Undergraduate economics teaching moves into 21st century

The CORE economics curriculum, designed to provide an introduction to economics that reflects economics as it is today rather than as it was decades ago, has won justified praise from John Cassidy. I also think it is brilliant, not just for first year undergraduates but also for interested non-economists. To wet your appetite, read this short account by two of the leading lights behind the project.

Rather than spend the rest of this post singing its praises, I want to ask why first year undergraduate textbooks represent a clear example of market failure. The failure I have in mind is the inability to teach economics as it currently is, rather than as it was decades ago. If you look at the standard first year, Econ 101 textbook, it does contain more modern stuff, but normally in later chapters after presenting the basic models/frameworks which have not changed for 30 years or more. As a result, textbooks tend to be both dull, seemingly irrelevant and much too large. (This is a blanket generalisation and I’m sure there some exceptions.)

Here is my theory, which I will try and explain in plain english rather than with economics jargon. Although the ultimate consumers of textbooks are students, they are chosen by teachers who set the course textbook. So why are Econ 101 teachers not demanding textbooks that are less dull and more up to date?

Suppose someone had written something like the Core material, and a publisher (as publishers do) had sent it out to people currently teaching Econ 101 for comments. The reaction they will have got from a good proportion of Econ 101 teachers would have been ‘that is interesting, but can we include at the start some of the stuff I have taught for the last five years’. They, naturally, do not want to completely rewrite their courses, and I fear in a few cases learn material that is new to them.

The publisher reports back to the author: ‘we cannot publish this as it stands, but if you start with the traditional material then maybe’. It is a market failure because publishers are looking at the current set of Econ 101 teachers, and not those who will one day teach it and would love to have something more up to date. Another force for conservatism is that the big names who dominate the market find it much easier to add new stuff on at the end as extra chapters than rewrite their textbook from scratch.

I could add more, but I have been rude to enough of my colleagues already. Let we add two other specific points about CORE. The first is that it is clearly mainstream: this is not the pluralist text that many heterodox economists would like. That I fear is inevitable: economics is mainly a vocational subject, not a liberal arts subject. (Thats upset a few more.) But I was surprised to see MMT people describe this textbook as not for them. I have, after all, argued that MMT is just standard macro without what I have called the Consensus Assignment. [1] So I had a look.

In the section on government finances (14.8) we get

“When there is a budget deficit, this means the government must borrow to cover the gap between its revenue and its expenditure. The government borrows by selling bonds.”

This is not correct, and nor does it follow modern macro. [2] There we write the government budget constraint to include a term in the change in the stock of high powered money. (If money does not appear, it is because the paper explicitly chooses to work in a moneyless world for simplicity.) In short, the government can finance the gap between revenue and expenditure by creating money. Ignoring money in this section is obviously an oversight, as the discussion in section 10 clearly shows. But it is an oversight that should be corrected. [3]

That apart, I was already a fan of the macro approach adopted in CORE, because it is a simplified version of the Carlin and Soskice textbook. I like the consistent claims approach as a way of talking about inflation. It emphasises the elementary point that you need both wage and price inflation to get sustained increases in inflation, something monetary policy makers seem to keep forgetting right now.

I like, as some may remember, abandoning the LM curve and explicitly talking about central bank policy. I also like the way that banks are now incorporated as part of the monetary transmission mechanism. If there was a clear manifestation of how outdated (at best, we could also say just plain misleading) most textbooks are, it is their continued use of LM curves and the money multiplier.

I really hope that CORE continues to be successful. It is time we stopped boring and confusing first year undergraduates, and started inspiring them with an understanding of the economic ideas that allow them to address the countless real world economic issues that they will have to face.

[1] The Consensus Assignment gives monetary policy the goal of macroeconomic stabilisation and fiscal policy the goal of stabilising government debt.

[2] We can go back to the work inspired by Carl Christ together with Blinder and Solow. I should add that CORE is not alone among textbooks in failing to properly set out the government’s budget constraint.

[3] Now we all know (and as MMT also clearly states) that there are limits to money financing: too much of it is inflationary. But this should not be internalised by teachers to the extent that money financing is ignored. In particular it gives the impression that to finance a deficit a government has to find someone to lend them money, an incorrect belief that can have very misleading consequences if the government controls its own currency. It is more complicated with independent central banks, but again they are not an excuse to ignore money financing.  

