Vines and Willis on the future of macroeconomics

Mainly for economists 

I want to talk about the latest Oxford Review of Economic issue on ‘rebuilding macroeconomics’, and particularly the first article by David Vines and Samuel Wills. The first thing I want to say is that the title is pretentious. Academic macroeconomics is reasonably happy doing what it is currently doing and in that sense there is nothing to rebuild. A better title is future directions for macroeconomics.

The Vines and Wills article suggests two major changes in direction. The first, following Blanchard, is to partly reverse the microfoundations hegemony, by allowing models or parts of models that don’t include microfounded models routinely back into the top journals. The second is to focus on models that allow more than one long run equilibrium. I will take each in turn.

Ending the microfoundations hegemomy

I have argued against the microfoundations hegemony for some time. My own article in this issue presents a classification of different types of macromodel that tries to extend Blanchard’s own list of types in a systematic manner. Here is a diagram that splits models according to their bias towards theoretical consistency or consistency with the data, and how detailed the models are.

At the most data consistent, we have VARs and variations on them. In a simple VAR the only theory involved comes in variable choice, lag length and identifying restrictions. At the theory consistent end we have microfounded models, where any admissible model has to be internally theoretically consistent. These models can be ranked by complexity. What I call foundational models are things like RBC or OLG models: the kind of very simple model that would be taught in masters courses. DSGE models are the workhorse of today’s macroeconomics, which you will find in most journal articles. Once we start having disaggregated agents or sectors in a DSGE model it becomes pretty complex. However the dividing lines between foundational, DSGE and more complex microfounded models is not rigid.

SEMs are models that academics have largely forgotten about, except when they teach IS/LM type models to undergraduates. Again they can be divided up by complexity, but the dividing lines are not precise. What is precise is that these models are not microfounded, even though they may involve equations which are derived from a substantial and very up to date theoretical base. What these models, which Blanchard calls policy models and I call Structural Econometric models (SEMs), fail to demonstrate is internal theoretical consistency.

Vines and Wills call the set of all IS/LM type models and foundational models ‘toy models’. Their paper includes a nice history of macroeconomic thought focused on which toy modes have been central at different times.

Why use SEMs instead of DSGE? Because they are likely to come closer to describing the real world, and they are very flexible to change. The former is very easy to demonstrate. Imagine a DSGE model, where you take each individual equation to the data, adding in terms that are significant and make theoretical sense at an informal level. You would then have a SEM which almost surely is a closer fit to the data than the DSGE model. Greater flexibility is obvious to anyone like myself who has used both types of model. You can incorporate a new theoretical idea in a SEM in a week. To do the same in a DSGE model takes much longer, because you have to ensure internal consistency.

Most policy institutions outside academia use SEMs, although they may also use DSGE models. The Bank of England is unusual in not using a SEM, and its macroeconomic analysis is poorer as a result. By calling SEMs ‘policy models’, Blanchard makes clear that he thinks that SEMs should be an essential part of policy analysis, wherever that is done. But whatever the merit of this argument, my paper argues that this is not going to happen within academia, because the microfoundations hegemony is well entrenched and progressive in the Lakatos sense.

The only way to end the microfoundations hegemony is for central banks or the IMF to start commissioning work on equations or sectors that could be the basis of changes to their SEM model. That will then put pressure on journal editors to include empirical work which is not either microfounded or general equilibrium. This would mean that work like that outlined by John Muellbauer in his article in this issue, and work done in policy institutions all the time, can get published in the top journals. However, for reasons given in the paper, I’m pessimistic this will happen.

Multiple Equilibrium

The other key theme in the Vines and Wills article is the need for non-linearities in models. He gives three interesting toy examples of toy multiple equilibrium models, related to asset markets, growth and inflation. Other examples, related to geography (the paper by Venables in this issue) or beliefs (the paper by Farmer) are discussed. This is all interesting stuff.

However I do query that, quoting Martin Sandbu, “there is no question this would be a very big change in how macroeconomics is done.” To just give a personal example, when I taught part of an advanced macro class in Oxford a few years ago, two of the four models I looked at had multiple equilibrium. However it is also true that non-linear models are more complex, which undoubtedly puts researchers off. This brings us back to allowing non-microfounded models to be, at the very least, a preliminary investigation of new theoretical ideas as a prelude to ‘doing it properly’, as most academic macroeconomists would say.

My other question is whether, if you want to model the impact of severe recessions on long run output, two or more equilibrium models of the kind that Vines and Wills look at are the answer. It may be simpler and also more realistic to add forms of endogenous growth to a standard model, as various people have done, which gives you hysteresis. Indeed such an approach is used (in a more informal way) by the OBR to calculate the long run impact of the COVID crisis.

Which brings me back to revolutions. Many people outside the mainstream, such as Servaas Storm here, want a revolution that removes the many things about the mainstream they don’t like. But revolutions happen because mainstream economists see that one is needed. The Keynesian revolution occurred because academics and politicians saw that depressions were not inevitable. The neoclassical counter-revolution was a revolution within mainstream academia. Because the microfoundations hegemony is progressive, there will be no revolution. Neither financial crises or pandemics are impossible to model using standard tools.

