The differences between Labour and the Conservatives on fiscal policy

The Conservatives have learnt the lesson of 2017, and have ditched austerity in order to offer higher spending to the electorate.They hope voters decide that there isn't much difference between the two parties on this score. But voters would be wrong to do so. In Labour's case the extra spending is sustainable, whereas for the Tories it will not be. There are two reasons for this.

The first is that the Tories are not proposing large tax increases, while Labour almost certainly will - in the last election corporation taxes and taxes on high earners. (In 2017 the IFS suggested their match between extra current spending and higher taxes wasn’t perfect, but they agreed Labour would keep within its fiscal rule, which is what matters.) That means for a given fiscal stance Labour should have more money to spend on non-investment public spending than the Conservatives. And, assuming there is no collapse in demand ahead, their fiscal stance is now similar. (If there is a collapse, see below).

The second reason is Brexit. The Tories have negotiated a very hard Brexit, leaving the Customs Union and Single Market. I have argued that Brexit will not happen under Labour, but even if it did a much softer Brexit means less economic damage. Soft or no Brexit means higher incomes under Labour which in turn means higher taxes, and so higher spending.

What the Tories are counting on is that analysis by the IFS and others of the two party's programmes will ignore the second difference, and use a common baseline (as the Resolution Foundation does here). Once you factor in Brexit, the Tories extra spending is unlikely to be sustainable. They willl be forced to raise taxes or cut spending to keep to their current balance target. It will be even worse if Johnson throws in some last minute tax cuts in a desparate attempt to ensure he gets a majority. The OBR might have shown all this in its budget forecast, but the budget was conveniently postponed.

Not only will Labour spend more on day to day government expenditure, but they also plan a much more radical increase in public investment spending. Whether you think that is a good idea will depend on how seriously you take the need for a Green New Deal, how much you want to reduce regional inequalities and how much social housing you want the government to build, among other things. That will mean more borrowing under Labour, but public investment of this kind should be financed by borrowing. No one should argue we cannot invest to reduce climate change because it means borrowing more!

Those are the headlines from yesterday. The rest is only of interest to those who worry about fiscal rules. For the details of what each party's new rules are I'm relying on this account by the Resolution Foundation.

1) Both Conservaives and Labour are now targeting the current balance: the deficit minus net public investment. The Tories have given up Osborne's foolish move to target the total deficit, and like Labour's Fiscal Credibility rule will not constrain investment in the deficit part of the rule. There are two differences. Labour targets the current balance five years ahead using a rolling target, whereas the Tories will target it three years ahead with no rolling target. I argue in my paper with Jonathan Portes that in a mature economy with a fiscal council like the OBR a rolling 5 year target makes more sense, because it is more robust to shocks just at the end of the target period.

2) Labour's Fiscal Credibility Rule departed from the suggestions in that paper by having a target for debt. The big change in this election is that this is replaced by a target that includes government assets as well as liabilities, a suggestion that both the Resolution Foundation, INET and the IFS’s Green Budget have made. If you are going to have a stock target (see below) this type of target makes more sense. The Tories have a weak and conventional 'falling debt/GDP' target.

3) Both rules appartently include limits for debt interest in relation to taxes. I'm even less keen on these than debt targets, but they have been suggested by others.

4) Labour’s Fiscal Credibility Rule has a knockout that occurs when interest rates hit their lower bound. This was a key proposal in my paper with Jonathan Portes, and as a result Labour's rule was ahead of its time. When interest rates hit their lower bound, the fiscal rule would be temporarily suspended and fiscal policy would focus on an economic recovery. When John McDonnell launched his rule in 2016 one BBC reporter called the knockout a loophole, despite the fact that it would have created a much faster and quicker recovery and avoided austerity! Other than that mediamacro hardly discussed the knockout.

