How BBC balance and bad think tanks discourage evidence based policy

The Knowledge Transmission Mechanism (KTM) is how knowledge produced by academics and other researchers is translated into public policy. Evidence based policy is the result of this mechanism working. The media is, in theory, an important conduit for the KTM: media publicises research, policy maker sees/hears/reads media and gets their civil servants to investigate research. Or media communicates policy consensus on issue, and politician is questioned by the media on why they are not following this consensus.

The rigid application of political balance in the broadcast media is in danger of negating the KTM, and therefore evidence based policy. The moment an issue (call it issue X) is deemed ‘political’ by the media, balance dictates that any view expressed on issue X is an opinion rather than knowledge. As a result, when the media want to talk to non-politicians (‘experts’) about issue X, the imperative of balance remains.

Now suppose that in the knowledge world there is in fact a consensus on issue X. That would be a problem for balance broadcasting, because it would be difficult to get an expert to argue against the consensus. The BBC overcame this problem valiantly during Brexit, using Patrick Minford (who is not known as a trade economist) time and again to balance the IMF, the OECD, more than 90% of academic opinion etc. But another way of solving this problem is to use certain think tanks.

There are two types of think tank. The good kind can be a vital part of the KTM. There is often a genuine need for think tanks to help translate academic research into policy. Sometimes these think tanks will be very like universities (like the IFS for example). Other times they will be think tanks that have a broad left or right orientation. These think tanks are an important part of the KTM, because they can establish what the academic consensus is, translate academic ideas into practical policy, and match policy problems to evidence based solutions. The IPPR is an obvious example of this type of think tank. They are part of evidence based policy making.

The bad kind are rather different. These produce ‘research’ that conforms to a particular line or ideology, rather than conforming to evidence or existing academic knowledge. Sometimes these think tanks can even become policy entrepreneurs, selling policies to politicians. This is often called policy based evidence making. It would be nice to be able to distinguish between good and bad think tanks in an easy way. The good type seeks to foster the KTM, and ensure policy is evidence based, and the bad type seek to negate the KTM by producing evidence or policies that fit preconceived ideas or the policymaker’s ideology.

I would argue that transparency about funding sources provides a strong indicator of which type a think tank is. Why is this? One obvious reason why you would not want, say, company Y listed as a funder is if you subsequently produced a report that was directly in the interests of Y. A clear example is the IEA’s arguments against plain packaging of cigarettes, and its funding from tobacco companies. To be clear I am not suggesting that the IEA (who have been in the news recently) is insincere about the arguments it makes, but if funding was transparent it would be very easy to suggest their arguments on plain packaging were contrived by just pointing out its funding sources. So that is an obvious reason to keep funding secret. In contrast, an IFS type think tank has no reason to hide its funders, because it is not in the business of producing policies that meet the specific wishes of these funders. [1]

It has been suggested to me that IEA type think tanks need to keep their funding secret because some personal donations would get individuals into trouble with their employers if they became public. It would be interesting to know from some IFS type think tanks how much funding they lose for this reason. Perhaps the answer is not much, and that in any case the principle of transparency is more important than a few extra donations.

Another good indicator of a bad think tank is their relationship to academia. I have told the story about how the IEA under Philip Booth tried to cultivate the idea that the 364 academics who famously objected to the Thatcher government's 1981 budget were embarrassingly wrong, when in fact they were proved right. The IEA’s media and political connections are sufficiently strong that even good BBC economics journalists were taken in by their line. To the extent that it emboldened Osborne to ignore the majority of academic economists over austerity it was a dangerous myth to cultivate.

In the case of global warming the BBC has been forced (I don’t think that is an inappropriate word, as it often breaches the guidance) to treat man made climate change as a fact rather than an opinion that always has to be balanced. That is not going to happen for some time over any economic issue, however strong the academic consensus (like Brexit). This is partly because the pressure from academia is much less, and partly there is still a prejudice against social science (as if evidence based policy making cannot occur for economic or social policy!). But the BBC does need to explain their attitude to the use of think tanks. Why do they use think tanks that do not declare their funding sources, and when they do why is this information not passed on to its audience?

[1] To understand why arguments like the IFS gets money from the government or the EU and therefore it is biased do not work, see here.

