Did the UK really almost go bankrupt?

I normally publish posts in the first half of the week, but two separate attempts were overtaken by events, and they will have to wait for another day. I finally wrote something for the Guardian on the Governor’s interview that led to nonsense headlines about the UK almost going bankrupt. The piece explains why they are nonsense, but I should note here that the headlines are classic mediamacro, appealing to the idea that governments are like households.

Frances Coppola makes the same point a different way. You could describe what happened in March this year as a short term liquidity problem. There is no suggestion the UK is insolvent. And the thing about countries with their own currencies is that they never have a liquidity problem because they create money. She also notes that no headlines talked about the fragility of our commercial banks around the same time. You would think, after the GFC, that would be the big news. Here is a quote from Frances’s blog:

“I found the interviewers' constant focus on government financing a serious distraction from what was an important story about the Bank's vital responsibility for ensuring the smooth operation of financial markets. When financial markets melt down as they did in 2008, the whole world suffers. Central banks saw the same thing happening again in March 2020, and acted to stop it. And their action was extremely effective. It seemed to me that this was the story Bailey really wanted to tell, but the interviewers were intent on pushing him towards the issue of monetary financing and the Bank's independence.”

This episode was not, as some have suggested, an example of fiscal dominance. To make that clear, I give an example of what fiscal dominance would be in the article, where the Bank is forced to monetise borrowing against its better judgement. Dealing with market disorder in a pandemic is not that. But, rather more controversially, I do suggest that fear of fiscal dominance may make central bank governors not that objective when discussing fiscal policy.

So why does the media hype up some short run disorder in markets to be something it isn’t? Perhaps it all goes back to mediamacro’s view that government deficits are bad, whatever the causes. (I stress here that not every journalist thinks like mediamacro.) We have seen huge increases in these deficits as a result of the pandemic, which some in the media have written up with horror rather than as only to be expected. So maybe the media is looking for the markets to validate their view. I would be interested in what media folk think about why his interview was written up the way it was.

The Brexit interest rate increases and misunderstanding inflation

Last week’s rise in UK rates has been extensively analysed (see for example Tony Yates here) so I will be very selective. First, the justification for the title of this post is provided by an extract from the inflation report:

“The overshoot of inflation throughout the forecast predominantly reflects the effects on import prices of the referendum-related fall in sterling. Uncertainties associated with Brexit are weighing on domestic activity, which has slowed even as global growth has risen significantly. And Brexit-related constraints on investment and labour supply appear to be reinforcing the marked slowdown that has been increasingly evident in recent years in the rate at which the economy can grow without generating inflationary pressures.”

The last sentence is particularly important: in plain language it is saying that Brexit is contributing to lower trend productivity growth, which the Bank now put at 1.5% compared to a pre-recession level of 2.25%. The wording is chosen carefully: they are not talking about uncertainty effects, but permanent effects from a likely deal. So last year worries about the demand side effects of Brexit led the Bank to reduce rates, and now concerns about the supply side effects of Brexit are contributing to higher rates.

Whether these modest increases in interest rates continue, as the Bank are signalling, should largely depend on whether the pickup in earnings growth they anticipate actually happens. As Torsten Bell from the Resolution Foundation argues here, the set of information that might justify the Bank’s expectations of an imminent recovery in earnings growth is not empty, but nevertheless many economists regard it as a brave forecast.

However the labour market is not the only reason the Bank is raising rates. Putting labour market issues aside, they think that because firms are operating with little ‘spare capacity’, any large increases in demand will be met by firms raising prices. Ergo the Bank’s job is to use higher interest rates to stop demand rising too fast. I think this is conceptually wrong, because it underestimates the role that demand and expectations about demand play in determining investment decisions.

A firm can meet rising demand in three ways: by investing in more productive processes, by raising prices or by using more of its spare capacity. In a traditional economic upswing firms first use spare capacity, then invest, and when capacity utilisation is at a peak and there are no profitable investments to make it raises prices. At that point it is right for a central bank to step in to moderate demand growth.

