We need a political party that is tough on the causes of Brexit

I fully share the anguish of so many people over the madness of Brexit. All the evidence points to not leaving the EU, and the reasons given for leaving are generally vague or false. The vote on which this crasy policy is based was deeply flawed. As an economist I can clearly see the damage Brexit is doing and will do. While I could see the rationale for Labour’s triangulation strategy over Brexit before and immediately after the 2017 election, during 2018 as public opinion began to move it stopped making sense in electoral terms, and of course their policy often appeared unicorn-lite or, more realistically, close to a policy of Brexit in name only which only gives away control. The new party that will surely follow the formation of the Independent Group, if it continues to promote a People’s Vote, should be quite attractive to people like me.

But I’m in the more uncommon position of having been in the similar place twice before in the last decade. The reason is very simple. I have been all my life a macroeconomist, and for the last twenty odd years an academic. That gave me a perspective on 2010 austerity and the 2015 election which was largely absent from the popular debate. As a result, I can see that Brexit was not an isolated event, the result of one bad decision by Cameron, but part of a pattern suggesting deep problems with how UK politics works.

Understandably, most people are against austerity because of the impact it has had on those in need who depend on the NHS, local authority care and the welfare state. They are also now seeing its impact on schools, on our justice system and much more. But that still leaves open the idea that somehow austerity was necessary for the good of the economy as a whole. As Conservative politicians never tire of saying, they came into office in 2010 with the country on the edge of a crisis created by the previous Labour government. As an academic macroeconomist I know that is completely false.

Pretty well every first year undergraduate textbook tells students why in a recession you need an expansionary monetary and/or fiscal policy and you should ignore the deficit. When interest rates run out of road, as they had in the UK by 2009, then fiscal expansion was vital. One of my own specialist fields is fiscal policy, so I also know that state of the art models also suggest exactly the same thing as the textbooks. The insights of Keynes that have been accepted by most academics ever since remain valid today. It is this received wisdom that the UK followed in 2009 before the Coalition government came into power.

Just as many feel that Brexit makes no sense, I felt that austerity which started in 2010 went against all our knowledge and evidence. The one doubt I had was that an irrational financial market might suddenly stop buying UK government debt, but this was dispelled when I realised the Bank of England’s unconventional monetary policy of buying government debt to keep interest rates low (Quantitative Easing) would quickly kill any panic. That analysis begins my book based on the blog I started as a result of austerity.

Just as both main political parties now support some sort of Brexit, so both at the time supported austerity, with the argument being over how much, how quickly. Neither the Coalition nor the opposition argued for the right policy, which is to delay fiscal consolidation until the recovery was underway and the Bank started raising interest rates. Experts on trade or the EU Brexit negotiations are infrequently heard in the media, but they were almost never seen over austerity.

My point in making these parallels is that evidence based policy making on major issues didn’t end with Brexit, but six years earlier with austerity. In both cases these are policies that create great harm to all, and acute harm to many. I calculate austerity cost the average household £10,000, and NEF using similar methods get an even larger figure. No government since the war, including those of Thatcher, has embarked on prolonged austerity during an economic recovery, and so it is no surprise we had the weakest recovery for centuries.

Brexit is therefore not the exception in a period of otherwise normal government. If you ask why Brexit happened, it was not that David Cameron made one mistake in an otherwise capable period as Prime Minister. There is evidence that austerity encouraged the growth of UKIP and by implication the Brexit vote. I remember often hearing people in areas that are described as ‘left behind’ dismissing the economic impact of Brexit by saying things could not possibly get worse than they are now. But austerity was not the main cause of why Brexit happened.

To see what was we need to look at the second period where I felt similar to how I feel today about Brexit, and that was the run up to the 2015 general election. Political commentators had decided from polling that the economy was the Conservative’s strong point, indeed perhaps their only strong point going into that election. To a macroeconomist that made no sense. Not only had we had the worst recovery for centuries but real wages had suffered their worst fall since records began. The government extolled record employment growth, but given the slow recovery they were in reality just celebrating the flatlining of UK productivity that was a key factor behind falling real wages.

Economists like David Blanchflower, John Van Reenen and myself set out just how bad UK economic performance had been over the previous 5 years, but once again expertise was ignored. As far as the media were concerned reducing the deficit had become the most important priority for the economy, and that was how they judged politicians. You will not find that in any textbook either, but the media had either sold or been sold a narrative and they didn’t want to know any different.