Delegation as a reaction to the politicisation of advice

In my last post I used the example of Brexit to show that politicians, even when their ideas are seen as seriously harmful by most experts, will still find policy entrepreneurs to give them enough information to sound knowledgeable when they appear on the media. But this may be an extreme example of a more general phenomenon, which I would describe as the breakdown of the way expertise is utilised by government: a breakdown of what I call the Knowledge Transmission Mechanism.

It is nothing new, of course. The first example I ever had experience of was as an economist at the Treasury when Mrs. Thatcher became Prime Minister. As far as her new Treasury team were concerned, most Treasury civil servants were not ‘one of us’, and they had little time for their advice. When Treasury economists predicted a recession in 1980, they were ignored. (There was a recession.) As the young Treasury economist I was then, the contrast with the ever curious Denis Healey was quite shocking.

Even back then, Conservative ministers tended to seek advice from City economists rather than academic economists, which may be one reason why the record of Conservative Chancellors in running the economy from Thatcher onward is so much worse than the 13 years of Labour government. Part of the role of right wing think tanks is to hide that fact, which they do very successfully. It is why the 364 academic economists in 1981 who attacked Conservative macro policy are generally thought to have been wrong, when in reality they were broadly right. This was perhaps the beginning of the Conservative party’s disdain of experts who interfered with their ideological projects.

The use of partisan think tanks and experts by the political right is now well established in both the US and UK. In contrast the last Labour government was much more open in its use of at least economic advice, but its biggest mistake was in ignoring expert advice on Iraq. There may be some on the left that would like to replicate the way the political right works for Labour under its new leadership, by suggesting for example that conventional economists are inherently hostile to its policies.

But this is not how the Knowledge Transmission Mechanism (KTM) is supposed to work. Good ideas and good evidence do not have to come with a left, right or centre political label attached. When I have advised political parties or governments or economic institutions I have not given them advice which is only appropriate if the recipient wears a particular political colour. A good understanding of how the economy works does not require a particular political allegiance.

I wonder how much the trend towards the delegation of decisions to independent bodies, and suggestions to do more of that, is a reaction to this growing politicisation of expert advice. I was listening to an interesting Resolution Foundation podcast based on a new book from Paul Tucker, which was all about the conditions for successful delegation. One of the participants, Kate Barker, gave an example where she thought proposals for delegation went too far: the LSE’s Growth Commission.

I turned quickly to the Growth Commission’s 2017 report to see what Kate had in mind. I suspect it could be this.

“The ultimate objective is a long term industrial strategy that is isolated from political cycles. An independent body should strive to overcome fragmentation across different levels of government.”

Now there may be a case for delegating the implementation of an industrial body to an independent body, just as the implementation of monetary policy is delegated to the Bank in the UK. Just as Chancellors may alter the timing of interest rate changes for political ends, ministers may also skew the distribution of industrial policy to favour some constituencies over others. To a considerable extent this is what the Growth Commission proposes. But I suspect saying that you want industrial policy “isolated from political cycles” portrays an underlying deep discontent with how the Knowledge Transmission Mechanism has broken down.

This is not a post about the merits or otherwise of delegation (on which Paul Tucker has sensible things to say), but an attempt to describe one reason why experts or civil servants may be increasingly inclined to suggest delegation. Put simply, if politicians base policy on an ideology that requires shutting expertise out, independent bodies that let expertise back in become increasingly attractive.

Brexiter nonsense and policy entrepreneurs

Brexiters typically sound convincing if you know little about what they are talking about. Ian Dunt takes a typical example from Rees-Mogg (still favourite to be next Conservative leader). Rees-Mogg asserts, with absolute certainty, that a House of Lords committee have missed a crucial aspect of trade law related to WTO rules. Trade experts spend some time scratching their heads wondering what on earth he is talking about. They finally work out where the idea comes from, and why it has next to zero applicability to Brexit. (See also Jim Cornelius here.)

As Dunt points out, nonsense of this kind is effective. Because broadcasters often fail to match Brexiters with trade experts, they get away with their nonsense. By the time the nonsense is revealed as such, and enough people know why it is nonsense. the discussion has moved on and new nonsense appears. The fantasy that is Brexit remains intact at the level of public discourse.

Politicians like Rees-Mogg are not able to generate this nonsense themselves. How could they when they seem to spend most of their lives going from one broadcast studio to the next. Because this nonsense normally has some tenuous connection to reality, it has to come from someone with some knowledge of international trade and trade agreements. Welcome to the policy entrepreneur.