On criticising the existence of mainstream economics

I’m very grateful to Unlearning Economics (UE) for writing in a clear and forceful way a defence of the idea that attacking mainstream economics is a progressive endeavor. Not criticising mainstream economics - I’ve done plenty of that - but attacking its existence. The post gets to the heart of why I think such attacks are far from progressive.

It is very similar to debates over whether economics teaching should devote considerable time to the history of economic thought and non-mainstream ideas, and whether economists have much too much power and influence. More critical thinking, real world context and history - yes. This is what the CORE project is all about. But devoting a lot of time to exposing students to contrasting economic frameworks (feminist, Austrian, post-Keynesian) to give them a range of ways to think about the economy, as suggested here, means cutting time spent on learning the essential tools that any economist needs. As Diane Coyle and I argue, economics is a vocational subject, not a liberal arts subject.

Let me start at the end of the UE piece.

“The case against austerity does not depend on whether it is ‘good economics’, but on its human impact. Nor does the case for combating climate change depend on the present discounted value of future costs to GDP. Reclaiming political debate from the grip of economics will make the human side of politics more central, and so can only serve a progressive purpose.”

Austerity did not arise because people forgot about its human impact. It arose because politicians, with help from City economists, started scare mongering about the deficit. We had ‘maxed out the nation’s credit card’ and all that. That line won not one but two UK elections. Opponents of austerity talked endlessly about its human impact, and got nowhere. Every UK household knew that your income largely dictates what you can spend, and as long as the analogy between that and austerity remained unchallenged talk about human impact would have little effect.

The only way to beat austerity is to question the economics on which it is based. You can start by noting that none of the textbooks used to teach economics all over the world advocate cutting public expenditure in a recession. You can add that governments have not tried to do this since the Great Depression of the 1930. If necessary you can add that the state of the art macro used by central banks also suggests cutting government spending in a deep recession will have harmful effects. You can explain why this happens, and why a Eurozone type crisis can never happen in the UK.

That does not dilute the human impact of austerity. What it does is undercut the supposed rationale for austerity on its own terms: mainstream economics. Having mainstream economics, and most mainstream economists, on your side in the debate on austerity is surely a big advantage.

Now imagine what would happen if there was no mainstream. Instead we had different schools of thought, each with their own models and favoured policies. There would be schools of thought that said austerity was bad, but there would be schools that said the opposite. I cannot see how that strengthens the argument against austerity, but I can see how it weakens it.

This is the mistake that progressives make. They think that by challenging mainstream economics they will somehow make the economic arguments for regressive policies go away. They will not go away. Instead all you have done is thrown away the chance of challenging those arguments on their own ground, using the strength of an objective empirical science.

Where UE is on stronger ground is where they question the responsibility of economists. Sticking with austerity, he notes that politicians grabbed hold of the Rogoff and Reinhart argument about a 90% threshold for government debt.

“Where was the formal, institutional denunciation of such a glaring error from the economics profession, and of the politicians who used it to justify their regressive policies? Why are R & R still allowed to comment on the matter with even an ounce of credibility? The case for austerity undoubtedly didn’t hinge on this research alone, but imagine if a politician cited faulty medical research to approve their policies — would institutions like the BMA not feel a responsibility to condemn it?”

I want to avoid getting bogged down in the specifics of this example, but instead just talk about generalities. Most economists would be horrified if some professional body started ruling on what the consensus among economists was. I would argue that this instinctive distaste is odd, as UE’s medical analogy illustrates, and also somewhat naive. I would argue that economists’ laissez faire view about defining the consensus (or lack of it) has helped the UK choose Brexit and the US choose Trump. I personally think economists need to think again about this.

However to do so would go in completely the opposite direction from what most heterodox economists wish. It would greatly increase the authority of the mainstream, when there was a consensus within that mainstream. It would formalise and make public the idea of a mainstream, and inevitably weaken those outside it.

Economics, as someone once said, is a separate and inexact science. That it is a science, with a mainstream that has areas of agreement and areas of disagreement, is its strength. It is what allows economists to claim that some things are knowledge, and should be treated as such. Turn it into separate schools of thought, and it degenerates into sets of separate opinions. There is plenty wrong with mainstream economics, but replacing it with schools of thought is not the progressive endeavor that some believe. It would just give you more idiotic policies like Brexit.

