The Chancellor continues his steady fiscal tightening

A few things you probably won’t read about what the Chancellor announced yesterday. You will have read that the budget measures as a whole amounts to a significant fiscal giveaway. In which case the following chart may appear surprising.

Negative numbers represent a current budget surplus, and growing surpluses are a fiscal tightening. You can see that with the exception of this fiscal year, when policy is tighter, the current balance profile of rising surpluses has not changed very much. The reason for this apparent contradiction is simple enough. If nothing had been done, the higher taxes than forecast represents a significant fiscal tightening compared to previous expectations, albeit a tightening that represents forecast error rather than policy decisions. [1] What the Chancellor did yesterday from next year onwards is restore the policy stance to what it was before the forecast error was discovered.

What this means is that the Chancellor has kept his path of modest fiscal tightening over the next five years, As I have said many times, this is simply not appropriate in a situation where interest rates are close to their lower bound and the immediate outlook is highly uncertain. But then this government has never understood about monetary and fiscal coordination.

Labour’s fiscal credibility rule (fcr) allows us to see how differently a Labour government would run the non-investment part of fiscal policy. The ficr requires the government to aim for current balance in 5 years time. That, of course, is zero on this chart. That tells you that, if this is indeed the path the current balance follows, Labour will have extra spending or lower taxes than the Conservatives worth over 1% of GDP. That covers the gap the IFS suggested in their costings from the 2017 manifesto with plenty left over.

As I have already suggested, Labour’s overall fiscal stance if they stick to the fcr makes a lot more sense The Conservatives are trying to reduce the level of debt to GDP by too much prematurely. That does not make sense from a precautionary Keynesian point of view, or from a simple tax/consumption smoothing point of view. But macroeconomics remains an excluded consideration from Conservative/Treasury budgets, and mediamacro pretends the government is just like a household that needs to pay off its debts within its lifetime.  

[1] Suppose the forecast error was X. Then imagine that error had not occurred, but the Chancellor had raised taxes by X. The latter would clearly be a fiscal tightening by the Chancellor. But in macroeconomic terms taxes rise by X in each case, so the two are equivalent.

Why should someone who is anti-austerity care about debt

Most of the posts I have written about austerity have been aimed at countering the idea that in a recession you need to bring down government deficits and therefore debt. But what if you accept all that (you are anti-austerity). Why should you care about debt at all? Why do we have fiscal rules based on deficits? Why not spend what the government needs to spend, and not worry that this resulted in a larger budget deficit?

The story often given is that the markets will impose some limit on what the government will be able to borrow, because if debt gets ‘too high’ in relation to GDP markets will start demanding a higher return. You can see why that argument is problematic by asking why interest rates on government debt would need to be higher. The most obvious reason is default risk. But for a country that can create its own currency there is never any necessity to default.

However there is another reason to demand a higher nominal interest rate on debt, and that is if you think there will be additional inflation in the country. Spending more without raising taxes will tends to increase inflation. But if the government or central bank is sure to raise interest rates to offset this inflationary pressure then the concern about inflation disappears.

In MMT inflation is also the fundamental constraint on how far you can raise spending without raising taxes. MMT also says that you do not need to worry about the deficit, but this is only true if - as they advocate - fiscal policy rather than monetary policy controls demand and inflation. Under MMT the link between the deficit and inflation is direct (assuming no change in the composition of either) .

When inflation is controlled using interest rates the situation is fundamentally different. There is now no single point at which the deficit is consistent with stable inflation. In the short term there are a whole range of interest rate/deficit combinations that keep inflation stable today (e.g. high deficit and high interest rates or low deficit and low interest rate). Does this mean we do not need to worry about the deficit and the debt it leads to because monetary policy will always take care of inflation?

The answer is no, if we think about dynamics. What happens if we choose a high deficit high interest rate combination because we want higher government spending without paying more in taxes? There are two important dynamic effects here. The most basic is that a high deficit raises the stock of government debt. Because of interest rate payments on that debt the deficit rises further. In addition raising interest rates to stop inflation will itself tend to raise debt interest payments. This is an unstable debt interest spiral. You cannot say why not fund the additional debt interest payments by creating money, because that will tend to reduce interest rates and raise inflation.

This means that over the longer term you have to adjust spending and taxes to keep government debt relative to GDP stable, That does not mean debt has to be stabilised at a particular level, but just that if there is not a compelling reason to do otherwise you need to keep debt stable rather than rising upwards. A recession is one such compelling reason, and there are others (like adding to the public sectors stock of assets).

Stability does not mean deficits have to be zero because we have to allow for the growth in GDP. The maths is simple (see [1]). Take the stock of debt to GDP as a fraction of GDP (say 0.8), multiply by the trend rate of growth of nominal GDP as a fraction (say 0.04), and you approximately have what the total deficit should be as a fraction of GDP to keep debt stable (0.032), which is a deficit of 3.2% of GDP. .

