On V shaped recoveries, and where the Treasury’s deficit obsession will matter

I should perhaps go through some of the thinking that lay behind my Guardian article about not repeating austerity, because I fear there is a danger of worrying about the wrong thing. I have always been reasonably confident that we would not get an exact repeat of 2010, where the Chancellor says at the low point of a recession (i.e. before a recovery has begun) that we have to start cutting back spending because the deficit is too high.

There are two reasons for that confidence. First, the circumstances that allowed 2010 were uniquely advantageous. We had just had a global financial crisis, so false claims about what financial markets might do seemed plausible. There was also a Euro crisis. Everyone was saving more (or borrowing less) as a result of the financial crisis, so you could easily persuade people the government should too. And finally we had had a period of strong growth in some public services under the Labour government.

None of that holds today. Most people have had enough of austerity, something our Prime Minister understands. He knows there are huge political dangers in worrying about debt just after a pandemic where the government’s decisions have been woeful. The media will obsess about the deficit, but I think the government at the moment is going to ignore them.

I wrote the Guardian piece because I realised that not only had the media not changed, but neither had the Treasury. The leaked document I discuss in that article showed that, but there was much stronger evidence of their concern, and that was the Chancellor channeling their pressure to ease the lockdown as soon as possible.

Austerity is a type of short term penny pinching by the government leading to much larger longer term costs. The only justification for relaxing the lockdown by forcing large sections of (typically working class) workers to go back to work is saving the Treasury money on furloughing, which is why the pressure to relax furloughing is coming from the Chancellor and the Treasury rather than No.10. The cost of this is to raise R (how many people someone who has coronavirus infects). The point I make here is that most of the economy will only recover once people are no longer fearful of catching the virus, which means the number of new infections nationally per day must be very low, maybe even single figures.

If R is currently something like 0.2, and if the recent relaxation raises it to 0.3, then the number of new infections is going to fall pretty rapidly anyway. But if R was 0.8, and it now becomes 0.9 as a result of more people at work, then it will take considerably longer to get infection numbers down. So pressure to save some money on furloughing may in the end cost much more by setting back the date of recovery by months.

There is a second sense in which Treasury penny pinching may end up costing a great deal, and it reflects what happened with austerity from 2013 onwards. There has been a great deal of discussion about the nature of the economic recovery from this pandemic, and how much long term damage it could do. When I suggested that in principle there was no reason for the economy not to bounce back, the general consensus on twitter was that there was no way that is going to happen.

The problem with the belief that the economic recovery will be neither quick or complete is that it can be self-fulfilling. It always amazes me how many economists were quite happy to believe that the sudden stop in UK productivity growth after 2010 was somehow caused by the financial crisis (or something else) and had nothing to do with a sustained period during which aggregate demand was being depressed. Once policymakers start believing that, you don’t get the stimulus measures you need to get a complete recovery. Once economic actors believe in it, then it becomes a self-fulfilling result.

Exactly the same could happen after the pandemic, particularly if it takes time before the number of daily infections becomes very low. Consumers may be cautious about embarking on forms of social consumption again, and so it appears as if the V shaped recovery is not going to materialise. What should happen at this point is that the government stimulates the economy in some way, to quickly mop up the additional unemployment created by the pandemic. Instead, I fear that inside the Treasury concerns about the deficit will override their responsibility to stabilise the economy when interest rates are at their lower bound. Indeed I have never been sure that this Treasury accepts that responsibility.

I have always thought that if the pandemic is handled properly, with good support during lockdown and appropriate stimulus subsequently, then a V shaped recovery will happen. There is no reason to have additional unemployment or permanently lost output once the virus is tightly controlled and consumers recognise their chance of getting it are minimal. We will see something close to a complete recovery in the countries that have handled the pandemic well, restrained only by what is happening in the countries with less capable governments. What will stop us having a V shaped recovery is government incompetence, both in handling the pandemic and in how macroeconomic policy supports the recovery.

A response to Gudgin, Coutts & Gibson

The authors have a post on the Prime website in which they, among other things, respond to two blog posts of mine where I mention their work on Brexit. In the first post they mention [1], I use a graph from their paper to illustrate how important the Single Market was for UK exports. Here is the graph.

