The austerity story in extensive form

My London Review of Books article is now available online. It is much longer than the normal blog post, so it allows me to put together a lot of points in one place. It tells the history of the macroeconomic policy response to the Great Recession. How in 2009 policy responded in the right way (in terms of direction if not magnitudes), but how in 2010 it all went very wrong with the move to austerity. It is told from a UK perspective, but similar stories can be told for the US and Eurozone. It says why austerity was a mistake, and how both politicians and most of the media have tried to avoid this conclusion.

Besides length, the other main difference is the effort I have made to write clearly for non-economists. (Whether I have succeeded you can judge, but to the extent I have the editorial team at LRB deserve a lot of the credit.) Of course I would like to do this all the time in my posts (unless I signal otherwise at the beginning), but I’m acutely aware that I often fail. Mostly it reflects lack of time. I try to always do one read through thinking how would a non-economist interpret this, but as anyone who reads through their own work knows, if it is something you have just written it is quite difficult to be objective. My ‘post the next day’ rule helps here, but I do not always stick to that rule! (Occasionally jargon can be descriptive: ‘automatic stabiliser’ and ‘lender of last resort’ spring to mind from the article.)

Writing a piece like this also makes it clear how difficult macroeconomics in particular is. Everything is, at least potentially, connected. To tell the story of fiscal austerity you do not only need to talk about the impact of spending cuts on demand and output. You also need to talk about monetary policy, and therefore Quantitative Easing. Not just to discuss potential monetary policy offset, but also why the Eurozone is different, which means talking about the relationship between short term interest rates and interest rates on government debt. I do this all the time when writing academic papers of course, but for a non-academic audience the rules for what you include and what you leave out have to be different.

The hardest thing is to switch off the academic part of me which is saying: you really should cover that, or that is a very imprecise way of making that point. For example in the LRB article I did not go into a discussion of whether, because UK inflation was high in 2011, interest rates might have increased if there had not been austerity. That discussion you can find in detail in my NIER article, but I decided including it in the LRB discussion was both unnecessary and distracting. However I did mention helicopter money (by request), because a natural question for a non-economist to ask is why the central bank is creating money to buy financial assets rather than giving it directly to people? (Actually that is a pretty good question for an economist to ask as well!) What I wrote was that financial assets can be sold again when the recovery is complete if the bank judges that there is too much money in the economy, but that of course begs the question of whether there are other means of reversing helicopter money. You just have to stop somewhere, and leave important issues out.   

The other thing that struck me writing both the LRB and NIER articles was how little depends on the benefits of hindsight. When I did my analysis of fiscal policy under Labour, the major criticisms did reflect subsequent events: in particular that the fiscal rules should have aimed for a gradually falling debt to GDP ratio. With the Coalition, the key mistake was obvious at the time. What has come with hindsight are in a sense details, albeit important ones: exactly why the Eurozone was special, the motivations behind the policy, and mediamacro. However I think the more interesting comparison, from a UK perspective, is between macroeconomic policy under the Coalition and the 1979 government under Margaret Thatcher. That would be an article I would like to write sometime.

Encouraging dialogue between economists and social scientists

In a way this is a rather trivial post, about language and attitudes as much as anything, that follows from some of the reaction to this post and related debates. One big difference between most (not all) mainstream economists compared to their heterodox or other social science colleagues is insularity. Political scientists will talk to sociologists who in turn talk to international relations people as a matter of routine. Economists by and large talk to each other. This is not because their subject matter is narrow - economists are notorious for applying their tools way beyond economics.

Most of the time I think that is fine, but sometimes it is not. How do we deal with the times that are not? I want you - as either an economist or social scientist or interested spectator - to think about a visit to your doctor. Why? Because economists should really think of themselves like doctors. (I know some want to think of themselves as physicists, but what can we do.) They are trying to understand highly complex and erratic systems based on a small number of principles, where most of the time they have very little idea of what is going on. But they have data, and some of the time they can make a lot of difference to people’s lives.

Now supposing your doctor prescribes you a course of treatment. It involves drugs that you have read a little about, and you have some concerns. If you were a social scientist would you say to your GP something like the following:

“I’m a little worried about this. I feel that you may not have adequately addressed the ontological and epistemological issues that are raised here. What exactly is ‘treatment’, and when is it necessary? Have you thought about the complex social and economic interrelationships that lay behind your prescription? Is the nature of what you call ‘illness’ really independent of the nexus of interactions that could be loosely called the medical profession?”

I kind of hope you wouldn’t, because I do not think you would get very far if you did. You might be much better off asking something like the following.

“I’m a little worried about this. Have you thought about whether this treatment is appropriate to my particular circumstances (HT Ben Goldacre), or are you reacting to pressure from the drug company or someone else? Has that company published all its trial data, or only the trials that were successful, and how was success defined in this case. Is this really going to make me better, or just increase someone’s profits?”

It is a simple and obvious (I did say trivial) point - you will get much further if you talk specifics in a language your doctor will understand, rather than in generalities and terminology they will not. Economists want (or need) to know why their approach is missing key issues or linkages which compromise their analysis, just as the doctor needs to know why they might be recommending the wrong treatment. You would not insist that your doctor needed to have studied economics before they can be a good doctor.

But if you were an economist, would you think it legitimate for your GP to respond like this.

