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.

The UK’s 1976 IMF crisis in the light of modern theory

During the arguments over austerity, its supporters would often point to 1976 as evidence that it was possible for a country with its own currency to have a debt funding crisis. At the time this was frustrating for me, because I had been a very junior economist in the Treasury at the time, and my dim recollection was of an exchange rate crisis rather than a debt funding crisis. But I could not trust my memory and did not have time to do much research myself.

So with the publication of a new book by Richard Roberts on this exact subject (many thanks to Diane Coyle, whose FT review of the book is here), I thought it was time to revisit that episode combining Robert's comprehensive account with our current understanding of macroeconomic theory. I think any macroeconomist would find what happened in 1976 puzzling until they realised that senior policymakers did not have two key pieces of modern knowledge: the centrality of the Phillips curve, and an understanding of how the foreign exchange market works.

In terms of where the economy was, there is one crucial difference between 1976 and 2010. In the previous year of 1975 CPI inflation had reached a postwar peak of 24.2%. Although that peak owed a lot to a disastrous agreement with the unions, it probably also had a lot to do with the ‘Barber boom’ which had led to output being 6.5% above the level at which inflation would be stable in 1973 (using the OBR’s measure of the output gap). Although this output gap had disappeared by 1975 and 1976, inflation was still 16.5%. Given the lack of any kind of credible inflation target a period of negative output gaps would almost certainly be required to reduce inflation to reasonable levels.

The lack of understanding by senior policymakers of how the foreign exchange market worked was due to floating exchange rates being a novelty, Bretton Woods having broken down only 5 years earlier. We had a policy of ‘managed floating’, where policymakers thought the Bank of England could intervene in the FOREX markets to ‘smooth’ the trajectory of the exchange rate. My job at the time - forecasting the world economy - was a long way from where the action was, but my main recollection of the time comes from one of the periodic meetings of all the Treasury’s economists. It seemed as if the Treasury’s senior economists believed in the ‘cliff model’ of the exchange rate. The cliff theory suggests that if the rate moves significantly away from the target that the Bank was aiming at, it would collapse with no lower bound in sight. At the meeting I remember some more junior economists (but more senior than I) trying to explain ideas about fundamentals and Uncovered Interest Parity, but their seniors seemed unconvinced.

It is much easier to understand the 1976 crisis if you see it as a classic attempt to peg the currency when the markets wanted to depreciate it, and this is the main story Roberts tells.. The immediate need of the IMF money was to be able to repay a credit from the G10 central banks that had been used to support sterling. It is also true that sales of government debt had been weak, but Roberts describes this as stemming from a (correct) belief that rates on new debt were about to rise - a classic buyers strike. Although nominal interest rates at the time were at a record high, they were still at a similar level to inflation, implying real rates of around zero.

Here we get to the heart of the difference between 2010 and 1976. If there had been a strike of gilt buyers in 2010, the Bank of England would have simply increased its purchases of government debt through the QE programme, the whole aim of which was to keep long rates low. They could do this because inflation was low and showed no sign of rising. Contrast this with 1976, with inflation in double figures but real rates were near zero.

I think what would strike a macroeconomist even more about this period was the absence of the Phillips curve from the way policymakers thought. Take this extract from the famous Callaghan speech to the party conference that Peter Jay helped draft.

“We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you with all candour that that option no longer exists, and so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step”

As a piece of text it only makes sense to modern ears if there is a missing sentence: that we failed to raise taxes and cut spending in a boom. Far from a denunciation of Keynesian countercyclical fiscal policy, it was an admission that politicians could not be trusted with operating such a policy, essentially because they imagined they could beat the Phillips curve using direct controls on prices and incomes. The fact that fiscal rather than (government controlled) interest rate policy was being used as the countercyclical instrument here was incidental.

Reading this book also confirmed to me how misleading the Friedman (1977) story of the Great Inflation was, at least applied to the UK. These were not policymakers trying the exploit a permanent inflation output trade-off, but policymakers trying to escape the discipline of any kind of Phillips curve. They were also policymakers who had not fully adjusted to a floating rate world, and the IMF crisis was superficially a failed attempt to manage the exchange rate. More fundamentally It was also a reaction by the markets to a government that was not doing enough to bring down an inflation rate that was way too high. The IMF loan was useful both as a means of paying back existing foreign currency loans, but also a means of getting fiscal policy and therefore demand to the level required to reduce inflation.

Although inflation fell steadily until 1979, another boom in 1978 together with rising oil prices reversed this, and through the winterof discontent helped elect Margaret Thatcher. Unfortunately the IMF crisis and the 1970s more generally is another example of the consequences of politicians, in this case particularly those on the left, not accepting basic lessons from economics.            

