Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 13 January 2017

Miles on Haldane on Economics in Crises

Anything that says economics is in crisis always gets a lot of attention, particularly after Brexit (because economists are so pessimistic about its outcome), and Andy Haldane’s public comments were no exception. But former Monetary Policy Committee colleague David Miles has hit back, saying Haldane is wrong and economics is not in crisis. David is right, but (perhaps inevitably) he slightly overstates his case.

First an obvious point that is beyond dispute. Economics is much more than macroeconomics and finance. Look at an economics department, and you will typically find less than 20% are macroeconomists, and in some departments there can be just a single macroeconomist. Those working on labour economics, experimental economics, behavioural economics, public economics, microeconomic theory and applied microeconomics, econometric theory, industrial economics and so on would not have felt their sub-discipline was remotely challenged by the financial crisis.

David Miles is also right that economists have not found it difficult to explain the basic story of the financial crisis from the tools that they already had at their disposal. Here I will tell again a story about an ESRC seminar held at the Bank of England about whether other subjects like the physical sciences could tell economists anything useful post-crisis. It was by invitation only, Andy Haldane was there throughout, and for some reason I was there and asked to give my impressions at the end. In the background document there was a picture a bit like this.
UK Bank leverage: ratio of total assets to shareholder claims. (Source Bank of England Financial Stability Report June 2012) Added by popular request 17/1/17 [3]

I made what I hope is a correct observation. Show most economists a version of this chart just before the crisis, and they would have become very concerned. Some might have had their concern reduced by assurances and stories about how new risk management techniques made the huge increase in leverage seen in the years just before the crisis perfectly safe, but I think most would not. In particular, many macroeconomists would have said what about systemic risk?

The problem before the financial crisis was that hardly anyone looked at this data. There is one institution that surely would have looked at this like this data, and that was the Bank of England. As Peter Doyle writes:

“ .. it was not “economics” that missed the GFC, but, dare I say it (and amongst some others), the Bank of England.”

If there is a discussion of the increase in bank leverage and the consequent risks to the economy in any Inflation Reports in 2006 and 2007 I missed it. I do not think we have been given a real account of why the Bank missed what was going on: who looked at the data, who discussed it etc. I think we should know, if only for history’s sake.

What I think David Miles could have said but didn’t is that macroeconomists were at fault in taking the financial sector for granted, and therefore typically not including key finance to real interactions in their models. [1] As a result, the crisis has inspired a wave of new research that tries to make up for that, but this involves using existing ideas and applying them to macroeconomic models. There has also been new work using new techniques that has tried to look at network effects, which Andy Haldane mentions here. Whether this work could be usefully applied much more widely, as he suggests, is not yet clear, and to say that until that happens there is a crisis in economics is just silly.

The failure to forecast that consumers after the Brexit vote would reduce their savings ratio is a typical kind of forecasting error. Would they have done this anyway, and if not what about the Brexit vote and its aftermath inspired it, we will probably never know for sure. This kind of mistake happens all the time in macro forecasting, which is why comparisons to weather forecasting and Michael Fish are not really apt. [2] That is what David Miles means by saying it is a non-event.

What is hardly ever said, so I make no apologies for doing so once more, is that macroeconomic theory has in some ways ‘had a good crisis’. Basic Keynesian macroeconomic theory says you don’t worry about borrowing in a recession because interest rates will not rise, and they have not. New Keynesian theory says creating loads of new money will not lead to runaway inflation and it has not. Above all else, macroeconomic theory and most evidence said that the turn to austerity in 2010 would delay or weaken the recovery and that is exactly what happened. As Paul Krugman often says, it is quite rare for macroeconomics to be so fundamentally tested, and it passed that test. We should be talking not about a phoney crisis in economics, but why policy makers today have ignored economics, and thereby lost their citizens' the equivalent of a lot of money.

[1] In the COMPACT model I built in the early 1990s, credit conditions played an important role in consumption decisions, reflecting the work of John Muellbauer. But as I set out here, proposals to continue the model and develop further financial/real linkages were rejected by economists and the ESRC because it was not a DSGE model.

[2] Weather forecasts for the next few days are more accurate than macro forecasts, although perhaps longer term forecasts are more comparable. But more fundamentally, while the weather is a highly complex system like the economy. It is made up of physical processes that are predictable in a way human behaviour will never be. As a result, I doubt that simply having more data will have much impact on the ability to forecast the economy.

[3] Total asset are the size of the bank's balance sheet. Shareholder claims are the part of those assets that belong to shareholder, and which therefore represent a cushion that can absorb losses without the bank facing bankruptcy. So at the peak of the financial crisis, banks had over 60 times as many assets as that cushion. That makes a bank very vulnerable to loss on those assets.

15 comments:

  1. Whilst I take your point (one made regularly by members the science community), how mainstream was Rogoff's work and did Osborne take it fully on board or cherrypick for ideological purposes?

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  2. Knowing who said what and to whom in the run-up to the 2008 crisis in the BoE is critical to understand what happened.

    When 'Mervyn King: Britain better off going for hard Brexit' (Guardian, Rowena Mason, Monday 26 December 2016) is being said, I want to know he is making that comment from some sort of knowledge not because he is trying to avoid a 2008 reputation that is fully deserved.