I hope this issue of OXREP, together with the earlier companion volume, will do two things. First to help give ideas to younger academics about going beyond models with a single equilibrium. Second to help economists in policy institutions to see that there are other ways of doing things beyond microfoundations, and that many of the stories they were told about why policy models have to be microfounded are not as true as perhaps they once thought.

As things stand, the chances of defeating Johnson at the next election are minuscule

 

I don’t think this is understood by the leadership of the main opposition parties, along with many others. The Conservatives are way ahead in the polls at the moment, because the government had the right policy on vaccine procurement and delivery. That will fade, but it could quickly be replaced by an economic recovery bounce. The economy is likely to grow rapidly both this year and next, so the recovery bounce could last until 2023. As usual, much will be made of ‘record growth rates’ and rather less to where we are in comparison to pre-pandemic. For this reason, I suspect Johnson will call an election well before he needs to (having repealed the FTPA). Their erroneous reputation for managing the economy will appear enhanced. The Conservative election campaign will be slick, with vast amounts of money spent on social media, and the electorate will be rigged by insisting on ID. Johnson's victory will be assured.

Of course, as a former Conservative PM is said to have said, “events, dear boy, events”. For example Johnson could rush on with ending his third lockdown even though R becomes greater than one, and combined with not enough people being vaccinated this leads to another wave of COVID cases, possibly involving virus variants that make some vaccines less effective. But even during the second wave, the severity of which was entirely down to government ineptitude, Labour never took a consistent lead in the polls. [1] For reasons including those outlined in my last post, everything has been stacked against the opposition for some time.

Yet it is imperative that this government is defeated as soon as possible. It is an authoritarian government with immense power because of its solid majority, and the longer it stays in power the more difficult it will make the life of any opposition. So the only relevant question is what can the opposition to this government do to maximise its chances of winning before it becomes even harder to win.

The most obvious and familiar example of how it can be done is the United States, and the first lesson has to be for all of the opposition parties to cooperate in fighting seats in the next election. What that has to mean is that just one opposition party fields candidates in key marginals, as the LibDems and Greens did in 2019. Biden would not have won if there had been another significant liberal party contesting virtually every state.

Another way to see why a socially liberal (aka progressive) alliance is essential is to divide voters using two dimensions, the familiar left right and social liberalism or conservatism (sometimes called authoritarian). This breakdown is essential to understand politics today, and for those unfamiliar with it I outline the reasons why it is essential in an appendix. Without doubt nearly all socially conservative right wing voters will vote Tory, and socially liberal left wing voters will not vote Tory, and the two groups are similar in size. The battle in any election is to win over those in the other two quadrants: left wing social conservatives and right wing social liberals.

Once you see this, the folly of dividing the English socially liberal vote among three parties becomes obvious. Cooperation of the kind mentioned above will greatly increase the chances that the Conservatives will not win. Given the strong possibility of an election at the end of 2022 or early 2023, the sooner discussions start the better. An alliance is a clear win for the two main UK wide opposition parties (by seats). Labour will play a leading role in the next government rather than staying in opposition. The Liberal Democrats will win more of their target seats where there are currently many wasted Labour votes.

But such an alliance alone is not enough, as the appendix explains. Each party needs to play to its strength. The LibDems target seats are winnable in part because right wing social liberals could be persuaded to vote with their liberalism rather than their pocket. But that in turn means Labour have to focus on winning socially conservative left wing voters. The Tories know that is their route to power, which is the reason for all this nonsense about wokeness, being nasty to asylum seekers, ending the right to demonstrate and so on.

I should say at the start what this post is not about. It is not an argument for Blue Labour. Labour’s base today is socially liberal, and if Labour were to become a socially conservative party its core vote would go elsewhere.

Nor is this post about the left vs centre-left within Labour. What I have to say is relevant to Labour led by the Left or Centre-Left. After my last post, many on the left pointed to 2017 as proof that Labour could do relatively well without compromising its liberalism. But in 2017 the issue that divided social liberals and conservatives in a way no issue has for decades was Brexit (see appendix). Because Labour in 2017 supported Brexit, then this together with a strong left wing economic package helped win many social conservative left wing voters.

The activist, marginal voter divide

I recently wrote a post trying to justify Starmer’s strategy of avoiding being seen to champion social liberal issues. I think it is fair to say that many people hated that post. But to try and convince people that I was right in principle, I want to reference a fascinating discussion between Noah Smith and political data scientist David Shor. Although that concerns US politics, the parallels with UK politics are very close. What Shor is saying is very similar to what I was trying to say in my earlier post.

One of the first points Shor makes in this discussion is that party activists are the worst judge of what works at winning elections. He gives the example of the mirror ad used by Clinton in 2016, which used Trump’s derogatory comments about women. The Clinton people thought it was a great ad and put a lot of money behind it. What Shor found was that among the marginal voters that any Democrat needs to win over, the white socially conservative working class (and to some extent the non-white socially conservative), it actually lost votes.