The term policy entrepreneur comes I believe from Paul Krugman’s first book from 1995, Peddling Prosperity, which unfortunately remains as relevant as ever. The book begins with the Laffer curve and the economists - including Laffer - who promoted the idea that cutting taxes would raise revenue. It is a typical piece of nonsense. It takes the reality that if taxes were 100% lots of people would stop working, and mutates this into the idea that taxes are already so high that cutting them would encourage more growth such that tax revenue will rise. It is typical political bullshit: giving an imagined respectable gloss on something that too many Republicans just wish were true.

But in the latter part of Peddling Prosperity things got personal, as Krugman describes how different policy entrepreneurs took some of Krugman’s own research and used it in a way Krugman would not to lobby President Clinton for trade protection. Economic theory suggests that if a profitable opportunity arises and there are no barriers to entry people will exploit that opportunity. I think the policy entrepreneur is a good example of that happening. Some politicians want to pursue a policy but want some kind of rationalisation for it, and the policy entrepreneur steps up with some nonsense erroneously derived from economics or some other discipline to provide that veneer of respectability.

Policy entrepreneurs can be academics: in the UK the most obvious example many would point to is Patrick Minford. But they can just be good lobbyists, who put themselves in the right place at the right time. In the case of Brexit, the policy entrepreneurs from whom the Brexiters get most of their information are in the Legatum Institute. BuzzFeed has a very good profile of their until recently director of economic policy, Shanker Singham. It is worth quoting from it.

“BuzzFeed News spoke to multiple economists, policy wonks, Conservative advisers, politicians, and journalists who said they’re baffled that he’s become so prominent in the Brexit debate. They say his standing in the trade world has been overblown. They don’t dispute that he knows the subject, but most hadn’t heard of him before he emerged at Legatum. They find it exasperating that he’s been portrayed in the UK as a vastly experienced trade negotiator, as if he were one of the decision-makers in the room when the world’s biggest trade agreements were hammered out. He wasn’t that close to the action, they say.”

But of course someone with more experience or more knowledge could not take Singham’s place, because they would not be the true believer that Brexiters require. When you have faith as the Brexiters have, you do not seek real knowledge, but just enough facts to sound good and thereby promote the cause.

Policy entrepreneurs, whether they are seeing a profit opportunity or really are true believers, are a symptom that what I call the knowledge transmission mechanism has broken down. As Krugman’s book indicates, Brexit is not the first time that policy entrepreneurs have helped politicians enact destructive policies. Here I argue that that the knowledge transmission also broke down when it came to austerity. (Paper here.) It is possible for policymakers to use intermediaries like civil servants to find the best research and use it - it has happened in the past - but today it seems like the exception rather than the rule.

Very Serious People and the deficit

I'm glad Paul Krugman liked my General Theory of Austerity paper. But he wonders whether I might be missing something, in not explaining why Very Serious People (VSPs) in the US, or mediamacro in the UK, presume that deficit reduction is always a good thing. The constant call for deficit reduction seems to transcends party politics, and furthermore should be something that the wise always promote.

I do talk about the influence of the City/Wall Street and central banks, but perhaps there is something in addition which I talked about in a recent post: deficit bias. Keynes talked about 'practical men' who tended to absorb some of the wisdom of 'academic scribblers' of 'a few years back'. The wisdom in this case was deficit bias: the tendency that many economists discussed before the financial crisis for deficits and debt to tend to rise over time, across cycles.  Perhaps VSPs and mediamacro have absorbed this particular area of academic analysis?

I think you can tell a similar story about academic scribbling of years past when it comes to the roles of monetary and fiscal policy. In the UK George Osborne argued explicitly that the economic consensus was now that monetary policy should deal with stabilising output and inflation, while fiscal policy makers should look after their own deficit. I have called this the consensus assignment. If he, or his advisors, absorbed this piece of conventional wisdom, so may VSPs and mediamacro.

So the headline academic scribbling was governments should control deficits, not the economy, and they are bad at it. Some of the theories put forward to explain deficit bias involve politicians knowingly deceiving voters by pretending tax cuts or spending designed to capture votes were 'affordable', and relying on general lack of understanding of the government finances to not be found out. That gives VSPs and the media more generally a clear role in providing a public service to help counteract the wickedness of politicians. VSPs might even think it was their public duty to constantly advocate deficit reduction to counter deficit bias.