I then wrote

“But didn’t the CBR report say that the benefits of the Single Market had been exaggerated by the Treasury? Yes it did. Here is some of its reasoning. That growth in UK export share after the Single Market is not as impressive as it looks, because there is an underlying 6% positive trend in the share, which you can detect before we joined the EU. That looks pretty on a picture, until you realise it is nonsense. A 6% trend rise in an export share will imply that at some point not too far away UK exports to the EU will be as high as total EU GDP. UK exporters are just not that much better than exporters in other countries. There is no underlying trend rise in the UK’s export share.”

By export share, it is obvious that I’m talking about share in destination GDP, as in the chart. In my paragraph there is an error. I used a 6% figure rather than the correct 3.5% figure for their trend in export penetration relative to the non-EU penetration. It was a particularly stupid error, because just below Chart 7 is Chart 8, which contains the correct figure.

But, as the authors must know, this error is not important to my argument. Replace 6 by 3.5 in the relevant paragraph and it still makes perfect sense. What I was criticising was the notion that there was any substantial underlying trend in export penetration, and that the impact of EU membership should be judged relative to that trend. You can see from this chart how ludicrous a 3.5% trend is: it implies that without EU membership the UK exports share would be now above 10% and rising fast. This trend seems to be an important part of their judgement that UK export penetration relative to the EU would fall by substantially less than the Treasury assume in their analysis. The trend makes no sense, unless the aim is to make the impact of EU membership look small.

So what is the authors’ response to my basic criticism in their Prime piece? There is none.

As far a the 6 rather than 3.5 is concerned, it is also odd is that this is the first time they have mentioned the error to me. The post was from mid-January, and I would have happily changed 6 to 3.5 if they had pointed it out to me earlier.

The second post was a discussion of the notion of ‘fake economics’. I said fake economics could be described as “economic analysis or research that is obviously flawed but whose purpose is to support a particular policy.” or “We can equally talk about evidence based policy and its fake version, policy based evidence.” Here is what I wrote in full about their study in that post.

“The CBR analysis is less obviously fake. However Ben Chu has gathered the views of some academics who are experts in trade theory, including Richard Baldwin (who has just written a definitive and widely praised book on the ‘new globalisation’) and Alan Winters, both hugely respected with immense experience, who pour some very cold water over the study.”

How do the authors respond to this second post in the Prime piece. They write

“It is unusual for Wren-Lewis to rely uncritically on mainstream economists, but he was willing to do so in this case. With many of Wren-Lewis’ articles being used by one of us in economics teaching to encourage students to query and to test what is considered ‘mainstream’ it seems more than a little surprising to be discredited for daring to do so.”

This is wrong in many ways. First, I was not relying on others, as I had serious misgivings about their use of trends that I outline above. Second, I made no mention of ‘mainstream’ and heterodox anywhere, so any suggestion that this was behind what I wrote is their invention. Finally, there is no problem with anyone challenging anyone else.

Let me reproduce one of the quotes from Ben’s piece

“The HMT [Treasury] use of gravity model was perfectly in line with best practice. It was classic evidence-based policy analysis”, said Richard Baldwin, Professor of International Economics at The Graduate Institute of Geneva. Professor Baldwin went on to accuse Mr Gudgin himself of engaging in “policy-based evidence making” and “using evidence the way a drunk uses a lamp post – for support, not illumination”.

So Richard Baldwin was accusing the authors of exactly the fake economics that I talked about. Given my suspicions about their treatment of trends discussed above, I felt justified in writing about their piece in this context.

I could have ignored Richard Baldwin’s criticism and my own suspicions, and not included them in this post. But here is another quote from Ben’s piece:

“Dr Graham Gudgin of the CBR criticised the Treasury’s analysis, which predicted a major hit to the UK economy by 2030 if the UK experienced a “hard Brexit”, in unusually strident terms describing it as “very flawed and very partisan”. Dr Gudgin said he “suspected” Treasury civil servants had been leaned on by ministers to produce the results David Cameron and George Osborne wanted.”

Recall that the Centre of Economic Performance argued, based on their own extensive analysis, that the Treasury had underestimated the costs of Brexit, so presumably the accusation of ‘very flawed and very partisan’ applies to their analysis too. If one of the authors was happy to argue that the analysis of others had been designed to produce certain results, I felt it only fair to ask the same question of the authors.