That narrative said that the Coalition had brought down the deficit that the previous government had allowed to grow out of control. Of course in reality the worst recession since the Great Depression of the 1930s caused by a Global Financial Crisis had pushed up the deficit, but the media had pushed, or accepted, the idea that the Coalition was clearing up the mess that a profligate Labour government had left. I had written a paper on fiscal policy under the Labour government and there was no way they were profligate, but because Labour didn’t challenge the accusation the media accepted something as true that was obviously false.

To the media the fact that the Conservatives were thought to be strong on the economy only confirmed their narrative. In reality the causality was the other way. There is a growing literature identifying the power the media has to influence elections and shape popular narratives. The 2015 election was a precursor for Brexit in three important ways. First, and most obviously, the media helped elect a Conservative government that was committed to an EU referendum. Second it showed that politicians could tell huge lies and get away with it. Finally it showed the power the media had to influence a popular vote.

Brexit would not have been possible without the UK media. A large part of the press pushed anti-EU propaganda, and the broadcast media balanced the view of the overwhelming majority of experts against the lies of a few. Viewers desperately wanted information, and the broadcast media gave them politicians rather than experts and balance rather than facts. Fear of immigration was important in deciding how many people voted, and it was the right wing press that had since the beginning of the century pushed countless negative stories about immigrants. Although austerity may have played a role, it was the media that played the major part in giving us Bexit.

Although the Independent Group (IG) may have a more attractive policy on Brexit, and they will talk the talk on a broken politics, the group is made up of politicians who either believe their government did the right thing over austerity, or who in opposition urged accepting Osborne’s policy. Deficit obsession is damaging to the economy, but it also shuts the gate to so much else that needs to be done. It means the IG will be unable to undertake the far reaching and radical industrial policy that is needed to tackle the huge regional inequalities within the UK, and help those left behind that voted for Brexit. It means no Green New Deal. Although so far policy light, they have pledged to keep our current ‘free media’, which will mean they would do nothing to mend much of our dysfunctional press that acts as a propaganda vehicle for their owners, or a broadcast media that balances truth with lies and is largely expert free.

Brexit was not an aberration in an otherwise well functioning UK democracy, any more than Trump was in the US. They are symptoms of a deeper malaise. I cannot put it better than Anthony Barnett when he says if all you want to do is stop Brexit and Trump and go back to what you regard as normal, you miss that what was normal led to Brexit and Trump. Unless we have politicians in power who understand the need for radical change, the snake oil sellers who sold us Brexit and US voters Trump will happily carry on plying their wares.

Nominal wages are not real wages, and why it matters in the UK

This post is just an extension of a recent tweet from Chris Dillow. I think it is worth writing more about it because it reflects on an issue that is widely misunderstood, by some on both the left and the right. Here is the share of employees compensation and corporate profits in total income since 1948. Note that everything below is about the UK experience: the US is different.

I have gone back to 1948 to show that the wage share can change, and has fallen from the 1950s until the end of the century, from 60% to 50%. But that has not been accompanied by a rise in the profit share, which has stayed pretty close to 20%. The missing pieces, that are the counterpart to the fall in the labour share over this period, are income going to indirect taxes, self employment and unincorporated businesses.

The key point I want to make is that neither the wage share or the profits share has changed over the last 15 years. This busts two myths that you will often see.

Myth 1 Immigration has kept real wages low.

There was a large increase in non-EU immigration at the end of the 1990s: if anything the wage share increased at the same time. The second large increase in immigration, this time from the EU, was from 2004, and there was no noticeable impact on the labour share. Immigration may have been depressing nominal wages, but those lower nominal wages were allowing lower output prices, leaving real wages unchanged. This is consistent with the econometric evidence that immigration has no significant impact on real wages.

This evidence is often dismissed in two ways. The first is that it does not correspond to workers 'lived experience'. But that experience reflects either the impact of immigration on their own nominal wage, or falls in real wages which reflect the lack of productivity growth and sterling’s depreciation. It is just possible that immigration might have discouraged firms from investing in higher productivity techniques, but it is rather more likely that immigration has allowed firms to produce in the UK who would otherwise have produced abroad. For other reasons why intuition on immigration may be misleading see here.

