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.

The BBC and Patrick Minford

Over the last few days the BBC has given considerable publicity to Patrick Minford’s new report published by the ‘Economists for Free Trade’. I have looked at both the BBC News website entry and listened to the Radio 4 Today programme’s discussion. They are both classic ‘2 sided controversy’ formats, with Monique Ebell from the National Institute of Social and Economic Research (NIESR) providing the main opposition.

So why was this coverage something the BBC should be deeply ashamed about? There are two main reasons, but first let me make a more general point which applies to journalism more generally. There is no quality control in most of the media when it comes to giving publicity to a report like this. There is a very simple reason for this, and that is the primacy given to immediacy. In a better world, when a report like this came out, journalists would spend a few days ringing around to see what the reaction of other experts were, or nowadays just look at reactions on twitter.

In this particular case such a strategy would have thrown up some apparently large errors, and this should have led journalists to question whether they should give the report any publicity. They might at the very least have waited until the full report was published next month.

Let me give an analogy. Suppose a report of a medical trial had suggested a miracle cure for some serious disease. The report had not been peer reviewed, and its author had connections to a drug company that stood to benefit from the alleged cure, but the BBC had decided to give it considerable publicity nevertheless. Within days it became clear that there were serious problems with the report, and that there were other existing papers that came to a completely different conclusion. The BBC would then look very foolish, and many sufferers from this disease would have been given false hope. I suspect for that reason the BBC would be much more cautious. Yet if the report is about a subject matter with any political implications this caution appears to go out of the window.

Now let me get to the two reasons why the BBC should be ashamed in this case. First, Patrick Minford is no expert in international trade. He is a macroeconomist, who in his younger, less obviously political, days served as something of a role model for me. He published a very similar argument about the benefits of unilateral trade liberalisation during the referendum campaign. It was heavily criticised by individuals or groups that are experts in international trade. So we have already had the quality control, yet the BBC decided to ignore that. Returning to my analogy, it is as if there had been earlier claims of miracle cure that had been thoroughly debunked by medical experts and the BBC had ignored these.

Second, at no point in either of the two items I looked at is there any mention that the overwhelming consensus among academic economists is that Brexit would be harmful to the economy. We just have reports that give two opinions, with no context whatsoever about which opinion is the consensus view and which is the maverick. It is exactly equivalent to giving considerable publicity to a report from some climate change denial outfit, and including a response from one or two climate scientists with no mention of what the consensus among climate scientists is. Again to draw on my analogy, it is like reporting a miracle cure and failing to say that nearly all doctors thought this was rubbish.

This last point about ignoring the clear consensus touches a particular nerve for me, because it is exactly what the BBC appeared to many of us to do during the referendum campaign. Yet when the Royal Economic Society complained about this, they were told that the economic consensus had been mentioned in this and that bulletin. Whether this was cherry picking by the BBC is not easy to establish after the event. [1] Well here is an example where it was not mentioned, and I would like to hear from the BBC why this information was not thought to be useful to convey to its audience. [2] 

On both counts, this is very bad journalism, even if you do not think economics has the same standing as medicine. The BBC may have thought they had brushed off complaints from economists, but here is a specific example where they really do have a serious case to answer. As Ben Chu rightly says: “The legitimate news story around Minford’s work is how bad science can survive and thrive when it supports the desires and prejudices of powerful people in our society … the BBC ... has become part of the problem.” Brexit is the Emperor's New Clothes, and no one - including the BBC - dares say that the Emperor has no clothes.

[1] Not easy but not impossible: it would cost a few thousand pounds in research time for someone to go through the main news reports during the Brexit campaign and establish how many times the economic consensus was mentioned.

[2] Channel 4 News did put the point to Minford that many economists thought his work was flawed, to which he responded by saying “all these trumped up economists and the consensus they are all hired hands”‘. A very political answer from a very political economist, and therefore very revealing, but not a question the BBC apparently thought worth asking.  

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.  

Brexit and the Left

There seem to be two strands of opinion which encourages people on the left to vote Leave. The first is an intense dislike of what has happened in the the Eurozone: see Larry Elliott for example. The second is a wish to take seriously working class concerns over immigration.

I share the intense dislike over what has happened in the Eurozone (EZ). You only need to read, for example, what I have written about Greece to see that. Yet I cannot see how UK exit from the EU will change for the good how the EZ works. Crucially why should it change the current politics of Germany that has been so important in many of the bad decisions the EZ has made. As we are not part of the EZ, it is difficult to see how UK exit will help its demise, if that is what you want.