In my view a great deal of comment on twitter is based on this fallacy. Activists typically want their politicians to talk about the issues they care about, and get upset when they don’t. But if a party leader just talks about what activists want them to talk about, they will probably do badly in an election. Specifically for Labour, a leader who wants to win elections needs to appeal to socially conservative left wing voters. Labour almost certainly, and a progressive alliance probably, cannot win without these voters. No Labour leader in opposition is going to change these voters socially conservative beliefs (for what does, see later). That means a Labour leader has to focus on economic issues from a left wing perspective, and not champion social liberal issues and concerns.

A Labour leader who understands the argument above has to walk a tightrope. If they go so far as to advocate for socially conservative issues, they risk losing their socially liberal base to one of the other social liberal parties (or to not voting). The clearest case of that was Labour during the course of 2019. Labour leaders do best when they don’t adopt socially conservative issues, but don’t push socially liberal issues either. (Issues where many social conservatives agree with liberals are fine.) A progressive alliance avoids that tightrope to a large degree, because social liberals fed up with Labour’s silence on these issues don’t get the chance to vote Green or LibDem in key marginals. But it does not eliminate it entirely because voters may not vote, but more importantly it is crucial to keep your base onside [2].

Because it is a tightrope, it is very easy for Labour leaders to get this wrong. In particular a leader, or the team around them, may become so focused on their target voter that they go too far in denying their social liberalism. [3] The recent bill allowing the police to prevent noisy protests or protests that cause annoyance is a good example of where Starmer made a mistake and corrected it. The best thing to do is turn an issue around so that people think about it differently. Whatever you think about Blair, his ‘being tough on crime and the causes of crime’ did exactly that.

What you do, and what you talk about

Many of the reactions to my earlier post failed to make the distinction between what an opposition talks about to win power, and what it then does in government. Not talking about certain issues in an election campaign is not the same as being indifferent to them in government. All I am talking about is what a Labour opposition uses its scarce airtime to talk about.

This point is so obvious to Conservatives that it is second nature. A Conservative party will not campaign on privatising the NHS but that does not stop them doing it when in office. Equally the Labour party under Blair did not campaign for an independent Bank of England, but it still enacted one.

What many people remember is a Labour government, both with rhetoric and actions, trying to appease the anti-immigration mood created in large part by the right wing press. That was worse than pointless, because it failed to put the case for immigration and validated the idea that immigration was a problem. It failed to use the government’s ability to put a case (which a Labour opposition hardly ever has), and alienated many of its own voters. Once again, that is not what I’m talking about here.

Election campaigns, which for oppositions last five years, involve promoting your most popular policies. For successful Labour oppositions that is going to involve left wing economics policies but not socially liberal policies. Governments have much more latitude in how they conduct election campaigns. Because they get much more exposure in the media, they can focus on the popular things they have done rather than the more unpopular. To take an example, Shor argues for the US that on gay marriage making those issues partisan is dangerous.

Another reaction I got to the earlier post was that someone needed to champion social liberalism when the Conservatives are in power. But Shor argues that what changes public attitudes in a liberal direction is the broadcast media. The broadcast media, either through documentary or fiction, can normalise minorities among those who were previously antagonistic to them. The reason the broadcast media promotes social liberalism (and has done so during the steady advance of social liberalism over the last 50 years) is that programmes are typically made by younger people with university degrees, who tend to be socially liberal.

That does not mean activists should just sit back and wait for this progress to happen. There is a key role for non-partisan campaigns to put issues on the agenda, and to expose government hypocrisy on issues like climate change. But a Labour leader fighting an election campaigning on social issues that divide social conservatives and liberals is unlikely to persuade any marginal voters and will just lose Labour votes.

[1] The broadcast media is critical here. The Conservative politician that persuaded Johnson not to follow the scientific advice in September was the Chancellor Sunak, yet Sunak remains the most popular politician. The reason is that the broadcast media never mention this key point, so it remains largely unknown to most voters.

{2] This is one reason why Starmer attacking Corbyn is a bad idea. Not only does it not play well with many activists, it also reminds voters of party divisions.

[3] Basing policy too closely on red wall focus groups can be a big mistake in many ways. To give one recent example, I agree with Michael Walker here that Starmer failed to present an alternative way of thinking about the pandemic. He needed something positive rather than the negative of Johnson acting too late. In particular he needed to bust the excuse the government uses constantly of having to trade off lives with the economy, and he needed to quote numbers for the deaths the government caused. What might appear negatively as an aggressive and unsupportive stance among focus groups will reap dividends in the period which matters, which is post pandemic.

Appendix: Two dimensional mapping of voters

Rather than just categorise voters as somewhere on the left-right continuum, more recent voter analysis has looked at two dimensions, where the second axis is social liberal to social conservative. To assess where voters are on this axis, a standard method is to look at answers to questions of national surveys. You can then see how those individuals voted on key issues. Here is an example from the Financial Times at the end of 2017.

The labels given to the extremes of the ‘cultural’ axis vary a lot. I prefer social liberal to libertarian for obvious reasons. Here is an example of the kind of questions used to plot where voters are, taken from a presentation by Paula Surridge.