The second way that some people argue that there ‘must be’ a link between real wages and immigration is to invoke simple supply and demand. That is just fallacious: immigration shifts the labour supply curve but it also shifts the demand curve. A slightly more sophisticated argument is that the demand curve does not fully shift to compensate for greater supply immediately after an increase in immigration because it takes time to invest, but if that was the case we would see a temporary fall in real wages and a rise in the profit share following periods of immigration, and we do not.

Myth 2: Real wages have fallen because labour is now weak compared to employers.

Since the Global Finance Crisis (GFC) and subsequent recession, nominal wage growth may be slow because the labour market is weak, but the data shows that employers are not taking advantage of this to increase the profit share. Low wages are being passed on into lower prices.

There are two main reasons why real wages are currently low: almost non-existent productivity growth since the crisis and the depreciation in sterling which has raised the cost of imports and therefore consumer prices.

Note that I am not at all saying that the labour market is not as weak as it appears. In many areas conditions of employment seem to have deteriorated since the GFC. What I am saying is that real wages depend on prices as well as nominal wages, and in the UK at least there seems to be sufficient pressure on firms to pass on low wages into low prices, leaving the relationship between real wages and productivity unchanged.

It is also important to point out that the wage share is different from median wages. As the study by Pessoa and Van Reenen I examine here shows, median wages from 1972 to 2010  declined relative to the average compensation because of rising non-wage benefits and rising inequality. A good part of this rising inequality reflects incomes of the top few percent.  

It is often difficult to convince those on the left that weakening labour power over wages can be a good thing, if lower nominal wages are passed on to lower prices. It can be a good thing because it allows the central bank to raise demand and therefore output by more than they otherwise could while keeping inflation stable. It reduces the sustainable unemployment rate: the NAIRU. Furthermore lower wages are more likely to be fully passed on into lower prices if the goods market is highly competitive, and that is more likely to happen if the economy is open to overseas trade.

Brexit and neoliberalism

In a recent post I talked about the “neoliberal fantasists who voted Leave”. Here is Ryan Bourne from the influential Institute of Economic Affairs. He notes that “the mood music from the post-referendum Conservative party — with former Remain backers in No 10 and the Home Office overcompensating with a caricatured view of what voters want — is not a good sign for the short-term”. But he still believes that Brexit can be transformed into some kind of neoliberal wet dream, with a bonfire of regulations and a unilateral abolition of UK tariffs on trade.

The economics of this was always fantasy, as John Van Reenen and colleagues painstakingly demonstrate here, but it also seems politically naive. After all the Leave campaign was a success largely because it promised to control immigration as a result of leaving the EU, controls which are distinctly anti-neoliberal. Controlling immigration is not a caricature of what the majority of Leave voters wanted, but instead what most were voting for. It does seem naive to believe that a government after Brexit would try and quietly forget about this, particularly when led by someone who had spent the previous 6 years trying and failing to control immigration. It also seems naive to imagine that this turn against neoliberalism would not go beyond immigration.

And yet, the ‘southern strategy’ was highly successful for the Republican party in the US. This combined an economic policy that favoured finance and corporates, increased inequality and free markets with an identity politics that appealed to race, religion and cultural identity. (I could perhaps add geographical identity here as well: see this article by David Wong.) Perhaps the UK party of the right could follow a similar course, using immigration as a substitute (and for some a proxy) for race, whilst pursuing an otherwise neoliberal agenda?

Is this what the Conservative party tried to do under Cameron and Osborne? Actually I think that is the wrong question, for reasons I will come to shortly. In terms of what the Coalition government actually did, Jonathan Portes summarises it thus:

“The promise to cut net migration to the “tens of thousands” was generally regarded by immigration policy experts as unachievable, or achievable only at an economic cost no sensible government was willing to pay. In practice, the latter course was never tested: resistance from within government from the Department of Business, supported to a greater or lesser extent by the Treasury, meant that even non-EU migration was only reduced very substantially for non-HE students; for most other routes it has stabilised. Non-EU net migration is currently about 150,000 a year, slightly higher than EU net migration

This does not mean the policy changes had no impact: the increase in the regulatory burden on business and the education sector has been substantial, and has certainly resulted in some reduction in skilled and student migration. The most damaging single decision was probably the closing of the Post-Study Work Route. However, overall, any economic damage was considerably mitigated.”