“How inappropriate of you to ask me these questions. I’m a doctor, and I know from my years of knowledge and experience what is the right treatment for you. As you cannot know what I know, then you should not get involved in these issues. Some of the things you mention are really none of my business, and I do not see why I should worry about them.”

Now as an economist you know that such a response from your doctor would be both arrogant and naive. The doctor should ask about the quality and objectivity of the information they receive, and know full well that drug companies exist to make money. But might your response to a social scientist be as arrogant and naive?

Let me take a real world economic problem: the response to the financial crisis. Some have suggested that banks have become too large and need to be broken up, or that the activities of high street banking need to be separated from the activities of the casino. Your economic analysis tells you that networks of many small entities can be as subject to crises as networks involving a few large banks. You are also able to devise a system of Chinese walls that mean that the activities of the casino can be separated from those of the high street even within the same company, and your political masters seem to prefer this approach. You recognise that different assets differ in their liquidity, and so you devise complex weighting algorithms for computing capital ratios. Your suggestions form the basis of negotiations between officials and bankers, and a set of rules and regulations are agreed.

Over the next few years you watch in dismay as your complex system begins to unravel. The CEOs of the large banks seem to constantly have the ear of politicians, who in turn gradually compromise your elaborate controls to render them less and less effective. Those in charge of administering the rules find it much more lucrative to work for the banks, and so regulators gradually lose expertise and resolve.

And you realise that right from the start you made the wrong choice. You decided to focus on what you knew, which was how to design systems that worked well as long as those systems remained unchanged, but which were not robust to intervention by self-interested parties. In short, they were too open to rent-seeking. You realise that actually the best thing to have done was to break up the banks so that their political power was forever diminished. And you recall a conversation with your social science colleague when this all started, who might have been trying to tell you this if only you had understood the words he was using.      

Is economics jargon distortionary?

Employees are already beset by red tape if they try to improve their working conditions. Now the UK government wants to increase the regulatory burden on them further, by proposing that employee organisations need a majority of all their members to vote for strike action before a strike becomes legal, even though those voting against strike action can still free ride on their colleagues by going to work during any strike and benefiting from any improvement in conditions obtained. Shouldn’t we instead be going back to a free market where employees are able to collectively withhold their labour as they wish?

I doubt if you have ever read a paragraph that applies language in this way. Yet why should laws that apply to employers be regarded as a regulatory burden, but laws that apply to employees are not? Labour markets, alongside financial markets, are areas where the concept of a ‘free’ market uncluttered by regulations is a myth. Here, as elsewhere, language has been distorted to suit a neoliberal agenda.

Is this also true with terminology used in academic economics? That is the argument put forward by Charles Manski in this Vox piece in the context of economists’ discussion of taxation and lump-sum taxes. He writes:

“Students of economics learn that the formal usage of the concepts 'inefficiency', 'deadweight loss', and 'distortion' in normative public finance refer to a theoretical setting where a private economy is in competitive equilibrium and a government can use lump-sum taxes to modify the endowments of individuals. In this setting, classical theorems of welfare economics show that any Pareto efficient social outcome can be achieved by having the government use lump-sum taxes to redistribute endowments and otherwise not intervene in the economy. Income taxes and other commonly used taxes logically cannot yield better social outcomes than optimal lump sum taxes but they may do worse. Deadweight loss measures the degree to which they do worse.”

The big problem with this terminology and associated research agenda, he argues, is that it presumes lump sum taxes are a feasible option, whereas in reality they are not.

“The research aims to measure the social cost of the income tax relative to the utterly implausible alternative of a lump-sum tax. It focuses attention entirely on the social cost of financing government spending, with no regard to the potential social benefits.”

Indeed, lump sum taxes (a.k.a. a poll tax) are not a feasible option precisely because they achieve non-distortion at the cost of being unfair, and in the real world taxation is as much about fairness as allocative efficiency.

The counterargument is that the idea of a lump sum tax is just a useful analytical device, which allows research to focus on the taxation side of the balance sheet, without having to worry about what taxes are spent on. It would be equally possible to look at the benefits of different types of government spending, all of which were financed by a lump sum tax. Equally the competitive equilibrium against which real world taxes are distortionary is an imaginary but analytically useful reference point - everyone knows the real world is not like this competitive equilibrium.

It is not our fault, the counter argument would go, that non-academics abuse these analytical devices. No serious economist would talk about the costs and benefits of a policy to cut a particular tax in isolation, when that cut has been financed using a lump sum tax. Governments that do that have clear ulterior motives. Equally no serious economist would talk about the benefits of reducing a tax designed in part as Pigouvian (i.e. a tax designed to offset some market externality), within the context of a model that ignores that externality. (For a recent example where the UK Treasury published a study that managed to do both of these things, see here.)

I think the key here is to clearly differentiate analysis from policy advice. I have used lump sum taxes in my research, and I often talk about taxes being distortionary. I think both general and partial equilibrium analysis is useful, and devices that allow abstraction are invaluable in economics. (I have less sympathy for the concept of Pareto optimality, for reasons discussed here. See also the excellent series of discussions by Steve Randy Waldman.) However these devices can often allow those with an agenda (including the occasional economist) to mislead, which is why economists need to be very careful when presenting their analysis to policy makers, and why they also need to have the means to alert the public when this kind of deception happens.