How to predict a crisis

I was sorting through some old papers over the weekend (don’t ask) and I found an article I wrote for the Financial Times on 19th October 1990, which is also the month we entered the European Exchange Rate Mechanism (ERM). The article, based on work I had done earlier with colleagues at the National Institute (final published version here), argues that we were entering at the wrong exchange rate. The final paragraph starts with

“The danger is that the government will attempt to defend the present exchange rate bands at all costs. As a result it may produce, or fail to prevent, a recession on the same scale as 1980-81.”

According the current data vintage, GDP was already falling at that point, yet interest rates were not reduced by enough to prevent a recession because of concerns about pressure on sterling. GDP continued to fall almost continuously until we were forced out of the ERM (Black Wednesday). Leaving the ERM allowed interest rates to be lower and produced a 10% depreciation in sterling, which helped ensure a strong recovery.

I’m sure I wasn’t alone in making this prediction, but we were in a minority and we did produce the best analysis. The Global Financial Crisis (GFC) was of course a much bigger event, and far fewer saw it coming, so quite rightly 10 years later those economists who predicted something like it are getting media attention. They were very different events, so can we draw any parallels between them, or more generally is there anything that links disasters of this kind?

One common factor is using the markets as an excuse to avoid economic analysis. One of the two main excuses to ignore our ERM analysis was to look at the exchange rate at the time as say ‘the market must know what it is doing’.Of course before the crisis too many people who saw the data thought the banks must know what they are doing as they pumped up leverage.

Perhaps another is never let new ideas crowd out the knowledge embodied in older ideas. The other excuse that particularly academics used to disregard our analysis about the ERM entry rate was that the models we were using were a little old fashioned. (I talk more about that here.) Bankers fooled themselves that they had new methods of evaluating risk that meant they could ignore systemic risks. If we think of the other two major UK macroeconomic crises, the same applies. The Treasury predicted the recession of 1980 pretty well, but the analysis was trashed as the work of old fashioned Keynesians by Lawson et al from the Thatcher government. Austerity of course also ignored basic Keynesian truths.

One obvious final question is whether we learn from crises of this kind. Ten years after we left the ERM the Treasury asked me to do their entry rate analysis for possibly joining the Euro, so that at least implies some learning, but maybe being a different government helped. Perhaps Black Wednesday created a general distrust of fixed exchange rate regimes in the UK that helped Gordon Brown argue against joining the Euro.

Have we learnt the lessons of the GFC? Some changes to the banking system have been made, but I think the general consensus is its is not enough, and there still seems to exist a large implicit public subsidy for the major banks. If for no other reason that is why you should take note of what those who predicted the GFC say. In terms of how you recover from a financial crisis we certainly had learnt some of the lessons of the 1930s, but not all. As I argue in my last post, we have hardly begun the process of creating a macroeconomic policy regime that can deal with a future recession, let alone a crisis.

Academic knowledge about economic policy is not just another opinion

Does the financial crisis reveal that economists are at the leeches and mercury stage of their subject, and as a result policy makers and the public have every right to ignore what they say? Does the fact that economists working in finance failed to recognise the prospect of a systemic crisis, and that macroeconomists both took finance for granted and as a result failed to investigate financial-real links, mean that we should ignore what economists say when it comes to Brexit?

Speaking for my own subject, I think the financial crisis does raise serious questions about the methodology macroeconomists rely on, as I have explained at length elsewhere. But does it mean that everything macroeconomists have learnt in the last 80 years is virtually worthless, or at least no better than the opinion of the average politician? Why don’t we look at what has happened since the financial crisis.

Macroeconomists, having learnt the lessons of the 1930s, immediately recommended that policy makers do three things after the crisis: cut interest rates sharply, embark on fiscal stimulus and bailout banks. Policy makers took that advice in 2009, and as a result we avoided another Great Depression. Many said that rising government debt was sure to send interest rates on that debt rising: academic economists using basic ideas from Keynes said they would not and they were proved right. Many others said that Quantitative Easing (central banks creating money to buy government debt) would cause hyperinflation, but again academic economists looking at more modern New Keynesian models said that was nonsense and again they were right.