As they say, a little knowledge can be a dangerous thing. Those of us working on the front line of monetary and fiscal interaction, or who had studied economic history or looked at the lost decade in Japan, knew the conventional assignment broke down when interest rates hit their lower bound. We knew that a liquidity trap was absolutely not the time to worry about deficits, and if you did so you would cause tremendous damage. And we were right.

So if you believe this story, the lesson for VSPs and mediamacro is you really need to talk to economists in the front line more often.

MMT and mainstream macro

There were a lot of interesting and useful comments on my last post on MMT, plus helpful (for me) follow-up conversations. Many thanks to everyone concerned for taking the time. Before I say anything more let me make it clear where I am coming from. I’m on the same page as far as policy’s current obsession with debt is concerned. Where I seem to differ from some who comment on my blog, people who say they are following MMT, is whether you need to be concerned about debt when monetary policy is not constrained by the Zero Lower Bound. I say yes, they say no, but for reasons I could not easily understand.

This was the point of the ‘nothing new’ comment. It was not meant to be a put down. It was meant to suggest that a mainstream economist like myself could come to some of the same conclusions as MMT writers, and more to the point, just because I was a mainstream economist does not mean I misunderstood how government financing works. It was because I was getting comments from MMT followers that seemed nonsensical to me, but which should not have been nonsensical because the basics of MMT are understandable using mainstream theory.

One comment on that earlier post provided a link to a very useful Nick Rowe post, who as ever has been there before me. This suggested that MMT assumed a vertical IS curve (there is no impact of interest rates on aggregate demand). If the IS curve is vertical, then it explains the puzzle I have. In the thought experiment I outlined in my previous post, if the government started swapping debt for money the decline in interest rates that would follow [1] would have no impact on demand, so there would be no rise in inflation. Indeed what else could it be besides an assumption of a vertical IS curve, as MMT does not deny that excess demand would lead to inflation at full employment.

I now think that is putting it too strongly. The view that many MMT writers have is that interest rates have an unreliable impact on demand relative to fiscal instruments. In that case of course you would have to use fiscal policy to control demand and inflation. That would be the focus of the fiscal rule. It is a similar regime to one I suggest would be appropriate for individual Eurozone countries. Inflation would be a discipline on deficit bias. [2]

What about a world where monetary policy did successfully control demand and inflation, which is the world I’m writing about? Evidence suggests you then need a fiscal rule stopping deficit bias (a gradual rise in the debt to GDP ratio over successive cycles). In a country with its own central bank (so no concern about forced default) and where all debt is owned domestically, the standard reasons why you would be concerned about deficit bias are intergenerational equity, crowding out of capital, and having to raise distortionary taxes to pay the higher debt interest bill.

There is a lot you can say on all three, but the point I want to make is simple. Being in that world means you do not need to worry about other sector balances because of their impact on demand. By being in that world at no point am I misunderstanding how government financing works, or ignoring the role of money. It does not mean I read the government budget constraint from left to right or vice versa! Yet I still get comments like this one left on a more recent post.

“Your political yourself Simon. One thing more than anything really annoys me. Why do you never announce or go public and say that taxes do not fund government spending?”

Comments like the one above, taken without context from some MMT paper, just appear stupid. By all means criticise my view that monetary policy is effective, or that rising debt has costs, but in future comments like that will just be ignored.

Let me make the same point using another example. Alex Douglas in a post argues that MMT does make an original contribution to political economy. He looks at a Warren Mosler claim that the state creates unemployment, and this is the only reason unemployment exists. It seems to me (with some additional help from Alex) that this involves two elements. The first sounds like a combination of points that mainstream economists might make: deficient demand exists because we are in a monetary economy, and some combination of monetary and fiscal policy can always get rid of deficient demand. The second is that money exists because the state requires taxes to be paid with it. Now I’m less sure about that second argument, but the point is that I can unpick what I agree with and what I do not using perfectly standard economic ideas. Yet if he had simply sent me a comment which said “the state currency is fundamentally a device for coercing labour” I wouldn’t have had a clue what he was talking about.