This has not been a typical recovery from a recession. Firms have used up spare capacity, but have not invested in more efficient processes. This is what measures of capacity utilisation suggest (taken from an earlier Bank of England Inflation Report).

If you just take these surveys as measuring the state of the cycle (and if we ignore the Bank Agents) since 2013 the economy has been experiencing an economic boom. Yet from 2013 core inflation has been below target and falling. You can resolve this paradox by thinking about firms acting unusually, by failing to invest and meeting additional demand by utilising capacity as if they are in a boom The result of that is stagnant productivity growth.

The conceptual error is to read these capacity utilisation numbers as indicating that there are no profitable investments to make. We know these profitable investments exist, because leading firms are improving their productivity.* What we have is an innovations gap, where lagging firms are not copying leading firms and are instead holding back on investing. We do not know why they are holding back, but one obvious reason is they have expectations of low future growth and/or high uncertainty about this growth. Empirical evidence shows the strongest determinant of investment is output growth, and the obvious rationalisation for that ‘accelerator effect’ is that current growth influences expectations about future growth.

If this is right, increases in demand will be met by firms finally coming off the fence and investing, rather than raising prices. But if the central bank starts raising interest rates to choke off demand, even when it is growing slowly by historical standards, it will validate the pessimism that has been holding back investment and productivity will continue to stagnate. There is a very real danger that the Bank may be playing its part in a self-fulfilling low growth recovery.

*Postscript (8/11/17) Discussion here by Berlingieri et al shows this growing divergence between leading and lagging firms is a global phenomenon.

Productivity and monetary policy

The Bank are warning of imminent rises in interest rates. As Chris Giles points out, we have been here before, and before that, but that shouldn’t mean we should dismiss this talk, because one day it will happen. [1] They (the MPC) certainly sound serious. But why when current growth is so slow are they even contemplating it? Here is a clue from Mark Carney’s latest speech (my italics).

“On the supply side, the process of leaving the EU is beginning to be felt. Brexit-related uncertainties are causing some companies to delay decisions about building capacity and entering new markets. Prolonged low investment will restrain growth in the capital stock and increases in productivity. Indeed, if the MPC’s current forecast comes to pass, the level of investment in 2020 is expected to be 20% below the level which the MPC had projected just before the referendum. Net migration has also fallen by 25% since the Referendum.

As a result of these factors and the general weakness in UK productivity growth since the global financial crisis, the supply capacity of the UK economy is likely to expand at only modest rates in coming years.”

When people, like me, say how can the Bank be thinking of raising rates when demand is so weak, the response from the Bank would be that supply has been at least as weak.

This pessimism about the supply side comes straight from the data. If I hear people talking about the UK being a ‘strong economy’, I know they either have not seen this chart or are just lying.

UK Output per hour, whole economy (ONS)

The red line is a trend that pretty well matches the trend in the data until the end of 2007, with the amount you can produce with an hours worth of labour increasing by 2.2% a year. Since the global financial crisis (GFC) there has been almost no growth at all. If you want to know the main reason real wages have stopped increasing, this is it. [2]

I hear some people say this is just oil and financial services. It is not, as this table from a recent Andy Haldane speech shows.

Start at the bottom: total average growth has been non-existent since the crisis. The rest of the table looks at the contribution of each sector to that total. To see what productivity growth would be excluding financial services, just add that figure to the total: 1.8% 1998-2008, 0.4% 2009-2016. That table makes it clear that the productivity crisis is economy wide.

It is worth looking at aggregate productivity since the GFC period in more detail (same data). I often hear people say the productivity slowdown started before the GFC. From the chart below, it clearly did not. (We have just seen the tenth anniversary of Northern Rock going bust, and the UK productivity slowdown started shortly after that event.)