Since 2016, however, first the IPPR, then INET and then the Resolution Foundation have suggested very similar knockouts, reflecting a growing consensus that fiscal stimulus will be needed for the next recession. In another post I might discuss the small differences between these different knockouts, but the principle is the same and kind of obvious - if conventional monetary policy can no longer do its job fiscal policy should take over. But as we are not yet at this lower bound, Labour were quite right in 2017 not to base policy on the knockout happening, and I suspect they will do the same again in this election. As far as I know there is no knockout in what the Conservatives' propose.

The difference between the rule suggested in Portes and Wren-Lewis and the Fiscal Credibility Rule is that the latter initially contained a target for total debt, and now contains a target for public sector net wealth. While the latter is a definite improvement on the former, I personally think targets for any kind of stock in a fiscal rule are a bad idea. The reason to target the deficit rather than debt is basic to fiscal rules. Adjustment of taxes and spending should as far as possible be done slowly.

Suppose some temporary fiscal shock raises both the deficit and debt. Because the shock is temporary, there will be no impact on future deficits. At most debt interest payments may rise slightly, requiring some very tiny increase in taxes or cut in spending. Debt will gradually fall back to its pre-shock level. That is smooth adjustment. However with a debt target you need a much bigger adjustment in taxes or spending to get the debt stock down within the target period. Exactly the same logic applies to permanent fiscal shocks.

This is the basic logic of preferring deficit target to debt targets This is not to say that the debt ratio or some other stock measure are not important, but they should guide what deficit targets should be, and not be targets themselves. An analogy is a road trip where you are delayed by some congestion. A sensible person does not start taking risks by driving very fast to make up for lost time as quickly as possible, but instead think how they can make up the time gradually over the entire journey. As no one has any good idea of what the optimum level of debt is, the journey in this case is decades not 5 years.

There is a technical argument that you should target both if your deficit target is the current balance, which excludes investment. If that is so, and it should be so, then in theory without some form of debt target the government could increase debt without limit by keeping investment very high. My response is that, if this really is a worry (has it ever happened in the UK over the last 50+ years?), have a target or limit for the investment to GDP ratio, as the new Conservative fiscal rule does. In this one respect I think their rule is better than Labour's, if you ignore their silly change in debt target! An investment target would avoid the dangers of having a stock target.

It would be much more sensible in my view to have just a current balance deficit target, which is occasionally revised after suggestions by the OBR in light of movements in various measures of government debt and wealth. In their recent Green Budget the IFS are very pessimistic, suggesting fiscal rules will never last a long time. I think there is a simple reason for this, and that is that rules generally contain some form of debt target. But they seem very popular with politcians in all countries, and many of those that advise them, which alas may mean fiscal rules may not be as robust as they could be.

Postscript (12/11/19)

I saw it suggested yesterday that you could ignore the points I make here because I once advised the Labour party (that role ended in 2016). Over the last decade I have advised all three of the main parties on various issues. I believe it is an economist's duty to give politicians their expertise if asked, with very mild conditions set out here. Giving that advice on technical issues should never be mistaken for being partisan, just as economists should never let their own political views influence the advice they give on these issues. 

The IPPR Commission’s plan for a new economy

The final report of the IPPR’s Commission on Economic Justice is released today, with the full title of Prosperity and Justice: A Plan for a New Economy. [1] I was lucky enough to get an advance copy, and it is a very impressive document: very well researched and well argued. It is nothing less than a blueprint for a new progressive government. Of course there are some proposals I have doubts about, but it is sufficiently authoritative that in future anyone should ask of any progressive economic programme how does it relate to the recommendations of this report.

As far as my own area of monetary and fiscal policy is concerned, I’m not sure I have seen in one place as clear and comprehensive a summary of the lessons of the recent past and a better set of proposals for the future. I wrote about an early draft of this chapter in April, so I will be brief here. Their proposed fiscal rule separates current and investment spending, but suggests the ONS and OBR look to obtain a measure of spending that helps future generations that is better than the national accounts definition of public investment. They suggest a substantial increase in public investment, while current spending in constrained by a rolling five year target for balance. However they suggest that if interest rates are stuck at their lower bound, the focus of fiscal policy (current spending and taxes as well as investment) should be stimulus. Readers familiar with this blog will know this is very similar to the proposals in Portes and Wren-Lewis, 2015 and the Labour Party’s fiscal credibility rule.