There is always the temptation for politicians to raise debt now, and let future governments stabilise debt at a higher level. In the past the US under Republicans and other countries (but not the UK) tended to let this happen in the 30 years before the GFC, and economists call it deficit bias. Fiscal rules began life because it was hoped they would reduce deficit bias.

So why not raise the level of debt by spending more for a period, and then stabilise it by cutting spending or raising taxes a generation later? Here we have to note that the stabilising deficit (the deficit that keeps debt to GDP stable) includes debt interest payment. What we call the primary deficit is the total deficit less interest payments, You should now be able to see the problem with allowing debt to increase and stabilising it later. If you raise the level of debt to GDP and then stabilise it, debt interest payments will be higher and the level of the primary deficit left over is smaller than the one you started with. This is one sense in which letting debt rise today takes from future generations. [2]

This is why it is never a good idea to increase the stock of government debt without good reason, as Trump is doing, because it either cuts spending or raises taxes in the long run. This logic does not mean that future GDP is any lower (although there may be other theoretical reasons why higher debt can reduce output), but it means that if debt to GDP is stabilised, debt interest rates will be higher and so something else has to adjust to compensate, which means higher taxes or lower spending. [3]

There is an important caveat to this dynamic, which becomes clear if you do the maths. You only get a debt interest spiral if the nominal interest rate exceeds the growth rate of GDP (call the difference between the two the ‘very real interest rate’). If the very real interest rate is negative, extra debt for a given deficit allows a higher primary balance. Journalists sometimes look at the level of debt interest as a share of GDP (currently 2% in the UK) and say government spending could be 2% of GDP higher (or taxes lower) if we didn’t have to pay interest on debt. But if you could somehow magic your debt to zero so debt interest rates were zero, the stabilising deficit would fall from a current level around 3% to 0, requiring a 3% fall in the primary balance. This reflects that the current very real interest rate is negative.

Does this mean we do not have to worry about the debt interest rate spiral, and therefore debt? Only if we know that the very real interest rate will stay negative. This is unlikely to happen, particularly if interest rates are having to rise to combat the inflationary effects of high deficits. Because debt levels should never be adjusted down quickly, it is best to act as if the very real interest rate will become positive at some point.

This is not the only reason why raising government debt to GDP in the long run can be detrimental, but this one is simple because it depends only on some basic economics, algebra and logic. This and other reasons will never be enough to justify cutting deficits in recessions, not even close. But being anti-austerity does not mean we can forget about debt completely, as long as we are using interest rates rather than fiscal policy to control demand. (On why you might want to do that see here.)

[1] G is government spending, T taxes, r is the nominal interest rate, and B the stock of debt. Little letters mean as a ratio of nominal GDP (Y). x is the growth rate of nominal GDP, delta means change in. We ignore money for reasons given in the text. The budget identity is

G - T + rB = deficit = delta B

So dividing by GDP gives

g - t + rb = deficit/Y

In continuous time (or approximately otherwise) we can write

deficit/Y = delta b + xb

So for delta b to be zero, deficit/Y = xb

Or equivalently g - t + (r-x)b = 0

[2] More strictly in this case it takes from future generations the benefits of public spending or adds to the cost of taxes, and transfers it to bond holders.

The day Theresa May lied in parliament about something I wrote

When I became part of John McDonnell’s Economic Advisory Council I knew that would put me in the political spotlight. I write about what I helped achieve in that role in my forthcoming book. I left over Labour’s support for Brexit in part because my clear and public anti-Brexit views could be used to attack Labour, when the people driving Brexit were Conservatives. I found out yesterday that at PMQs the Prime Minister was carrying on regardless, although in this case it was over Labour’s 2017 manifesto.

In reality I was strongly supportive of Labour’s overall fiscal stance in 2017. I wrote a lot in my blog before the election, and a summary of my views are in a chapter in a book of essays by various authors published by Verso and edited by John McDonnell. The point I wanted to stress was that it didn’t matter if the IFS were right that the numbers didn’t add up, because the fiscal stance was good for the economy, and could well satisfy Labour's very good Fiscal Credibility Rule.

The paragraph that says all this in the book starts

“Let us suppose the IFS was correct, …”

and I go to argue in that case that the ex ante deficit would have boosted the economy and it might not have added to the deficit ex post.

Unfortunately she said, holding a copy of the book in her hand

“In an article by an economic adviser to the Labour Party, he says about their manifesto, “the numbers did not add up”. That this was a “welcome feature” and “largely irrelevant”Well it may be irrelevant to the Rt Hon Gentleman and the Shadow Chancellor but it’s not irrelevant to the people’s whose taxes go up, whose jobs are lost and whose taxes pay Labour’s debt”

Nowhere in the article did I say I thought the numbers did not add up. I was clearly misquoted. If you say otherwise, imagine I write an article that says ‘suppose austerity is expansionary’ and go on to explain how that generates consequences that contradict reality. It is called a proof by contradiction, and that is similar to the structure of my argument. To report that I said “austerity is expansionary’” would be ridiculous. If it was done to score political points you would conclude it was a lie.