Now you might ask at this point why is it so important to be able to put MMT arguments in the language of standard macro. MMT is a coherent school of thought, using a language that those who have read the important texts understand. [3] Someone like me should just take the time out to read those texts. Well I have read some MMT papers, but I can assure you I have read many more than pretty well every mainstream macroeconomist I know. So what you may say. But it is a fact, and you may think it is an unfortunate fact, that mainstream macroeconomics is pretty dominant in both academic and policy circles. And it will stay that way: heterodox economists have been predicting the downfall of mainstream economics for longer than I have been an economist. [4] So if MMT is to have any influence, it will be through changing how mainstream macroeconomists think.

You gain that influence by properly understanding the mainstream. Bill Mitchell, writing in 2013, lambasts economists like me who try to suggest that the fixation with debt since 2010 does not come from mainstream macro. He does not believe it, and writes

“Why is there mass unemployment if government officials understood all our claims? It would be the ultimate example of venal dysfunctional politics to hold that that everybody knows all this stuff but are deliberately disregarding it – for what?”

But that is the tragedy of what has happened since 2010. Politicians, either out of panic or with ulterior motives, decided in countries with their own currencies that we should start worrying about the market no longer buying government debt, and austerity was the result. In this they were supported by a media that thought the government was like a household, and economists from the financial sector who had their own reasons for promulgating this myth. True, they did find support from some mainstream academic macroeconomists, but that support was never based on mainstream theory.

What mainstream theory says is that some combination of monetary and fiscal policy can always end a recession caused by demand deficiency. Full stop: no ifs or buts. That is why we had fiscal expansion in 2009 in the US, UK, Germany, China and elsewhere. The contribution of some influential mainstream economists to this switch from fiscal stimulus to austerity in 2010 was minor at most, and to imagine otherwise does nobody any favours. The fact that policymakers went against basic macro theory tells us important things about the transmission mechanism of economic knowledge, which all economists have to address.

[1] Bill Mitchell appears to suggest that in this case the central bank could maintain its interest rate by selling its stock of government debt. However pretty soon it would run out of assets to sell. This is exactly why some central bankers are reluctant to undertake helicopter money. One solution with helicopter money is to get the government to recapitalise the central bank, but of course to do that would involve creating more government debt. The central bank could start creating its own debt, but if governments stopped creating their own debt and asked the central bank to do it for them, nothing has really changed. 

[2] It is not clear to me that in such a world debt would always be tied down. A government that used an effective (in multiplier terms) fiscal instrument in booms (e.g. government spending) but an ineffective one in depressions (tax breaks for the wealthy) might experience an upward drift in debt. But what is clear is that in such a regime, concern about the debt stock should never justify significant departures from demand and inflation stabilisation.

[3] Although, as the range of comments to my earlier posts showed, what people understand MMT to mean varies quite a lot.

[4] I personally would not welcome the disintegration of macro back into separate schools of thought. Economists should be like doctors, and I do not want to have to ask my doctor what medical school of thought they belong to. I have relied on doctors using the same language and being able to understand each other. However I also realise that the unwise fixation of the current mainstream with microfoundations methodology can act as an exclusion mechanism, which encourages the formation of alternative schools of thought. This is yet another reason to be very critical of this methodological hegemony.  

Exploring one set of reasons why austerity happened

In a new paper (here or here) based on my talk at the IMK anniversary in Berlin, I discuss the intermediaries between academic economists and politicians. Very few politicians have much knowledge of economics themselves, and so rely on intermediaries to transmit that knowledge. One important intermediary, particularly if you are not in government, is the media, and another is what Paul Krugman called policy entrepreneurs. In government you have the civil service. In the case of fiscal policy, central banks are a potential intermediary.

In the paper I look at how needless austerity could represent a failure in that transmission mechanism. I do not think for one moment that they are as important a reason as political opportunism by those on the right that want a smaller state. But I still think they are important, particularly in helping to explain why so many on the left feel unable to counter the populist line that the government must ‘tighten its belt’ even in the midst of the deepest recession since the war.

It is also important in explaining how opportunist politicians can get away with it. Just imagine if central banks had used their models to quantify the impact of austerity, and had made that analysis public. Imagine also if there had been some authoritative way of conveying the wisdom of the majority of academic economists, like the National Academy of Sciences in the US or the Royal Society in the UK. In the UK and US I think that might have made a difference.        

Letter wars, and how policy is made

This one is UK focused, although similar points may apply elsewhere

First there was the letter in the Guardian written by economists providing support for Corbyn’s macroeconomic stance, and then there was a letter in the FT written by other economists suggesting Corbyn’s policies are potentially damaging. I was asked to sign both, but declined, so I can be completely impartial and objective! There are two ways to read this letters war, but it also tells us something about how economic policy can actually be made.

