Real wages are mainly a macro issue

What do I mean by this? Macroeconomists have many faults, but one clear positive is that we think about systems as a whole rather than just one particular component. One area where it is important to do this is in thinking about what determines economy wide real wages. Take, for example, this recent post by the Flip Chart Rick. (His posts are brilliant and I try and read every one, but unfortunately this one is too good an illustration of the problem I have in mind.) He starts with this chart from the FT that I reproduce below.

Why is the UK unique in having a combination of negative real wage growth but positive GDP growth? Now it just so happened that I had written a post about this, explaining I thought pretty well the key reasons. But Rick mentions none of these, but writes about a whole bunch of stuff related to labour market structure and trade union power that I think are largely irrelevant. I think he is making the same mistake that people make when they say immigration reduces real wages, or that we would all be better off if only unions were more powerful.

All these things are important in influencing nominal wages, and perhaps the distribution of wages between workers. But real wages also depend on prices, which are set by domestic or overseas firms depending on where goods are made. If nominal wages go up, prices are likely to go up.

So what do I think accounts for the fall in real wages in the UK over the last decade? We need to start with GDP per head rather than GDP: growth in the latter has been boosted by immigration. Here is what has happened to GDP per head over the last ten years.

GDP per head fell in the recession, and then steadily but slowly recovered: the slowest recovery in at least a century. To see how that is related to real wages (using ONS average earnings divided by the CPI), which I call real consumer wages, we first need to look at an intermediary measure: real product wages. These are real wages divided by the price of UK output: the GDP deflator.

This is an interesting measure because its closely related to a simple identity relating GDP to labour income and profits. We can see that real product wages have not changed very much over this period: the recession mainly hit profits, or it created unemployment. (Real wages are wages divided the number of workers, GDP per head is GDP divided by the total population, which includes the unemployed.) But if we are comparing 2007 with 2015, real product wages were as stagnant as GDP per head.

So why did real consumer wages fall? That must be because consumer prices rose more than output prices. There are two reasons why this happened in this case: indirect taxes increased (remember the 2011 VAT hike), and a large sterling depreciation during the GFC worked its way into higher prices for imported goods. It is of course another depreciation after the Brexit vote that is cutting real wages once again right now. As I always try and stress, real GDP growth per head is not a good guide to real income growth if the price of imported goods rise or the price of UK goods sold overseas falls (what economists call a decline in the UK’s terms of trade).

Real wage growth in the UK has not been lousy because of lack of union power, immigrants or higher profits, but because economic growth (properly measured) has been stagnant, austerity included raising indirect taxes and we have now had two large depreciations in sterling. [1] That is not to say that these labour market factors are not important. At a macro level they are important in keeping inflation low, which should have allowed a more rapid expansion of GDP growth than we have actually had. That is where fiscal austerity and Bank of England conservatism come in. At a micro level labour market structure helps influence the distribution of earnings between different labour groups. [2]

What I say about the unimportance of profits is factually true for the UK over this period, but it is not always the case. In the US and elsewhere we have seen a gradual shift from wages to profits over the last few decades. But even here it is not obvious that weak nominal wage growth is the main cause, because in a competitive goods market lower nominal wages should get passed on as lower prices. One explanation that is attracting a lot of interest is the rise of superstar firms. These firms make unusually high profits, or equivalently have low labour costs, and if output is shifting towards these firms labour’s share will fall. What these firms do with their profits then becomes an important issue. More generally, it may be the case that governments have become too lax at breaking up monopolies, allowing a rise in the overall degree of monopoly.

The consequence of growing concentration, superstar firms and a rising share of profits is that income derived from profit grows faster than income from labour. I say derived from profit because I would include in this CEO and financial sector pay, which in effect extracts a proportion of profits from large firms. The net result is that most of the proceeds of economic growth are going to those at the top of the income distribution. But it would be good if we could change that by making the goods market more competitive and removing the incentive for CEOs to extract surplus from firms [3], rather than by making the labour market less competitive.

Technical appendix

For those who are lucky enough to have learnt economics using the Carlin and Soskice text, this is a classic application of wage and price setting curves. If workers become weaker, this shifts the wage setting curve towards the (perfect competition) labour supply curve, reducing the equilibrium real wage (unless the price setting curve is flat) but increasing the equilibrium level of employment. An increase in the degree of monopoly (the mark-up) shifts the price setting curve further away from the perfect competition labour demand curve, which reduces equilibrium employment as well as the real wage.

[1] One possible caveat here is that low wage growth may have encouraged firms to use more labour intensive production techniques, which has depressed investment and productivity. But if we want to incentivise firms to invest in more productive technology, increasing demand is a much better method than increasing nominal wages.