For monetary policy they suggest ending the primacy of inflation, and adding underemployment and nominal income as primary targets. In addition, they suggest that QE involve creating money directly to expand the activities of a National Investment Bank (NIB) when a large macroeconomic stimulus is required. Note that, unlike a fleeting proposal by Corbyn, money creation to expand the NIB remains a call made by the independent Bank of England in a recession rather than by the NIB itself or anyone else. I would go further on the Bank’s mandate, but otherwise the IPPR’s proposals look eminently sensible.

The chapter on industrial policy seems sensible, with some ideas from Mazzucato (e.g. public sector led missions) clearly evident. Beside the NIB already mentioned, there is an emphasis on direct support rather than via the tax system (e.g. patent box) which often have large deadweight losses. They argue an industrial strategy should not just be about helping and adding to innovation clusters based around universities, but also in increasing productivity in what they call the ‘everyday economy’. In my view it is higher productivity and not greater union bargaining power that will raise real wages in a sustainable way, although in other areas a greater union presence can be helpful (see below).

For many one of the most interesting ideas - of course not new - is to end the shareholder model, and replace it with a stakeholders model where workers have an influence on the board and executive pay. It represents a move from a US to a more European model. While I find this argument fairly convincing, the idea under reforming the financial system that the Financial Policy Committee (FPC) of the Bank should target house price inflation is misconceived. What the economy needs is falling house prices, and once you make house prices a target the pressure will be to stop that happening.

The idea of a citizen’s (social) wealth fund is interesting, but I’m not sure a strong case for it is made here. Why should a government hold assets and issue debt, for example? If you want to redistribute wealth from the wealthy old to the poorer young, why not do so directly? On tax the proposal to combine income tax and national insurance seems sensible, as is the idea of a replacing bands with a formula based system (as in Germany). The same goes for a lifetime gifts tax to replace inheritance tax, and a land value tax.

There is so much else in the report, but let me end by talking about one issue: executive pay. There is a cute chart in the report that I reproduce below.

The report starts, quite rightly in my view, by emphasising the dangers of inequality. It also suggests that this cannot just be tackled ‘after the fact’ i.e. by tax and welfare measures. But will the stakeholder measures talked about above, or greater union influence, be enough to reverse runaway corporate pay? The rise of the share of the 1% starts with the advent of a neoliberal US and UK, and it has made the rest of us noticeably poorer. The report involves reversing many aspects of neoliberalism, but an interesting question is whether that is enough to achieve a decline in the 1% share, or whether other measures like higher top taxes are an essential part of doing that?

It is a fascinating report for anyone interested in a progressive economic policy. Do read it.

[1] This is a personal nostalgic footnote, which I am only writing because I could not easily see this information online. New Economy also happened to be the title of the IPPR’s journal in the early 1990s, which is now called Progressive Review. I remember it well because between 1993 and 1995/6 I wrote a number of articles for it based around simulations of the macroeconometric model I had developed with Julia Darby and John Ireland. The idea to do that came from IPPR’s Economic Director Dan Corry, with Gerry Holtham as overall Director at the time. Apart from members of the modelling team, Rebecca Driver helped write a number of the articles. The first article over that period had the title “What’s so Bad about Borrowing?” (plus ça change), and the last “Avoiding Fiscal Fudge” which proposed an independent fiscal institution or fiscal council for the UK. That took 14 years to come to fruition, and I hope many of the proposals in this report do not have to wait so long.

Macroeconomic Policy Reform the IPPR way

Monetary and fiscal policy makers in the UK seem to think they had a good recession. You can tell that because neither group seem particularly interested in learning any lessons. This is despite the fact that we had the deepest recession since the 1930s, and the slowest recovery for centuries. It is also despite the fact that the level of UK GDP is almost 20% below the level it would be if it had followed pre-recessions trends, and all previous recessions have had the economy catch up with that trend.