Of course that resistance from the Department of Business came from a Liberal Democrat, Vince Cable, and not a Conservative. Which leaves open the possibility that the economic damage from attempts to hit the immigration target might have been greater if just the Conservatives had been in power. So it is not clear that the Conservative focus on immigration was just so they could win elections with zero cost to their more neoliberal objectives. It still remains the case that, just as Trump exposed the flaw in the Republican’s southern strategy, so Brexit was the critical flaw in Cameron’s emphasis on the problem of immigration and his failure to meet his own targets.

I said it was the wrong question, because I think in this case it was not a political party that was calling the shots but a section of the print media: the right wing tabloids. As Andy Beckett writes in this comprehensive history of this part of the UK media:

“[Brexit] was an outcome for which the tabloids had campaigned doggedly for decades, but never more intensely – or with less factual scrupulousness – than this spring and summer, when the front pages of the Sun, Mail and Express bellowed for Brexit, talking up Britain’s prospects afterwards, in deafening unison, day after day. Two days before the referendum, the Sun gave over its first 10 pages to pro-Brexit coverage.”

And the principle means the tabloids used to obtain this result was the “endless xenophobic nudges of its immigration coverage.” Of course these newspapers will say they were just expressing their readers fears, but when they are reduced to making up stories to encourage this fear any claim to innocence becomes very hollow. Fueling anti-immigration feeling was their version of a southern strategy, and Brexit saw its culmination.

Having achieved this objective, will the tabloids start ignoring the immigration issue, enabling the greater immigration and zero tariffs that Mr. Bourne desires? Or will the influence of these tabloids, perhaps now greater than it has ever been, start to fade away? To the extent that these seem silly questions reveals the political naivety of the neoliberal Leavers. It is highly unlikely that Theresa May will become squeamish about damaging business through immigration controls to enable her to meet her immigration target. The best hope of those who do not want to go down this path is that, as Jonathan Portes expects, the Brexit vote itself starts to reduce the immigration numbers.

Brexit will also put other pressures on May which are likely to move her away from neoliberal policies, as the assurances given to Nissan indicate. As Bourne writes in a recent blog: “if this is a commitment to permanent or semi-permanent support to almost ‘make up for’ changed trade arrangements then it is hugely misguided.” Misguided it may be, but that is the direction the politics will push a Prime Minister determined to be seen as making a success of Brexit. Just as Republican’s have agonised over how to deal with Donald Trump, so it will become clear to UK neoliberals the damage to their cause that Brexit will generate.

If only someone had warned us

The title is pinched from a tweet by Tony Yates, who was one of many economists who did warn of the impact of Brexit. Of course we economists need to ask ourselves if and why our message was ignored, but that is no reason to stop us feeling angry that it happened. This post from the economist who did more than most to try and get the message across, John Van Reenen, expresses that anger better than I could.

What John’s work showed, backed up by similar analysis in the Treasury and elsewhere, is that Brexit would not just cause a short term economic downturn: cutting wages and increasing unemployment for just a year or two. By making it harder to trade with our immediate neighbours it will reduce UK trade overall, and the evidence suggests that this will permanently reduce people’s living standards. The markets clearly agree, which is why sterling fell immediately and substantially after the Brexit vote. In terms of people’s living standards that was not a ‘might be bad, might be good’ event: it makes everyone in the UK poorer. (Never start from a price change, but ask why prices changed.)

The tricky thing to do now is know how much the current downturn is just a foretaste of that, and how much is something over and above that. To the extent that it is the latter, how much

of that is offset by some short term benefit to exporters (before the impact of actual Brexit kicks in) as a result of the depreciation? That is initially the Bank of England’s problem.

Their response today, a cut of 0.25% plus more QE, tells us it is not just their problem. We are back at the lower bound for nominal interest rates, which is why the Bank is doing more QE. Because the impact of the QE is extremely uncertain, and in the absence of helicopter money, we now need fiscal action to back up this interest rate cut. That is what Labour’s fiscal credibility rule, and the academic work by Jonathan Portes and myself, utilising textbook and state of the art macro, tells us we should do. When interest rates are at the lower bound, forget about the deficit and focus fiscal policy on avoiding a recession. As the Bank’s QE action makes clear, there is no good reason to delay this: it should happen now.