As we will be leaving the EU and not the EZ, the message Brexit sends to Europe is not that the EZ is fundamentally flawed but rather that the UK is incapable of being part of any cooperative agreement among European countries. I am internationalist by nature so I do not want that. The idea that Brexit will shock the EZ into mending its ways, then thank us for showing them the light and invite us to rejoin whatever is left is pure fantasy.

There is one way the EZ crisis has impacted on the UK, and that is migration. It seems reasonable to assume that one reason immigration into the UK from the EU is currently high is because of considerable youth unemployment in many EZ countries. Which brings us to immigration concerns.

Take this from Kate Hoey for example. She seems to be arguing that free movement in the EU is a means of keeping down the wages of the low paid. The first point to make is if labour mobility keeps wages down in the destination country, it should increase wages and/or reduce unemployment in the country the migrant came from. As migrants move from lower to higher wage countries, then migration tends to equalise incomes. This should normally count as a plus from a left wing perspective.

But does migration have this effect on the receiving country? There are many reasons why it might not, and the evidence does not point to strong negative effects on wages. But I think the case for migration is stronger than that. A pretty robust finding is that migration at the kind of levels we are now seeing does not do any harm to GDP per head, and could improve it. Another robust finding is that current migration benefits the public finances. This is both important and pretty obvious..

Migrants tend to be young, healthy and working. They provide more in terms of resources than they take out by using public services. I remember having a conversation about this with someone who lived in Spain. He said if anyone should be angry about free movement it is Spain, in having to take lots non-productive British pensioners who will be a burden on Spain’s health service. This was also one reason why Merkel could be so open to refugees: Germany is really worried about the implications of their aging population. [1]

If migration falls following Brexit (a big if), and if we add in the other negative effects of Brexit, we will have a large increase in the government’s budget deficit even at full employment. Given government policy on how holes in the deficit are to be filled, this NIESR analysis suggests you are talking about large hits to the lower paid.

None of this is to deny real grievances about reduced public services and lower pay. Once again I do not think I and many others could be accused of keeping quiet about the stupidity of current austerity. But just as the grievances are real, it is also important to understand the real causes.

A consistent result in polls is that migration is a concern mainly in areas where there is little of it. In this poll only 19% of people say they believe immigration has had a negative effect on them personally. (More believe they have experienced positive effects.) Yet over 50% say it has had a negative impact on the NHS. In reality the NHS is in crisis because of government policy, not because of immigration. But to know that you need to talk to the experts and look at the figures. Instead most people will just have read the newspapers, many of which have taken every opportunity to play up the ‘threat’ of migration. As Paul Mason nicely puts it, you can tell this is a fake working class revolt from looking at those leading it.

This is part of a more general point on migration. Migration appears to be at worst neutral and probably beneficial for medium term UK prosperity, so if there are problems for some groups that can be fixed. At which point those on the left say that is naive because it will not happen. That is a reasonable point, but the same point applies in spades to the immediate aftermath of Brexit, which will amount to yet another shift to the right. The regulations that those running the Leave campaign want to ‘free’ us from are those protecting workers and the environment.

To make this clear, think of two realities (economists would call them states of the world). One (the status quo) involves those currently in charge remaining in charge. The second (left renaissance) involves left wing governments coming to power in the UK and elsewhere. It seems to me that if you stay in either one of these two realities, Brexit is clearly bad. (For a similar argument, see this by Alex Andreou.)

Under the status quo, the EU is currently a moderating influence on this right wing UK government. A post-Brexit Boris Johnson government would take away worker rights that the EU currently ensures and, as the deficit deteriorates, cut welfare benefits including tax credits. This alone will dwarf any benefit working people might get from less immigration. Under a left renaissance migration benefits the economy as a whole as well as those who migrate, and these gains could be fairly distributed. My feeling is that some Brexit supporters on the left move freely between these two realities in order to justify a vote for Brexit.

[1] One fair point made in comments on earlier posts is that migrants need to be housed, so resources are used to provide additional housing. (More generally new labour needs new capital of various kinds.) But housing also represents why migration can be beneficial to everyone. We need to build more houses anyway, but according to the industry we have an acute shortage of skilled construction workers. Of course this is an indictment of UK training programmes, but that cannot be turned around quickly. For those with construction skills, it is surely better to be building houses where they are really needed than being unemployed in places they are not.