Was this an unfortunate case of misreading? It seems extremely implausible. I’m certain that when the PM or more probably some adviser misquotes someone in a draft PMQ response, someone - possibly even the person themselves - checks that the quote is correct. You have to have serious comprehension difficulties to misunderstand the meaning of “Let us suppose”.

So I tweeted this

“Apparently the Prime Minister quoted me saying about Labour's 2017 manifesto "the numbers did not add up" In fact I said "Let us suppose the IFS was correct" and examined consequences. I have never taken a view on whether they did/didn't add up. If that is what she said, she lied”

I later looked at a recording of PMQs and she did indeed say that. Now maybe I am wrong about a deliberately lie told to gain political effect. If it was an honest mistake she or someone who works for her can explain to me how that mistake was made. I asked CCHQ for an apology, but I am not holding my breath.

The Mirror picked it up here, as did the BBC in their PMQ factcheck. In the scheme of things the issue is very minor, but the Prime Minister lying whatever the context should be important. But the sad thing is that no one is surprised by this kind of thing any more. We in the UK look at Trump’s lying with horror and think this is something uniquely American. But this government has been pulled up countless times (e.g. here) for misleading the public by misusing statistics and of course the lies of the Brexiters are shameless. The majority of press titles will ignore or play down any criticism of Conservative ministers or the PM (unless it is over Brexit), and the BBC is timid to say the least. It is asymmetrical of course: any mistakes the other side makes are examined in great detail. If you do not have the media to call out lies, they will pass as the truth and democracy dies.

MMT and Labour’s fiscal rule

I’m afraid this will probably only interest those familiar with MMT, but in its favour it has to me at least a surprising end. Bill Mitchell has been criticising Labour’s fiscal rule for some time, and my work that lay behind it (with Jonathan Portes) in particular. In one posts he says “Wren-Lewis just should stick to Twitter. He seems to like that. It would save us the time reading the other stuff.” In his latest post on the subject, after he met John McDonnell and his team, involves general assertions that the rule is neoliberal, but he does have two concrete criticisms. He has the following objection to a current balance target.

“But as I’ve written many times in the past, if a nation encounters a serious recession that results in a significant deficit, and then within the last years of the rolling window, it may have to introduce major cuts in recurrent outlays in order to move the recurrent balance towards zero.”

Now that is a cogent criticism of a fixed date rule, which does suffer from the danger of a recession just before its time period ends. The only problem is that Labour’s current balance target involves a rolling window. It is a target for the current balance (what Mitchell calls the recurrent balance) over the next five years. One year later it remains a target for the next five years. That is what ‘rolling’ means. So you never get caught out by an event ‘just before the target date’. With a rolling target this criticism makes no obvious sense.

Incidentally, this rolling window allows the government to pursue a countercyclical policy if it wishes to do so. The standard assumption is that mild booms and downturns are reversed by monetary policy within 5 years, so as long as the fiscal stimulus was not planned to last more than 4 years it is quite consistent with a rolling target. Whether government would want to when interest rates are doing the stabilisation is another matter.

What about a more major recession, where rates hit their ZLB. The rule’s knockout then applies, and fiscal policy becomes the primary stabilisation tool. This brings us to his second criticism.

“I noted that this was another neoliberal aspect of the approach. The reason for that conclusion is that the rule as stated requires the Monetary Policy Committee of the Bank of England to indicate to the Treasury that its monetary policy instruments are no longer effective. So in effect, the elected and accountable Chancellor can only enjoy fiscal freedom when the technocrats in the Bank of England handover the imprimatur to him. That is a basic Monetarist tenet – that monetary policy has primacy over fiscal policy. That is neoliberal central. Moreover, the MPC may not indicate monetary policy ineffectiveness, even if the target interest-rate is at zero (the so-called zero bound). As we have seen in the recent years, central banks have been willing to explore all sorts of weird and wonderful policy interventions to remain relevant in the macroeconomic policy sphere.”

Again its a cogent criticism. But this time Bill must know he is not talking about Labour’s rule, because he talked to Labour’s team. The MPC is asked to indicate when interest rates have reached their lower bound, not when they think all monetary policy instruments are ineffective.

MMTers on twitter tried to defend this line by saying the Bank might deliberately deceive. But think what that would have to involve. In a major recession the MPC would keep rates deliberately high and claim that they could cut them if they wished, but they do not wish to do so. I think the concern in that rather fantastical scenario is whether the MPC is any longer fit for purpose.

For much of the time I was arguing with MMT twitter about all this Bill Mitchell was copied in, but he did not respond to my criticisms of his post. But at one point he did send me this about a particular tweet I wrote

“Stop slandering me or you will face the legal consequences. I have nothing to do with the way others behave on Twitter.”