[1] Actually the second post by date: the two post were a day apart.

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

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

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

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

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

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

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

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

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

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

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

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

The Treasury and Brexit

I pointed out two days ago that the real costs of Brexit are long term, which unfortunately means that those who argued for Brexit will never be held responsible in political terms for the damage it will do. As John Springford argues, that also strengthens the hand of those arguing for a hard Brexit (aka maximum damage). So who will speak for the 48%+ who want to limit the damage?

Potentially the majority of MPs do. We have united opposition from the SNP and LibDems. The great majority of Labour MPs also oppose Brexit. Polly Toynbee suggests this should become their unifying cause whatever the leadership does. And of course around half of Conservative MPs probably voted, in a personal capacity, to Remain. That has to be a worry for Theresa May, which is why she has made it clear that MPs will have no effective say in the Brexit negotiations.

So is this just going to amount to a lot of despairing and angry complaints as the Brexiters do their worst. Not quite. There is one source of opposition left standing (in the sense of having some power): Philip Hammond and H.M.Treasury. The Treasury has always been the job Hammond wanted, and not because he wanted to radically change that institution. It should also not be forgotten that it was Treasury economists who wrote the analysis suggesting the long run impact of Brexit on the UK economy could be very large, and the larger the further away from the single market we ended up being. Some will think this was a stitch-up job to please Osborne, but I think that is extremely unlikely. After all the Treasury analysis was pretty close to other estimates, and it was overseen by Charlie Bean who is excellent at judging what is academically kosher.

It is for this reason that we are already seeing headlines talking about Hammond blocking Brexit ‘progress’. How much power he has to do this will depend on the Prime Minister. If Theresa May sides with her Brexit ministers against Hammond, as it seems increasingly likely (see Martin Wolf here), this will mark the end of a long period where the Treasury has dominated economic policy in the UK.

That dominance started after a meeting in an Islington restaurant, where Gordon Brown extracted the maximum price for standing aside in favour of Tony Blair. The Treasury under Brown not only stopped Tony Blair from adopting the Euro, but also exerted a control over the economic aspects of other departments that had not been seen before. Under the Coalition government Osborne and Cameron worked very closely together, and the austerity strategy - supported by key Treasury civil servants - dominated the domestic agenda. If May sidelines Hammond over Brexit, the Treasury will have moved from dominance to playing second fiddle very quickly indeed.

When finance ministries no longer need many macroeconomists

Years ago, when I worked at H.M.Treasury, there was a large team of macroeconomists. My first three jobs involved forecasting, and my last looked at the economic effects of the budget, a pattern that was fairly typical at that time. Since central bank independence in 1997, and particularly the creation of the OBR in 2010, that requirement for a large team of macroeconomists to be working at the Treasury has gone.

If all macroeconomic decisions had been delegated to these two external bodies then this would not present any problems. But of course that has not happened. The remit for the Monetary Policy Committee is, quite rightly in my view, set by the Treasury. The Treasury still decides on the fiscal policy rule that governs all the of detailed micro measures we see in the Budget. And occasionally big decisions that have important macroeconomic aspects have to be made, and the Treasury is required to provide the evidence on those. Brexit is just the latest example.

The problem with this set up is that the need for macroeconomists within the Treasury is periodic. Fiscal and monetary rules are reconsidered at intervals involving a number of years. We have seen two crucial referenda quite recently, but I hope that will not become a regular feature. That creates a resourcing problem. While we insist that there is always the electricity generating capacity available to deal with peak loads, the idea that civil servants are spending time with little to do for large periods is an anathema for the public.

The danger is clear. Because a large team of macroeconomists are not needed all the time there is a tendency to cut back. As a result, when they are really needed to help make important decisions they are overstretched. Alternatively economists with expertise elsewhere might make badly informed macro decisions. More speculatively, with a small mass macroeconomists will have less influence over key decisions than, say, those charged with controlling public spending.

An interesting and I think important question is what you do about this. Do you separate out the macroeconomists into their own (rather small) ministry? Can you mobilise some kind of reserve army in academia or elsewhere, to be brought in when big decisions have to be made? I would be very interested in (sensible) solutions to this problem. (There is an incentive: if it is a good idea it might acquire some legs.)