Reforming Econ 101

Noah Smith has some good ideas on this, and the CORE project (here is a presentation at INET’s annual conference) should have a new curriculum by the end of this year. But the reactions of many will echo Noah’s: there is just no room for any new stuff. It is certainly true, speaking about the macro component, that there is a danger we teach much too much material at this level. Some of what we teach appears contradictory: like the AS curve and the Phillips curve.

So my first point, which I have made before, is that we can get rid of a lot of stuff that is simply out of date. Like the LM curve (and theories of money demand that go with it). And the Aggregate Demand curve which is derived from it. And Mundell Fleming which is an open economy version of it (and inconsistent with UIP to boot). And the money multiplier (which, apart from being very misleading, is unnecessary if we stop fixing the money supply). But why not really get this bonfire going? Do we need to teach the Keynesian multiplier? As there are good reasons to think that the closed economy government spending multiplier (with a given level of real interest rates) is around one, what is the point?

Of course a lot of this would come back, in some form, in a more advanced macro course. However I have always thought the acid test for what should be included in an introductory course is whether it is something that a person who studies no more economics really needs to know. I would submit that all of the above fail this test.

What has to stay in? The IS curve of course: monetary policy is all about using interest rates to control aggregate demand. However I agree with John Cochrane that this should be based on the two period consumption model (which students with large loans can relate to), and not investment theory. The Phillips curve is central to how pretty well everyone thinks about macro, so that has to be there. It can be taught as an empirical regularity, introducing the macro history of the 1970s at the same time.

Sometimes people have told me that you need to say something about money if you want to talk about Quantitative Easing (QE). I think exactly the opposite is true: QE shows up how ridiculous the LM curve stuff is. QE represents a huge increase in bank reserves - and the money supply hardly moves (thank you money multiplier). How much simpler, and more realistic, to just talk about short and long interest rates. Dispensing with money allows us to spend time talking about the zero lower bound, and events since the financial crisis. I would use this to motivate a discussion of fiscal policy and debt.

Would I replace the LM curve with a ‘monetary policy curve’, expressing preferences over inflation and output, or a Taylor rule? I’m tempted not to, because when you do something like this, students stop thinking about monetary policy as a choice. The example I sometimes use is an accidental (not countercyclical) temporary fiscal expansion that is foreseen. So many students let that increase output and inflation, and then have a Taylor rule react. But of course if the fiscal shock is known, any sensible monetary authority would attempt to completely counteract the impact of that shock.

What about the ‘supply side’. I agree with Mankiw’s text that we can treat labour supply as fixed at this level. Together with a medium term assumption of fixed capital gives us all we really need to motivate a Phillips curve with a natural rate. Deriving a labour demand curve from profit maximisation tells us that increases in labour saving technology do not lead to increases in unemployment, which is nice, but it has the cost of confusing students (and policymakers) when we subsequently assume demand determined output.

I would replace Mundell Fleming with a combination of a net export function (which gives us a relationship between aggregate demand and competitiveness) and Uncovered Interest Parity (UIP). A key idea that should be taught at this level is that in a small open economy, it is the real exchange rate and not the real interest rate that ensures aggregate demand equals supply in the medium term. I think introductory macro should also say something about fixed exchange rate regimes.  

So there you have it. Econ 101 with just three basic relationships: an IS curve, a Phillips curve and UIP. I would use some of the space created to talk about basic issues and common confusions, like the relationship between price flexibility and output gaps, or between involuntary unemployment and wage flexibility, or why Says Law does not hold and why the General Theory got written. Comments welcome on anything else that really should be in there. 

But which inflation?

               In an earlier post, I used recent UK experience to suggest looking at other inflation measures besides consumer prices. The two widely published alternatives are the GDP deflator (the price of all that is produced rather than consumed in an economy) and average earnings/wages. The reason I gave for looking at these other inflation measures was purely pragmatic. Some shocks (like value added tax or commodity price changes) could have a significant impact on consumer prices, but it was difficult to know whether their impact is just temporary or whether they could initiate something worse. Looking at output prices and wages would give you a much better handle on that.

               But consumer prices are what ultimately matter, right? They are what we care about. Well no, not necessarily. Individuals as consumers do not like consumer prices going up, but wages going up are good for individuals as workers, unless they are someone else’s wages. The first thing we need to do is distinguish between inflation in an abstract sense and movements in real variables. (The two may be associated, of course, which may help explain public attitudes.)