This is a first for me at least. Given this threat I cannot tell you what I wrote that provoked that, or give you a link to it, because I cannot afford a court case. Of course Bill Mitchell is not responsible for what his twitter followers say, but he is responsible for his distortions about what Labour’s fiscal rule says. I have criticised the way he argues his case in his defence of Lexit here.

After that threat I did then take the opportunity of asking him why he distorted his description of the ZLB knockout in the way I describe above, but he never replied. I wrote this about MMT and its followers, and these events only confirm this view.

Crashed by Adam Tooze

My review of Crash: How a Decade of Financial Crisis Changed the World is finally out at the London Review of Books (subscribers only I’m afraid). From what I’ve read it has received glowing reviews elsewhere, and mine is no exception. Reflecting its ambition it is no quick read (the main text is 600 pages). There is an introduction which does summarise some of the key ideas, but the triumph of the book is that it combines a detailed account of the events of the last ten years with an analytical overview which makes sense of the detail and which makes good sense. It has the additional advantage from my point of view that it is broadly consistent with many of the arguments made on this blog, although I don’t think I ever managed to match the quality of his prose.

The argument that binds the whole book together is that the crisis was not the result of the specific shocks of Subprime debt or the housing markets of Ireland and Spain, but an inevitable consequence of a global banking system that became chronically short of buffers to cushion against any kind of significant systemic shock. To use the technical term the system became over leveraged: lending too much in relation to the capital it had to cover loans going bad. This is the same theme as the book by Tam Bayoumi I discussed here, but in fact the two compliment each other: Bayoumi focuses on the regulatory changes that created global megabanks, while Tooze deals with the consequences of when these banks crashed.

Key to how the crisis played out was how different governments reacted to the crisis, and this is the central part of the book. After the mistake of Lehman, the US government took comprehensive action on a huge scale. To quote Tooze:

“It was a class logic, admittedly – ‘Protect Wall Street first, worry about Main Street later – but at least it had a rationale and one operating on a grand scale.”

The UK did the same, but because there were no widespread defaults in the UK there was no failure to help borrowers.

The contrast with the Eurozone is emphasised by Tooze. First Eurozone countries tried to suggest this was an anglo-saxon crisis, despite their own banks being deeply embedded in this global network, and was particularly rich as the Fed was (as Tooze shows) providing billions of dollars to European banks to keep them afloat. Germany with the help of the ECB refused to participate in a joint Eurozone response, and then later attempted the ‘bait and switch’ of blaming the Eurozone crisis on excessive government debt: bait and switch is the title of my review, and was originally used by Mark Blyth who in his book Austerity: the History of a Dangerous Idea saw earlier than most that the crisis was all about banks. Again to quote Tooze on the Eurozone response:

“‘It is a spectacle that ought to inspire outrage. Millions have suffered for no good reason.”

I have to add for those reading in the UK that this was about how individual Eurozone governments behaved within the Eurozone system, and has nothing to do with the trade relationships and regulation pooling that is the EU.

There is a lot more in my review (LRB gives you the luxury of over 3,000 words), and many important things in the book that I did not have space to comment on. For those into international relations as well as economists and historians this book is a goldmine.

On the subject of books, my own more modest effort is out shortly: it can be ordered at a 20% discount here, rising to 35% if you join the publisher’s mailing list.)

There is a Brexit deal the country can live with, but the government cannot

Brexit logic starts, as it always has, with Ireland. The EU will not do a deal without a permanent backstop, which means Northern Ireland (NI) stays in the Customs Union (CU) and Single Market (SM) for goods. (It could allow for an end to the backstop when both sides agree there is a technological solution that makes it unnecessary, which is another way of saying the backstop will be permanent.)

If the government were prepared for extensive customs checks in NI ports, the UK would still have considerable freedom to choose whatever deal it liked. Some of those arrangements would be very costly in economic terms, but they would be possible. But the DUP, as has been clear from the start, are against any such checks, and they are effectively part of the government because the Conservatives would lose every controversial parliamentary vote if the DUP voted against them.

If there cannot be additional customs checks in NI ports, that implies the whole of the UK has to be part of the CU and SM for goods. While the EU will allow a bespoke deal for NI to preserve the letter and spirit of the Good Friday agreement, it is unlikely to do so for a country that wants out. As a result, the backstop plus no customs checks means the UK has to remain in the full SM, including freedom of movement. In other words BINO (Brexit in name only) or equivalently extended transition: both mean pay, obey but no say. That is the basic logic of Brexit that has been obvious since December 2017 if not before.

A majority of people in this country today want to remain in the EU, but I think they could also live for a time with BINO if it was accompanied by additional controls on EU immigration allowed under EU rules. (These two studies are useful in that respect.) Perhaps the same is true for a majority of Conservative party MPs. But unfortunately a large minority of the Conservative party and the DUP cannot. They are lost to dreams of being free from EU regulations (the SM) and global Britain.