You might claim that in all this economists were just advocating what was obvious. The acid test came in and after 2010, when fiscal stimulus turned to austerity. What evidence we have suggests this move was opposed by a majority of academic economists, a majority that grew over time. There was a minority that supported austerity, at least for a time, and they gained a lot of publicity because politicians latched on to what they had to say. But the majority followed both textbook and state of art economics, and this majority was right. The recovery would have been stronger and faster if politicians had gone with this majority.

If we look back before the financial crisis at UK macro policy, we can again look at the record of economics compared to politicians. The obvious place to start is with the 364 economists, who despite all attempts by politicians and think tanks to suggest otherwise were right: tight fiscal policy in the 1981 budget delayed a proper recovery by over a year. We can look at the following recession in the early 1990s. A key driver behind that was the UK joining the ERM at far too strong an exchange rate. Here it gets personal. With colleagues at the National Institute I undertook what was acknowledged at the time to be the most comprehensive analysis of the appropriate entry exchange rate, and we argued that our entering at the then current rate was folly. We were ignored, and as a result the UK was the first to be kicked out of the ERM in 1992.

The next time the UK had to decide to join in this case the ultimate fixed exchange rate regime, the Euro in 2003, it was the economics that persuaded the Labour government not to join. In this case macroeconomic analysis played a critical role in making the right decision.

All this suggests to me that macroeconomics, if we compare it with medicine, is well beyond the bloodletting stage. It would be very surprising if we were not, given 80+ years of study and the huge amounts of data now available. Of course that does not mean academic macroeconomics will not make mistakes, and of course unconditional forecasters of the kind you read about endlessly in the papers will always get things wrong: our own models tell us they will. But when it comes to macroeconomic policy, experience suggests you are much more likely to get economic policy right if you ask an academic macroeconomist than if you ask anybody else. [1]

The other key thing to say is that the discussion above has virtually nothing to do with the long term impact of Brexit, which depends on international trade. The key bit of analysis that means trade with the EU cannot be simply replaced with trade elsewhere are gravity equations. Gravity equations do not come from theory but from the data: countries are much more likely, even today, to trade with near neighbours than far away countries after allowing for other factors. So when Rees-Mogg suggests that the Treasury must have fiddled the numbers, when the government’s analysis confirms those of other studies that Brexit will be costly for all of us, we know he is slandering civil servants for his own political gain. That he is also the favorite to replace May as leader of the Conservative party tells you all you need to know about the current mess the UK is in and why it is in this mess.

Of course we do not condemn engineering science when a new bridge wobbles or an oil rig fails, and we do not say that all medical science is nonsense when medics get things wrong, as they frequently do. But with economics, there are too many people who either want to replace the mainstream with their own school, or who like Rees-Mogg want to discredit economics because they suggest his preferred policy is harmful. As a result, whenever economics does make mistakes, as it will, there will be plenty of people around who want to bury the whole discipline. But when you look at all the evidence and not just one observation, as economists are trained to do, you find that you are better off following the advice of academic economists when it comes to economic policy than anyone else.

[1] The argument that academic economists should be modest or humble when giving their views should be seen in this light. They should certainly be honest about their own views compared to their colleagues, and they should also if they are given the opportunity express the uncertainties. But being modest and humble should never mean leaving politicians unchallenged when they proclaim economic nonsense. 

Economic Competence Revisited

My last post was designed to show clearly that the UK has not been a strong economy since the Conservatives started running it. Now I would be the first to say that this proves nothing about how competent the Conservatives are. It may be just bad luck. My point was about the media debate. This should be about whether it is the government’s fault that we have a weak economy, or alternatively whether they have done the best they could in the circumstances. Instead of that discussion, we have mediamacro’s presumption that we have a strong economy when clearly we do not.

The political debate should really be about economic competence. Mediamacro assumes that the Conservatives are more competent at running the economy because that is what the polls say, and the polls say that in part because mediamacro assumes it. It is a self-reinforcing loop, where the last thing the media thinks of doing is asking academic economists. How would I, as an academic macroeconomist, assess competence when it comes to running the macroeconomy?