The first way to read the letters war is that this is all about which side you are on in the Labour leadership contest. That is the interpretation newspaper headlines give, and it is the case that there are committed Corbynites who signed the first letter and committed ABCs (Anyone But Corbyn) who signed the second. However the first letter explicitly states that not all its signatories support Corbyn, and some of the signatories of the second letter are clearly not Labour supporters.

The second reading is that the letters are about different things. The first letter focuses on austerity: “His opposition to austerity is actually mainstream economics”. The second talks about nationalisation and what should be called Corbyn’s QE. So another possible interpretation is there is no disagreement between the two letters. This reading is supported by the fact that the second letter says “public investment — in many areas much needed — can be financed conventionally”, which appears to be in tune with the first letter which attacks current austerity. As I have noted before, every academic economist I have read thinks now is a good time for higher public investment. (As far as I am aware, there was no letter to counter this attack by economists on Osborne’s new fiscal rules.) Finally the first letter does not explicitly endorse nationalisation or Corbyn’s QE.

So in terms of their texts the two letters could be quite consistent with each other. I am certainly against current and past austerity. I have also been publicly critical of Corbyn’s QE because of the (perhaps unintended) implications for Bank of England independence, and the (perhaps unintended) implicit acceptance of deficit constraints. Which is why I did not sign either letter, but perhaps I could also have signed both! [1]

As many economists signed each letter, I think both readings are correct. It is tempting at this point to lapse into a negative discourse about how hopeless letters are, or how hopeless economists are at writing letters and commenting on policy. In fact the opposite reading is correct. What the letters illustrate is how hopeless actual policy making on macroeconomic issues can be.

I think most people imagine politicians outside government as having at their disposal a huge network of assistants, each of which is plugged into a huge network of advice coming from individuals and think tanks. There is certainly a huge amount of advice out there, but you need some knowledge to filter good from bad, research based ideas from ideological ones etc. And that is the problem: there is no army of experienced assistants doing that job. Politicians instead often have to rely on a few (generally political) contacts and perhaps one or two inexperienced assistants.

It is therefore just inevitable that in something like a party leadership election you might see some poorly thought out policies. Politicians, or those that advise them, will not have the time or resources to filter and consult. That letters may follow should be no surprise. It is what happens next that matters. The danger is that politicians get committed. That is why those who have expertise need to shout loud and soon, by letter or any other means at their disposal.

So before you are tempted to make fun of poorly written letters and fall back on clichés about economists never agreeing, you need to suggest how else policy proposals could be criticised and debated. And before you criticise a politician for changing their minds, recognise the advice they initially get is often imperfect and changing their mind is often the wise thing to do. A culture that penalises ‘flip flopping’ leads to politicians who just follow convention and mouth platitudes, and in this Labour leadership election at least it is clear that is not what a good part of the electorate wants.

[1] Not really. I didn’t sign the first because I had clear misgivings about Corbyn’s QE. The second says things about nationalisation I either do not know about (efficiency), or that appear to accept a false view about the impact of privatisation/nationalisation on the public finances. If the state buys a profitable business at a fair price and keeps it profitable, there is no issue of fiscal space or ‘affordability’, just as privatisation per se does not improve the public finances. Economists of all people should see through this aspect of short term deficit fetishism. The only issue with privatisation/nationalisation should be which method of ownership/control is more efficient.   

Going backwards on fiscal rules

I was preoccupied when it first came out, but I wanted to note the excellent discussion by Jonathan Portes of the government’s new fiscal rules. It draws heavily on our joint paper on the same subject. (The published conference volume version is now available online for those with access: working paper version here.) Jonathan gives a typically measured analysis, and in my opinion the analysis is fully consistent with the sentiments expressed in the letter I discuss here.

Before some you say what’s new, note that in terms of the form of the rule, our paper and Jonathan’s discussion is rather supportive of the framework that Osborne introduced in 2010 as a way of conducting fiscal policy in normal times. Remember that this aimed to hit a rolling target for the cyclically adjusted current balance within five years. (The target happened to be zero, but there is no reason why the target could not be a number other than zero for the surplus or deficit.) The big problem was to apply this rule in a situation when interest rates were at their lower bound. That aside, the rule makes a lot of sense because it exerts some control while still allowing the deficit to be a shock absorber, which is what economic theory tells us it should be.