The last nine months have been an attempt by Theresa May to fudge that essential logic. Each time it looks like a fudge might work, she gets pulled back by the Brexiters. Last week was no different..Talks ended up being postponed because five or so cabinet members demanded that an Irish backstop had to be time limited, but there is no way that the EU would agree to that because it negates the whole point of the backstop. And at every stage, except Chequers, May has preferred to kick the can down the road by making impossible demands of the EU to avoid further splits in her government. The clearest example of this is when in December she agreed an Irish backstop only to declare agreeing to it as inconceivable a month or two later. 

At a fundamental level this constant appeasement of the Brexiters does not make sense, because they have nowhere to go except No Deal, and May together with parliament will not allow No Deal. Whatever they may say in public, the Brexiters accept the logic above. They know that any kind of trade deal with the EU has to involve the backstop. They cannot accept the backstop, but are content to see the return of a hard Irish border. Which means No Deal is the only possibility left for them.

So why does May continue to try and keep some of them in government? She cannot do without the DUP of course. But she knows from December that it might be possible, for a short amount of time, to fool enough Brexiters into believing something that is not true.(hence, I suppose, the invention of obscure jargon like a backstop to the backstop). I suspect, however, that the scope for further deception is insufficient for the task in hand. More important is that May probably believes that delay helps her ability to get a deal through parliament, and this is worth any loss of faith in eventually agreeing things that she failed to agree to earlier. 

Finally there are two interesting asides from this basic argument worth making. I talked to a very well known BBC presenter last week who was convinced that Brexit was nothing to do with the BBC. They are wrong on the economic costs, because the BBC did not regularly say that the overwhelming view of academic and business economists was that Brexit would do economic harm. Too often they assumed that this was self evident because all the major institutions (OECD, IMF etc) said this, but the ‘anti elite’ theme of Leave was designed to counter that, and giving equal time to both sides without any context (and of course constant newspaper propaganda) allowed Leavers to believe they would be better off.

But my criticism of the BBC is not just about the economic costs. One of the Leave messages that was attractive to many people was being able to do trade deals with other countries. I do not remember constant reminders from journalists saying that this was incompatible with membership of the SM, and so we had to choose between frictionless trade with the EU or doing these new deals. This statement is not controversial but a simple fact. It is also a fact that anything short of a CU and SM for goods will require a hard Irish border. This was the kind of basic information that the public craved for, and the BBC did not give it because their priority was not to upset either side. It is academic how important this all was to the final vote: the fundamental point is the BBC departed from its mandate to educate and inform at just the point the public needed and wanted it most..

The second aside is about Labour. One of the consequences of a failure by parliament to agree a deal could be a general election. Suppose that resulted in a Labour win. Labour would then have two Brexit options that the current government cannot take. The first is to have a border in the Irish Sea, because they are not beholden to the DUP. Corbyn has said that this would be very difficult, and the reason he gave had nothing to do with some vague idea of sovereignty. The chances are that Labour would end up agreeing something close to BINO. This means that a Labour government can deliver a form of Brexit that the country can live with, while with the current government it is like getting blood out of a stone.

Implications of German export success

I have finally got around to reading this excellent CEPR ebook on Germany’s exceptional recovery. That German GDP growth since the Global Financial Crisis (GFC) is higher than average Eurozone growth or French growth can be seen below.

GDP growth (source OECD Economic Outlook)

However the relative performance in terms of unemployment is remarkable.

Unemployment (national definitions, source OECD Economic Outlook)

The tremendous success in reducing unemployment is discussed in two papers in the book, and both suggest that it had more to do with changes in the nature of firm-union bargaining than the Hartz reforms. (John Springford has a nice chart showing how the German Phillips curve has shifted.) I have for some time noted how wage increases in Germany after 2000 were too low in the context of a 2% inflation target, and this helped drive an export boom and is a factor behind a huge current account surplus of 8% of GDP.

Other chapters in the ebook argue that there were other, perhaps as or more important,  factors behind this export boom, and I’m convinced that other factors did play a role. However the point I want to make in this post is that, as long as these factors are permanent, they imply that the real exchange rate in Germany has to rise at some point. This is exactly the same point as saying that not all of the German current account surplus of 8% is structural. Some of that surplus is because the German real exchange rate is undervalued.

There are two ways the German real exchange rate can appreciate. The first is via an appreciation in the Euro, and the second is for German inflation to be higher than average Euro area inflation. Below is a chart of one measure of competitiveness for both Germany and the Euro area.

The level is arbitrary: it is how the two series move over time and relative to each other that matters. You can see how Germany gained competitiveness.over other Eurozone countries from 2000 to the GFC. You can also see how that gain has been partially but not fully unwound over the last 7 or 8 years. Looking at Euro area competitiveness, it is a little below its average level over the past and also its level in 2010 when I calculated it was close to its equilibrium rate to the dollar. (This work was unpublished, but uses a similar model to the one I used to calculate the optimal entry rate of Sterling into the Euro as part of the 5 tests.)