The FT diagram is typical: most Labour voters are somewhere in the social liberal/left quadrant, and most Tory voters are in the opposite quadrant. It is the two other quadrants that are more contestable by the two main political parties. I’m going to follow an excellent paper by Noam Gidron and label those voters who are left wing but socially conservative 'welfare chauvinist', and those that are right wing but liberal 'market cosmopolitan'. The trick for parties of the left or right is to get voters in these two groups to vote for them. Gidron argues that the decline in left wing parties in Europe is due to both groups tending to vote for right wing parties rather than left wing parties.

The policy in the UK that did this most successfully for the Conservatives was Brexit, as the diagram shows. It is clear that Brexit appealed almost exclusively to social conservatives, capturing the welfare chauvinist group. It follows that this was why Corbyn’s 2017 campaign was the most successful for Labour since Blair: Labour appeased social conservatives (by accepting Brexit, and also talking about police funding) and focused on left wing economic policies, thus capturing many welfare chauvinists.

In both the UK and US, geography together with unusual voting systems mean that the marginal voter is left wing but socially conservative (welfare chauvinists). Social liberals are concentrated in large cities or university towns, and are normally in the minority elsewhere. That means that in a battle between social conservatives and liberals (like Brexit) voters may be evenly balanced in numbers but social conservatives will win far more seats. The 52% to 48% Brexit referendum, if fought over seats, is estimated to have produced 406 Leave seats and just 242 Remain.seats.

The Royal Family is today’s England

 

Don’t worry, this isn’t really about that interview. But what struck me most about the whole situation is that the Royal Family had turned down a huge opportunity to revitalise its image, and the main reason it has done this was because of the right wing press, and possibly fear of change, and possibly race. Now I know many reading this don’t spend much time worrying about the Royal Family’s image (neither do I) but please bear with me.

Looking at how public opinion about the affair splits by age should be very worrying for a monarchy that wants to survive. If the Palace had embraced the couple, which would have meant publicly defending Meghan against press misinformation and supporting her as much as they could in dealing with that misinformation, it would have shown a monarchy that had no problem welcoming a mixed race divorced American celebrity to their midst and a monarchy that was strong enough to take on the press in defence of one of their own. There was also the bonus that the couple were very good at doing their job.

Anyone who has seen the film The Queen will know how bad the Palace can be at adapting to public opinion. But the lesson they seemed to have learnt from that episode is to follow the tabloid press. Harry in the interview talked about the ‘invisible contract’ between the monarchy and the tabloid press. In this case that contract involved not trying to stop the press trashing a member of the royal family. A sacrifice to keep the beast on side perhaps. While the Queen is untouchable, I think Prince Charles is very worried that he is not untouchable. To again use a phrase from Harry in that interview, the monarchy are trapped in a relationship with the press. A press, as Anthony Barnett points out, where the owner of a large part of the press is a republican.

That, remarkably, is the most favourable view to the Palace of what happened. The alternative is that elements within ‘the firm’ connived with the press in making the couple feel unwelcome. Whichever it was, my overriding impression is of a monarchy that has allowed itself or has chosen to live in the past rather than embracing the future.

Thinking about how parts of Britain (England for sure, and perhaps Wales) have moved over the last decade you could not avoid concluding that it had made much the same mistake the royal family made over Harry and Meghan. The decade began with a Conservative party campaigning against high immigration on the back of a concerted attempt by the right wing tabloids to publish as many negative stories about immigration it could. This was coupled with a Labour government that had given up arguing the positive case for immigration because they feared the power of the right wing press. It also saw a period of unnecessary austerity that typically encourages nationalism and attacks on minorities..

London is a remarkable cultural mix that seems to work pretty well, but just like the royal family might have effectively scorned a mixed race American, most English towns and rural England decided they preferred the monoculture they knew or remembered, in large part because of fear stoked by the right wing press or simple racism. Brexit was really a continuation of the same, but here the return to an imagined past was much clearer. The idea that the UK could divorce itself from the Europe that surrounds it can only be imagined if you are steeped in a mythical past where the UK stood alone. Global Britain (far less global as a result of Brexit) appealed to ideas of Empire. But the idea of taking back control proved irresistible, even though what they were trying to take back had not been taken away by the EU.

Just as the right wing press had been pivotal in generating fear of immigrants, so it was critical in persuading a tiny majority of the UK to start a divorce with most of Europe. If there are any in the 'firm' that wanted the split with the Duke and Duchess of Sussex, they were equivalent to those Conservative politicians who wanted to go back to that mythical past and so pushed Brexit. With the phrase “the will of the people” (in reality just over half the people allowed to vote on the day of the referendum) the Brexit press entrenched the idea that Brexit was unstoppable, and anyone who tried to stop it by democratic means became in their eyes a traitor. Only a country that is living in its past could think that attacking a statue is worse than attacking and seriously injuring a human being. 

A large section of the British public also has an implicit contract with their press. They read it for celebrity gossip or sport, and in exchange readers allow their attitudes to be influenced in whatever direction the owners of the press (mainly old white men) choose, frequently laced by nationalism. Attitudes to royalty are part of this. Readers do not have any first hand experience of Meghan Markle, so their opinions are bound to be heavily influenced by what they read in the press. Younger people who are far less influenced by this press think differently. Part of the age difference also reflects the fact that younger people have a better understanding about what racism is, and a greater interest in living in the modern world.