The obvious thing to do is to look at key macroeconomic decisions made by governments, and how they turned out. I would be particularly hard on governments when they chose to go against the prevailing academic consensus, and this choice did not turn out well. I have written about this before on a few occasions: see here and here for example. Let me summarise why I think, once again, it is the Conservatives rather than Labour who have a lot of explaining to do.

We can start with monetarism, which in its most basic form is setting policy according to movements in monetary aggregates (the ‘money supply’). It was a short lived failure. A particular failure was the 1981 budget, raising taxes in the middle of a recession, which was famously opposed by 364 economists. The economists were right: the recovery (properly defined) was delayed by 18 months. This is not the story told by mediamacro, but it is an account that fits the facts.

The next economic disaster was the Lawson boom of the late 1980s, which combined a monetary and fiscal stimulus that increased inflation. I was once told by someone close to decisions at the time that Lawson wanted to reduce the top tax rate to 40% in 1988, and it was thought to be politically expedient to combine this was a standard rate cut even though we were in the middle of a boom. Monetary policy involved shadowing the DM, so could not counteract the fiscal stimulus and other inflationary pressures.

By 1990, the Lawson boom was becoming a recession, and the Conservative government decided to formally fix the exchange rate. Their chosen rate was much too high, as the work I carried out with colleagues at NIESR clearly showed. Black Wednesday, when the UK was forced to abandon the fixed exchange rate regime, rightly lost the Conservatives their reputation for economic competence for some time to come.

Between 1992 and 1997 the management of the economy was better, but without any major decisions or events. Widening the definition of policy you can justifiably credit Thatcher with weakening trade union power, but her failure to emulate Norway and establish a sovereign wealth fund from North Sea Oil revenues was a clear mistake.

Under Labour there were three major macroeconomic decisions, and all three were successes. First most academics agree with central bank independence, and I think most would agree that the design of the Monetary Policy Committee in 1997 was particularly good. Second, the decision not to join the Euro in 2003 was clearly correct, which was taken after extensive economic analysis. Third, the decision to embark on fiscal stimulus after the Great Recession was correct, in much the same way as Obama’s slightly later stimulus was correct.

Should we count the financial crisis, and the failure to prevent it happening, as a clear negative against economic competence? I would argue not, as (a) the opposition argued for less financial regulation, and (b) the government did follow the consensus view at the time. If any institution is to blame, it is the Bank of England for ignoring the rise in bank leverage. As to a profligate fiscal policy, this is simply a myth.

The incoming coalition government set up the OBR, which deserves credit just as setting up the MPC under Labour does. However their decision to embark on austerity in 2010 was a huge mistake, which once again probably went against majority academic opinion, particularly as it involved cutting public investment sharply. And then we have Brexit. Although arguably mandated by a referendum, the decision to leave the Single Market and customs union are down to the Conservative government alone.

We will be able to compare the economic policies of the two parties this time when they publish their manifestos. This post is about track records. It shows clearly that Labour tend to get things right, while the Conservatives have created a number of major policy-induced disasters. As with the ‘strong economy’, mediamacro have got it completely wrong about macroeconomic competence. But I’m afraid, as was the case in 2015 and 2016, it will be mediamacro rather than reality that carries the day. That, alas, is how democracy currently works in the UK.  

Economics, DSGE and Reality: a personal story

As I do not win prizes very often, I thought I would use the occasion of this one to write something much more personal than I normally allow myself. But this mini autobiography has a theme involving something quite topical: the relationship between academic macroeconomics and reality, and in particular the debate over DSGE modelling and the lack of economics in current policymaking. [1]

I first learnt economics at Cambridge, a department which at that time was hopelessly split between different factions or ‘schools of thought’. I thought if this is what being an academic is all about I want nothing to do with it, and instead of doing a PhD went to work at the UK Treasury. The one useful thing about economics that Cambridge taught me (with some help from tutorials with Mervyn King) was that mainstream economics contained too much wisdom to be dismissed as fundamentally flawed, but also (with the help of John Eatwell) that economics of all kinds could easily be bent by ideology.