Economists say no to Brexit

Today the Times has published a letter about Brexit. It is short and sweet.

Focusing entirely on the economics, we consider that it would be a major mistake for the UK to leave the European Union.

Leaving would entail significant long-term costs. The size of these costs would depend on the amount of control the UK chooses to exercise over such matters as free movement of labour, and the associated penalty it would pay in terms of access to the single market. The numbers calculated by the LSE’s Centre for Economic Performance, the OECD and the Treasury describe a plausible range for the scale of these costs.

The uncertainty over precisely what kind of relationship the UK would find itself in with the EU and the rest of the world would also weigh heavily for many years. In addition, there is a sizeable risk of a short-term shock to confidence if we were to see a Leave vote on June 23rd. The Bank of England has signalled this concern clearly, and we share it.

The simplicity of the letter was deliberate, as it was designed to show the extent of the consensus among economists on this issue. In a relatively short space of time Tony Yates, Paul Levine and I got 196 signatories, most of whom are UK academic economists. (The letter was originally intended just to focus on academic economists, but others wanted to sign.)

Why bother? After all doesn’t everyone already know that nearly all economists think Brexit would have significant costs? Only yesterday NIESR published their own estimates of costs, nicely summarised by Martin Sandbu. There are two important points here. First, a large section of the print media is committed to Brexit. Second, the BBC has pledged to be balanced, which means always matching stories about the economic cost with those who believe it will be a benefit.

Some may have noticed the disparity in the standing of those anti and pro Brexit, but equally others may have used attempts at balance to say to themselves that economists are always disagreeing and therefore dismiss warnings about costs. There are two reasons why you will never get unanimity from economists: it is a science about people and therefore inherently uncertain, and the views of a few economists are influenced by their politics. There is the joke that if you put 10 economists in a room you get 11 opinions. Which means that when all but a handful agree about something, you can be pretty sure the theory and evidence are strongly pointing in one direction.

There is therefore a huge disparity between the overwhelming majority of economists that say we would be worse off with Brexit and the handful that say otherwise. That is as near to unanimity among economists as you will ever get.

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.

Policy, risks and public discourse

Another post where I use the UK as an example to illustrate a more general point

Along with their normal forecast, the National Institute has also used their model NIGEM to analyse the macroeconomic impact of the different political parties fiscal plans post 2015, which is published in the latest Review. (Chris Giles has a FT write-up.) There is no great surprise here: the more fiscal austerity you undertake, and if monetary policy fails to perfectly offset the impact on demand, the lower output will be.

This is not the main reason why I am against further fiscal consolidation post 2015. If you go back to 2010, the OBR’s main forecast didn’t look too bad: the recovery was continuing, and interest rates were able to rise as a result. But good policy does not just look at central projections, but it also looks at risks. Then the risks were asymmetric: if the recovery became too strong, interest rates could always rise further too cool things, but if the recovery did not happen, interest rates would be stuck at their lower bound and monetary policy would be unable to keep the recovery on track.

In 2010 and beyond that downside risk came to pass, and the recovery was delayed. Fiscal policy put the economy in a position where it was particularly vulnerable to downside risks, which is why it was an entirely foreseeable mistake. Quite how large a mistake is something I discuss in my article in the same Review (see also this recent post). Exactly this point applies to 2015 and beyond. The problem with further fiscal consolidation while interest rates remain at their lower bound is that it makes the economy much more vulnerable to downside risks.

This is something that all economists understand, and economists do their fair share of complaining about how difficult it is to get policymakers, let alone the public, to recognise the importance of risk analysis. However in writing about the role of fiscal policy in creating a weak recovery not just in the UK but the world generally, I was struck by how little public model based quantification of this there was even after the event, let alone before. (For some of the few ex post studies related to the Eurozone, see here.) Central banks nearly all maintain models capable of doing the kind of risk analysis I am talking about, but how much of that work gets into the public domain, or is even seen by fiscal policymakers? In the UK there has definitely been technological regress in this respect, as I note here.

So we have a paradox. In academic macro there has never been so much quantified model based policy analysis, some of it analysing just the kind of robustness to risks that I have been talking about. Yet in public discussion of macro policy, it is quite rare to see this. Central banks tend to keep what they do to themselves, and they appear to have a taboo on analysing alternative fiscal policies. In the UK the OBR, which does the government’s fiscal forecasting, is not allowed to look at alternative fiscal policies in the short term. I think I know why this paradox has arisen, but that will have to wait for a later post.