The invisible contract between the royal family and the tabloid press is dangerous to the royal family because it reduces support for the monarchy among the young. This invisible contract between parts of the English public and the press is much more dangerous, because it threatens meaningful democracy in the UK. There were two kinds of politician that backed Brexit. The first were more like the public who were nostalgic for an imaginary past. The second, and far more dangerous, were those who saw this nostalgia as a means to permanent power. These are the politicians who lead this government today.

Permanent power is achieved in four ways. The first, taking its cue from the US Republican party, is to make any election battleground about this socially conservative/liberal divide that was at the core of Brexit. The right wing press and this government’s ‘war on woke’ is designed to achieve exactly that. The second means to permanent power, again borrowed from the US right, is to make it more difficult to vote, and to saturate elections with social media ads paid with uncontrolled amounts of money. The third, and most dangerous, is to control enough of the media to ensure they will always win. (Controlling the media is the most important part of a general attack on a pluralist democracy as outlined by Mark Thomas here, and which in turn is the hallmark of populist leaders like Trump or Orban.) The fourth, which follows from the third, is to lie constantly in order to construct an alternative reality it’s supporters can believe in: an alternative reality where the important issues of the day involve preserving a mythical past rather than the health of the economy [1], and where fighting a mythical cosmopolitan elite is more important than preserving civil liberties and minority rights.

Control of the media requires first control of (or working in tandem with) a majority of the press, and that has been assured at least since Brexit. The right wing press has become a propaganda machine working very closely with the government. With a compliant tabloid press and reactive broadcast media, the government can get away with corruption, bullying and other scandals. However most people who read this press also watch or listen to the BBC, and in the past this has been a check on the ability to construct an alternative reality. Because of popular trust in the BBC, it prevents the use of the Trumpian tactic of talking about fake news.

So key to controlling the media has been to tame the BBC, and this has also been largely achieved. Of course all governments attempt to influence what the BBC does, but when these attempts are coupled with enough senior appointments and threats to the BBC’s existence it will have a much larger effect. The aim is not to control every BBC programme, but just the main news bulletins that most people watch. Fact checking or Newsnight is not threatening on its own, because the government’s target voters don’t read or watch them. Nor is the aim to change this into a state run media, but just to ensure coverage in these news bulletins does not threaten the government’s alternative reality. For example the government needs to ensure that these bulletins never call out Johnson’s lies and never acknowledge government corruption. [2]

People often point to Biden’s victory to suggest that this kind of strategy can easily fail. But in the US most newspapers and media networks are not so intimately bound to the right wing project as they are in the UK (hence Trump's frequent use of fake news), and the opposition to the Republicans is not fragmented as it is in the UK. A better model to what is happening in the UK is the recent past in Hungary, which still appears to be a democracy but in reality a democracy in name only, with total government control of the media. Hungary bans protests during the pandemic just as the UK does, but even Hungary is not attempting to ban demonstrations because they might be noisy.

An increasing number of people in the UK are beginning to think about this country in the same way that Harry and Meghan think about the monarchy, but most do not have the fame, resources or even desire to leave. The only way to safeguard UK democracy is to recognise the unique severity of the threat and the difficulty of stopping it. We need to put factionalism to one side in trying to persuade England to leave the past behind, make peace with our neighbours and return to the modern world.

[1] This can be achieved if your core vote is protected from economic stagnation. Pensions protected from earnings stagnation, and using subsidies to keep house prices high, may be enough to ensure this.

[2] For this reason cancelling a satirical comedy programme, I suspect largely watched by those who will never vote Tory, seems to be off message. But authoritarian leaders hate one thing more than they hate someone telling the truth: they hate the idea of being made fun of. And for many in the government/press, the ultimate goal may remain destruction of the BBC by removing popular support for it.

Why are the Conservatives so bad at running the economy?

 

Despite their reputation, over the last forty odd years Conservative Chancellors have been very bad at running the economy. Given the general view which suggests the opposite (twice as many think the Tories are better at managing the economy than Labour) , it is worth setting out the record, but also to ask why they have been so bad. I’m going to start in 1979, with the Thatcher government, because Thatcher represented a new type of Conservatism. Before 1979 the Conservative party was more paternalistic, less neoliberal, and generally accepted the largely Keynesian methods for running the economy. (That is a huge oversimplification of course, but we have to start somewhere.)

Above is the path of GDP per head over the period of Conservative government that started in 1979. As you can see it contains two recessions, in the early 1980s and early 1990s. Both were associated with big macroeconomic policy mistakes. The first was monetarism. Monetarism did succeed in getting inflation down quickly, but other than that it was chaos. Monetary targets were never hit and interest rates were forced up to levels that decimated the UK manufacturing sector, leading to rapid deindustrialisation and persistently high unemployment for most of the remaining decade.

Essentially the government lost control of the economy, and as a result quickly abandoned monetarism. The period is also interesting because in 1981 we had the first brief experiment in austerity. Famously 364 economists wrote to the Times to complain. But austerity was very quickly abandoned (it started being unwound a year later) and as a result GDP recovered to previous trend levels with a brief delay caused by 1981 austerity.