My idea that by working at the Treasury I could avoid clashes between different schools of thought was of course naive. Although the institution I joined had a well developed and empirically orientated Keynesian framework [2], it immediately came under attack from monetarists, and once again we had different schools using different models and talking past each other. I needed more knowledge to understand competing claims, and the Treasury kindly paid for me to do a masters at Birkbeck, with the only condition being that I subsequently return to the Treasury for at least 2 years. Birkbeck at the time was also a very diverse department (incl John Muellbauer, Richard Portes, Ron Smith, Ben Fine and Laurence Harris), but unlike Cambridge a faculty where the dedication to teaching trumped factional warfare.

I returned to the Treasury, which while I was away saw the election of Margaret Thatcher and its (correct) advice about the impact of monetarism completely rejected. I was, largely by accident, immediately thrust into controversy: first by being given the job of preparing a published paper evaluating the empirical evidence for monetarism, and then by internally evaluating the economic effects of the 1981 budget. (I talk about each here and here.) I left for a job at NIESR exactly two years after I returned from Birkbeck. It was partly that experience that informed this post about giving advice: when your advice is simply ignored, there is no point giving it.

NIESR was like a halfway house between academia and the Treasury: research, but with forecasting rather than teaching. I became very involved in building structural econometric models and doing empirical research to back them up. I built the first version of what is now called NIGEM (a world model widely used by policy making and financial institutions), and with Stephen Hall incorporated rational expectations and other New Classical elements into their domestic model.

At its best, NIESR was an interface between academic macro and policy. It worked very well just before 1990, where with colleagues I showed that entering the ERM at an overvalued exchange rate would lead to a UK recession. A well respected Financial Times journalist responded that we had won the intellectual argument, but he was still going with his heart that we should enter at 2.95 DM/£. The Conservative government did likewise, and the recession of 1992 inevitably followed.

This was the first public occasion where academic research that I had organised could have made a big difference to UK policy and people’s lives, but like previous occasions it did not do so because others were using simplistic and perhaps politically motivated reasoning. It was also the first occasion that I saw close up academics who had not done similar research but who had influence use that influence to support simplistic reasoning. It is difficult to understate the impact that had on me: being centrally involved in a policy debate, losing that debate for partly political reasons, and subsequently seeing your analysis vindicated but at the cost of people becoming unemployed.

My time at NIESR convinced me that I would find teaching more fulfilling than forecasting, so I moved to academia. The publications I had produced at NIESR were sufficient to allow me to become a professor. I went to Strathclyde University at Glasgow partly because they agreed to give temporary funding to two colleagues at NIESR to come with me so we could bid to build a new UK model. [3] At the time the UK’s social science research funding body, the ESRC, allocated a significant proportion of its funds to support econometric macromodels, subject to competitions every 4 years. It also funded a Bureau at Warwick university that analysed and compared the main UK models. This Bureau at its best allowed a strong link between academia and policy debate.

Our bid was successful, and in the model called COMPACT I would argue we built the first UK large scale structural econometric model which was New Keynesian but which also incorporated innovative features like an influence of (exogenous) financial conditions on intertemporal consumption decisions. [4] We deliberately avoided forecasting, but I was very pleased to work with the IPPR in providing model based economic analysis in regular articles in their new journal, many written with Rebecca Driver.

Our efforts impressed the academics on the ESRC board that allocated funds, and we won another 4 years funding, and both projects were subsequently rated outstanding by academic assessors. But the writing was on the wall for this kind of modelling in the UK, because it did not fit the ‘it has to be DSGE’ edict from the US. A third round of funding, which wanted to add more influences from the financial sector into the model using ideas based on work by Stiglitz and Greenwald, was rejected because our approach was ‘old fashioned’ i.e not DSGE. (The irony given events some 20 years later is immense, and helped inform this paper.)