So there is perhaps some scope for a further appreciation in the Euro, but it seems unlikely that will be enough on its own to achieve the required German real appreciation. German nominal wages have increased by more than the Euro average in recent years, but the differences have been small. That difference needs to increase to get Germany's real exchange rate to sustainable levels. Germany should not think of that as a problem, but rather the way their export success has to be translated into higher incomes for German workers..

Talk on where macroeconomics went wrong

I gave a short talk yesterday with this title, which takes some of the main points from my paper in the  OXREP 'Rebuilding Macro' volume  It is mainly of interest to economists, or those interested in economic methodology or the history of macroeconomic thought. When I talk about macroeconomics and macroeconomists below I mean mainstream academic economists.  

I want to talk today about where macroeconomics went wrong. Now it seems that this is a topic where everyone has a view. But most of those views have a common theme, and that is a dislike of DSGE models. Yet DSGE models are firmly entrenched in academic macroeconomics, and in pretty well every economist that has done a PhD, which is why the Bank of England’s core model is DSGE. To understand why DSGE is so entrenched, I need to tell the story of the New Classical Counter Revolution (NCCR).

If you had to pick a paper that epitomised the NCCR it would be “After Keynesian Macroeconomics” by Lucas and Sargent. Now from the title you would think this was an attack on Keynesian Economics, and in part it was. But we know that revolution failed. Very soon after the NCCR we had the birth of New Keynesian economics that recast key aspects of Keynesian economics within a microfoundations [1] framework, and is now the way nearly all central banks think about stabilisation policy. But if you read the text of Lucas and Sargent it is mainly a manifesto about how to do macroeconomics, or what I think we can reasonably call the methodology of macroeconomics.And on that their revolution was successful, and it is why nearly all academic macro is DSGE.

Before Lucas and Sargent complete macroeconomic models, of both a theoretical and empirical kind, had justified their aggregate equation using an eclectic mix of theory and econometrics. Microfoundations were used as a guide to aggregate equation specification, but if this equation fell apart in statistical terms when confronted with data in would not become part of an empirical model, and would be shunned for inclusion in theoretical models. Off course ‘falling apart ‘ is a very subjective criteria, and every effort would be made to try and make an equation consistent with microfoundations, but typically a lot of the dynamics in these models were what we would now call ad hoc, which in this case meant data based. .

Lucas famously showed that models of this kind were subject to what we call the Lucas critique [2], and that forms an important part of Lucas and Sargent paper. They argue that the only certain way to get round that critique is to build the model from internally consistent microfoundations. But they also ask why wouldn’t you want to build any macroeconomic model that way? Why wouldn’t you want a model where you could be sure that aggregate outcomes were the result of agents behaving in a consistent manner

If you want to crystallise why this was a methodological revolution, think about what we might call admissibility criteria for macro models. In pre-NCCR models equations were selected through an eclectic mixture of theory-fit and evidence-fit. In the RBC and later DSGE models internal theoretical consistency is an admissibility criteria. Or to put it another way, a DSGE model never got rejected because one of its equations didn’t fit the data, but if one equation had a theoretical foundation that was inconsistent with the others it would certainly not be published in the better journals.

Have a look at almost any macro paper in a top journal today, and compare it to a similar paper before the NCCR, and you can see we have been through a methodological revolution. Unfortunately many economists who have only been taught and who only known DSGE just think of this as progress. But it is not just progress, because DSGE models involve a shift away from the data. This is inevitable if you change the admissibility criteria away from the data. It inevitably means macroeconomists start focusing on models where it is easy to ensure internal theoretical consistency, and away from macroeconomic phenomenon that are clear in the data but more difficult to microfound.

If you are expecting me at this point to say that DSGE models where were macroeconomics went wrong, you will be disappointed. I spent the last 15 years of my research career building and analysing DSGE models, and I learnt a lot as a result. The mistake was the revolution part. In the US, DSGE models replaced traditional modelling within almost a decade [3]. In my view DSGE models should have coexisted with more traditional modelling, each tolerating the other.

To get a glimpse of how that can happen look at the UK, where a traditional macromodelling scene remained active until the end of the millenium. Traditional models didn’t stand sill, but changed by adopting many of the ideas from DSGE such as rational expectations. Here the account gets a little personal, because before I did DSGE I built one of those models, called COMPACT. There are not many macroeconomists who have built and operated both traditional and DSGE models, which I think gives me some insight of the merits of both.

COMPACT was a rational expectations New Keynesian model with explicit credit constraints in a Blanchard-Yaari type consumption function, a vintage production model, and variety effects on trade. So in terms of theoretical ideas it was far richer than any DSGE model I subsequently worked with. Most of COMPACT’s behavioural equations were econometrically estimated, but it was not an internally consistent model like DSGE.