You can tell from this paragraph that I do think serious changes are required to how monetary and fiscal policy are done. So does the IPPR, and their detailed analysis and proposals are set out in a new report by Alfie Stirling. The analysis is not too technical, well presented, well researched and I agree with a great deal of what is said. I will look a monetary policy first, and then fiscal policy.

What the Great Recession showed us (although many macroeconomists already knew) is that once nominal interest rates hit their effective lower bound (ELB) [1], monetary policy makers lose their reliable means of combating a recession. The report is dubious about Quantitative Easing (QE) for much the same reason that I have been for anything other than a last resort instrument. In brief, the impact of QE is very uncertain because it is not routinely used, and in addition there may be important non-linearities. It is not a reliable alternative to interest rates.

The report makes much the same point about negative nominal interest rates: partially or perhaps fully removing the lower bound. To quote:

“Like QE, the impacts of negative rates are uncertain and, depending on the behavioural response from banks and savers, could actually reduce spending in the economy, or else increase the number of risky loans (see for example Eggertsson, Juelsrud and Wold 2017).”

I know some macroeconomists will disagree with that assessment, but I think the point is valid.

The report also rejects helicopter money as a solution to the ELB problem. Here I found their discussion less convincing, but they do recognise that a form of helicopter money has already been undertaken by some central banks through creating money to change the relationship between borrowing and lending rates, a point that Eric Lonergan has stressed.

The two reforms to monetary policy that have been suggested and which the report does support are adopting unemployment or nominal GDP as either a second target or as an intermediate target, and raising the inflation target by one or two percent. I have argued strongly for a dual mandate and also for using nominal GDP as an intermediate target, so I have no objections here.

The report recognises, however, that none of their proposed reforms to monetary policy eliminates the ELB problem completely. We have, inevitably, to think about the other reliable and effective instrument that we have to stimulate aggregate demand: fiscal policy. Their proposed fiscal rule is very similar to Labour’s fiscal credibility rule. It includes (a) a ‘knockout’ to switch to fiscal expansion if interest rates reach their ELB, (b) 5 year rolling target for a zero current balance (c) a 5 year rolling target for public investment (d) a similar target for debt to GDP. The last in this list you will not find in Portes and Wren-Lewis, in essence because it involves double counting, and debt targets are less robust to shocks than deficit targets.

If governments followed this fiscal rule, then the ELB would not be the serious problem that it is, because reliable fiscal stimulus would replace reliable monetary stimulus at the ELB. But the IPPR worry that governments might not do what the fiscal rule, and with the knockout what the Bank of England, tells them to do. They are concerned that what they call ‘surplus bias’ might be so strong that the government would not run the deficits that the Bank asks them to run.

To overcome this concern, they suggest an alternative to QE at the ELB: the Bank should create reserves to fund projects that are part of a National Investment Bank (NIB). The NIB would be independent of government in terms of the projects it funded (but not its high level mandate), and it would normally raise funds in the open market. (This makes it different from proposals that the NIB be entirely funded by the Bank: see here.) In an ELB recession, the Bank of England would ask the NIB to fund additional projects, with the Bank providing the finance.

As public investment is particularly effective as a countercyclical tool if undertaken immediately, and as it is usually possible to some degree to bring forward investment projects, this proposal seems a superior alternative to QE, as long as the link between additional purchases of NIB debt and additional investment by the NIB was reasonably clear. The key point here is that although conventional QE might try to stimulate private investment by reducing firm borrowing costs, in a situation where there is chronic lack of demand that can be like trying to push on a string. The same problem should not arise with an NIB. In that sense it just seems like a good idea.

Whether it would be enough alone to circumvent the problem of a rabid surplus bias government during a recession I doubt. The kind of public investment that is easy to ramp up quickly in a recession are things like flood defences or filling holes in the road, rather than the kind of things an NIB would fund. A government suffering strong surplus bias could cut these things quicker than an NIB could fund additional projects. Some form of QE would be more powerful in this respect. The danger in either case is that you just encourage the government to try and get down debt even faster: if QE gives money directly to people, the government just raises VAT.