But Brexit was not the first time economists have been ignored. For some years now the clear consensus among academic economists is that, when rates are at their lower bound, you need fiscal stimulus. Although Conservatives have disowned 2015 Osborne austerity, they appear not to have backtracked on his 2010 version. If they do nothing now, we will know that they are wedded to pre-Keynesian 1930s economics.

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.  

The EU referendum and the media

The government is to send a 14 page leaflet to every household setting out the ‘facts’ that make a vote to stay in the EU the sensible thing to do. Anything wrong or undemocratic about that? US readers might be rather surprised to learn the official In and Out groups are only allowed to spend up to £7m each on campaigning: we in the UK have this rather quaint and intensely democratic idea that money should not be able to buy elections. But the government’s leaflet, which will cost nearly £10 million to produce and distribute, does not count as part of that. [1]

For that reason alone, this leaflet is both unfair and undemocratic. But most of the complaints about this seem to have come from those supporting the Leave campaign. Is this because others who might normally be expected to speak up for fairness and democracy are staying quiet because they support staying in the EU? I honestly do not know, for reasons that will become clear.

What I think is pretty clear is that a large majority of what you might call the establishment, and also a majority of what was once called ‘the chattering classes’, plus a majority of academics (e.g.), are in favour of staying in the EU. One of those is Timothy Garton Ash, who wrote an article in the Guardian recently about BBC coverage. He complains that because the BBC is focused on being fair to both sides, it is failing to be informative. I couldn’t help thinking to myself as I read this (very fair and sensible) article, welcome to the world that many scientists (including social scientists) have had to live with for quite some time. Here is the BBC’s mission, which I was discussing recently in a talk on a different topic.

The world that Garton Ash describes is a world where, on any subject that is contested by significant (to the BBC) groups, evidence is only presented with counter evidence for balance, even when the quality of the counter evidence is weak or non-existent. It is a world where the view of the massive majority of scientific researchers has to be ‘balanced’ by the pseudo science of special interests. It is a world where everyone is an expert on economics. It is a world where the visual media refrain from presenting facts if those facts might be seen as ‘political’. It is the ‘shape of the earth:views differ’ world, and the world where everyone just knows that in 2010 the UK government was saved from the brink of bankruptcy. [2]

As we are seeing in this EU referendum, setting up everything as a two sided debate does little to inform anyone. It can even be counterproductive, setting the climate change scientist (full of natural scientific caution) against the climate change denier (chosen for their rhetorical ability). It is a format that militates against evidence: you cannot normally show a chart in a debate, and so instead we get the presentation of summary statistics that are selected on the basis of how best they support a view rather than how best they summarise the data. (UK spending on flood prevention is a clear example of how that happens.) It is a format where even numbers lose their meaning, and where dots are hardly ever connected. [3]

It is not hard to see how that happens, particularly when media organisations are fighting for their survival. Some things can be done, as long as they are seen to be non-political. For example journalists can use statistics in a way that informs rather than confuses. For example less status should be given to journalists who have good political contacts, and greater status given to those who know their subject and can quickly source experts. Above all else, we have to do all we can to resist government attacks on the public media.

But these changes will not make a major difference. I suspect that the BBC, for example, will only start to fulfil its mission to inform and educate when it is safe for it to do so. In the meantime we will have to put up with the uniform ‘views on the shape of the earth differ’ style of reporting. The government’s leaflet on the EU may be one consequence. Our membership of the EU may become another.

[1] That the government has resorted to trying to rig the vote in such a blatant way is interesting on many levels. (If you think this language is too strong, how would you react to the government doing the same before a general election?) I suspect the government was unprepared for the impact of being on the wrong side of most of the print media. In many other respects, it reflects chickens coming to roost. (One I did not mention here is voting ‘reform’ which tends to exclude the young who tend not to vote Conservative, but who also tend to favour the EU.) But the move may also reflect continuing hubris. Is it wise to associate the Remain side so clearly with a government which is right now losing popularity? It would have been so much better to do a 2003 Euro entry type exercise. The government must have known it would come out in its favour, so why was this not done?