We could describe this data as five phases. 1) Productivity in the recession fell, as it often does in a recession for various reasons. 2) As the economy begins to grow again, so did productivity growth. 3) As it becomes clear, in 2011, that the ‘recovery’ is going to be very weak because of austerity, productivity growth stops growing. 4) By the end of 2013, with stronger growth under way (although still no catch up to previous trends, so not a true recovery) productivity starts growing again, although rather slowly. 5) Since the 2015 election, with the prospect and then the reality of Brexit, even that modest growth disappears. (My data does not include 2017Q2, which saw a very slight fall.) I could shorten the description as follows: recession, modest optimism, pessimism, even more modest optimism, uncertainty.

That is my gloss on the numbers, but I’ve done it to make a point. Productivity growth invariably requires an investment of some kind. It may not be physical investment, but just training someone up to be able to use some new software. Whether a firm incurs that cost will depend, in part, on their expectations about the future. There is a regrettable tendency in macro (I blame RBC theory) to treat productivity growth as manna from heaven. But the idea that potential improvements in technology stopped after the GFC, and just in the UK, is simply ridiculous. The problem is that firms are not investing in new technology. What I call the ‘innovations gap’ has emerged in the UK because of weak growth and the consequent pessimistic expectations of most firms. [3]

The idea that the economy could get itself in a low growth expectations trap is increasingly being put forward by economists: here is George Evans, for example. The UK has got itself into that trap because on the two occasions that a recovery of sorts appeared to be under way, the economy has been hit with terrible policy errors (austerity and Brexit). But the idea that UK firms are incapable of upgrading their production techniques is nonsense. They will do so initially if they can be confident that the demand for their products will increase, or subsequently when the innovation pays for itself even though demand is flat.

Which is why an increase in interest rates right now would be very bad news. It would confirm the pessimistic expectations of most firms that demand is not going to grow fast enough to make innovation worthwhile. Formally, the job of the MPC is not to worry about productivity but to control inflation. But elsewhere, where the same process may be happening to a lesser extent (the productivity slowdown is worldwide, just most acute in the UK), central banks are puzzled at why inflation just refuses to rise. 

The concept of an innovations gap is one solution to that puzzle. Expanding demand allows firms to invest in more productive techniques, and so there is less incentive to choke of demand by raising prices. I suspect in an alternative world where Brexit had not happened the Bank of England would also be puzzling over why prices were not rising. As a result, if the MPC do finally raise interest rates this year, it would be one more mistake to add to the growing list under the heading Brexit.

[1] On each occasion I also wrote a post saying that they should not raise rates, starting I think at the beginning of 2014.

[2] I discussed in earlier posts why real wages are falling by even more than output per head.

[3] Or perhaps the pessimism of the bank manager lending money to those firms. The Haldane speech shows that productivity growth has remained strong among the top, frontier companies. Why? Because these companies, given their position, will be seeing growth relative to the average, and have got to the frontier through a culture of innovation.

The Brexit slowdown begins (probably)

When the Bank of England after the Brexit vote forecast 0.8% GDP growth in 2017, they expected consumption growth to decline to just 1%, with only a small fall in the savings ratio. But consumption growth proved much stronger in the second half of 2016 than the Bank had expected. As this chart from the Resolution Foundation shows, pretty well all the GDP growth through 2016 was down to consumption growth, something they rightly describe as unsustainable. (If consumption is growing but the other components of GDP are not, that implies consumers are eating into their savings. That cannot go on forever)

This strong growth in consumption in 2016 led the Bank to change its forecast. By February

their forecast for 2017 involved 2% growth in consumption and GDP, and a substantial fall in the savings ratio.

What was going on here? In August, the Bank reasoned that consumers would recognise that Brexit would lead to a significant fall in future income growth, and that they would quickly start reducing their consumption as a result. When that didn’t happen the Bank appeared to adopt something close to the opposite assumption, which is that consumers would assume that Brexit would have little impact on expected income growth. As a result, in the Bank’s February forecast, the savings ratio was expected to decline further in 2018 and 2019, as I noted here. Consumers, in this new forecast, would continually be surprised that income growth was less than they had expected.