 For economists, inflation is the phenomenon where, over some period, all nominal magnitudes are rising together, without any particular implications for real incomes. There are a number of reasons why inflation so defined may be costly. One is that holding money becomes more expensive, because its purchasing power decreases with inflation. In this case a focus on consumer prices is probably correct. But there is another cost of inflation where the source of inflation does matter.

It has been known for some time that inflation goes hand in hand with greater variability in relative prices. To the extent that inflation causes this relative price variability, it is costly, because relative price changes caused by inflation alone distort the market mechanism. One clear reason why this might happen is that many prices are changed infrequently at different times. If the price of good X is changed each April, and the price of good Y is changed each October, then inflation will cause good Y to be too cheap relative to good X in the summer and too expensive in the winter. There is no reason in terms of supply or demand for this pattern in the relative price of X in terms of Y, so if it leads to changes in consumption or production it misallocates resources. The higher the rate of inflation, the greater this misallocation cost.

               Is this cost of inflation important? Keynesians certainly believe that slow or 'sticky' price adjustment is pervasive, and is largely responsible for generating persistence in business cycles. The reasons why many prices are sticky appear diverse and complex, but imperfectly competitive markets do seem to be important. In recent years a number of Keynesian economists (following pioneering work by Michael Woodford in particular) have attempted to quantify the costs of the relative price movements generated by inflation and sticky prices, and these calculations suggest that changes in inflation generate significant changes in social welfare through this route. This means that the type and source of inflation is important. If inflation occurs in commodities where prices are changed frequently, then it is much less costly than if inflation occurs in prices that are sticky. In other words, some types of inflation are more costly than others.

This focus on inflation in goods where prices are sticky bears some relation to the idea of focusing on 'core' inflation[1]. It is possible using similar reasoning to argue that the price inflation measure central banks should target is actually output prices (the GDP deflator) rather than consumer prices.[2]  (If there are trends in relative prices, then this idea also influences the optimal inflation target: see Alexander Wolman here, for example.) The same type of argument also suggests that central banks should be concerned with wage inflation as well as price inflation.[3] This is because wages are themselves 'sticky', and so wage inflation will generate costs by changing relative wages in a distortionary manner just as price inflation causes distortionary relative price changes. All this is explained clearly, in considerable technical detail, by Michael Woodford here.

To see why this is important, consider the recent impact of higher oil prices. This has a direct and fairly immediate impact on inflation. A hard-line inflation targeter would say that an inflation target is an inflation target, so the monetary authority should try and make non-oil price inflation fall to offset the impact of higher oil prices. However oil prices, and some things they influence like petrol prices, are pretty flexible. If inflation is costly because it induces unnecessary relative price distortions in prices that are sticky, then it makes sense to focus on inflation measures that give much less weight to oil prices than the consumer price index. In other words, core inflation is not just useful because it helps predict longer term trends in actual inflation, it is important because it actually matters more than actual inflation.

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[1] A seminal paper here is Aoki, K (2001), Optimal monetary policy responses to relative-price changes, Journal of Monetary Economics, vol. 48, pp 55-80. See this on the relationship between actual inflation, core inflation and commodity prices in the US.

[2]  For the rationale, and some additional and pretty technical complications, see Kirsanova, Leith and Wren-Lewis (2006) ‘Should Central Banks target consumer prices or the exchange rate?’ Economic Journal, 116, F208–F231.

[3] : The key paper here is Erceg, Christopher J., Dale W. Henderson, and Andrew T. Levin, “Optimal Monetary Policy with Staggered Wage and Price Contracts,” Journal of Monetary Economics 46: 281-313 (2000).

The Euro: an alternative moral tale

                Part of the austerity mindset that I talked about in the context of the Irish referendum is the belief that transfers from creditors to debtors are unfair (HT MT) because they result from the feckless behaviour of the debtor. There is a clear parallel with the attitude to benefit recipients within a society, which Chris Dillow talks about here. I do not want to get into the economics or politics of attitudes of this kind, but just claim that they are important in influencing policy, a position I think David Glasner supports here. Instead I want to confront this mindset with an alternative moral tale. Let’s talk about the Core countries and the Periphery, because I want to look at why they became creditors and debtors.