[2] Just in case anyone does not get the reference, more detail here. I’m not sure whether this example represents ignorance, or journalists talking to the wrong people (i.e. some City economists), or not presenting the facts because this would be seen as ‘being political’. Probably a mixture of all three.

[3] For example, compare how much information you get from this 2 minutes (from the excellent John Van Reenen) to ten times that amount of normal reporting.

Protecting the public from policy entrepreneurs

One of Paul Krugman’s first books, Peddling Prosperity, made a distinction between academic economists and people he called "policy entrepreneurs". These are individuals who promote particular intellectual positions and ideological policy prescriptions which have little or no academic support, but which may appeal to certain politicians.

I remember it as a great book, and unfortunately one of the main subjects - the idea that tax cuts pay for themselves - is still current in the US. It remains the case that this idea has virtually zero academic support, but for whatever reason - the activities of policy entrepreneurs being one - it still has a tight hold on the Republican Party.

I also remember being dissatisfied with the concept of the policy entrepreneur. It seemed to me that the book failed to situate them in a more general framework of how different interests influenced policy. Why were policy entrepreneurs particularly prevalent in economics? Could academics also be policy entrepreneurs? But that was the social scientist in me speaking. It was clear that such people existed, and that their influence could be far from benign.

I was reminded of all this when someone referred me to Andrew Sentance’s latest piece where he advocates moving to a zero inflation target. Coupled with George Osborne and David Cameron proclaiming zero inflation as a great success, a horrible thought occurred. If these guys were re-elected, might they find the arguments of Andrew Sentance appealing, and actually go for zero inflation? (In the UK, the Chancellor sets the inflation target.) Getting rid of inflation completely - sounds like a vote winner!

Why is it a horrible thought? Because all the academic discussion has been going in the opposite direction, for a very good reason. The Great Recession has highlighted the problems caused by the lower bound for nominal interest rates. That problem will not go away if that lower bound turns out to be -1% rather than zero. The discussion of secular stagnation has highlighted how the ‘underlying’ level of real interest rates has steadily fallen over the last few decades. Put the two together, and you see that a 2% inflation target may mean that we hit the interest rate lower bound far too frequently for comfort. A higher inflation target is one way, although not the only way, of reducing this problem.

Given this, calling for a zero inflation target seems perverse. In response, Andrew Sentance says this: “And the fact that a target of zero inflation may not allow central banks to easily impose negative real interest rates may actually be a good thing – protecting savers, who have suffered heavily as a result of very low interest rates since the financial crisis.” This is just the kind of thing a policy entrepreneur would say: identify your target interest group, and appeal to their interests over the common good. A politician who wants to appeal to savers might think that sounds like a good idea, and before you know it the policy is in place.

I suspect things have moved on a little since Peddling Prosperity was published. The role of think tanks is probably greater. The good ones are a means of channelling academic research, as in this very recent discussion of how to enhance real wage growth from the Resolution Foundation (which I would call excellent if it didn’t have a contribution from me). But they are matched by others that are effectively the institutional equivalent of policy entrepreneurs.

One answer to this problem is delegation. If you delegate an issue to a non-political body, that institution is going to be less swayed by the policy entrepreneur, and more influenced by knowledge and evidence. The independent central bank is an obvious example. It is interesting that one of the contributions to the Resolution Foundation volume, from John Van Reenen, calls for a “permanent infrastructure strategy board”, to improve the level and quality of national infrastructure. Of course with delegation comes the danger of power without accountability, and one particular central bank is a good example of that.  

Is delegation the only way we have of protecting ourselves from the policy entrepreneur? I have one final thought. (The idea comes from Chris Dillow, but he said it on my blog first!). Policy entrepreneurs exist in part because of sectional interests. The problem arises if sectional interests drown out evidence based policy. Society as a whole clearly has an interest in evidence based policy, but one institution that is well placed to protect society’s interest here is academia. Although - in the UK at least - academia encourages the dissemination of research, most academics are always going to value their research above its dissemination, because that is how internal incentives work. So maybe the academic sector needs to create a few policy entrepreneurs of its own, whose mission is to disseminate not their own research, but research in a whole field. One of two examples already exist - maybe we should have more of them.  