How seriously should we worry about (design policy for) a government offsetting everything the Bank is able to do to stimulate demand in a recession? The answer may be given by imagining the following scenario. The government operates a fiscal rule that has an explicit ELB knockout. The Bank of England, when rates hit the ELB, requests the government undertake fiscal stimulus. If Cameron/Osborne had been faced with both those things, would they have still cut back public investment? I suspect the answer is no. That of course by implication means that central bankers in Europe played a large part in facilitating (or encouraging) austerity, which in the UK stemmed from a failure to admit the problems of the ELB because of a naive faith in QE.

Which brings us to central bank independence and what I call the conventional assignment (outwith the ELB, monetary policy deals with macroeconomic stabilisation). The IPPR stay with the mainstream macroeconomic consensus in wanting to keep both. People with a more MMT type view, like Richard Murphy, would reverse [2] the conventional assignment, and have fiscal policy doing the macroeconomic stabilisation. I have written a great deal on the distinction and will not repeat that here. However it is worth making one point on independence.

The reasons for making central banks independent are not peculiar to monetary policy. They are that if the complex task of macroeconomic stabilisation is left in the hands of politicians who get secret advice, they can mess things up for political ends. [3] Messing things up can be minor (e.g. delaying necessary measures), structural (e.g. time inconsistency) or explosive (e.g. hyperinflation). Austerity shows that this fear is justified. MMT’s answer to the IPPRs concern about a surplus bias government is that this is just a cost of democracy or the good guys would always be in power, which I suspect many might not find reassuring. Yet that is also why European central bank’s encouragement of austerity was far from helpful to the case for the delegation of macroeconomic stabilisation.

[1] 'Effective' because in practice it is up to the central bank to decide at what point they cannot reduce nominal rates further. 

[2] Not strictly true. In the conventional assignment monetary policy does inflation/aggregate demand and government looks after its debt, while in MMT fiscal does inflation/aggregate demand and government debt looks after itself.

[3] I hope time inconsistency can be subsumed under this broad definition.

Revolutions in Economic Policy

The Commission on Economic Justice hosted by the Institute for Public Policy Research (IPPR) has just published a substantial and comprehensive report on the UK economy called ‘Time for Change’. I hope to write about aspects of that report later, but its basic premise is that we need a revolution in economic policy making, akin to the revolutions enacted by the post-war Attlee government and Mrs. Thatcher. The thinking behind the idea of economic policy revolutions is outlined by Alfie Stirling and Laurie Laybourne-Langton in a paper in The Political Quarterly.

The authors adapt the ideas of Thomas Kuhn’s The Structure of Scientific Revolutions to economic policy. I do not want to get hung up on the legitimacy or details of this. The basic idea that some periods involve profound changes in economic policy is not really contentious. Also the idea that the ‘failing paradigm’ will first try to adapt itself before being replaced by the revolutionary idea is straightforward. You only need to look at the state of current politics in the UK and US to take seriously the idea that what could be called the neoliberal era - the set of policies and world view associated with Thatcher and Reagan - is coming to an end.

There is a lot in the paper that I agree with, at least until the conclusions. [1] But I think my main critical comment would be that the paper focuses too much on macroeconomics, and as a result goes a little astray. It is if, having borrowed Kuhn’s idea and applied it to economic policy, the authors feel obliged to keep going back to an actual academic discipline, macroeconomic theory, rather than staying with economic policy as a whole. Let me set out first how I see the macroeconomic transformation that took place around the time of Thatcher and Reagan.

A key mistake that many people make is to say that conventional Keynesian macroeconomic theory was unable to explain stagflation, and that policymakers adopted monetarism or new classical ideas as a result. The basis for understanding stagflation and reducing inflation was known since at least Friedman’s famous address in 1968 giving his account of the expectations augmented Phillips curve. This Phillips curve was not used to guide monetary or fiscal policy before the end of the 1970s because most policy makers and some economists were reluctant to raise unemployment as a way of reducing inflation. [2]

In the UK this use of demand management to control inflation (or its counterpart, which was to abandon attempts at direct control like incomes policies) coincided with the election of Thatcher, but in the US it was initiated by Paul Volcker under Jimmy Carter. In both the UK and US it was associated with attempts to control monetary aggregates, but this lasted only a few years. You could argue that abandoning incomes policies was neoliberal, but to me it looks like the inevitable result of double digit inflation.