As my modelling work had always been heavily theory based, I had no problem moving with the tide, and now at Exeter university with Campbell Leith we began a very successful stream of work looking at monetary and fiscal policy interactions using DSGE models. [5] We obtained a series of ESRC grants for this work, again all subsequently rated as outstanding. Having to ensure everything was microfounded I think created more heat than light, but I learnt a great deal from this work which would prove invaluable over the last decade.

The work on exchange rates got revitalised with Gordon Brown’s 5 tests for Euro entry, and although the exchange rate with the Euro was around 1.6 at the time, the work I submitted to the Treasury implied an equilibrium rate closer to 1.4. When the work was eventually published it had fallen to around 1.4, and stayed there for some years. Yet as I note here, that work again used an ’old fashioned’ (non DSGE) framework, so it was of no interest to journals, and I never had time to translate it (something Obstfeld and Rogoff subsequently did, but ignoring all that had gone before). I also advised the Bank of England on building its ‘crossover’ DSGE/econometric model (described here).

Although my main work in the 2000s was on monetary and fiscal policy, the DSGE framework meant I had no need to follow evolving macro data, in contrast to the earlier modelling work. With Campbell and Tatiana I did use that work to help argue for an independent fiscal council in the UK, a cause I first argued for in 1996. This time Conservative policymakers were listening, and our paper helped make the case for the OBR.

My work on monetary and fiscal interaction also became highly relevant after the financial crisis when interest rates hit their lower bound. In what I hope by now is a familiar story, governments from around the world first went with what macroeconomic theory and evidence would prescribe, and then in 2010 dramatically went the opposite way. The latter event was undoubtedly the underlying motivation for me starting to write this blog (coupled with the difficulty I had getting anything I wrote published in the Financial Times or Guardian).

When I was asked to write an academic article on the fiscal policy record of the Labour government, I discovered not just that the Coalition government’s constant refrain was simply wrong, but also that the Labour opposition seemed uninterested in what I found. Given what I found only validated what was obvious from key data series, I began to ask why no one in the media appeared to have done this, or was interested (beyond making fun) in what I had found. Once I started looking at what and how the media reported, I realised this was just one of many areas where basic economic analysis was just being ignored, which led to my inventing the term mediamacro.

You can see from all this why I have a love/hate relationship to microfoundations and DSGE. It does produce insights, and also ended the school of thought mentality within mainstream macro, but more traditional forms of macromodelling also had virtues that were lost with DSGE. Which is why those who believe microfounded modelling is a dead end are wrong: it is an essential part of macro but just should not be all academic macro. What I think this criticism can do is two things: revitalise non-microfounded analysis, and also stop editors taking what I have called ‘microfoundations purists’ too seriously.

As for macroeconomic advice and policy, you can see that austerity is not the first time good advice has been ignored at considerable cost. And for the few that sometimes tell me I should ‘stick with the economics’, you can see why given my experience I find that rather difficult to do. It is a bit like asking a chef to ignore how bad the service is in his restaurant, and just stick with the cooking. [6]

[1] This exercise in introspection is also prompted by having just returned from a conference in Cambridge, where I first studied economics. I must also admit that the Wikipedia page on me is terrible, and I have never felt it kosher to edit it myself, so this is a more informative alternative.

[2] Old, not new Keynesian, and still attached to incomes policies. And with a phobia about floating rates that could easily become ‘the end is nigh’ stuff (hence 1976 IMF).

[3] I hope neither regret their brave decision: Julia Darby is now a professor at Strathclyde and John Ireland is a deputy director in the Scottish Government.

[4] Consumption was of the Blanchard Yaari type, which allowed feedback from wealth to consumption. It was not all microfounded and therefore internally consistent, but it did attempt to track individual data series.

[5] The work continued when Campbell went to Glasgow, but I also began working with Tatiana Kirsanova at Exeter. I kept COMPACT going enough to be able to contribute to this article looking at flu pandemics, but even there one referee argued that the analysis did not use a ‘proper’ (i.e DSGE) model.

[6] At which point I show my true macro credentials in choosing analogies based on restaurants.  

What do macroeconomists know anyway?