As Jonathan points out, and as I have discussed in earlier posts, Osborne’s new surplus rule goes backwards in two major ways. First, it is for the total deficit rather than the current balance, so it puts a squeeze on investment just at a time that investment should be high. (Aside to journalists: I cannot recall reading a single economist who disagrees that now is the time to increase public investment.) Second, even with the get-out clause on growth, the new rule is likely to make the deficit much less of a shock absorber, and so lead to unnecessary volatility in taxes or spending.

The question that naturally arises is how could a Chancellor replace his own (normal times) good rule with such a poor rule? A lot of the credit for the good rule should probably go to Rupert Harrison, and no doubt his background at the IFS probably helped here too. (Even more credit should be laid at his door for the establishment of the OBR.) Harrison has now left, but not before the surplus rule was proposed, so the puzzle still remains, particularly as Harrison must know that in economic terms his/Osborne’s original rule is clearly superior to the new one.

The simple answer is politics. All too often, Osborne’s budget decisions seemed to have been designed to embarrass the opposition (for which, I should add, the opposition have only themselves to blame). Short term political expediency once again triumphs over sensible long term economics. This is one reason we have independent central banks. It also seems to be another example of the failure of the knowledge transmission mechanism that I talked about here.

On this occasion I’m inclined to put some of the blame for this failure on academics. There is quite a bit of academic research which has relevance to fiscal rules, but few academics have tried to translate this into practical knowledge that governments can use. This in turn is because there is no incentive for them to do so: papers like Jonathan and mine are not the kind of thing that normally gets into the top journals. I have always thought that this is an obvious gap which fiscal councils like the OBR could fill, but at present the OBR has no remit to do so.     

The F story about the Great Inflation

Here F could stand for folk. The story that is often told by economists to their students goes as follows. After Phillips discovered his curve, which relates inflation to unemployment, Samuelson and Solow in 1960 suggested this implied a trade-off that policymakers could use. They could permanently have a bit less unemployment at the cost of a bit more inflation. Policymakers took up that option, but then could not understand why inflation didn’t just go up a bit, but kept on going up and up. Along came Milton Friedman to the rescue, who in a 1968 presidential address argued that inflation also depended on inflation expectations, which meant the long run Phillips curve was vertical and there was no permanent inflation unemployment trade-off. Policymakers then saw the light, and the steady rise in inflation seen in the 1960s and 1970s came to an end.

This is a neat little story, particularly if you like the idea that all great macroeconomic disasters stem from errors in mainstream macroeconomics. However even a half awake student should spot one small difficulty with this tale. Why did it take over 10 years for Friedman’s wisdom to be adopted by policymakers, while Samuelson and Solow’s alleged mistake seems to have been adopted quickly? Even if you think that the inflation problem only really started in the 1970s that imparts a 10 year lag into the knowledge transmission mechanism, which is a little strange.

However none of that matters, because this folk story is simply untrue. There has been some discussion of this in blogs (by Robert Waldmann in particular - see Mark Thoma here), and the best source on this is another F: James Forder. There are papers (e.g. here), but the most comprehensive source is now his book, which presents an exhaustive study of this folk story. It is, he argues, untrue in every respect. Not only did Samuelson and Solow not argue that there was a permanent inflation unemployment trade-off that policymakers could exploit, policymakers never believed there was such a trade-off. So how did this folk story arise? Quite simply from another F: Friedman himself, in his Nobel Prize lecture in 1977.

Forder discusses much else in his book, including the extent to which Friedman’s 1968 emphasis on the importance of expectations was particularly original (it wasn’t). He also describes how and why he thinks Friedman’s story became so embedded that it became folklore. The reason I write about this now is that I’m in the process of finishing a paper on the knowledge transmission mechanism and the 2010 switch to austerity, and I wanted to look back at previous macroeconomic crises.

If it wasn’t a belief in a long run inflation unemployment trade-off, what was it that allowed inflation to gradually rise during those two decades? Forder has a lot to say on this, but the following is my own take. I think two things were critical: the idea that demand management was primarily designed to achieve full employment, and that full employment had primacy over the objective of price stability. Although more and more economists over that period began to see the policy problem within a Phillips curve framework, many still hoped that other measures like prices and incomes policies (in the UK in particular but also in the US) could override the Phillips curve logic. The primacy of the full employment objective meant the problem was often described as ‘cost-push inflation’ rather than a rise in the natural rate of unemployment.