There was a revolution in macroeconomic theory, but I have argued elsewhere that it does not fit into the Kuhnian framework. The New Classical Counter Revolution (NCCR) did not come up with an alternative analysis of inflation: instead their concerns were more methodological. It is true that that many who promoted the NCCR also favoured neoliberalism, and you could relate reductionism to individualism (and hence neoliberalism), but I think the appeal of the NCCR owed much more to a collection of good ideas that the then mainstream resisted, like rational expectations.

Inflation targeting by central banks involves an attempt to manage the economy in much the same way as Keynesian fiscal activism had done before. The central bank is a part of the state. Central bank independence didn’t come to the UK until 1997, and existed in the US well before Reagan. What I call the Consensus Assignment (monetary to demand management, fiscal to debt control) was dealt a fatal blow by the GFC, but the popularity of this assignment owes little to neoliberalism. Attempts to link inflation targeting to neoliberalism, which are frequent, are in my view a mistake.

Trying to fit macroeconomics into an account of the rise of neoliberalism is therefore problematic, and more importantly it detracts from the real economic policy revolution that neoliberalism represented, which was a change in the attitude of policymakers to state intervention of almost any kind. Out went government partnership with industry (described as ‘picking winners’), together with a regional and industrial policy serious enough to counteract the effects of globalisation and technical change. There was a corresponding shift from the collective (including attacking trade unions) to the individual, together with the idea that ‘wealth creators’ (aka high earners) had to be incentivised by cutting ‘punitive’ taxation. Public money became ‘taxpayers money’ and so on.

All this was a successful neoliberal revolution, where by success I mean it took hold for decades. It, together with subsequent overreach, has caused serious problems and is therefore ripe for review. But ironically the attempt at a truly neoliberal macro policy - hands-off monetary targeting with no demand management - failed within a few years of being tried.

[1] I should say why I think the conclusions do not follow from the rest of the paper. There are some simple mistakes, such as “the failure of these same models to predict accurately the effects of the UK vote to leave the EU threatens to renew the crisis of confidence in economic theory.” But there is also an implicit very misleading equation pair: neoliberal policy=mainstream economics, revolution=heterodoxy.

First, the two previous revolutions in macro theory came from within the mainstream, not from outside. Second, neither austerity or Brexit have anything to do with mainstream economics. More generally, mainstream economics is as much a critique of neoliberalism as a support. As a result, a revolution in economic policy making could quite easily originate from within mainstream economics (see here, for example).

[2] Today, that view has been revived by members of the MMT school, who call using the Phillips curve to control inflation amoral.

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.  

Bold macroeconomic policy changes for a new government

One of the features of the incoming 1997 Labour government was that it undertook significant and progressive changes in macroeconomic policy. Not only was it right to give independence to the Bank of England [1], but the institutional framework they created for this was innovative and effective. As I have written recently, the fiscal framework established a year later was also clear and progressive compared to past practice and what was being done elsewhere.

So could the government that gets elected in 2015 be equally bold? I think it could be. Furthermore, the suggestions I make below apply to many advanced economies. Yet why look two years ahead now, when recovery from recession is either far from complete, or for many countries has not begun? One reason is that the lags in policy making can be quite long. A new government will not have spent the year before an election working out its policies - it will have been too busy campaigning. Policies get decided much earlier. To have a chance in that decision making process, ideas need to be bounced around earlier still.

On monetary policy, the new government needs to acknowledge that the recession has indicated clear problems with the inflation targeting regime. Three things need to change. First, the medium term inflation objective should be accompanied by an objective of minimising the output gap - in other words the UK should have a dual mandate like the US. Second, nominal GDP should be adopted as an intermediate target, to guide the MPC as to how best achieve these two objectives. Third, the inflation target of 2% is too low, because it increases the risk that we will soon suffer another Zero Lower Bound (ZLB) recession. In the UK the government fixes this target (which is one reason why the 1997 decision was progressive), and it should raise it. All of these changes will assist the process of recovery as well as help in the longer term.