  

Asymmetries and Uncertainties

This post starts off talking about the UK, but goes on to make more general points about why we may have wasted resources on a huge scale over the last five years, and why this waste may be continuing.

I presented my new National Institute Economic Review paper on the macroeconomic record of the UK Coalition government yesterday, and reaction mainly focused on my conservative estimates of the cost of the move to austerity in 2010 and 2011: a cumulated loss of 5% of GDP or £1500 for each adult and child. The basis for those figures is outlined here, and their conservative nature comes from taking OBR estimates for the impact of fiscal contraction, and assuming (rather improbably) that the output lost through austerity was entirely recovered by 2013.

The key issue with numbers of this kind involves monetary policy. Some argue that without austerity monetary policy would have been more contractionary: the ‘offset’ argument. Of course some of the large increase in UK inflation in 2011 was the direct result of austerity: the VAT increase is the obvious example. In addition, the inflation of 2011 was not foreseen in 2010, so it does not alter the fact that austerity was a policy mistake, but just influences any calculation of the size of the mistake.

The paper addresses the offset argument. I use Bank of England forecasts to suggest that monetary policy was not able to hit its target for forecast inflation for much of this period, implying that the Zero Lower Bound (ZLB) constraint was biting. If the ZLB constraint bites, there will be no offset. Not surprisingly, when that target for expected inflation was not met, the Quantitative Easing programme was expanded. There was only a brief period in 2011 when this was not true, which was the period in which 3 out of 9 MPC members voted to increase rates. So if we had not had 2010 austerity, then at most interest rates might have begun rising in 2011, which given lags might have reduced GDP to some extent that year. But crucially the OBR numbers that I use already embody some monetary offset, because they are based on empirical estimates of average multipliers over the past. To use these OBR numbers and then do some monetary offset involves double counting.

However, I want to stay with my ‘no austerity’ counterfactual to make a more fundamental point. If interest rates had been raised in 2011, and this had reduced GDP in 2011 and 2012, we would now be talking about the MPC’s 2011 mistake, rather than the government’s 2010 mistake. I would be calculating how much GDP had been wasted in 2011 and 2012 as a result of premature monetary tightening. I would be right to do so, because the costs of delaying a recovery from a deep recession dwarf any benefits from reducing inflation a bit following a commodity price shock.

This indicates a fundamental problem, which policymakers have still not taken on board. For whatever reason (resistance to nominal wage cuts being the most obvious), inflation ceases to be a good indicator of underutilised resources when inflation starts off low and we have a major negative demand shock. Policymakers are continuing to make this mistake today: core inflation is not too far away from target, and growth is quite healthy, so it is OK to do nothing (or in the Eurozone, it is OK to wait for ages before doing anything). However it seems quite possible that GDP continues to be quite a few percentage points below where it could be without inflation exceeding its target, so we continue to waste resources on a huge scale. This is money down the drain that we will never get back. It is like taxing households thousands of pounds or dollars or euros a year and burning that money.

One way to put this point is to go back to the basic rationalisation behind flexible inflation targeting. It is OK to have a target based on inflation alone, with no mention of the output gap, because you cannot in the long run keep inflation at target without also keeping the output gap at zero. This is sometimes called the divine coincidence. However if, at low inflation rates, inflation becomes a noisy, weak and asymmetric indicator of the output gap, then focusing on inflation is going to perform badly. In these circumstances it could be many years before it becomes clear that we have been continually running the economy under capacity, and needlessly wasting resources. Unfortunately even when that point of realisation arrives, for obvious reasons monetary policymakers are going to be reluctant to acknowledge the mistake.

Lines between macroeconomics and politics

The National Institute (NIESR) is old enough to count as a venerable British institution. I am a governor of that institution. The National Institute relies on research funding from a number of sources, which includes many that are directly or indirectly funded by the government. So when an MP of the governing coalition suggests publically that this institution should stop doing its job because its findings have political implications I have a direct concern.

Jonathan Portes today posted an extract from the (unedited) transcript of his recent appearance in front of the Treasury Select Committee. In the extract he is questioned by Jesse Norman, a Conservative MP. Mr. Norman finds it difficult to understand why Jonathan Portes does not credit the government for keeping interest rates on UK government debt low, and why he wrote an article for the Spectator (a right wing magazine) entitled ‘Plan A has failed’. But that is not the issue. What Mr. Norman suggests is that in saying such things Jonathan Portes is transgressing a line between the economic and the political, and to quote “My suggestion is that such things may not do the long-term well-being of the NIESR much good.”