In defence of George Osborne over Brexit

This by Fraser Nelson in the Spectator (HT Tim Harford) starts well: “Sometimes, George Osborne’s dishonesty is simply breathtaking.” Who could disagree with that? Except that the statement Nelson objects to is the following:

“Britain would be permanently poorer if we left the European Union, to the tune of £4,300 for every household in the county. That’s a fact everyone should think about as they consider how to vote.”

Nelson does not object to the economics behind the number, set out clearly in a Treasury study released yesterday. (For an excellent review of the study, which makes both of the points I make below, see Chris Giles here.) Instead he has two objections:

1. With economic growth we would not be poorer under Brexit, just less richer than we would have been if we had remained in the EU
   
   
2. The household figure is derived by dividing the GDP ‘loss’ by the number of households in the UK.
   
   

Nelson makes the point that household after tax income is only about two thirds of GDP/households. So implicitly he is saying is that we shouldn’t count lower taxes (and therefore government spending) and investment (future incomes) when assessing whether people would be poorer. But that seems silly. We all benefit from total government spending and investment, so we would feel less well off if we lost some of that. [1]

Indeed I have done exactly as the Chancellor has done when assessing the impact of 2010 austerity. I calculated, using OBR figures, that austerity cost each UK household at least £4000. The two figures appear comparable, but in fact they are not. My figure is a total one-off cost, on the (admitted very optimistic) assumption that the UK economy had completely recovered from 2010 austerity by 2013. The Brexit cost is a continuing loss each year.

Alas for Fraser Nelson dividing any GDP loss by the number of households is standard practice among economists (see John Van Reenen here for example), and we do it to make our analysis more relevant to those who do not commonly think in terms of GDP. It is also common practice to think about counterfactuals: if we did X (Leave) rather than Y (Remain) how much better/worse off would we be. It is just much clearer to do things that way. Who knows how much richer we will be by 2030: that would be a pretty unreliable forecast, because it depends on pretty well everything. In contrast we can be much surer (although still uncertain) about what the impact of just one change (leaving the EU) will have.

Now if you wanted to avoid any ambiguity, you could rewrite the first sentence of the Chancellor’s statement as follows:

““Britain would be worse off if we left the European Union compared to if we stayed in, to the tune of £4,300 for every household in the county by 2030, and for each and every year after that.”

If this is honest, does that make the original version dishonest. I do not think so.

If this report illustrates anything, it is that it would have been much more effective to have launched a 2003 joining the Euro type exercise immediately after the 2015 election victory, consulting widely among outside experts, and perhaps getting some of them to write key parts of the report. That would have produced a wider range of numbers for the cost, and the Chancellor could have then chosen the higher one, simply inserting ‘up to’ in front of it. But here I am, defending George Osborne and advising him on spin. I think I better go and lie down for a while.

[1] Slightly pedantic economic point: we should really use GNP rather than GDP, but it makes little difference here.  

Austerity, the Treasury and Spending under Labour

Philip Stephens of the Financial Times lashes into George Osborne’s plans for more fiscal austerity over the next five years. He argues that cuts of the order of magnitude proposed, on top of previous cuts, can only harm public services that people want or need. He writes “The really intelligent thing to do, though, would be to defer or, better still, abandon his silly fiscal target.” Bravo to that.

He also says something else which I found interesting. He writes Osborne has “been egged on by a Treasury obsessed with expiating its sins of carelessness and hubris during the pre-crash years.” As I think I have said before, one of the interesting and as far as I know untold tales about UK austerity is the extent to which it is encouraged or discouraged by senior management in the Treasury. I raise this in ignorance of which it is: I have on a few occasions seen senior civil servants defend austerity, but that is their job, and I’m not a good enough mind reader to know whether their heart was in it.

I have, however, made a general point about finance ministries and independent central banks. Delegating macroeconomic stabilisation means that finance ministries no longer need to have so much in house expertise on how the macroeconomy works. Furthermore in the UK the establishment of the OBR, which took over responsibility from the Treasury for macro and aggregate fiscal forecasting, reduced the need for that expertise still further. This means that in any contest between controlling spending (which finance ministries always have to do) and looking after the broader economy, it has become more likely that the economy will lose out.