Bonus culture

Diane Coyle has an excellent article in the FT about an apparent puzzle. Why do executives get incentive bonuses (extra pay on meeting some target), but most workers do not? Her article is based around a classic paper by Bengt Holmstrom and Paul Milgrom. Their basic argument is that incentive pay linked to specific targets works (it increases effort) when tasks are simple and effort can be easily measured. However if tasks are complex, and only some aspects of performance can be accurately measured, incentive pay can distort the allocation of effort between those tasks, leading to undesirable outcomes. As Diane says “pay structures not only incentivise effort and direct risk-taking, they also determine the worker’s allocation of effort between different tasks.”

So target related bonuses make sense for workers conducting simple tasks where effort can be easily measured, but are a bad idea for workers undertaking complex tasks where only some aspects of performance can be measured. To quote Diane:

“Indeed, the best arrangement would seem to be the opposite of the pattern we observe now. Corporate executives and senior bankers doing complex jobs involving many impossible-to-monitor activities are the last people who ought to be paid via an incentive scheme; while bonuses for fast-food workers or shop-floor employees make more sense.”

The implication she draws is straightforward: the bonus culture for corporate executives and senior bankers should end. But this leaves us with a puzzle: why did this bonus culture arise in the first place? Perhaps bonuses created something beneficial that we are missing.

Here is a simple conjecture, based on another paper by Piketty, Saez and Stantcheva which I discussed here. They note that increases in executive pay are strongly correlated with reductions in the top rate of income tax. Their explanation notes that executive pay is the result of bargaining between the executive and the firm. The executive has a lot of bargaining power (what successful firm wants their CEO to quit), but whether they choose to use it depends on the reward from doing so. If top tax rates are low, the rewards are high.

The executive still has to convince their firm to pay them more. What better way to do this than to suggest they get paid a lot more only if the company is successful. In the climate of the 1980s and 1990s in the UK and US (when the income share of the 1% took off) that argument would have seemed pretty convincing. My conjecture therefore is that bonus pay became endemic among executives and senior bankers not because it was more efficient for the firm, but because it was a useful tool in a bargaining game. [1]

This argument completely reinforces Diane’s conclusion. Executive bonuses are a way for senior management to extract rent from their firms, which is a quick way of saying that these high salaries redistribute money from everyone else to themselves. A consequence was that they reduced efficiency by diverting the executive’s attention to just hitting specific targets. One final thought, as we in the UK are obsessed with Brexit right now. It was the EU that passed laws limiting bonuses in the financial sector, and it was George Osborne that spent the UK public’s money trying to stop that law coming into effect.

[1] Bonuses can play a useful role in small firms where revenues are volatile, as Chris Dillow notes. That argument hardly applies to the CEO of a large multinational.  

Why high house prices are partly down to austerity

Diane Coyle, in reviewing Rowan Moore’s book Slow Burn City: London in the 21st Century, focuses on the idea that forever rising house prices could gradually kill off what is now a vibrant city. As housing gets steadily more expensive, getting people to work there will get more and more difficult. In the meantime, young people who can afford to buy get more and more into debt. I wonder whether soon mortgage providers will become more interested in the wealth of borrowers parents than in the borrower’s own earning capacity. (This is not just a London problem: see here about New York for example.)

The reason for this that everyone focuses on, understandably, is stagnant housing supply. However, housing can also be seen as an asset. Just as low real interest rates boost the stock market because a given stream of expected future dividends looks more attractive, much the same is true of housing (where dividends become rents). Stock prices can rise because expected future profitability increases, but they can also rise because expected real interest rates fall. With housing increasingly used as an asset for the wealthy, or even as a way of saving for retirement, house prices will behave in a similar way. A shortage of housing supply relative to demand raises rents, but even if rents stayed the same falling expected real interest rates raise house prices because those rents become more valuable compared to the falling returns from alternative forms of wealth.

That is why a good part of the house price problem comes from the macroeconomy: not just current low real interest rates, but also low expected rates (secular stagnation). The idea that house prices are tied down by the ability of first time buyers to borrow (and therefore to real wages or productivity, modified by changes in the risks lenders were willing to take) seems appropriate to a world where the importance of the very wealthy was declining, and most people could imagine owning their own home. We now seem to be moving to a more traditional world (remember Piketty) where wealth is more dominant, and with low interest rates that may also be a world where renting rather than home ownership becomes the norm for those who are not wealthy and whose parents are not wealthy.