The first estimate for 2017 Q1 GDP that came out yesterday showed growth of only 0.3%, about half what the Bank had expected in February. This low growth figure appeared to be mainly down to weakness in sectors associated with consumption (although we will not get the consumption growth figure until the second GDP estimate comes out). So what is going on?

There are three possible explanations. The first, which is the least likely, is that 2017 Q1 is just a blip. The second is that many more consumers are starting to realise that Brexit will indeed mean they are worse off (I noted some polling evidence suggesting that here.), and are now adjusting their spending accordingly The third is that consumption was strong at the end of 2016 because people were buying overseas goods before prices went up as a result of the Brexit deprecation.

If you have followed me so far, you can get an idea of how difficult this kind of forecasting is, and why the huge fuss the Brexiteers made about the August to February revision to the Bank’s forecast was both completely overblown and also probably premature. All Philip Hammond could manage to say about the latest disappointing growth data was how it showed that we needed ‘strong and stable’ government! I suspect, however, that we might be hearing a little less about our strong economy in the next few weeks.

Of course growth could easily pick up in subsequent quarters, particularly if firms take advantage of the temporary ‘sweet spot’ created by the depreciation preceding us actually leaving the EU. Forecasts are almost always wrong. But even if this happens, what I do not think most journalists have realised yet is just how inappropriate it is to use GDP as a measure of economic health after a large depreciation. Because that depreciation makes overseas goods more expensive to buy, people in the UK can see a deterioration in their real income and therefore well being even if GDP growth is reasonable. As I pointed out here, that is why real earnings have fallen since 2010 even though we have had positive (although low) growth in real GDP per head, and as I pointed out here that is why Brexit will make the average UK citizen worse off even if GDP growth does not decline. If it does decline, that just makes things worse.  

The Kerslake Review of the Treasury

This review, published today, was commissioned by John McDonnell but is entirely independent. Although it is ultimately Lord Kerslake’s review, it is the product of a small panel of which I was a member, and also reflects submitted evidence and meetings of invited experts. I can say that in my area, macroeconomic policy, this external evidence was very influential and let me thank again all those involved. This post just focuses on these macroeconomic aspects of this review of the Treasury. [1]

The obvious place to start is to think how the role of the Treasury has changed in the last two decades. In 1997 setting monetary policy was delegated to the Bank of England. In 2010 the forecasting aspects of fiscal policy were delegated to the OBR. To a government obsessed by cutting the size of the state that might suggest that the Treasury did not need to have a large macroeconomic capacity, But if you think about the major macroeconomic disasters if the last decade, that view is completely misguided.

One way of thinking about these disasters is that they reflect a failure to consider potential risks to the economy, and what might be done to both mitigate those risks and respond to them if they occurred. No one was ever going to predict the exact time and date of the financial crisis, but someone in government should have been thinking about what risks a rapidly expanding banking sector might pose. There were not many who warned about the risks, but enough to warrant a risk analysis. As I have said before, I doubt that this could have avoided a crisis - the banking lobby is too strong - but at least the government would have given some thought about what to do if it happened before it happened.

When it came to austerity, everything would have been relatively unproblematic if the economy had grown at the pace at first expected in 2010, because monetary policy would still have had control. (Interest rates would have been above their lower bound.) But someone should have been focusing on what happens if things turned out to be less rosy, and making sure ministers had to address these risks. At the very least that analysis would have pinpointed the need to change fiscal policy the moment that more pessimistic outcome came to pass, but perhaps also thinking about this risk might have injected a note of caution into policy before this happened. In a secret Treasury that might not have stopped a determined politician, but if this risk analysis had been made public?

Who in government should have been doing this risk analysis? The obvious institution is not the central bank, which can be far too tentative in the area of fiscal policy and too biased on financial policy, but the Treasury. The Treasury, to use a phrase suggested at one of our evidence gathering meetings, should be “the country’s risk manager of last resort”. The Treasury is uniquely capable of getting information from all the parts of government, including the Bank, and putting it together within a consistent macroeconomic framework.