By the late 1980s the economy was booming (see chart above). Monetary policy was shadowing the DM, so it was up to fiscal policy to curb what was turning into an inflationary boom. But the Chancellor Nigel Lawson wanted to cut higher rate tax (from 60% to 40%), and he felt it was not politically possible to do that without also cutting the basic rate. So we had a cut in personal taxes in a boom, and inflation took off (rising to over 9%).

At this point the UK decided to join the European ERM, at an exchange rate that was overvalued. I was leading the macro team at the National Institute at the time, and we did extensive analysis suggesting that attempts to stay in the ERM at that overvalued rate by raising interest rates would create a recession and was doomed to fail. We got the recession in 1991 and 1992, and we were forced out of the ERM on black Wednesday in 1992. The devaluation that followed did produce a strong recovery.

Moving on to the Labour government, the chart above ends in 2007 for reasons I will discuss. The first and most important thing to note is that the path of GDP per head is much smoother than in the previous charts. (The trend is unchanged compared to the previous chart.) The main reason for this was that Labour followed mainstream academic advice in giving the task of macroeconomic stabilisation to an independent Monetary Policy Committee, made up of Bank of England staff and outside appointees.

The Labour Chancellor did, however, have a big decision to make, and that was whether to join the Euro. After completing an extensive analysis involving Treasury staff and outsiders (Disclaimer - I was one of the outsiders) Gordon Brown made the right choice, and persuaded Tony Blair not to join.

Am I cheating by not including the Global Financial Crisis (GFC)? The reason I don’t is in the name. This was a crisis that started in the US housing market and spread all over the world, with the UK being hit by more than most because of its large banking sector. Now if the Conservative opposition had argued since 1997 for greater financial regulation, then you could say with some credibility that this crisis was in part due to the comparative inability of a Labour government to run the economy, but of course the Conservatives were arguing for more deregulation over this period. The truth is that the GFC came as a surprise to most people, including the Bank of England who were very late to see how serious it would be.

The GFC was the background to the final period of Conservative government, from 2010 until today. Growth in UK GDP per head did not recover from the GFC (there was no return to previous trends unlike earlier recessions) and trend growth was cut in half. Osborne’s austerity is not the only reason for that, but it probably paid a part. As a policy it turned basic macroeconomics principles on their head. The consensus today (and what the majority of academic macroeconomists said at the time) is that if interest rates are stuck at their lower bound you should use fiscal policy to stimulate the economy, not the reverse.

Austerity continued until slightly beyond the next macroeconomic disaster, Brexit. The origin of this crisis was Cameron’s decision to hold a referendum because of internal political problems in the party and UKIP. The OBR calculate (p34) that Brexit will reduce UK productivity by 4%.There was a brief but selective reversal of austerity in 2019.

Which brings us to Coronavirus. In the autumn of last year the Chancellor persuaded the Prime Minister not to follow expert advice that some form of lockdown was needed to check rising case numbers, and the result was a devastating winter of tens of thousands of unnecessary deaths and a further large hit to GDP. Unfortunately just one more example of how Conservative Chancellors tend to damage the economy.

This brings us up to date. We have just had a budget which is essentially austerity mark 2: less severe, backloaded and more tax than spending, but still a budget at the start of a recovery period that focuses on fiscal contraction rather than stimulus. There may come a time for tax rises, but not until the output gap is closed and forecast inflation together with interest rates are above 2%. The Chancellor had an excellent opportunity to raise public spending in a number of areas, but instead it was cut.  

Why do Conservative Chancellors keep making mistakes? I think it’s a combination of three things. The first is a lack of respect for academic economists and their received wisdom. The second is the search for popularity and election success. The third is ideology. Let’s go through this short history looking at all three.

Thatcher chose the ideas of right wing economists over most academics in adopting monetarism. Lawson wanted to cut higher rate taxes, but to preserve popularity he also cut all taxes in an inflationary period. Austerity combined all three elements: the majority of academics were ignored because Osborne wanted to shrink the state under a pretext that was popular. Brexit ignores consensus trade economics, producing the only trade agreement that makes trade harder to do, but it also played well to the electorate that the Conservatives needed to win over. I can only ascribe the mistakes over an Autumn lockdown to an ideology most clearly seen in the right wing press. This last budget ignores the academic consensus for stimulus because Sunak wants to retain the media image that equates responsibility with fiscal consolidation.

In contrast Labour achieved macroeconomic stability by adopting mainstream academic advice on the wisdom of independent central banks, but added a degree of political control on what targets should be. Labour looked at academic wisdom when choosing not to adopt the Euro.

Am I really suggesting that one of the failings of Conservatives is ignoring academic economists? Don’t we know that economists can never agree and are often wrong? Part of that reputation comes from economic forecasts, which academic economists and forecasters know is only slightly better than guesswork, but the media pretends otherwise. But on policy in the UK, the majority of academic economists were right in 1981, right that independent central banks would stabilise the business cycle, right that austerity was a terrible idea, right that Brexit would reduce output, and right that there was no economy/health trade-off beyond a few weeks during the pandemic. Academic economists make mistakes on policy of course, but as the ERM episode shows it is always best to use academic knowledge in making decisions.