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

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

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

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

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

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

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

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

Left, Right and Macroeconomic Competence

The title of one of my recent posts was a bit of a cheat. It was meant to surprise, because it contradicted the prevailing view, but the post didn’t actually try to answer the question the title posed. This post does try to assess whether a political party’s place on the left-right spectrum might influence its macroeconomic competence.

It should be obvious that, for any individual country, looking at some macro outcome (like growth) and drawing some conclusion can be meaningless. For example, growth under Republican presidents has been far worse than under Democratic presidents, but that could so easily be down to luck rather than judgement. To make headway we need to think of mechanisms and particular instances when they applied.

In the US, for example, there is a belief on the right that cutting taxes will increase tax revenue, a belief that is also clearly wrong. So you would expect Republican administrations that acted on that belief to run up bigger budget deficits than their Democratic counterparts, and that seems to be what they do. That may not be the whole story, but at least it is a mechanism that seems to fit. However it seems like a story that is rather specific to the US, at least for the moment.

Just now you could argue that parties of the right are more prone to austerity, because they want a smaller state than those of the left, and austerity can be used as a cover to undertake policies that reduce the size of the state. In a situation where interest rates are stuck at zero that has the damaging macroeconomic consequences that we are seeing today. However this is a story that is specific to liquidity traps.

An alternative source could be different views about the relative costs of inflation and unemployment. You might expect governments of the left to have higher inflation and those of the right to have higher unemployment. While that mechanism loses much of its force when you have independent central banks, it can resurface in a liquidity trap.

A final left/right difference that might impact on macroeconomic outcomes is different views on the need for state intervention. Those on the right might favour less intervention, leading them to favour simple rules, and to argue against the use of fiscal policy for macroeconomic stabilisation.

Is any of the above helpful in looking at UK policy since 1979? I use this place and period as a case study because I am most familiar with it. In the past I have talked about three major macroeconomic policy errors over this period, all of which occurred when the Conservatives were in power. However that alone proves nothing: Labour was in power for fewer years and might have been lucky. [1] 

The period starts with Margaret Thatcher and the brief experiment with monetarism. Here you could use the inflation/unemployment contrast - the policy succeeded in getting inflation down very rapidly, but at high costs in terms of unemployment, which persisted because of hysteresis effects. A secondary question is whether, given any particular preferences between inflation and unemployment, the policy was inefficient because it attempted to run monetary policy according to a simple rule which failed. Many at the time argued it was, because it put far too much of the burden of lost output on the traded sector, which in turn was because the policy generated Dornbusch type overshooting effects (i.e. a large appreciation in the exchange rate).

The 1990 recession can also be linked to left/right influences. The rise in inflation that preceded the recession (and to some extent made it necessary) was partly down to Nigel Lawson’s tax cuts. I have been told by one insider that the key wish at the time was to cut the top rate of tax, but it was felt that to do this alone would be politically damaging, so tax cuts were made across the board. That was not the only reason for the late 80s boom - there was also the decline in the aggregate savings ratio that in my view had a great deal to do with financial deregulation - but it was a factor.

The macroeconomic failure that everyone knows about from that period was the forced exit from the ERM in 1992, and that was costly because it made monetary policy too tight beforehand. Although you could say fixing the exchange rate is a simple rule that the right might prefer, that would be stretching things: ERM entry was favoured by Labour as well (although with the notable exception of Bryan Gould). According to my own and colleagues analysis at the National Institute the entry rate was too high, which might follow from a preference for low inflation, although it could just have been a choice based on poor macroeconomic analysis.

Inflation targeting followed the ERM debacle, and it was augmented by central bank independence at the start of the Labour government of 1997. One major decision that, if it had gone the other way, we might be scoring as a major error would have been if the UK had joined the Euro in 2003. I have argued that the decision not to was based on an intelligent and well researched application of current academic knowledge (subsequently vindicated by additional but related problems that academics did not anticipate), rather than any left/right policy preference.