Which inclines me to the view that Treasury management had a more encouraging than discouraging role, but it would be interesting to know if this is right. I was also struck by the phrase “sins of carelessness and hubris during the pre-crash years.” At first sight this suggests that the Treasury allowed Labour to embark on a large increase in public spending as a share of output, much of which was waste that could be reduced by greater efficiency. This relates to another point you often hear, which is that 2010-2015 austerity was largely painless.

Let’s fact check the numbers. When Gordon Brown took over the Treasury, total spending was around 37% of GDP. By following existing plans this fell to about 36%, but by financial year 2007/8 it was 40% of GDP. That is where we should stop if we want to exclude the impact of the recession. An increase worth 3% of GDP certainly sounds significant. However public net investment in 1997 was unsustainably low at 0.5%. If we just look at current spending it shows an increase of only 2% of GDP between 1997 and 2007.

Was that increase waste and inefficiency? If we look at the share of NHS spending over that period, it rose by around 2.5%. In other words, the increased share of government spending was largely accounted for by higher NHS spending. That was not Treasury carelessness and hubris, but a deliberate policy decision.

One final point. There are two ways that you can squeeze the public sector without much visible pain, besides greater efficiency. First you can cut investment, which no one notices until much later (unless you are unlucky enough to have a lot of rain). Second, you can cut spending on groups who do not have a public voice. Those who find they are excluded or reassessed for benefits, or the elderly who have had their support from their local authority cut, would not call past austerity painless. It seems that painlessness, like beauty, is in the eye of the beholder.      

Howes that

Geoffrey Howe will probably be first remembered as the politician who brought down Margaret Thatcher by delivering a devastating resignation speech to MPs. Its most famous line (see link above) is his description of negotiations with Europe

“It is rather like sending your opening batsmen to the crease, only to find... that their bats have been broken before the game by the team captain"

This cricket metaphor is one poor excuse for the title of the post: a second, equally poor excuse follows.

I personally will remember him as Chancellor when Margaret Thatcher came to power. In 1981 I was a young Treasury economist who happened to be in charge of calculating the economic effects of the budget using the Treasury’s macro model. I was too junior to go to most budget meetings involving ministers, but I did go to one. I was there as the technical backup in case the Chancellor asked a difficult question about the model simulations. I was naturally psyched up, but it turned out for no reason. There were no questions about the simulations, or even about any macroeconomic effects. The most technical any interrogation by the Chancellor got was to ask ‘how’s that figure arrived at?’, to which the reply was ‘by summing the numbers above, Chancellor’. As one senior civil servant told me afterwards, arithmetic was not Howe’s strong point.

Why was there so little interest in the macroeconomic effects of that notorious 1981 budget (of letter from 364 economist fame)? It is difficult to understate the culture shock that occurred in the Treasury after Mrs Thatcher’s election. Treasury ministers, including Nigel Lawson (who succeeded Howe as Chancellor and is now an active climate change sceptic), believed that Treasury advice - including anything from its macro model - was outdated Keynesian nonsense and that monetarism was the way forward. When internal Treasury model forecasts predicted their policies would create a recession within a year, they were dismissed with the assertion that the unemployment impact of tight monetary targets would be small and very temporary. (Unemployment doubled and only returned to 1979 levels in a sustained manner by the end of the century. We got classic Dornbusch overshooting, as this 1981 Brookings paper by Willem Buiter and Marcus Miller describes, probably followed by unemployment hysteresis.)

It may be that high unemployment was necessary to bring inflation down. It may even be that a contractionary budget in 1981 was sensible to achieve a better monetary/fiscal mix. What is almost certainly not true is that this was calculated by Howe, Lawson and Thatcher. Instead policy can best be described by another cricket metaphor. It was as if a batting side had made a respectable score not through skill, but instead by taking wild swings at the ball that went to the boundary by repeatedly just missing the hands of fielders.

Apprenticeships and Conservative Governments

The UK budget included the creation of an employer levy to help finance a large increase in apprenticeships. It is a key part of this government’s belated attempts to deal with poor productivity growth, although lack of workforce skills has been a UK problem for as long as I can remember. I hope the goals are achieved, but this is not my area so I cannot comment on whether they will be. Instead let me tell an anecdote, and reference two good sources.