One half of the reason why the public perception of economic management abilities is the opposite of reality is that Labour is blamed for a global crisis. But the other half is that too often Conservatives, through their think tanks and compliant media, get to write the history. The common perception is that the 364 economists turned out to be wrong, while in reality they were right. The media told everyone from 2010 that the economy was like a household and needed to balance the books, which could just be an innocent misunderstanding but could also be because the Conservative government controls the media narrative.

We can see this very clearly in some 2013 YouGov polling. Labour are preferred on living standards, jobs and inflation, while the Conservatives are preferred on controlling the deficit and helping people get on the housing ladder. Yet the media's emphasis on deficit control meant that the Conservatives are clearly preferred on the economy. Only when the media start to see a Chancellor's job in controlling the economy with better living standards, jobs and inflation rather than deficits will perceptions about who can manage the economy start corresponding with the historical record.  

The budget should create a balanced recovery, but instead it will be about the deficit

 

Some obvious points first. We are still in a pandemic, and so support measures for employees, the self-employed and businesses should continue. The chancellor should also, belatedly, increase sick pay substantially. The success of the government’s COVID strategy will depend on persuading those who otherwise cannot afford to isolate to do so.

The following remarks are based on the assumption that the government’s strategy works, and there is no return to NHS crises and lockdowns. Contrary to the perception you get from the media, encouraged by the government, it is far from certain that their strategy will work as planned. In addition, what I’m proposing here is what a Conservative Chancellor could conceivably do, rather than the budget I would enact if I was Chancellor. For reasons I will give later, it is not the budget I expect to see.

The overall macroeconomic context is for once fairly straightforward. Most academic economists, as well as the IMF and OECD, agree that you use fiscal stimulus (i.e. tax cuts or spending increases) to get you out of recessions, leaving monetary policy to control inflation outwith recessions. That means this budget should be all about ensuring a balanced recovery and not at all about fiscal consolidation. The last ‘recovery’ we had from a major recession was in 2010, when George Osborne thought the priority was to reduce the deficit. The result was a disaster, as this chart shows.

After the Global Financial Crisis the Treasury estimated trend GDP might fall by 5%. By 2010 GDP was 10% below the pre-austerity trend, and by 2013 that gap had increased to 14%. Of course austerity was not the only reason for this: productivity was gradually falling in most advanced economies and the UK was hit hard by the banking crisis. However it stretches credibility to believe that austerity was not a part of the reason why GDP and real wages fell by so much around that time, and failed to recover before Brexit hit. 

We need after this recession to focus on a recovery, but importantly on a balanced recovery. I think there is a good chance that most consumers will take the opportunity to spend some of the savings they have built up during the pandemic without any incentives from government. A lot depends on psychology and how COVID cases evolve. If cases this summer fall to levels that are similar to last summer, then with the additional protection of vaccination many will take the opportunity to do rather more of the things they would do normally but couldn’t do in the pandemic. We could call this ‘pent-up consumption’. However if cases start rising again in the autumn this may be short-lived.

In short, what will determine the consumption of most consumers will be the success or otherwise of the strategy to end the pandemic rather than any tax cuts. Because of the risk of cases increasing in the autumn another subsidy to eating out would be a bad idea. All this means that in terms of stimulus, tax cuts (either general or specific) should not be on the agenda. There is also no need to extend the stamp duty holiday, which moves house prices in the wrong direction. However tax increases, in the form of not uprating allowances, would be a bad idea because they focus on the deficit and not the recovery.

There is a very important exception to the bounce back in consumption, and that is the 20% of households in the lowest income quintile. They have seen savings fall rather than rise during the pandemic. This is no fault of their own, but a consequence of the jobs hit by the pandemic and the way the benefits system works. The Chancellor has agreed to the principle that people should be supported during the pandemic, yet those who need that support most have not received it.

If we want a balanced recovery, in which everyone participates, then the Chancellor should use the benefits system to help the lowest quintile. That means at the very least making the universal credit uplift permanent, and should include going further to reverse the real terms cut to benefits over the last decade. In addition it makes sense to provide incentives for people made redundant during the pandemic to get back into work as soon as possible. All this should be popular, because public opinion on welfare has shifted a lot, but the Chancellor will do a lot less because he is worrying about the deficit. 

All this applies just as much to sectors of the economy as it does to income quintiles. The cap on public sector pay is a bad idea during an economic recovery, and should be scrapped. There is an incredibly strong case for giving a thank-you payment to all the doctors and nurses that have worked so hard this year, and risked their lives in doing so.

A balanced recovery requires increases in investment as well as consumption. The impact of corporation tax on investment is very uncertain, but higher corporation tax will probably discourage investment and FDI to some extent. As a result, there seems no reason to announce any increases in corporation tax in this budget, particularly if the motivation for it is to reduce debt. (Expectations matter, so delaying increases by a year or two does not make much difference to their impact on investment.) Raising corporation tax makes sense when the recovery is complete, but there is a strong economic case not to anticipate or pre-announce this. [1]

A balanced recovery should also involve additional public spending as well as private spending. The demand for most public services does not go down in a recovery. There is a strong case against cutting overseas aid, and for additional funds to certain parts of the public sector including local authorities. A large increase in council tax is again not a good idea in a recovery, and it is up to central government to give local authorities funding to avoid this and more.