But this isn’t the only reason why the Treasury still needs a strong macroeconomic capacity. It sets the rules by which fiscal and monetary policy operate, and the danger of not having this capacity is that the rules get determined by political whim, or don’t change through inertia. And it also needs the capability to undertake large pieces of complex analysis very quickly, as we have again seen over the last two decades.

What do I mean by capacity? Above all people: people who have the ability to do and understand state of the art macro analysis. If you compare the number of macroeconomists at the Treasury and the Bank there is a huge imbalance which is not conducive to good policy making. It is absurd to think that you need suites of models to set interest rates, but virtually nothing to set monetary and fiscal policy rules and analyse the impact of potential risks to the economy.

None of this is guaranteed to stop the Treasury become obsessed with the deficit and ignoring macro analysis, but the stronger the macro team is in the Treasury the less likely this is to happen. One other way that is often suggested of combating this danger, and which we considered, involves splitting off from the Treasury key aspects including macro policy into a new Economics ministry. My own view, which is similar to that expressed in the report, is that such a split just runs the danger of institutionalising the dominant role of balancing the budget in policy making.

There is one final benefit of enhancing the macro capacity of the Treasury, and that would be to provide the potential to increase openness. I take it as given that greater openness would be a good thing, and also being an essential way of utilising existing expertise around the country. It is far from clear why risk anaysis has to be secret. To take just two examples, the Bank makes a concerted attempt to find out what is being done in UK universities that might be useful to it, and it publishes a regular blog where their economists can flag interesting data and analysis. It would be good if the Treasury had the capacity to do something similar.

[1] There is a great deal more in the report, both about macro policy and issues around devolution, working with other departments, the overall goals of policy and much more. I also feel I need to note one area where I disagree with how Bob talked about the report yesterday (on Peston’s show and to the Guardian). While I’m sure it is true that the Treasury has lost trust as a result of its incorrect pre-referendum short term forecast, by highlighting this in the context of this report you inevitably give the impression that it did something unprofessional. But both assessments were signed off by Charlie Bean. and the Treasury were hardly alone in expecting negative short term impacts from Brexit. Worse still, it risks suggesting that their long term analysis is suspect.

How Brexit advocates intend to smear economics

Those who are devoted to Brexit have only faced one real enemy: economics. It is in the DNA of economics that trade is good, and so anything that makes trade more difficult will be costly. On top of this basic insight on which so much of society is built is a host of detailed evidence on the impact of trade agreements and the effect of more trade on the economy. This knowledge had become received wisdom among most MPs, probably as much if not more through their contacts with business.

What Brexit advocates had on their side was the huge advantage of fanatical support from most of the Tabloid press as well as the most widely read broadsheet . It is a schoolboy error to say that because newspaper circulation is declining its influence is also declining. More people may get their news online, but newspapers remain a primary news source online, either directly or indirectly. The broadcast media also tends to take their lead from newspapers. This is why Leave wanted a referendum, because they thought they could win, not because they had any great belief in this form of democracy. [1]

In the referendum itself economists were largely sidelined, and when their arguments did appear via the predictions of organisations like the IMF they were generally accompanied by a matching segment from the tiny band of “economists for Brexit”. For this and other reasons I have discussed at length in earlier posts, the Brexit advocates won, narrowly. But the advocates of Brexit still face a problem. If the news as Brexit happens is all bad, then maybe people will begin to hear about what the overwhelming majority of economists have been saying.

And sure enough, that has been happening. Sterling crashes the moment markets hear about the vote, and this will gradually reduce consumers’ real incomes. The Bank has to cut rates to their lower bound and restart QE. Forecasts of the public finances deteriorate, most recently here. So they needed some way of smearing all these negative medium term economic predictions. When the Bank of England revised up their forecast of UK GDP growth in 2017 from 0.8% in August to 2% in February (see this post), they saw their chance.

