Economists and the Euro: for the record

Almost every time I write something about Brexit, I get at least one comment along the lines of ‘you economists got it wrong on the Euro, so why should we take any notice of you on Brexit’. This is beginning to annoy me, because in reality the opposite is true: it was because of economics and economists that we didn’t join the Euro in 2003. So the next time someone says the same to you, send them this blog post.

As far as I can see, the source of this ‘you got it wrong’ line is a poll that the Economist magazine did of academic economists on whether the UK should join the Euro in 1999. In that poll 65% said yes, and 35% said no. It was a good piece of journalism and a sensible survey, and it roughly corresponds with how I viewed academic opinions at the time. Claims by Andrea Leadsom that the Bank and IMF also recommended joining are simply wrong.

This poll has zero relevance to the Brexit issue for the following reasons:

1. Academic economists split 2 to 1 in favour of joining in 1999. In the case of Brexit, for every one economist that thought leaving was a good idea, there were 22 that said the opposite. So while a majority of economists favoured joining the Euro, the overwhelming consensus was that Brexit would involve economic costs.
   
   
2. Ask any academic about the Euro, and they will tell you that there are pros and cons, and it is largely a matter of judgement whether the pros or cons win. A key issue which I did some work on (with Rebecca Driver) was whether countercyclical fiscal policy could deal with asymmetric shocks. Our work suggested they could to a significant extent, but that made the proposed Stability and Growth Pact a concern. Others, looking at other types of risk, might come to a different conclusion.
   
   The contrast with Brexit is total. There are no major economic pros that need to be compared with the cons. Instead there are just economic costs, and the debate is about how large these will be.
   
   
3. Euro membership involved macroeconomics. Membership of the EU is mostly about trade. These are different branches of economics with little in common. Brexit involves the impact of geography on trade (gravity equations) and the impact of trade on productivity, while Euro membership involves the macroeconomic response to asymmetric shocks. It is a bit like refusing to have your hip replaced because your flu jab didn’t stop you getting flu.
   
   

The poll was in 1999. The UK did not decide to make a decision whether to join the Euro or not until 2003, and thankfully it did more than take a poll of economists on the issue. The Treasury was given plenty of time to analyse the pros and cons of entry, and it did so by undertaking a large number of studies. This is how policy advice should work in the absence of delegation: you do not ask the expert what the decision should be, but instead ask what the issues are and let the politician make the decision. I have discussed the so called 5 tests process, overseen by Dave Ramsden, in detail here. Most of the studies were done ‘in house’ by Treasury economists, but advice was sought from a large number of leading academics in the field. Peter Westaway was brought in from the Bank to write a couple, and I wrote a study on the optimal entry rate, extending and developing work I had begun back in the days before we entered the ERM.

The analysis was at the highest level, and I could detect no overt bias one way or the other. Some studies found significant benefits from joining, and others found significant costs or concerns. Although it is easy to be cynical, I have talked to some of the actors involved and it does seem as if the economics, encapsulated in these various studies, was critical in first convincing Gordon Brown and then Tony Blair that now was not the right time to join.

So the reality is that studies that summarised state of the art academic economic analysis stopped the UK joining the Euro. Without that, the decision on UK entry would have been down to politics, much like the formation of the Euro itself, and who knows how that would have gone. The economic analysis anticipated some of the problems behind the Euro crisis but not all. Economics is far from perfect, but that is no reason to ignore it when it says things you do not like to hear.

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: a battle lost but who will fight the war?

The Brexit vote was, in economic terms, an act of self harm. You do not need to just ‘trust the experts’ on this: it is pretty close to common sense. As Rebecca Driver clearly explains, leaving the single market will make it much more difficult for (particularly small) firms to trade in Europe. As Europe is on our doorstep and geography matters, that cannot and will not be compensated for by trading more elsewhere. [1] Finally greater trade is associated, for clear reasons, with higher growth. Lower growth will impact unfavourably on every area in the UK, whether they voted Leave or Remain.

The harm done is not just economic. As Ben Chu writes, “The crude majoritarian politics of this referendum has seen half of the population (a generally poorer, less well-educated and elderly half) effectively strip major freedoms and even a cherished identity from the other half (a more prosperous and predominantly younger half)”. Before the referendum, I had conversations with people arguing that a Brexit vote would be more harmful than a Trump presidency, and this deep sense of anger, loss and despondency will not go away. We therefore need to understand why it happened.

In my last post I argued that Brexit was a protest vote against both the impact of globalisation and social liberalism. The two come together over immigration, and of course the one certainty of the Brexit debate was that free movement prevented controls on EU migration. Globalisation has benefited the majority in the UK, so those who had not benefited could not alone have won a Brexit vote. Equally social conservatives have lost battle after battle in the UK on specific social issues. Brexit was the perfect storm where these two groups came together, and combined they just managed to win.

Explanations do not imply inevitability, but instead tell us why the result could easily have been different. We need a sensible discussion about immigration, rather than assume it is always and everywhere a problem. However to follow the social conservative route and say concern over immigration is just xenophobia is not helpful. [2] We need to challenge the view the right wing press has patiently built up that immigration is responsible for declining public services and making it difficult to get housing. Too many people continue to discount the power and influence of the media: that is a mistake, as this research on Fox news shows. It is not difficult to get across the benefits of immigration, given how much the NHS and our construction sector depend on immigrants, but it is not something many of our leading politicians have done for some time.