COMPACT had an explicit but exogenous credit constraint variable in the model because in our view it was impossible to model consumption behaviour over time without it. Our work was based heavily on work in the UK by John Muellbauer, and Chris Carroll was coming to similar conclusions for the US. But DSGE models never faced that issue because they worked with de-trended data. Let me spell out why that was important. Empirical work was establishing that you could not begin to understand consumption behaviour over a 20/30 year time horizon without seeing how the financial sector had changed over time, and at least one traditional macroeconomic model was incorporating that finding before the end of the last millennium.. Extensive work on exactly that issue did not begin using DSGE models until after the financial crisis, where changes in the financial sector had a critical impact on the real economy. DSGE was behind the curve, but more traditional macroeconomics was not. .

Now I don’t think it is fanciful to think that if at least some macroeconomists had continued working with more traditional data-based models alongside those doing DSGE, at least one of those models would have thought to endogenise the financial sector which was determining those varying credit constraints.

So the claim I want to make is rather a big one. If DSGE models had continued alongside more traditional, data-based modelling, economists would have been much better prepared for the financial crisis when it came. If these two methodologies had learnt from each other, DSGE models might have started focusing on the financial sector before the crisis. Of course I would never suggest that macroeconomics could have predicted that crisis, but macroeconomists would have certainly had much more useful things to say about the impact on the economy when it happened.

Just being able to imagine this being true illustrates that moving to DSGE involved losses as well as gains. It inevitably made models less rich and moved them further away from the data in areas that were difficult but not impossible to model in a theoretically consistent way. The DSGE methodological revolution set out so clearly in Lucas and Sargent's paper changed the focus of macroeconomics away from things we now know were of critical importance.

I’ve been talking about this since I started writing a blog at the end of 2011, but recently we have seen similar messages from Paul Romer and Olivier Blanchard in this OxREP volume. What I have called here traditional models, and in the paper I call Structural Econometric Models, Blanchard calls provocatively policy models. It was provocative because most academic macroeconomists think DSGE models are the only models that can do policy analysis ‘properly’, but Blanchard suggests policymakers want models that are closer to the data more than they want a guarantee of internal consistency, and they want models that are quick and easy to adapt to unfolding problems. The US Fed, although it has a DSGE model, also has a more traditional model that has similarities to a traditional model like COMPACT, and guess which model plays the major role in the policy process?

[1] Microfoundations means deriving aggregate equations from microeconomic optimisation behaviour

[2] The Lucas critique argued that many equations of traditional macroeconomic models embodied beliefs about macro policy, and so if policy changed the equations would no longer be valid.

[3] The difficulty of identification in single equation estimation highlighted by Sims in 1980 probably also contributed.  . 

How the left stopped being a party of the working class

I’ve been meaning for some time to write about a recent paper by Thomas Piketty, which looks at what characteristics influenced voters to vote for the left or right in France, the UK and US since WWII. (Simon Kuper has a nice little summary with a great title.) Here is a chart that shows how after WWII educated voters tended to vote right, but now tend to vote left (even after controlling for income, age etc - see box)

In all three countries, the number of educated voters increased in all three countries, reflecting in part the need for higher skilled workers.

In contrast (and if we exclude the most recent elections in France and the US) the income profile for voting has not changed very much over time: poorer voters are more likely to vote left than richer voters, particularly if we control for education, although poorer voters are increasingly unlikely to vote. So the shift in voting patterns among educated voters demands an explanation and has fascinating implications.

Unfortunately the paper does not focus on this question, but it does suggest that part of any explanation may reflect the fact that more educated voters tend to have more liberal attitudes in general, and more liberal attitudes to migration in particular (see here for example). The positive correlation between social liberalisation and education is well documented (see [1] for example), as was evident in the Brexit vote.

I suspect there are other factors as well. There are possible reasons why the interest of human capital (as economists would call it) are different from the interests of business or financial capital, or no capital at all. For example a more meritocratic education system suits them better than one where income buys education, so they are likely to be stronger supporters of a state based education system (or indeed they may be part of it). They will also be more likely to consume state subsidised culture. More generally there may be a wish to break down traditional class based networks and replace them with more meritocratic structures. On the other hand because human capital generates an income, they will be less keen on tax based redistribution than workers. All this may create what some might call an education ‘cleavage’.

The implication for parties on the left are that party members were increasingly from the educated middle class rather than working class, and this has gradually changed the structure, platforms and leaders of left parties. Together with the decline in trade unions, the counterpart to this will be a less visible representation of the working class. Piketty describes this as the emergence of the “Brahmin Left” elite, which can be compared to the “Merchant” elite on the right.

A consequence may be that the political elite as a whole becomes less interested in redistributive policies that used to favour the working classes, and helped continue the decline in wealth inequality before the 1980s that Piketty has famously documented elsewhere. That in turn makes it easier for the right to capture parts of the working class vote, particularly when these voters have socially conservative views. A recent book by Mark Bovens and Anchrit Wille takes a very dim view of these changes.