 

Real wages, monetary policy and innovation

In my drive into Oxford I pass a petrol station that offers a car wash service. Ten or twenty years ago you would have expected this to involve a large degree of automation. However in this particular case it involves a few workers with hoses, mops and buckets. Now anyone who has seen my own car will realise that I know very little about car cleaning technology. But with this caveat, it seems to me this garage offers a nice illustration of how labour productivity is a function of relative prices. If labour becomes expensive relative to capital, it is worth the garage investing in a car washing machine, but if the opposite happens, once the machine reaches the end of its life it goes back to the old labour based technology.

In technical terms what I describe above is just an example of factor substitution. This is one explanation of the UK’s productivity puzzle, investigated at the aggregate level by Joao Paulo Pessoa and John Van Reenen. They “argue that ‘capital shallowing’ (i.e. the fall in the capital-labour ratio) could be the main reason for [the productivity puzzle]”. Although initially the US did not see productivity fall, there are indications a milder form of this may be happening there too.

So why does this not happen in every recession? One answer, provided by Pessoa and Van Reenen, is that the behaviour of real wages in this recession has been very different. Real wages have been much more responsive to unemployment in this recession compared to the recessions of the 1980s or 1990s. Pessoa and Van Reenen suggest this could be the result of a combination of weaker union power and welfare reforms that keep effective labour supply high even when demand is low. You could also add greater availability of cheap labour from members of the EU where unemployment is high.

A counter argument might be that earlier recessions have been caused by tighter monetary policy, pushing up the cost of capital, whereas in the Great Recession interest rates have been at the zero lower bound. However there is evidence that the Great Recession has increased the cost of capital for large firms in the UK, and the impact on small firms will have been even greater. In addition a recession that involves a financial crisis is likely to leave firms feeling particularly reluctant to invest, because any borrowing will involve a long term financial commitment that leaves them more vulnerable. In the past they could have relied on their bank to see them over any temporary cash-flow problems, but now they are less sure. In these circumstances, labour intensive rather than capital intensive forms of production seem much less risky.

Indeed in a world of certainty the capital intensive form of production might actually be more efficient. In economic jargon, switching to people with buckets and hoses has actually reduced total factor productivity. But in a world where financial risk has increased, the firm may still choose the labour intensive form of production.

This process of factor substitution will also lead to a steady decline in survey measures of excess capacity. As the recession hits, the car wash business with a large machine will report excess capacity as people economise on car cleaning. However when the machine reaches the end of its useful life, it is replaced by people with buckets and hoses, and the firm reports no spare capacity.

What happens when demand begins to rise? Initially not much - the firm just hires more labour. Productivity does not increase. The situation becomes more interesting if labour becomes scarce. Does the firm start paying higher wages to attract more workers, or push up prices to choke off additional demand? Or does the firm now think that maybe it is time to invest in a car washing machine, which would in a more certain future allow the firm to reduce costs and prices (and lead to a reversal in the fall in productivity)?

Perhaps all of the above. But suppose that at the moment real wages or inflation begin to rise, the central bank tightens monetary policy. This would raise the cost of capital, and could be interpreted as an attempt to prevent real wages rising. In other words, a strong signal to the firm to stick with its labour intensive production methods. We enter a kind of low productivity, low wage trap. Monetary policy, which in theory is just keeping inflation under control, is in fact keeping real wages and productivity low.

Monetary policy makers would describe this as unfair and even outlandish. A gradual rise in interest rates, begun before inflation exceeds its target, is designed to maintain a stable environment. As the owners of the garage begin to appreciate this, they will eventually decide to invest in that car washing machine. On the other hand, if they sense that inflation might rise above target, they will not invest, however strong short term growth might be.

I’m not sure I believe this. As Chris Dillow argues here, investment may be particularly prone to confidence or animal spirits. Would these animal spirits be stimulated more by strong demand growth, even if it was accompanied by forecasts of 3% or 4% inflation, or by monetary tightening to prevent this inflation ever happening?  

I also have another concern about a monetary policy which tightens as soon as real wages start increasing. What little I know about economic history suggests an additional dynamic. As long as the firm is employing labour rather than buying a machine, there is no incentive for anyone to improve the productivity of machines. The economy where real wages and labour productivity stay low may also be an economy where innovation slows down. The low productivity economy becomes the low productivity growth economy.