For economists Project Fear is Brexit

Ironically we have the Union’s side in the Scottish referendum debate for inventing the idea of Project Fear. Alex Salmond, who knows a bit about spin, immediately saw its potential, and the economic case against Scottish independence was branded Project Fear by the SNP. The implication of that label is that those using Project Fear are hugely overplaying their hand to frighten voters.

In the Scottish referendum the UK government’s case was that people would be significantly worse off in the short to medium term in an independent Scotland. It may have been met with the jibe that it was Project Fear, but in reality it was a pretty reasonable assessment of what independence might mean, parts of which were backed up by independent analysis from the IFS and the OBR. But together with some wishful thinking of their own, the SNP were able to dismiss all this economics analysis as just scaremongering.

Yet in reality things turned out to be even worse than the Treasury and independent analysis had suggested. That analysis assumed that the high oil price at the time would stay high. What actually happened was a sharp fall in the oil price, which would have been a disaster for an independent Scotland. So in the end the UK government’s case against Scottish Independence was understated. But Nicola Sturgeon keeps calling it Project Fear and journalists hardly ever challenge her on that. So by the rules of the politicisation of truth, any reasonable but negative assessment of the economic consequences of change is now seen as potentially politically counterproductive because can be called Project Fear.

It was therefore inevitable that the Leave side would pick up on this trick. They too knew that the economic facts were stacked against them. So they called the analysis produced by the Remain side Project Fear, and political commentators in the broadcast media - being balanced and all - found it easier to repeat the label than try and go through the arguments.

Yet the arguments are not rocket science. Countries find it easier to trade with others that are close by. If you make that trade more difficult by leaving the single market, some of that trade will go elsewhere, but not all of it for sure. The end result will be less trade. It is common sense, which happens to be backed up by lots of empirical evidence. There is also strong evidence that less trade leads to lower productivity growth, which means incomes grow more slowly. What is a key reason why China been growing so rapidly since the 1980s? Because it opened up to trade.

It is also common sense that if we leave the EU, foreign investment into the UK will fall. Invest now and you get easy access to the huge market that is the EU, so after Brexit many firms will go elsewhere to gain that access. This is why 9 out of 10 economists think we will be poorer after Brexit, with only 4 in every 100 thinking we will be better off. [1] As the IFS’s Director Paul Johnson wrote: “That degree of unanimity on any poll of any group of people about just about anything is almost without precedent.”

Faced with this level of unanimity, some in the leave campaign have tried to suggest that economists generally get it wrong. Yet ironically, one of the examples they choose shows completely the opposite, as Paul Johnson notes and I had also pointed out earlier. The UK’s decision in 2003 on the Euro was similar to the Scottish and EU referenda in the following way. Some politicians, for essentially political reasons, liked the idea of doing something they saw as bold: in 2003 it was adopting the Euro. The Treasury did an incredibly thorough job of looking at all the pros and cons, taking extensive academic advice, and convinced first Gordon Brown and then Tony Blair that the risks were too big. And just as in the case of Scottish independence, that analysis underestimated the problems the Euro would face. Luckily neither Brown or Blair thought this analysis was Project Fear.

The 2003 Euro work, and the Scottish independence work, were both headed up by the same man: Dave Ramsden, now Chief Economic Advisor at the Treasury. Having got two big calls right, he is just the guy you would want to be in charge of the Treasury’s analysis of Brexit. That Treasury analysis is once again pretty reasonable, and - just as with the Scottish referendum - has been shown to be reasonable by other studies [2]. The idea that you shouldn’t trust economists now because they always get it wrong has it completely backwards in this particular case.

But as Paul Johnson, myself and others have noted, the message from economists is either being ignored or has not got through. I do not think it is being ignored, for reasons outlined here and here. Which is why journalists in the broadcast media must stop this nonsense of obscuring the truth by being too literal about political balance. The problem, as I noted here, is that one point in the overall debate is obvious: you cannot control immigration from the EU within the EU. So if the media insist on obscuring the economic costs of Brexit by putting up nonsense analysis against the consensus among economists, or continuing to dismiss that consensus as Project Fear, they are effectively taking sides. Let’s hear less from political journalists about Project Fear, and more about the economic consensus that after Brexit wages will be lower and there would be less money for the NHS.

[1] There is this strange idea among Leave supporters that we cannot say people will be ‘poorer’ under Brexit, because being poorer can only mean less well off than you were in the past. I guess if the Brexit side are going to misuse numbers (£350 million a week), they are going to try and misuse language at the same time.

[2] Martin Sandu has a brief summary

Is evidence based policy left wing?

The answer in principle is of course not. In practice, not so clear. This is something I talked about back in October 2013, and there are no signs that things are getting better. Alex Marsh makes the same point in the context of the latest budget. This antagonism to ‘unhelpful’ evidence is out there in plain sight for all to see in the UK government’s current attempt to deny academics in receipt of public funding the ability to talk about the policy implications of their work. I talked about this in terms of the misuse of the term ‘public money’ a few weeks ago, but it is also a pretty direct attempt to suppress unhelpful advice. (Note that ministers have the power under this proposed legislation to revoke this ban in individual cases, presumably when evidence is ‘helpful’ - to them.)