After I left H.M.Treasury, I found myself in a forum discussing Mrs. Thatcher’s economic policies. The person defending the government was a Treasury economist that I had worked for, and who was no fool. Most of the questions raised were macro, so I had no problem making critical comments. But then a question on apprenticeships came up. In the 1970s there was an apprenticeship levy covering most of British industry, administered by tripartite bodies. The Thatcher government had just begun dismantling that levy.

As this was hardly my field, I feared I would have nothing to contribute. But all my former colleague could say to defend the government’s dismantling of the levy system was that the government believed that individual employers were far better placed to do their own training. I could not believe what I was hearing. Even with the little microeconomics I had, I could see the flaw in that argument. Training employees with non-firm specific skills involved an obvious problem for the employer - the employee can be tempted to move to another firm, and the original firm gets nothing back from their investment. Firms that did pay for apprenticeships would always be vulnerable to others that attempted to free ride and poach their skilled labour.

Yet this ‘why should governments interfere’ mantra was the only justification the government could find for getting rid of the levy. Mrs Thatcher’s policies might have improved UK productivity growth for some reasons, but this was not one of them. As I often say, a neoliberal agenda (or whatever else you want to call it) is anathema to economics, a large part of which is about market imperfections, and how governments can sometimes be instrumental in fixing them. (Not always, as perhaps the German approach to apprenticeships illustrates.)

Two good recent pieces on apprenticeships are this short piece from Hilary Steedman, and something more detailed from Alison Wolf.

Abusing economic analysis: UK Treasury edition

For US readers, this is about the misuse of dynamic scoring in analysing tax changes

Ask most people if they think a particular tax - like fuel duty - should be reduced, and they will say yes. If you ask people do you think income taxes should be raised to pay for a cut in fuel duty, you will get a rather different response. So just asking people if they would like one particular tax to be cut without saying how it will be paid for is pretty meaningless. Unless of course your aim is to provide ‘evidence’ that taxes are too high, and you are not too worried about the nature of that evidence.

There is a slightly more sophisticated version of this trick, and the UK Treasury have just played it. Each individual tax potentially distorts the pattern of economic activity. If that pattern without any taxes is near some ideal, then we can call taxes ‘distortionary’. If we taxed apples and used this money to subsidise the production of pears, people would eat too many pears and not enough apples. However there is one tax that is not distortionary, because it does not influence incentives and therefore this pattern of economic activity. It is a poll tax - a tax levied on each individual independent of their income, wealth or what they spend their money on. Economists call this a lump sum tax. So cutting any distortionary tax, and paying for this by raising a poll tax, is bound to produce beneficial results in terms of reducing distortions.

There is only one problem with paying for a particular tax cut by raising a lump sum tax - in the UK we do not have a poll tax. We did very briefly - it was not very popular, because people care about fairness as well as the distortionary impact of taxes. For this reason, you should not expect to find a government department like the Treasury modelling the benefits of cutting fuel duty by assuming it was paid for by raising a poll tax. Unfortunately, that is exactly what has been done in a Treasury/HMRC report released this week

George Osborne is not planning to reintroduce a poll tax - veneration of a past Conservative Prime Minister would not go that far. I think the argument the Treasury would use to justify what they have done is simplicity. If you pay for a cut in fuel duty by, say, raising income taxes, you have to model the impact of two taxes on economic behaviour rather than just one. I don’t think that is a very good excuse, but even if we think it has some validity it has a direct implication: an individual study of this kind is meaningless on its own. It can only be used in conjunction with other studies that look at the impact of raising other taxes. Will Treasury officials therefore stop their masters using the numbers from this exercise to justify cuts in fuel duty? No prizes for guessing the answer. (They might if they could but they don’t have that degree of influence.)

So what could have been the beginning of an intelligent discussion of the costs and benefits of particular taxes (as in the Mirrlees review, for example) has been turned into a simple propaganda exercise.