There may be factors behind secular stagnation (low long term real interest rates) that we can do little about, but there are things we can do right now that will raise interest rates, and thereby tend to lower house prices. The most important of those is to stop taking demand out of the economy through continuing fiscal consolidation (aka austerity). This boost to demand that comes from ending fiscal consolidation will allow central banks to raise interest rates more quickly. While central banks may only be able to influence real interest rates in the short term, because so much uncertainty exists about what this long term involves the short term may have a powerful influence on more distant expectations.

We can also have some positive influence on the longer term by increasing public investment, including forms of public spending (that may not be classified as investment) that encourage private investment. It should also include building houses where (or of a kind) the private sector will not build. That will have beneficial effects in terms of raising real interest rates in both the short and longer term.

Ever rising house prices lead to unprecedented high levels of private debt, and also destroy the dream of many young people to own their own home. One answer is to build more houses, but another is to run better macroeconomic policies. That house prices continue to rise during a period of fiscal austerity is not an anachronism. It is not a bug but a feature of an age of austerity.

The trouble with macro

Diane Coyle, writing in an FT blog, says

 “There are two tribes of economists, the macro and the micro. I’m one of the latter group. We have our empirical controversies, of course – much of our applied research concerns public policy choices in areas such as education and health, so vigorous disagreement is inevitable. But I think it’s fair to say that few of the micro disagreements compare in intensity to the all-out war of words between different macroeconomists about the effects of fiscal stimulus or austerity.”

She goes on to say that it is macroeconomists’ “certainty that’s astonishing”. Her comments could be summarised as asking why macroeconomists are so sure and shrill compared to their micro colleagues.

Now it could be that there is something odd about those who choose macro rather than other types of economics, but I’m not sure I’ve noticed any character traits more evident in macro people. (But who am I to judge - an open invitation for microeconomists to comment!?) It could be something to do with the nature of the theory and empirics involved, but since macro became microfounded that seems unlikely. I think the problem is in a way much more straightforward.

I think you only need to look at the recent UK election to understand the problem. One of the central themes of the Conservative’s attack on Labour involved their alleged incompetence at running the macroeconomy when they were in power. For whatever reason, macro rather than micro policy issues become central in political debates. That makes macro unusual for various reasons.

One immediate consequence is that many beyond the tribe of macroeconomists think they can write with authority of macroeconomic issues. As a recent example of a shrill macro debate Diane cites Krugman vs Ferguson. But this is not to compare like with like. On one side you have an economics Nobel Prize winner who has made important contributions to macroeconomics, and as a result is careful about what he writes. Both data and theory are respected. On the other side … well I’ve said what I think in an earlier post.

To take another politically charged topic, I have seen plenty of debates between climate change scientists and deniers who are not scientists. Often the scientist will go into detail to get the facts straight, and say how uncertain everything is, while their opponent by contrast will be confident and clear. A scientist will not be fooled by this confidence, but many others will be. When one side argues out of conviction or ideology or political bias rather than knowledge, it is difficult for someone who does have that knowledge not to respond in kind if they want to be convincing.

There is a deeper reason for shrillness, however. The debate over austerity is not a normal academic discussion about the likely size of parameter values. Here Diane is mistaken in saying that the key issue is whether the multiplier (the size of the impact of cuts in government spending on output) is greater or less than one. In talking about UK austerity, I have typically quoted OBR figures which assume a multiplier below one, which gives me the £4000 per average household cost of UK austerity. My own best guess would be that the multiplier has been larger than one, which gives me significantly higher costs, but I have never suggested that I know with certainty what the size of the multiplier has actually been. However there has, to my knowledge, been no public debate on these terms.

Instead supporters of austerity typically want to suggest that the multiplier is close to zero. They want to suggest that sacking nurses and cutting back on flood defences will be very rapidly met by an increase in private sector labour demand and investment. Although theoretically possible via various different mechanisms, the evidence and recent experience overwhelmingly suggests this does not normally happen in the kind of situation we are currently in. For much of the time those arguing for the virtues of current austerity seem to be doing so from a position of faith or political convenience rather than evidence.

Why is it important to recognise this? Because there is a danger that microeconomists may misdiagnose the problem, and suggest that macro contains some fundamental flaw which undermines eighty years of intellectual endeavour. This provides useful cover to those who have an ideological or political agenda, and want policymakers to ignore the bits of the discipline that clearly work. Sometimes microeconomists seem to think that if only they could disassociate themselves from macro, economics would become a better and more respectable subject. That is an illusion: the ideological and political forces that cause such problems for macro are not unique to it.

So I’m not sure that academic macroeconomists suffer from an excess of certainty compared to their micro colleagues. Instead I think the trouble with macro is that it is prone to ideological and political influence: like all economics, but just more so.