Of course we are not talking about a hostility to evidence based policy by everyone on the right on all occasions. In a THE article by Ben Goldacre, where he also highlights the dangers of the government’s proposed legislation, he details the extent to which he is talking to ministers about evidence based policy. But that interest does not seem to extend to big macro decisions. I was reminded in reading this about what I regard as a triumph of evidence based policy making in my own area: the UK Treasury analysis of Euro entry in 2003. (Disclaimer: my little contribution is the fourth one down in the picture of the reports.) Why didn’t this government do something similar for both the Scottish referendum and the EU referendum?

Everytime I mention the 2003 exercise someone responds that it was just a smokescreen for a power play between Brown and Blair. I think this is an overly cynical view, a view that evidence never changes anyone’s mind. Ramsden’s own view is that the civil service, using the evidence, “ultimately persuaded both the Chancellor and in particular the Prime Minister that it wasn't right to join." It was also the right decision. With both recent referendums we have seen proponents of change putting out documents suggesting that change will not be economically damaging, when most evidence shows pretty clearly that it will be. With the EU referendum in particular, would it not have been better if the government had asked the Treasury to do a similar exercise to 2003, using outside experts where appropriate to provide or validate the technical analysis?

Ben Goldacre’s piece reminded me of my own recent place on John McDonnell’s Economic Advisory Council (EAC). From Ben’s tweets I knew that he was not the greatest fan of this government, and in particular their current treatment of junior doctors, so I asked him whether he had received any negative comments from doctors or others about him giving advice to the government. I was not surprised to hear he had not. Who could object to him taking the opportunity to argue for better use of data and trials in medicine and elsewhere with people who just might do something about it?

It is a shame that some people did not take the same view when I agreed to be on the EAC. I would lose credibility as a macroeconomist, I was told. When McDonnell did his U-turn about supporting the fiscal charter, some suggested this reflected badly on me, even though he had turned in the direction I thought was correct! One charge in particular was levelled at the time. We were being used to make the leadership look respectable, but our advice would in practice be ignored. A couple of weeks ago Labour adopted a fiscal rule which is based on my own work with Jonathan Portes, and in particular by a presentation I made to the group. Mariana Mazzucato’s own work has also featured strongly in Labour party speeches, with good reason.

At the end of the day, policy makers need to look at evidence. If they do not we need strong mechanisms that allow them to be confronted by this evidence. Policy makers that make space for evidence and take decisions based on it need to be congratulated for this, rather than being told their efforts were just a smokescreen. They should be congratulated because letting evidence in often involves a risk: not just to the policy maker’s priors or preferences but also for scrutiny of past actions. Equally we should regard policymakers who knowingly ignore evidence with great suspicion, and those that try to deliberately keep evidence out of the public domain should be condemned.

Is sterling overvalued?

One of the reasons that steel plants have been closing in the UK rather than Germany or France, and that UK manufacturing output has fallen for the last two quarters, is the strength of sterling and the weakness of the Euro. The weakness of the euro relative to the dollar could be explained (at least qualitatively) by interest rate expectations: whenever interest rates do rise in the US, they will surely rise well before they do in the Eurozone. When domestic interest rates are expected to rise relative to overseas rates, a currency should appreciate.

The same logic could be applied to sterling. Indeed some still believe interest rates could rise in the UK before they rise in the US. If the UK looks like the US, you would expect on these grounds for the pound relative to the dollar to be roughly stable, but sterling to follow the dollar in appreciating against the Euro. To a first approximation that is what has happened.

The only problem comes if you look at the UK’s external performance. The current account deficit as a percentage of GDP has wobbled around 2% for most of this century, but in the last few years it has increased sharply, coming in at over 5% of GDP in 2014. All these deficits are taking their toll on the UK’s net financial position: twenty years ago we owned about as many overseas assets as there were UK assets owned overseas, but we are now a net debtor by an amount that will just get larger if we continue to run large current account deficits. (For more on this, see Felix Martin in the FT.)

When I calculated an equilibrium sterling euro rate in 2003, my estimate was 1.365 E/£. As current rates are close to that, and given the point about expected interest rates, what is the problem? Unfortunately there are three. First, that calculation was based on an assumption that the sustainable UK current account was balance. In other words, if the rate had stayed at 1.365 E/£, then over time and on average the current account should have been in balance. Instead we have had persistent deficits. In the early 2000s that might have been partly explicable because sterling was a little stronger than my estimate, but since the beginning of 2008 quite the reverse has been true, but we have still run deficits. That either suggests my estimate was wrong (the equilibrium E/£ rate should have been lower), or the equilibrium rate has depreciated since 2003.

Second, persistent current account deficits that weaken our net foreign asset position will in any case imply a gradual depreciation in the equilibrium exchange rate. The worse our net asset position gets, the greater the trade surplus we need to pay interest on that net debt. Third, and perhaps more speculatively, if the recent stagnation in productivity also represents a stagnation in innovation in the variety and quality of goods produced in the UK, that will also mean a depreciation in the equilibrium exchange rate.