They will now claim that economists are completely discredited because they all thought GDP would collapse as a result of the Brexit vote and it hasn’t. Therefore anything they say about the public finances or growth in the medium term can be discounted. Now of course among those that know anything about economics this is nonsense. But most people do not know much about economics, they do not read the FT or Economist, so this kind of propaganda is effective. Don’t be surprised to hear it from political journalists in the broadcast media before long.

So for the record, before this happens, here is why it is nonsense.

1. (And most important) Short term unconditional macroeconomic forecasts are extremely unreliable: always have been and I suspect always will be. They are slightly better than guesswork, but for a central bank that slightly better is well worth having. Predictions about the long term impact of Brexit mainly come from the non-macro part of international trade: gravity equations and all that. Their empirical foundation is strong. The idea that lower immigration will hurt the public finances is also common sense once you recognise that immigrants are young, and therefore will pay taxes that finance their use of the NHS and other public services with plenty to spare. This has nothing to do with macro forecasting!
   
   
2. Actually it is not the case that economists universally thought GDP would collapse. Here is the FT survey: most thought it would collapse, but it was not universal. The FT survey focuses on City economists, not academic economists. One prominent academic economists, Paul Krugman, has always been very dubious about talk of a recession. What is true is that economists universally think Brexit will have bad long term effects.
   
   
3. As I wrote here in June last year, the macro impact of Brexit involves counteracting forces. The depreciation is partly in anticipation of the loss in trade Brexit will bring, but in the short term it could boost net trade. Consumers could beat (for now) the increase in the prices of imported goods by buying durables immediately. Most forecasters thought these effects would be counteracted by negative effects, and it was reasonable to do so, but a sharp downturn was never a one way bet. In contrast, there is no upside to making trade more difficult with your nearest neighbour. The only question is how bad will it be.

If you think this is all so obvious that the propaganda about economists being hopelessly discredited will not work, I think you need to get out more. The line 'they all got the immediate impact completely wrong so we cannot take their medium term predictions seriously, and who can forecast until 2030 anyway' will be repeated ad nauseam in the press and by Leave advocates. Most political journalists will not know this line is rubbish and full of elementary confusions, because they do not talk to academic economists either directly or indirectly. The one group who could puncture this bubble is business, but at present its voice has been fragmented and therefore weak.  

[1] For those who still doubt the power of the tabloid media, imagine there is a car market with a single best selling car, call it car R. A new rival is launched, car L. It is independently assessed to perform worse, but this assessment is not widely available. But car L gets a year of pre-launch publicity in 80% of the tabloid press, followed by a period of 6 months non-stop adverts for this car coupled with stories about the failings of car R. All discussion of the technical merits of the two cars in the broadcast media involve debates between advertisers for both cars. Now, honestly, are you going to tell me that under these circumstances car L would not capture a lot, perhaps a majority, of the market?

Does the Bank’s latest forecast mean Brexit has had no effect?

The focus of many (not all) journalists on GDP growth was in evidence again in the reporting of the Bank of England’s latest UK forecast.

Bank of England Inflation Report February 2017 and (in italics) my estimates

Growth rates of	2016	2017	2018	2019	Ave 98-07
GDP	2.0	2.0	1.6	1.7	2.9
Household Income	2	0.75	0.25	0.75	3.0
Savings ratio [1]	5.75	4.5	3.75	3.25	8.0
GDP per head	1.25	1.25	1.0	1.0	2.25 [2]
Household Income p.h.	1.25	0	-0.5	0	na

[1] Level [2] Average 1955-2007

The headline news was Brexit didn’t seem to be having much effect on GDP growth, despite earlier pessimism from the Bank. Leavers have never forgiven the Bank for giving their pessimistic views on the immediate impact of Brexit during the campaign. There is also an attempt to suggest that because many macro forecasters have been surprised by the resilience of the economy since the vote that must mean that the near universal view of economists that Brexit will be bad in the medium term is also now very suspect. Anyone who knows about these things knows that an unconditional macro forecast is very different from a conditional forecast based largely on international trade evidence, but as most people do not know these things (including most political journalists) it is an effective bit of propaganda.