[2] Another caveat. I'm not sure where the real wage data in the FT chart comes from, but the fall in UK real wages there is greater than you get by using the ONS average earnings data (which I have used), so it may be a different and more specific measure of real wages. In which cases labour market structure might be relevant in explaining that number, and I apologise to Rick in advance if that is what he had in mind. 

[3] By, for example, applying much higher tax rates on high incomes, or imposing a maximum wage.  

Macro teaching and the financial crisis

Some macro textbooks (not all) are a bit like extensively modified code. You can see the structure of the original code, even after extensive software development. This can mean that, as new capabilities were added to the programme, rather than rewrite the software from scratch, extra routines were just added on top. Not only is this inefficient, but the whole thing ends up looking like a confused mess.

Perhaps this is why we end up with textbooks that still have the completely out of date LM curve at their heart (and associated AD curves, plus Mundell Fleming, and even money multipliers), but additional chapters where the AS curve becomes a Phillips curve, and money targeting gives way to Taylor rules. The student ends up totally confused, if they ever get to those later chapters. And after the financial crisis, a new edition will have a chapter devoted to that crisis, but not much in earlier chapters will change.

This is not the case with the third textbook by Wendy Carlin and David Soskice. It has been around for a few months, but I at last got a chance to take a good look. 

I say third textbook rather than third edition because they do not do editions. This is a complete rewrite of their earlier ‘Macroeconomics: Imperfections, Institutions, and Policies’. Luckily all the features of that earlier book that I really liked are retained. For example, a supply side based on imperfect competition rather than perfect competition (although alas the price setting curve is still flat!). But most importantly, a core model (the 3 equation model) which dispenses with the LM curve, and replaces it with a ‘monetary rule’ curve, based on a central bank using interest rates to hit an inflation target. This is similar to the approach championed by David Romer. (So the 3 equations are the IS curve, the Phillips curve, and the monetary rule curve.)

There are also some major improvements compared to the second book. The open economy analysis is now fully integrated with the 3 equation model, and the remnants of Mundell-Fleming are gone. The Euler equation appears on page 22, as one of the foundations of the IS curve. It is a shame that the Phillips curve is still based on the traditional (this period’s expected inflation) rather than New Keynesian (next period’s expected inflation) version, but you cannot have everything.

But by far the most important change concerns the financial sector. After initial chapters on the demand side, supply side and 3 equation model, plus a fourth on expectations, we have three chapters on the financial sector. The first looks at the banking sector, and makes the key alteration to the 3 equation model: there is a wedge between the ‘policy’ interest rate and the interest rate relevant for the IS curve. You can see this chapter as looking at how the financial system works in ‘normal’ times, when the system is not a source of instability. The second chapter then looks at how the financial system can be a source of instability, through mechanisms like the financial accelerator or asset price bubbles. The third chapter applies this analysis to the financial crisis of 2008.

When I taught most of the finals macro course at Oxford, I used their earlier book. I did have a lecture on the financial crisis, but it was an add-on of the type I described above. This new book is almost enough to make me wish I was still teaching this course. It gives finance the position in macro that recent events suggest it deserves. Mark Gertler on the back cover writes: “This is an exciting new textbook. Overall, it confirms my belief that macroeconomics is alive and well”. That pretty well sums up my reaction.

Except to add that the front cover is a painting by Paul Klee. Perfect!

Attacks on mainstream economics and reforming economics teaching

Mainstream (orthodox) economics is having a hard time in the pages of the Guardian. First Aditya Chakrabortty writes “How do elites remain in charge? If the tale of the economists is any guide, by clearing out the opposition and then blocking their ears to reality. The result is the one we're all paying for.” Then Seumas Milne adds “Any other profession that had proved so spectacularly wrong and caused such devastation would surely be in disgrace.” In this post I want to say why such attacks are wide of the mark, but also say something about how these attacks gain traction, and why they suggest changing the way the subject is taught.

One frequent accusation, very evident in Milne’s piece, and often repeated by heterodox economists, is that mainstream economics and neoliberal ideas are inextricably linked. Of course economics is used to support neoliberalism. Yet I find mainstream economics full of ideas and analysis that permits a wide ranging and deep critique of these same positions. The idea that the two live and die together is just silly.

The absurdity of linking mainstream economics to all our current problems is also obvious if you think about austerity. As I never tire of saying, the proposition that austerity was a crazy thing to try in this recession is prominent in the pages of undergraduate and graduate textbooks. It is what mainstream economics, as practiced in central banks, tells us. Now I agree that it is a great shame that some influential economists sometimes seem to ignore or have forgotten what is in these textbooks, or put their own textbooks aside to provide support for particular political parties. However it remains the case that the most effective critic of austerity is using totally orthodox economics.