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  3. «In the COMPACT model I built in the early 1990s, credit conditions played an important role in consumption decisions, reflecting the work of John Muellbauer. But as I set out here, proposals to continue the model and develop further financial/real linkages were rejected by economists and the ESRC because it was not a DSGE model.»

    Every time I read your recollection of this I feel your "dismay", and it saddens me.

    «Peter Doyle writes: “ .. it was not “economics” that missed the GFC, but, dare I say it (and amongst some others), the Bank of England.”»

    The Bank of England is not the "loyal opposition", it cannot come out and undermine the government's policy. As to "economics", quite a few economists were well aware of that graph and other similar macroeconomic conditions: after all "Barber boom" and "Lawson bubble" are terms that have been used for more than 20 years, and *theoretically* "economics" members at large are rather more free to speak out than those at Bank of England can be, and some of them did, even if often ridiculed or detested as spoilsports.

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    1. "Every time I read your recollection of this I feel your "dismay", and it saddens me."

      Agreed. Let's all come together now to stop the right wing.

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  4. Thanks for putting this up Simon.

    Concerning the comparison with the weather, as I understand it, weather forecasts for more than 5 days in the future, aren't very reliable at all. But a common popular misunderstanding is that the macro predictions are based on scaling up micro predictions. The assumption is that in a system that is chaotic on the micro level it is absurd to predict anything at the macro level.

    So to move on to climate, climatologists cannot with any confidence predict which years over the next 10 years will show greatest global warming. Hot and cool or less hot years are entirely impossible to predict. However, they can predict with a very high level of confidence that in 30 years time global average temperatures will have significantly increased and within quite a strongly defined range.

    Systems that are entirely chaotic on the micro level can often be a lot more predictable at the macro level. It seems to me there are many parallels with the Brexit predictions. Exactly what would happen immediately after the Brexit vote was almost totally unforeseeable but the negatives that will almost certainly show themselves over the next 10 years are more easily predicted.

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  5. From a macromedia perspective it might be that the current run of attacks shown in the media are more founded on the fear that Keynesian economists got so much of the last 6 years right; so a pre-emptive attack to discredit new and Keynesian economists.

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  6. You miss the elephant in the room.

    And so does Haldane, let alone Miles, to a big extent. It is not true to say that economics performed well before the crisis. If it did there would not have been a crisis. What would have been more useful: understandingthe long run trends of capitalism as explained by pre-Samuelson writers like Marx (that explain wide divergences in inequality and deindustrialisation) and Minsky, or Lucas and Sargent with sticky prices? If Haldane had really read Minsky he would know that the Great Moderation was not a time when economies or economics performed well. It was during this time that the seeds for the crisis and the post-crisis crash environment were being sown. You blame austerity for a weak recovery and stagnation after 2008. But if you were historically literate you would be very sceptical about what conventional macro-economic stabilisation policy would be able to achieve. Most likely it would not fix deeply rooted industrial and social problems. Far more radical solutions are required.

    NK.

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  7. It would be good to know what the chart is showing. What is the ratio? Debt to GDP? For which country?

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  8. For non-expert readers, a chart heading, or explanation within the text of what it is, would have been helpful.

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  9. A key difference between the weather and the economy is that atmospheric entities are not reading the weather forecasts, nor constructing their own. There are profound epistemological problems with forecasting the properties of systems containing intelligent, adaptive entities, able to anticipate and pre-empt the interventions of forecasting policy-makers.

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  10. Simon - just a quick question. I can't access the David Miles article (behind a paywall for me). I was wondering if that would make the graph easier to understand to a lay reader like myself.

    Could you just explain a little more on what that graph indicates to you.

    Thanks

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    1. The image is titled bank leverage.

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  11. May I add my voice to ask for a description/definition of the chart. I assume it's actually just a failure of the posting method, but to build an article around the impact of a chart, without mentioning what the chart is showing, is either carelessness or the height of arrogance "if you don't know already you wouldn't understand."

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  12. "Basic Keynesian macroeconomic theory says you don’t worry about borrowing in a recession because interest rates will not rise, and they have not."

    This is rather disingenuous. Rates didn't rise because politicians were more concerned about making sure rates didn't rise than they were about maximising borrowing. The fear was sovereign default. That is why we had austerity and it is the paradox of Keynesianism as I have outlined here (http://cantab83.blogspot.co.uk/2016/08/who-is-afraid-of-bond-market-paradox-of.html).

    If you want to ensure that governments can borrow whatever they need to in a recession without worrying about the bond market or sovereign default then you have to ensure that they only borrow from their own central bank. A government can't go bankrupt if its debt is owned by its own citizens or institutions (see Japan). This policy would also have other associated benefits such as reducing the current account deficit and lowering the exchange rate.

    "New Keynesian theory says creating loads of new money will not lead to runaway inflation and it has not."

    In fact inflation during the recession and post-recession has been too low. If we had had more inflation then spending would have recovered faster and so would the economy. Which of course brings us back to MMT and financing the borrowing by printing money and not using the bond market.

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