A major reason for the more optimistic forecast now is that consumers so far have decided to reduce their saving, which the Bank had not expected. One possible reason for this is that a lot of consumers have decided to undertake major purchases like buying a car to beat the coming price rises expected as a result of the depreciation. That alone would imply that the decline in the ratio is temporary, but as we shall see, the Bank is now expecting it to continue.

It is hard to forget a remark made to a fellow economist during the referendum campaign by the member of the audience in a public meeting in the North West. After this economist had talked about the beneficial effects of joining the Euro on GDP growth, they said something like ‘it may have helped your GDP but it hasn’t helped mine’. In that spirit I want to make two points that were generally ignored by the media in their reporting of this forecast.

First (as regular readers will know), GDP is the output of the country, not the output of an average member of that country. Although the ONS now releases estimates of GDP per head (or per capita as it is often known) with its GDP estimates, most journalists seem to have not noticed. One reason for the focus on aggregate GDP is that forecasters like the Bank continue to publish only aggregate figures.

The table above is an attempt to adjust the Bank of England’s forecast for expected growth in the population. I’ve basically just taken the average population growth rate for the last few years and projected it forward. That could be on the high side if immigration from the EU falls off substantially over the next few years, but this would probably only increase the numbers by another 0.25%. Growth of 1% in GDP per head does not sound so good, particularly when you note it is less than half the historic average.

Second, over the following few years even GDP per head is likely to not feel like ‘my GDP’. We can see this from the Bank’s forecast for real household income. These fail to get above 1% growth. The reason is something Leavers do not like to talk about, and which therefore many journalists ignore: the impact of the Brexit depreciation in sterling. As this depreciation gradually leads to inflation not matched by higher nominal wages, real income growth will suffer.

Why is forecast GDP growth so much higher than income growth? The Bank now expects consumers to reduce their savings to unprecedentedly low levels. Why would they do that? The Bank operates a model where consumers base their current consumption on anticipated future income, and where expectations are rational. If, as economists universally expect, Brexit leads to slower income growth in the future, consumers should have reacted to that by cutting current consumption because their future income will grow more slowly relative to pre-Brexit vote expectations. This they clearly have not done, in part because many of them do not believe future income growth will be reduced by Brexit. That is at the heart of the recent forecast revisions. But this leaves the Bank without any guide to how the savings ratio will evolve. If consumers continue to believe everything is OK, despite the short term fall in their income growth, then further falls in the savings ratio are possible.

Of course even these numbers for household income are also inflated by likely household growth. (They measure all income going to households, not the income of an average household.) The final row adjusts for the expected growth in households. The average household size has remained constant over the last decade, and I have assumed that continues. As you can see, the income of the average household is at best going to be flat, and may fall slightly. So to say, as some Leavers have, that this forecast suggests Brexit will have no effect before we leave is completely wrong.

So how is the score in the match going between Leavers and economists, where goals are actual events rather than clever soundbites. The last time we looked the Leavers had let in two goals: the depreciation in sterling immediately after the vote, and then the Bank having to bring rates down to their lower bound again and start another round of QE. Nothing since then suggests those goals were invalid. If I’m feeling generous I’d say having to revise up a forecast could count as a shot on goal, but as it reflects a mixture of policy and consumers saving less I think it is also a miss.

But there has been a new goal scored by the Leavers, but unfortunately in their own goal. It is now clear to those not dependent on Brexit propaganda that as a result of Brexit we are going to be a supplicant to probably the most dangerous and right wing US president ever. Truly awful. Should never have been president. Got 5 million less votes, and that’s not counting those stopped from voting. Complete fluke. Only got the votes he did because of a biased media and fake news. FBI is an absolute disgrace. Everyone agrees. He’s got to go. Some people are saying he is unstable. Others that he is a stooge of the far right. Impeach the guy. Truly awful. (Sorry, couldn’t resist)

Which all means, the score is now

Economists 3 Leavers 0

and we haven’t even reached half-time yet. But there may be a lot more goals to come when the negotiations conclude. If the economists keep scoring, we can avoid extra time, which is desirable because that only ends in 2030!