On fiscal policy, we have to distinguish between policies pre and post recovery. If the government inherits an economy where the interest rate set by the Monetary Policy Committee is still at 0.5%, then its priority should be fiscal policies that promote recovery. I agree 100% with Paul Krugman that governments around the world have needlessly confused long term issues involving debt with this short run priority: here is one of many posts I have written arguing this. Yet the incoming government should also have a fiscal strategy post recovery.

This should involve both rules and institutions. Whatever fiscal rule is adopted, it should make three things clear. First, it does not apply at the ZLB. [2] Second, it should focus on a long term objective of reducing the debt to GDP ratio. Third, deficits have to be flexible in response to shocks in the short term. Now how you square these three things is tricky, and I still have an open mind on this, but for the moment you should read this very interesting proposal from Tony Dolphin at the IPPR as to how it might be done. That proposal utilises an enhanced UK fiscal council (OBR), which is the institutional leg of the reform.

Before discussing that, however, I want to say a bit more about why the policy goal should be to gradually reduce debt to GDP. I would give four main reasons. First, it allows room for fiscal policy to support monetary policy if it again hits the ZLB, without worrying about the bond markets. Second, it reduces real interest rates, which should encourage private investment (although the more open the economy the smaller this effect will be). Third, it reduces future distortionary taxation. Finally, future generations will need all the resources we can give them to help cope with their inheritance of hugely disruptive climate change.[3]

In the context of similar proposals from Hopi Sen [4], Chris Dillow recently raised some doubts. Some of these relate to the short term position: yes, investment probably responds more to expected future growth than the cost of capital, but with an active monetary policy, reducing debt to GDP should not inhibit growth. A more serious concern is that reducing real interest rates might increase the risk of hitting the ZLB, which is one reason why I propose raising the inflation target. [5]

The current government should be credited with setting up the OBR, but it did so with a very restricted remit. The OBR is not allowed to crunch the numbers on alternative policies, so it cannot even produce the raw material on which others can propose advice. Perhaps this made sense to avoid throwing a new institution into the middle of a fierce political debate in 2010, but it does not make sense in the longer term. At the very least the OBR should be given the freedom to look at alternative fiscal policies, but its role could go further still, as the IPPR proposal suggests.

[1] I should confess that before 1997 I was very dubious about central bank independence. In retrospect that was because I did not have the imagination to see how that the institutional set-up could be crucial. Despite my recent criticisms, I think the MPC has done much better than elected governments would have done. However my fears were that we would get something more like the ECB, so they were not groundless. I also worried that an independent central bank might be too conservative in the Rogoff sense, and that concern has also been realised. 

[2] Or equivalently, there should be a rule that directs policy in very different ways at the ZLB.

[3] In an ideal world, we would be dealing with climate change now, and perhaps - as I discussed here - using higher government debt to help pay for it. However we are not, and it does not look like this is going to change any time soon.
Postscript 24/6/13: As well as leaving capacity for fiscal stimulus after a large negative demand shock, Obstfeld argues that we need low debt to leave capacity for a (partial) bail out of the financial sector.

[4] I obviously disagree with Hopi on how the Labour party should respond to the myth that their fiscal mismanagement was responsible for the UK’s current plight. If you want to get into the apology idea, then it seems reasonable that governments should only apologise for major errors rather than every particular thing they could have done better. As I have argued before, there is no comparison between Labour’s fiscal errors and the current government’s mistakes. Governments that commit errors that go against expert opinion at the time bear a particular responsibility. Few (myself included) raised objections to the constant 40% debt to GDP ratio when it was adopted in 1998.

[5] In the UK I suspect that the main short term impact of a tighter fiscal regime will be a depreciation in the exchange rate rather than lower interest rates. In the context of the last Labour government, I think that would have been helpful.