                When the Euro was formed, its fiscal architecture was embodied in the Stability and Growth Pact (SGP). This architecture was the construction of the Core, not the Periphery. In political terms, it was the price that the low inflation countries of the Core laid down for their participation in the Euro. That fiscal architecture was all about containing deficits, and said nothing about using fiscal policy to control domestic demand. To many economists, this was something of a surprise. Much of the academic work leading up to the formation of the Euro had stressed the crucial role that countercyclical policy could play in reducing the consequences of asymmetric shocks in a monetary union. The SGP effectively ignored that work.

                Why? Perhaps because in the debate on the wisdom of setting up the Euro, the problem of asymmetric shocks (or asymmetric adjustment to common shocks) was the key argument used by the anti-Euro camp. So it was easier to deny that the problem would arise, rather than talk about how it might be reduced. However I suspect countercyclical fiscal policy was also ignored because many in the Core just did not believe in the kind of Keynesian world in which the policy worked. In that sense, we were seeing the forerunner to a belief in expansionary austerity. To put this in simple terms, the view was that any demand and competitiveness imbalances would be quickly self-correcting, as uncompetitive countries would lose exports, output would fall and inflation would decline. The Keynesian view that this self-correction might be slow, costly and painful, and that fiscal policy could reduce those costs and pain, was discounted.

                Much the same can be said about monetary policy and the ECB. This was designed by the Core. The ECB was independent of government, but also explicitly prevented from acting as a lender of last resort to governments.

                After the Euro was formed, interest rates came down substantially in the Periphery. There was a substantial amount of lending by the Core private sector to the Periphery private sector. This led to inevitable overheating in these periphery countries relative to the core. At this point the Core, and the bureaucratic apparatus that was essentially under the Core’s control, should have been sounding alarm bells. But instead they continued to follow the flawed fiscal architecture. In the case of Spain, as is well known, the budget deficit looked OK according to these fiscal rules, so the overheating there was allowed to continue. As a result, we got a housing and construction bubble. The aftermath of this is what countries like Ireland and Spain are dealing with now.

                So, the basic problem was one of excessive private sector borrowing in the Periphery, partly financed by excessive lending by the Core. The Core countries had set up a fiscal architecture that effectively ignored this kind of problem, and they did nothing to address their mistake in subsequent years.

                So who is to blame? Consider a parallel with the sub-prime crisis. Do we hold the low income households who took out mortgages they could not afford responsible for the financial crisis that ensued? Do we blame them for the Great Recession? Do we pity the poor financial institutions that lost money lending to these irresponsible people? I hope not. Instead we ask, how can the financial system have allowed this to happen? What was wrong with the architecture of regulation, and who was responsible for this?

                I think we should have the same response to the Euro crisis. What was wrong with the fiscal and banking architecture that allowed housing bubbles and the like in the Periphery, and who was responsible for this architecture?

                But in the case of the Euro, it gets worse. Even after the crisis, the Core countries continued with their anti-Keynesian mindset. As the immediate manifestation of the crisis was unwillingness by markets to lend to Periphery governments, then it was assumed the problem must be excessive borrowing by Periphery governments. Never mind that the problem in Ireland was in large part because the government bailed out its banking sector (and therefore lenders to that sector, some of whom were of course from the Core), and the problem in Spain was that it might be forced to do the same. (On Spain, read this from Yanis Varoufakis.) So the Core countries imposed sharp fiscal austerity on the Periphery, as the price for ‘rescuing’ these countries. It was conveniently forgotten that the reason these countries governments found it difficult or impossible to fund their deficits was because the common currency denied them their own central bank, and that the ECB had been designed by the Core such that it could not explicitly play that role. The terms of the rescue were hardly generous, because it was argued these governments needed to learn their lesson.

                It then got even worse. The austerity inflicted on Greece led the electorate there to believe that there was no hope down this path, and so the terms of their particular rescue needed to be renegotiated. Impossible, responded the Core. If you try to do that, you will have to leave the Euro. The damage that response has done to the operation of the Euro is immense, and entirely predictable. The gains from the ‘permanent’ abolition of exchange rate risk – gains that were central to the economic rationale for the Euro – are being unraveled.

                From this perspective, the actions of the Core from before the Euro was formed until the present day have been misguided and irresponsible. They risk destroying the Euro. It would not be the first time that the actions of a creditor had caused needless destruction. Bear this in mind when you next read about how the terms of Greece’s rescue cannot possibly be changed because of the message this would send to other Periphery countries. If the Euro is to survive, the Core has to stop thinking like the aggrieved party, and instead must recognise that it designed the system that, quite simply, created this crisis.