Unfortunately it gets worse. Fuel duty is particularly ‘distortionary’ because its rate is high (see Chart 2.1 of the Treasury paper). There might be a good reason for that. The tax could be high because it is trying to offset damage that is not prevented by the market: road congestion, pollution and of course climate change. In terms of the language of economics it is (at least in part) a Pigouvian tax designed to offset externalities. In that case the tax is not distortionary at all: a world without fuel tax would not be ideal, and imposing a fuel tax gets us nearer that ideal. As Chart 3.1 from the paper indicates, these beneficial impacts of fuel duty are not modelled by the Treasury’s CGE model. (This is why, as John McDermott notes, this kind of partial dynamic modelling tends to be attractive to right wing outfits. Is it significant that the paper does not actually include the words ‘climate change’, and just uses the vaguer term environmental damage?)

So what the Treasury have done is modelled all the benefits of cutting the tax, but ignored all the costs. If this was but one stage in a process that would subsequently look at the cost of these externalities, and would realistically model how these tax cuts were paid for, fine. As a stand alone exercise, I’m afraid the Treasury study is worthless.

As Chris Giles notes in an excellent report, this is really part of a political exercise to build the case for tax cuts. It has two unfortunate side effects. First, it just encourages the suspicion among many that anything coming out of the UK Treasury at the moment is worthless propaganda. Second, it encourages those on the left who think that mainstream economics is inherently biased. But if you saw an opinion poll that asked people if they thought a particular tax was too high, without also asking what tax they would increase to balance the books, you would not say that this shows opinion polls are inherently biased. Instead you would just conclude that the person commissioning the poll had a political agenda. You might also ask whether the polling company should have accepted the commission.

The 2013 Budget and UK Monetary Policy

The Budget yesterday included an important update to the remit of the Bank of England’s Monetary Policy Committee (MPC). Depending on who you listen to, this is either an important change that could offer a considerable additional stimulus to the UK economy, or a major disappointment. So which is it?

The document reaffirms flexible inflation targeting, and rejects alternatives such as nominal GDP targets. However the Treasury wants to make it clear to the MPC just how flexible it can be. It can, for example, ‘see through’ (i.e. ignore) any short term increase in inflation for a lot longer than the two years that has so far been part of the MPC’s mantra. It can create ‘intermediate thresholds’ as part of forward guidance. In short, it believes flexible inflation targeting is quite compatible with the MPC doing what the US Fed is currently doing. [1]

I think Britmouse has it exactly right when he writes:

“I see nothing at all in the new remit text which compels the MPC to do anything different to current policy.  It is all about judgement.  Neither did the old remit prevent the MPC from giving forward guidance if they so desired.”

To see why this is important, read the minutes just released of the last MPC meeting, where the committee voted 6 to 3 not to undertake any further Quantitative Easing. In para 27 it sets out the arguments for providing more stimulus, which include:

“inflation expectations were relatively stable; wage growth remained weak; there remained a degree of slack in the economy; and the potentially positive response of supply capacity to increased demand meant that higher output growth would not necessarily lead to any material increase in inflationary pressure”

Which all sounds pretty compelling. But then the next paragraph sets out the reasons for doing nothing, which basically boil down to

“Inflation was above the 2% target and was likely to stay above it for an extended period, and there was a risk that could lead to inflation expectations drifting upwards with adverse consequences for wage and price setting behaviour. Further monetary stimulus might increase that risk. It might also lead to an unwarranted depreciation of sterling if it were misinterpreted as a lack of commitment to maintaining low inflation in the medium term”

In other words, any attempt to use the very flexibility that the Treasury emphasises the MPC has risks a loss in the credibility of the medium term inflation target. So 6 of the 9 member committee decided it was best not take take that risk. I cannot see anything in the new guidance issued by the Treasury yesterday that would have influenced any of the 6 who voted to do nothing to change their minds.

Now I guess the Treasury is hoping that the new governor will persuade some on the committee to vote the other way (although note that the current governor was one of the minority who voted for additional stimulus). But surely the key question is why they need persuading in the first place. Why are possible risks to the credibility of the medium term inflation target allowed to outweigh the current almost 100% certainty that we have chronic demand deficiency which no one else is going to do anything to change. Perhaps a remit that places medium term inflation stability at its core, and says nothing about eliminating demand deficiency, might just have something to do with it. 

[1] In addition, it also believes that flexible inflation targeting allows the MPC to consider deviating from the inflation target if there is a “development of imbalances that the FPC may judge to represent a potential risk to financial stability”.