was not M Foot and his preferred policies, the problem was the labour insiders who were fronted by M Foot and their preferred policies. Just like in the infamous miners strike the problem was not the miners, but A Scargill and his clique.

    They all made even That Ghastly Woman and the economic policies of the clique she fronted look like the lesser evil even to many working class people, and it took a lot of «resolutionary socialism» to achieve that.

    And then her clique bought the loyalty of a large chunk of the working class, especially those close to retirement or retired, with huge tax-free effort-free Right-To-Buy profits, and the rest is history (New Labour's :->).

    1. Corbyn is said to want to reinstate the power of the Unions in his party. If Foot fronted the unions then, what can we expect from Corbyn?

  13. By the way, Simon, I'm about halfway through your chapter in "The New Consensus in Macroeconomics". I'm really enjoying it thus far, especially the comparisons between how central bank models were built in the 1980s and how the BoE DSGE model in the mid-Noughties was developed. I also thought your hypothesis regarding the decline of "school of thought" macro (except on internet comments boards!) seems correct.

    1. Although I think when I wrote that I overestimated the extent to which freshwater macro had been converted to New Keynesian ideas.

    2. That's probably true for the most part, although even there it seems to vary, e.g. I seem to recall that even Robert Lucas presenting a fairly New Keynesian analysis of the Great Recession at one point in a talk.

  14. As a coda to this, we might look at Krugman's recent blasting of Andrew Sentance.
    Which of course brings me back to the problem with an independent central bank.
    This man was on the MPC?


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