Nearly all complaints about that mainstream start off with the economics profession’s failure to foresee the financial crisis. Again it’s important to make some fairly basic points. First economics is not just (or even mainly) about trying to forecast the future. The percentage of the profession that made this mistake is tiny. Another one of my favourite lines back from when I did forecasting is that macro forecasts are only slightly better than guesswork. We know that, both from past evidence and the models themselves. It is a difficult message to get across, because a very visible part of economics - making decisions about interest rates - necessarily involves forecasts, and the media loves simplistic messages, but institutions like central banks do their best to emphasise the uncertainty involved.

It is also obviously not true that mainstream economics is incapable of understanding what led to the crisis, and what needs to be done to avoid it happening again. I think it’s fair to say that much that is in Admati and Hellwig’s The Bankers New Clothes is pretty mainstream. Perhaps in the past economists have been rather narrow, and even politically naive, in issues from regulation to overseas aid, but that is clearly changing and has been changing for some time. 

Having said all this, it would also be a mistake of equal magnitude to think that everything is just fine in the land of academic economics. I am struck about how economists, while at least partially defending their own particular field, are quite happy to express grave concern about what some of their colleagues in other fields do. I’ve noted Andy Haldane and Diane Coyle’s criticisms of DSGE modelling before, and you will find plenty of economists who can be very rude about their colleagues doing finance. More generally I suspect slightly less shrill versions of the sentiments expressed by the two Guardian columnists would attract considerable sympathy from lots of very sensible people who know quite a lot about economics.

Whether this should, or will, lead to any major upheaval in economic thinking – as suggested by Martin Wolf in this lecture for example – is a question for perhaps another post. What I want to focus on here is how the subject is taught, if only because that has a large influence on how the subject is perceived and how it develops. Both Guardian articles talk about student dissatisfaction (as expressed here for example), and there seems to be widespread support for the idea that economics teaching needs some fairly radical reform: see this recent meeting at the UK Treasury (which followed this) and Wendy Carlin’s article in the FT.

I think part of the problem with economics, which is very evident in the way it is taught, is how economists see themselves. (I think Alex Marsh describes this well.) The vision that I think many economists are attached to is that economics is like a physical science. So there is a body of knowledge, which has been accumulated over time in much the same way as the physical sciences have developed. This approach plays down the context in which that knowledge was developed - it may provide a bit of diversion in a lecture, but is not essential. There is certainly no need to worry about the methodology behind the way the discipline works.

An alternative and I now think better, vision would give more emphasis to how economics developed. Economic history would play a central role. Economic theory would be seen as responding to historical events and processes. For example placing Keynesian theory in the context of the Great Depression is clearly useful, given the events of the last five years. I think it is also important to recognise the links between economic theory and ideology. This is partly to understand why governments might not act on the wisdom of economists, but it also leads naturally to recognising that economists need to adapt to the social and political context in which they work. We should also be more honest that our wisdom might be influenced by ideology. Given the limits to experimental and econometric evidence, but with a very clear axiomatic structure, methodology is always going to be an important issue in economics. [1]

Of course this alternative vision can be taken too far. I do not think it is helpful to teach the subject like a course in the history of economic thought. The insight gained from trying to understand what some past great economist actually said (or still worse, actually meant) is small. We do not necessarily need to know the details of every historical debate. In addition some important ideas in economics do not come from problems thrown up by major historical events or ideology: rational expectations is a clear example. We do try and integrate solutions to new problems into a coherent overall framework. I do not want to go back to teaching a schools of thought type of macro, because the mainstream is much more integrated.

There is an additional problem in teaching economics relative to the sciences. The world that we attempt to describe and advise changes rapidly. This makes a model in which teaching is based on textbooks problematic. Not just because it takes time for textbooks to be produced and updated, but because they tend to want to appeal to those who learnt their subject many years ago, and are not actively researching in the field. How else can you explain the continuing centrality of things like the money multiplier in nearly every undergraduate textbook?  

So I look forward to seeing what comes out of the Institute of New Economic Thinking’s project to reform the undergraduate syllabus, headed by Wendy Carlin. Her macro textbook with David Soskice is innovative in replacing the IS-LM framework with a more realistic and up to date three equation model (IS, Phillips curve, monetary rule), and by giving imperfect competition a central role, and a new version where the financial sector has much more prominence is due out soon. While it is plainly nonsense to say that mainstream economics cannot explain the financial crisis and critique neoliberal policies, we need to do what we can to make that clear, and we should start with our students.

[1] In fact, I think the lack of interest in methodology among mainstream economists is itself revealing. The combination of a highly deductive theoretical structure with many alternative but problematic ways of getting evidence makes economics a fairly unique discipline from a methodological point of view, so it would be natural to want to explore the methodology of economics. However you might want to shy away from this if you pretended economics was just like biology of physics.