All this suggests to me that sterling may currently be overvalued. How can I say this when there are a huge number of people in that market trying to make money from getting the ‘right’ rate? Quite simply from experience. The market is totally focused on very short term movements, and pays very little attention to estimates of equilibrium rates. When I did my equilibrium rate calculation in 2002, the actual rate was wandering around 1.6 E/£, and there was no clear reason why it should be so much higher than the equilibrium rate. So, even allowing for expectations about interest rates, it would be quite possible for sterling to be currently overvalued.          

What do macroeconomists know anyway?

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

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

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

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

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

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

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

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

How knowledge transmission should work

The tenth anniversary of the UK’s 2003 decision not to join the Eurozone has just passed. With all my complaints about how bad macroeconomic policymaking has been recently, I thought it was worth analysing an example of a good decision. Good not just because it was the right decision given the events of the last few years, but good also because of how it was done, and the way academic knowledge was used.

If you want detail on the background and process itself, I recommend viewing or reading a recent lecture by Dave Ramsden, who was the civil servant who masterminded the process. Here is just a short summary. The UK opted out of being one of the founding members of the Eurozone, but the possibility of us joining shortly afterwards was always taken seriously. The Chancellor Gordon Brown announced 5 tests that would need to be passed if this were to happen, and the Treasury spent a couple of years doing extensive work on these five tests. It eventually published 18 studies, which I recommend to any students who want to take a serious interest in Optimal Currency Area (OCA) theory. Although there is some original work there (of which more later), they were mainly very good summaries of the relevant academic literature, and various academics were consulted to help ensure this was the case.

I should declare an interest here. I wrote one of those studies, which tried to assess what exchange rate the UK should join at, if the decision was yes. However I do not think this has any influence on what I have to say below, because in an important sense my study was secondary to the question of whether we should join. [1] In contrast, much more critical was modelling work done by Peter Westaway, at the time a Bank of England economist who had previously built the Bank’s core macromodel.

Now some will argue that these 18 studies, and the years of work that went into them, were window dressing for a decision that had already been made. I think that is simply incorrect. Some of the reasons I think that are described by Dave Ramsden: if the politicians involved had already made up their mind, they went to quite elaborate lengths to conceal the fact from those that worked for them. (Compare this to the Iraq war, for example, where a dodgy dossier sufficed.) Furthermore, the studies themselves contain some very strong arguments (probably too strong) why joining the Eurozone could be very beneficial, which is not the kind of thing you do if you want the analysis to back up a foregone conclusion.

As a result, I think the exercise was what it purported to be: an attempt by civil servants to give the best advice they could to politicians. What marks it out for me was the extent to which those civil servants involved academics, and placed academic work at the centre of their analysis. The merits or otherwise of the Euro did divide macroeconomists, but there was no attempt to just consult those who agreed with some predefined view. (See, for example, the space given to Andrew Rose’s empirical work of the benefits of OCAs.)

So why was this process close to what I consider an ideal of how academic knowledge should be used, when I have just written a post which is far more pessimistic about how these things are generally done? I should think about this some more, but here are three ideas. The first is that the decision, although it generated strong opinions on either side, was not fundamentally ideological. There was no existing political apparatus that was clearly aligned with potential winners and losers. The second is that you had a Chancellor who had a very strong respect for economic ideas, whatever else you may think of him as a politician. Third, the Chancellor had to convince the Prime Minister Tony Blair, and so whatever decision he came to needed to be backed up as strongly as possible.

Most people would now agree that the 2003 decision (only one the five tests were passed) was the correct one. [2] While the analysis, and particularly the work by Westaway, contained some of the elements that came to the fore in the Eurozone crisis, I think Ramsden in his 10 year retrospective is clear that the 18 studies also failed to foresee other elements of the crisis, perhaps not surprisingly as most macroeconomists missed these too. Yet the deeper point is this. The decision was based on the best analysis that macroeconomics at the time could provide. It is a shame that this way of making economic decisions now looks like the exception rather than the rule.  

[1] If anyone ever asks whether I can keep a secret, I always give this as evidence that I can. The original work I did for the study was done and written up in 2002. At the time the Euro/Sterling rate was at or near 1.6 E/£, and my analysis suggested something closer to £1.4 E/£ was sustainable. So for nearly a year I sat on information that was extremely market sensitive, and I received plenty of phone calls trying to extract any hint at what my analysis would be, and I’m glad to say no one got anything out of those calls. Alas I also felt it would be improper for me to bet on my own analysis, which had been funded by the Treasury - perhaps that just makes me an honest fool. (The morning my study was published - by which time the rate had fallen to much nearer my numbers, naturally - it did move the market by about one percent, but that is another story.)

[2] Will Hutton disagrees. In his counterfactual where we joined, the UK not only does better before the crisis because sterling stays at a competitive rate, but also the UK’s benign influence provides a counterweight to Germany. This alternative history deserves a proper analysis which I do not have space for here, but my initial take is that it involves a lot of wishful thinking.