Which brings us to George Osborne. I have just finished the first draft of a paper that appraises the coalition’s macroeconomic policy, and an interesting question that arises from that is why the coalition went for austerity despite the liquidity trap. While the 2010 Eurozone crisis might explain the change of mind of the minority partners in the coalition, it does not explain Conservative policy, which was against fiscal stimulus in 2009. If you look at some of Osborne’s speeches (and I’m not sure there is much else to go on), the rationale for austerity was a belief that monetary policy was sufficient to stabilise the economy, even in a liquidity trap (see the second part of this post). At the time that represented a minority view amongst macroeconomists. It could be explained in left/right terms in various ways: a dislike of additional state intervention, taking a risk that would lead to higher unemployment rather than higher inflation, or a devious way of reducing the size of the state.

So we have three major UK macroeconomic policy errors: the monetarist experiment of Thatcher, ERM entry and exit (and the boom that preceded it), and current austerity. In all three cases it is possible to link these to some extent to right wing political preferences. It may be equally possible to go back further and link the increased inflation of the 1970s to a left wing dislike of unemployment, but I cannot do that from memory alone so it would require some additional work going over the detailed history of that period.

However one additional point strikes me. Two of these three errors can be attributed to following a minority academic view. That monetarism was a minority academic view in the UK in the early 1980s became clear with the famous letter from 364 economists in 1981. In UK right wing mythology that episode represents the triumph of Thatcher over the academics. I have also noted that the Labour/Brown period perhaps represented a high point in the influence of academic economists within government, and the analysis behind the 2003 entry decision was an example of that. A belief that fiscal policy is not required in a liquidity trap is a minority academic view.

It may seem odd to some that those on the right might be more disposed to ignore mainstream academic opinion within economics, but of course academic economics can be described as the analysis of market failure. No one looking at debate in the US would dispute that minority academic views, or a more general anti-intellectualism, finds an easier home on the right than the left at the moment. Of course you can also find anti-intellectualism on the left - see here for a recent UK example - and my distant memories of the UK in the mid 1970s suggest that during this period they might have been at least as prevalent as those on the right. What may have happened over the last few decades is that what is currently called the left has become ideology light, and therefore more receptive to academic expertise and evidence based policy.

[1] If you want to call the gradual liberalisation of financial controls that facilitated the financial crisis a macroeconomic policy error that would make four, but I do not think anyone would seriously argue that this occurred under Labour because they were more predisposed to market liberalisation than the Conservatives.

On Major Macroeconomic Policy Mistakes

            I have spent the last week on a farm south of Matera in the Basilicata region of Italy. Wonderful scenery, sun, hospitality and food, but no internet access. Returned to find a very wet UK, and that the economy has officially entered a second recession.

When UK GDP fell in the last quarter of 2011, I wrote that the 2010 Budget should rank as one of the major UK macroeconomic policy errors since the war. A number of comments on that post and since have asked why I single out fiscal policy rather than monetary policy for such criticism? This is a good question, which has much more general applicability than to just the UK.

There are three charges that could be made against recent monetary policy.

1)                          That it could have done something to prevent the financial crisis itself, by raising interest rates by more in the middle of the last decade.

2)                          Following the crisis, central banks could have cut rates more quickly, or done more in terms of ‘unconventional’ monetary policy.

3)                          Policy should have moved to some form of price level or nominal GDP target. 

Let me take each in turn.

            Policy was clearly at fault in allowing the financial excesses that preceded the crisis. There is also a strong case that monetary policy should have reacted to excess leverage, as my recent post summarising Woodford’s new NBER paper suggests. There is plenty to debate about who should have seen the danger signals and ‘shouted from the rooftops’ about them. However I see the financial crisis as primarily a failure of financial regulation, and not conventional monetary policy. A laissez-faire attitude to the financial sector, rather than the setting of interest rates, was the major policy failure here.

            The second criticism is also probably valid. If the Bank of England had cut interest rates as rapidly as the US Fed, or if it had tried to orientate its Quantitative Easing policy to where the credit constraints were most acute, then this might have improved things somewhat. However I’m reluctant to label this a major policy error. Monetary policy, in contrast to fiscal policy, did move in the right direction. My view would be different if the UK had followed the ECB in raising interest rates in 2011, as they nearly did. 