I would suggest that it is Mr. Norman who has transgressed a line here. I have read a lot of what Jonathan Portes has written since he became director of NIESR in 2011. He and I obviously share the same views about Plan A and UK austerity, but on other issues that he writes about (like the impact of immigration) I have no particular views and can therefore be dispassionate. What strikes me about Jonathan’s writing is that he is not afraid to call a spade a spade, but he is also scrupulously careful to stick to the economics of an issue. That he is so good at that befits his previous experience as a senior civil servant working for governments of both major parties.

NIESR has always been the leading independent macroeconomics think tank in the UK. Macroeconomic policy is central for any government, and therefore it is bound to be political in that sense. Previous directors of NIESR have been equally forthright in public when they thought that the government was pursuing the wrong macroeconomic policy - I remember the two that I worked under being highly critical of the monetarism of Mrs. Thatcher’s government. As Jonathan Portes points out in the transcript, his predecessor Martin Weale was a constant thorn in the side of Gordon Brown’s fiscal policy, and with good reason.

In this sense, Jonathan Portes is continuing an honorable tradition, of running a politically independent think tank that is prepared to criticise the government when it thinks it is pursuing the wrong macroeconomic course. In today's world where think tanks often tend to have clear political agendas or allegiances, this is refreshing and publically valuable.

There are two things that are worrying about Mr. Norman’s line of questioning. The first is that he appears to be suggesting that because the macroeconomic judgements Jonathan Portes makes have political implications, he should keep quiet about them, or at least lose them in a fog of caveats. The potentially more serious is that by not keeping quiet he “may not do the long-term well-being of the NIESR much good.” But perhaps Mr. Norman was just offering some friendly advice, and intimidation was the last thing on his mind.

The impact of austerity in the UK and Eurozone

When I wrote this recent post on the impact of austerity in the UK, I was slightly nervous about the numbers. I suggested that the 2011 and 2012 cuts in spending on goods and services alone would have reduced GDP in 2012 by between 1.25% and 2.5%, but this was a back of the envelope calculation using simple aggregates and static multipliers, and it left out the impact of important tax increases and transfer cuts. However luckily we today have a rather more systematic analysis from Dawn Holland and Jonathan Portes at NIESR. This adds in the impact of tax increases and transfer cuts, and comes to a figure of over 4% for the impact of 2011 and 2012 austerity on UK GDP in 2012. 

Now at this point I should declare an interest of sorts. Holland and Portes use the Institute’s global econometric model NIGEM. I built the first version of this model. However that was so long ago, and I’m sure that the improvements subsequently made by Ray Barrell, Dawn Holland and others mean that nothing is left of my original construct.

What is especially interesting about the NIESR study is that they also do the analysis for the Eurozone economies. If we extend the calculations to 2013, Greek GDP in 2013 is over 13% lower as a result of 2011-13 austerity, Portugal’s GDP nearly 10% lower and Spain’s 6.7% lower: UK GDP is ‘only’ 5% lower. Now a cut in average incomes of 5% or more is a big deal, and it is why I keep saying that the welfare costs of these measures dwarf other considerations. But we know that this pain is not evenly spread: many people are not much affected by austerity, while others are receiving much larger cuts in their incomes.

The key point, which the NIESR study also puts numbers to, is that this pain is not in any way inevitable. It comes because austerity is being undertaken when monetary policy can do very little to counteract these effects. In more normal times, which means once the recovery is sufficiently underway such that interest rates begin to rise again, this scale of austerity will have a much smaller impact on GDP. In principle, its impact could be completely offset by monetary policy. So the argument that these large income cuts are inevitable because debt has to be brought down at some point is simply wrong.

However the NIESR study does miss one thing out of its calculations. Nowhere is there a confidence fairy that will magically persuade the private sector to spend because government debt is coming down. (As the NIESR study shows, the debt to GDP ratio actually rises because GDP falls by more than debt, but hey that’s a detail – GDP will recover one day, probably.)  Now to believe in fairies you need pretty good evidence, and that is just what we do not have. A few economists think they saw some in the data, but that is not enough - nothing like enough - to justify inflicting this scale of pain on so many. (Others, of course, saw nothing (e.g. pdf).) Unfortunately too many people just wanted to believe in the confidence fairy. Normally we find those who really do believe in 'real' fairies either rather amusing or rather strange. Unfortunately some of those who believed in the confidence fairy were put in charge of running our economies.