Last but not least, the 3% cap on public investment should be thrown out of the window. It is incredibly fortuitous that a desperate need for public investment to help green the economy takes place during a period of historically low real interest rates. It would be criminal if that opportunity was not exploited so that every potential investment that effectively reduced carbon use or protected us from things like flooding was undertaken. Keeping a lid on public investment that prevents projects with a high social return makes no sense at any time, least of all today.

How long should stimulating the economy through fiscal policy go on? The key here is not highly uncertain guesses about the output gap, but what is happening to short term interest rates and inflation. Fiscal policy makers should want to hand over macroeconomic stabilisation policy to central bankers (the MPC in the UK) when they are sure the economic recovery has gone as far as it can.

Looking at inflation alone is not adequate, because monetary policy is designed to keep inflation at target. Looking at interest rates alone is not adequate because we have very little idea of what a ‘neutral’ interest rate would be. So I suggest that stimulus continues until both forecast inflation is expected to be above 2% and the Bank’s base rate is above 2%. In other words, delay fiscal consolidation until both short interest rates and forecast inflation are above 2%.

Although a Conservative government could have a budget like the one I have set out, our current one will not. The reason is straightforward. Much of the public still associate fiscal consolidation with acting responsibly whatever the context. They haven’t learnt the folly of 2010 onwards because much of the media has not learnt it either. The big international economic institutions may have understood the need for fiscal activism during a recovery, but our media have not.

This is one of the reasons that a party that has done so much damage to the UK economy can be seen by the electorate as the more competent to run the economy. Since 1979 we have had high unemployment in the 1980s under Thatcher, botched (recession-inducing) ERM entry leading to Black Wednesday under Major, austerity under Cameron and Brexit under Johnson. Until a global financial crisis hit the UK, economic growth under Labour was strong, steady and accident free. The one big decision they had to take was Euro entry, which they managed very well and made the right call. On past evidence Labour are far better at running the economy than the Conservatives: stability and strong growth under Labour and chaos under the Conservatives.

Labour are right to call for no tax rises that could hurt the economy in this budget. The economic recovery may disappoint, and Labour need to point the finger at the Chancellor for this. Apart from this, Labour seem to have missed the one golden opportunity they had to try and dent the Tory lead on economic competence by not wanting to talk about Brexit. But the election is still a long way off, and in the meantime Labour can at least base their economic stance on the economic consensus rather than the mistaken beliefs of the media and voters.

Postscript (04/03/21)

In the post above I suggested the Chancellor could have produced a balanced recovery, but as expected his main focus was raising taxes (by freezing all allowances and raising corporation tax) in order to get public net debt falling in 5 years time. It is true that he has delayed tax increases until after the forecast recovery is over, but it seems unlikely that consumers and firms are going to ignore what he plans. As a result the recovery in consumption will not be as strong as it might have been, and the recovery in medium term investment will probably be lower than it could have been.

The rabbit out of the hat in the budget were the 130% investment allowances against corporation tax for the next two years. The danger of this measure is that it just brings forward investment, with little increase in investment over the next decade (see Chart 2.11 of OBR forecast, p63). In that case the main beneficiary is the balance sheet of large companies at the public's expense. With the recovery already forecast to be pretty rapid over the next two years, it isn't obvious why this bringing forward will be of much benefit.

What I was hoping for was a budget that created a balanced recovery, rather than a recovery driven mainly by better off consumers. There was absolutely nothing in the budget in this respect. We have public spending cuts (see page 8, some already announced but added to in this budget). Nothing to stop councils increasing council tax by 5% and repairing local services. The apparent cap of 3% public investment to GDP remains, despite the urgent need to help green the economy at a time of low interest rates. And nothing to help those from the lowest income quintile that have lost out in the pandemic. The increase in wealth inequality produced by the pandemic is not going to be reversed.

In the post above I say that fiscal consolidation should not start until both short interest rates and expected inflation are both above 2%. Neither is true in the OBR forecast. We have the crazy situation that fiscal retrenchment is happening while interest rates are forecast to remain at or below 0.5%. This makes no sense in economic terms. Macroeconomic policy is meant to stimulate a recovery, not to promise lots of higher taxes.

So we have an austerity budget. It may not be on the scale of George Osborne in 2010, but it remains about fiscal consolidation before we have begun to recover from a deep recession. The Conservatives have never come to terms with the gravity of their error from 2010 onwards, and remain attracted to playing on the media's false understanding of what responsible policy is. Next to what is happening in the United States, Sunak's policy seems totally perverse. What will suffer, just as under George Osborne, will be average prosperity in the UK.

[1] The left have criticised the Labour leadership a lot on this, with nonsense like this makes Labour to the right of the Tories. The position that you want to combine an increase in CT with additional stimulus (particularly anything helping investment) is perfectly respectable, but not transparent when the debate will be the economic consensus versus the mediamacro (we should worry about the deficit). When Sunak's economic stimulus falls short this Wednesday, the argument for raising CT becomes much harder to make.