The most serious charge against current monetary policy is that it is being too conservative in sticking to low inflation targets rather than moving to some form of price level targeting with, for a time, an implicitly higher inflation target. In 2009 or even 2010 such a change would have been seen as radical, but there now seems to be a growing weight of academic opinion (for example here) behind such a move. However, in the UK there is very little pressure to make any change. In part this is because – unlike the US - any move to price level or nominal GDP targeting would have to come from the government rather than the Bank of England. The government sets the Bank’s mandate, which has the 2% inflation target at its centre. Most academic expertise on UK monetary policy works through the Bank. One possibility would be to ask the Treasury Select Committee to take up this issue. If any UK academics reading this blog feel this would be a worthwhile thing to try and do, please contact me.

            So in retrospect the failure to move to some form of price level targeting may come to be seen as a major policy error. However, at least in the UK, in the absence of any great pressure from either academic economists or the opposition to make such a change, this error may reflect ignorance as much as anything. This was not the case with fiscal austerity in 2010.

            As I have noted before, the Conservative Party opposed the government’s countercyclical fiscal policy following the recession. They bought the idea of expansionary austerity, which many have pointed out contradicts basic macroeconomic theory in a liquidity trap. There can be no excuse that the right policy was new, untried and radical – the appropriate policy was simple and well understood. When a government chooses to ignore mainstream academic theory, and the economy suffers as a result, it has made a major error and it should be held to account for that.

            Does this make me a closet old fashioned Keynesian? Well for the record I think there have been only two errors of similar magnitude in the UK over the last 30 years, and both have involved monetary policy. The more recent was the decision in 1990 to enter to Exchange Rate Mechanism (ERM) at an overvalued exchange rate of 2.95 DM/£. Although an economic downturn in the early 1990s was probably inevitable given the overheating in the late 1980s, joining the ERM at an overvalued exchange rate made the recession unnecessarily sharp. On that particular occasion I really can say that ‘I told you so’. The other was the brief adoption of money targeting in the early 1980s. Once again, tightening of policy was required to reduce inflation, but the adoption of money targets led to deflation that was both too sharp and uncontrolled, and the hysteresis effects of the resulting large rise in unemployment blighted the rest of the decade. (The fiscal contraction in the 1981 budget that I have written about here was a mistake given the very tight monetary policy at the time, but a more optimal policy would probably have involved fiscal tightening and a looser monetary policy.)

            A common feature of all three episodes is that they caused increases in unemployment that were unnecessary, at a time when unemployment was already high. For reasons I have noted here, this implies a major decline in social welfare. Why have I not included any examples of errors that led to higher inflation? Well if I had gone back further then clearly the rise in inflation in the 1970s was a major policy error. The rise in UK inflation in the late 1980s was the result of policy errors, but I am being generous here because to some extent the consumer boom at the time was unexpected. (I discussed this briefly here.)

            Is it a coincidence that all three major errors were made by Conservative Chancellors? Perhaps. The catastrophic rise in inflation in the 1970s largely took place under Labour. The increase in government spending by Labour around 2005 was underfunded, but I would not call this a major policy error because I do not think it led to a large decline in social welfare.

            These three errors all had a uniquely national element. The US flirtation with money targets was briefer and much less damaging. Although German unification was the prime cause of the temporary collapse of the ERM, joining at an overvalued rate was the UK’s choice. Whereas many Eurozone countries have been forced into austerity by the markets and a lack of coordination by the ECB, the UK was never under similar pressure because it is not part of the Eurozone.    

            At least one characteristic connects all three episodes. They all get some of their appeal from simplistic macroeconomics. In 1980, it was the idea that there is a simple and reliable link between some measure of money and inflation. In 1990, it was that the medium term equilibrium real exchange rate is always equal to the PPP rate. And most recently, that private sector demand will automatically replace public sector demand (Says Law), or perhaps that monetary policy in the form of inflation targeting is always capable of stabilising demand. Most of the time I do not think sound macroeconomic policy is very complicated, but it is not that simple either.