Blanchard joins calls for Structural Econometric Models to be brought in from the cold

Mainly for economists

Ever since I started blogging I have written posts on macroeconomic methodology. One objective was to try and convince fellow macroeconomists that Structural Econometric Models (SEMs), with their ad hoc blend of theory and data fitting, were not some old fashioned dinosaur, but a perfectly viable way to do macroeconomics and macroeconomic policy. I wrote this with the experience of having built and published papers with both SEMs and DSGE models.

Olivier Blanchard’s third post on DSGE models does exactly the same thing. The only slight confusion is that he calls them ‘policy models’, but when he writes

“Models in this class should fit the main characteristics of the data, including dynamics, and allow for policy analysis and counterfactuals.”

he can only mean SEMs. [1] I prefer SEMs to policy models because SEMs describe what is in the tin: structural because they utilise lots of theory, but econometric because they try and match the data.

In a tweet, Noah Smith says he is puzzled. “What else is the point of DSGEs??” besides advising policy he asks? This post tries to help him and others see how the two classes of model can work together.

The way I would estimate a SEM today (but not necessarily the only valid way) would be to start with an elaborate DSGE model. But rather than estimate this model using Bayesian methods, I would use it as a theoretical template with which to start econometric work, either on an equation by equation basis or as a set of sub-systems. Where lag structures or cross equation restrictions were clearly rejected by the data, I would change the model to more closely match the data. If some variables had strong power in explaining others but were not in the DSGE specification, but I could think of reasons for a causal relationship (i.e. why the DSGE specification was inadequate), I would include them in the model. That would become the SEM. [2]

If that sounds terribly ad hoc to you, that is right. SEMs are an eclectic mix of theory and data. But SEMs will still be useful to academics and policymakers who want to work with a model that is reasonably close to the data. What those I call DSGE purists have to admit is that because DSGE models do not match the data in many respects, they are misspecified and therefore any policy advice from them is invalid. The fact that you can be sure they satisfy the Lucas critique is not sufficient compensation for this misspecification.

By setting the relationship between a DSGE and a SEM in the way I have, it makes it clear why both types of model will continue to be used, and how SEMs can take their theoretical lead from DSGE models. SEMs are also useful for DSGE model development because their departures from DSGEs provide a whole list of potential puzzles for DSGE theorists to investigate. Maybe one day DSGE will get so good at matching the data that we no longer need SEMs, but we are a long way from that.

Will what Blanchard and I call for happen? It already does to a large extent at the Fed: as Blanchard says what is effectively their main model is a SEM. The Bank of England uses a DSGE model, and the MPC would get more useful advice from its staff if this was replaced by a SEM. The real problem is with academics, and in particular (as Blanchard again identified in an earlier post) journal editors. Of course most academics will go on using DSGE, and I have no problem with that. But the few who do instead decide to use a SEM should not be automatically shut out from the pages of the top journals. They would be at present, and I’m not confident - even with Blanchard’s intervention - that this is going to change anytime soon.

[1] What Ray Fair, longtime builder and user of his own SEM, calls Cowles Commission models.

[2] Something like this could have happened when the Bank of England built BEQM, a model I was consultant on. Instead the Bank chose a core/periphery structure which was interesting, but ultimately too complex even for the economists at the Bank.

Miles on Haldane on Economics in Crises

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

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

David Miles is also right that economists have not found it difficult to explain the basic story of the financial crisis from the tools that they already had at their disposal. Here I will tell again a story about an ESRC seminar held at the Bank of England about whether other subjects like the physical sciences could tell economists anything useful post-crisis. It was by invitation only, Andy Haldane was there throughout, and for some reason I was there and asked to give my impressions at the end. In the background document there was a picture a bit like this.

UK Bank leverage: ratio of total assets to shareholder claims. (Source Bank of England Financial Stability Report June 2012) Added by popular request 17/1/17 [3]: 

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

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

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

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

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

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

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

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

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

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