More generally it is becoming increasingly clear how destructive the doctrine of neoliberalisation has been. Neoliberalism combines the encouragement of globalisation with demands for a much reduced role for the state. In the advanced economies the deindustrialisation implied by globalisation and the growth of China and elsewhere has been beneficial overall, but there are sections of society that have lost out, which invites a backlash. As Kevin O’Rourke shows, globalisation has often led to fierce resistance in the past. Dani Rodrik has demonstrated how state spending can protect, and has often in the past protected, the losers from trade. [3] (As an economist mights say, globalisation is a Kaldor/Hicks improvement, but in recent times the compensation part has been missing.) Brexit, like the financial crisis and perhaps also Donald Trump, are in this sense problems created not by globalisation alone but by neoliberalism.

For the UK it is worse than that. It is not just that austerity is the real cause of declining public services, and a failure to build houses is the cause of rising prices and rents. (See Chris Dillow or Mariana Mazzucato) It is that this government in particular has connived with the right wing press to transfer blame for an NHS in crisis and unaffordable housing from their own policies on to immigration. The Remain campaign was Cameron and Osborne, and neither were prepared to change their tune and start talking about how limiting immigration would mean there was even less money for public services. As I noted in the previous post, the NHS was an important concern for Leave voters, and they thought Brexit would make things better. Can you imagine a worse background for the EU referendum vote than a government that continually stressed the importance of limiting immigration, but failed to achieve those limits so spectacularly. [4]

This was not the only problem with the Remain campaign. In terms of getting the message across, Leave seemed to understand their target audience much better. (It is not my field, but this from Mark Hind makes sense.) To get the message across the Remain campaign relied on the institutions of the establishment: the Treasury, Bank of England, IMF etc. Fine for those for whom the establishment is respected, less so for those who regard it as remote and detached from their lives. Remain made very little use of academics, despite the fact that this group is trusted by the public. [5] Leave did seem to understand this, which is why they went to ridiculous extremes to discredit these experts. The broadcast media hardly ever noted the consensus among economists that Brexit would reduce everyone's standard of living, and instead did their ‘he says, she says’ thing. This media also failed to point out the lies Leave told, preferring ‘balance’ over truth.

All this implies that while the potential for a Brexit vote was always there, reflecting the perfect storm of anger against globalisation and social liberalism, it might not have been realised if the Remain campaign had been better, the Leave campaign had been honest and the broadcast media had not departed from its mission to educate and explain. The lies of the Leave camp are already apparent. The depreciation in sterling that immediately followed the vote is a cut in living standards for everyone in the UK with no lasting compensation. It is permanent unless the markets have got things spectacularly wrong. The economic downturn that is underway is as predicted. In both cases voters were told this was fear mongering by the Remain side: now those that promoted Leave are in the ludicrous situation of arguing that markets and firms have somehow been deceived by Project Fear.

In normal circumstances this would all be a cause for optimism. We do not need many voters to realise that they were conned by the Leave campaign before Leavers become a minority, or at least for the majority to favour a deal that can keep the UK in the single market with essentially free movement of labour. (There may have even been such a majority on the day of the vote.) To call this the denial stage in some ‘grieving process’ by Remain voters misunderstands the nature of the decision. Leaving is compatible with a whole range of alternative arrangements: some quite close to EU membership, some not. In that sense the vote only gave the green light to an ongoing struggle over what these arrangements will be. (For a discussion of the politics involved, see here but also here.) Thus those who say we should accept the verdict of the people are wrong, because a great deal is still to play for.

Yet circumstances are far from normal, and there seems little ground for optimism. Our new Prime Minister - who was as complicit in the sham targets for immigration as Cameron and Osborne - has appointed those who supported Leave to handle negotiations. She knows that the only way she can unite her party is to end free movement and therefore leave the single market.

Worse still, the government will do whatever it wants to do when it comes to the type of Brexit we have. Our official opposition will, if the polls are right, be the same opposition that was both ineffective and conflicted in the Brexit campaign, preoccupied as it will almost certainly be with cleansing the PLP rather than the details of trade arrangements. There is no alternative opposition with any strength. The SNP cannot speak for the rest of the UK, and anyway will be focused on trying (and probably failing) to drum up enough support for independence. As a result the 48% or more who did not want an end to the single market will not be able to do much about it. I fear that if you want a vision of what Britain after Brexit will become, you just need to look in the pages of the newspapers that were a vital part in bringing Brexit about.

[1] My impression was that discussion on broadcast news programmes, which is the main source many people have to unbiased news coverage, or even the debates never got to this point. We had someone from Remain saying trade with Europe would suffer, and someone from Leave saying we would be ‘free’ to trade with other countries. You do not need the Treasury’s gravity equations to make this simple point about geography and trade, but you need to go a little beyond soundbites.

[2] A similar point can be made about nationalism, which is hard to combat and may be a symptom rather than a cause.

[3] Rodrik, D. (1998), "Why do More Open Economies Have Bigger Governments?" Journal of Political Economy 106(5): 997-1032

[4] None of this was hard to see before the last general election. Those who in 2015 voted Conservative but also wanted to Remain need to ask why they took no notice of the warnings that some of us made. Those ‘business leaders’ who seemed to unanimously endorse Cameron need to ask, or be asked, why they were gambling with their company’s future in doing so.

[5] Part of the problem is that Leave voters tended not to trust anyone. This, by Jean Pisani-Ferry, is good on experts and trust.