There is a less pessimistic take on all this. As right wing parties have increasingly relied on pushing socially conservative/authoritarian/anti-minority policies to gain votes, left wing parties find that this combined with wealth/income protection is an unbeatable coalition for their opponents. (Perhaps this helps explain the decline in so many centre-left European parties.) The only way to beat that coalition is to rediscover economic policies that help the working class.

This long paper has other interesting results. In France, like the UK, public attitudes have seen a decreasing hostility to immigration over time. He also notes that the right’s socially conservative turn has helped to sustain an almost complete loyalty to the left from Muslims in the UK and France, and from blacks in the US. Finally a parochial point of interest, which is also a point that Torsten Bell has stressed recently.

Piketty notes that the dominance of the left among the young in the UK in 2017, as well as being unprecedented in the UK, was higher than in any of the two other countries at any point in time. It may be that this is part of a trend since 1997, but it could be exceptional because of Brexit, which amounts to the old taking opportunities away from the young.

[1] Education-based group identity and consciousness in the authoritarian-libertarian value conflict. / Stubager, Rune. In: European Journal of Political Research, Vol. 48, No. 2, 2009. .

How the media helped turn the worst recovery in 100 years into a strong economy in stable hands before the 2015 election

Are you exhausted and exasperated by Brexit? Do you despair when our foreign secretary compares the EU to the Soviet Union just because the EU will not change their rules to give us what we want? Do you wish that we could go back to how it was before Brexit? If so, I wrote my forthcoming book “The lies we were told” just for you. (It can be ordered at a 20% discount here, rising to 35% if you join the publisher’s mailing list.)

One of the posts in the book, written at the beginning of March 2016, anticipated a lot about the forthcoming campaign and how it would play out. I wrote

“The EU referendum is therefore another test of how much economic expertise can influence public opinion. As regular readers will know, we have been here before, and not just on austerity.”

One of those examples was the 2015 general election, which forms one of the nine chapters in the book.

As background, here is I think the best illustration of how poor the UK recovery from the 2009 recession was (from The Resolution Foundation).

As we can clearly see, the post-2009 recovery was slower than anything we have seen in the last 100 years. Now sometimes governments can be unlucky, as the economy follows events that they cannot control, but the recovery after the Global Financial Crisis was not like that.

In this chart, using OBR data, I compare the cyclically adjusted primary balance during the last three recessions.

Take the ‘ERM recession’ first. Fiscal policy did very little until 1992, when both fiscal and monetary policy became expansionary, leading to a strong subsequent recovery. (Fiscal policy moving in a downward direction is expansionary and vice versa.) This is a classic expansion, with both fiscal and monetary policy providing a stimulus together.

The ‘monetarist recession’ is more complex. During 1982 interest rates were reduced steadily from nearly 15% to 10%, but famously the April 1981 budget led to a sharp fiscal tightening (leading to the famous 364 economists’ letter). Contrary to right wing and media myth, the economy’s response to this contradictory mix was to grow at around the trend growth rate, so not a true recovery (by which I mean growth above trend, so we catch up with that trend). We only got a true recovery from 1983, when fiscal policy relaxed alongside monetary policy.

This is textbook stuff (hence the 364 letter). In early 2009 UK interest rates hit their lower bound, so fiscal expansion was needed more than ever, and that is what happened under Labour. But the Conservatives bought the myth about 1981, carefully cultivated by the Institute of Economic Affairs and swallowed by the media, that the 364 economists had been wrong, so in opposition they opposed the 2008/9 and 2009/10 expansion and in government started a fiscal contraction, a contraction that only came to an end in 2017.

The inevitable consequence was the weakest recovery for a 100 years. Combining a weak recovery with a large 2008 depreciation of sterling meant incomes literally stagnated for 7 years, as another chart from the Resolution Foundation shows. The Conservatives did not admit their mistake and pledge not to do it again, but preferred to create a false narrative instead.

The lie was the story of a profligate Labour government and how the Coalition government had been forced to clear up the mess. Voters bought it. Coming into the 2015 general election, polls suggested the economy was the Conservatives' strong point. They did so in part because the media never challenged the story, which was obviously false from just a brief inspection of the data. Rather than look at the data they preferred to talk to City economists (and not academics), and most City economists have an interest in backing a Conservative line and talking up the power and threat from the market. In that sense the media played a key role in winning the 2015 election for Cameron, which of course was the only way a referendum could happen. Evidence to back up all this is in the book. 

The Conservative party has never acknowledged their austerity error, and so we have every reason to think they would do the same again if another recession came along. Much of the media still prefer to let politicians make any nonsense economic claim they wish, and they rely on other politicians to challenge them rather than confront them with the facts or expert consensus.  

Having leading politicians spin a disastrous economic policy with lies and without challenge from the media did not start in 2016, but in 2010. Elsewhere in the book I try and explain why politicians on the right went off the rails in 2010, and also why the media facilitated a majority of the country going with them