If you find this hard to imagine, think about historians discussing the current period in a possible future in 2050. By then nonlinearities in the Phillips curve and the power the inflation target had in anchoring inflation expectations were firmly entrenched in mainstream thinking. Imagine that partly as a result in 2050 the inflation target has been replaced by a level of nominal income target. With the benefit of hindsight these historians were amazed to calculate the extent to which resources were lost decades earlier because policy had become fixated by a 2% inflation target and budget deficits. They will recount with amusement at the number of economists and policymakers who thought that the way to deal with deficient demand was by ‘structural reform’. Rather than construct folk tales, they will observe that even when most economists realised what was required to avoid being misled again policymakers were extremely reluctant to change the inflation target.

Austerity as a Knowledge Transmission Mechanism failure

In this post I talked about the Knowledge Transmission Mechanism: the process by which academic ideas do or do not get translated into economic policy. I pointed to the importance of what I called ‘policy intermediaries’ in this process: civil servants, think tanks, policy entrepreneurs, the media, and occasionally financial sector economists and central banks. Here I want to ask whether thinking about these intermediaries could help explain the continuing popularity amongst policy makers of austerity during a liquidity trap, even though there is an academic consensus behind the idea that austerity now would harm output.

In this post I looked at various reasons for thinking there was such a consensus, and one of them was that the framework generally used to analyse business cycles was the (New) Keynesian model. In this Keynesian framework cuts in government spending when interest rates are stuck at their lower bound clearly reduce output, with multipliers around one or more.

Where are these models used in anger? Among academics studying business cycles of course, but also within central banks. As far as I know, pretty well all the core models used by central banks to do forecasting and policy analysis are (New) Keynesian. (This includes the ECB.) An important point about the delegation of stabilisation policy to independent central banks is that expertise on business cycles has tended to shift from civil servants working in finance ministries to economists working in central banks.

Suppose you are a policy maker, who is genuinely concerned about what impact cuts in government spending might have in the period after the Great Recession. Where would you, or your civil servants, go to find expertise on this issue? Given the above, one obvious source, and perhaps the main source, would be independent central banks. One big advantage that independent central banks have over academics as a source for the received wisdom on this issue is that they are a single point of reference. No need to ask the many economists working in the central bank - just ask the central bank governor, who you would expect to distil the wisdom of their own economists.

Following this logic, you might expect to find central banks shouting the loudest about the dangers of austerity. After all, they get the rap for deflation, so anything that makes their job more difficult and uncertain when interest rates have hit their lower bound they should perceive as especially unwelcome. In front of committees of congress/select committees and the like, they should be banging on about how they cannot be expected to do their job if politicians continue to make life difficult by deflating demand. If they did this, some politicians (particularly on the centre left) would have had ammunition with which to counter homilies about Swabian housewives and maxed out credit cards. 

Of course this does not happen. The extent to which it does not happen varies among the major banks. In the US Bernanke did very occasionally (and somewhat discretely) say things along these lines, but he seemed reluctant to do so in any way that might prove influential. In the UK Mervyn King is believed to have actively pushed for greater austerity, and the Bank of England has never to my knowledge suggested that austerity might compromise its control of inflation. The ECB, of course, always argues for austerity. It is one of the great paradoxes of our time how the ECB can continue to encourage governments to take fiscal or other actions that their own models tell them will reduce output and inflation at a time when the ECB is failing so miserably to control both.

So what is going on here? I think there are two classes of explanation, related to the distinction between the roles of interests and ideas in political economy (see Campbell here, for example). The first class talks about why the interests of the elite might favour austerity, and how these interests could be easily mediated through senior central bankers. It could also explore the interests of finance, and their close connections to central banks.

The second class might focus on ideas involving perceived threats to central bank independence. In the US, this might be nothing more than a desired quid pro quo whereby central bankers avoided mentioning fiscal policy so that politicians steer clear of comments on monetary policy. More seriously, amongst other central bankers it may represent a primal (and in the current context quite unjustified) fear of fiscal dominance: being forced to monetise debt and as a result losing both independence and control of inflation. In this context I often quote Mervyn King, who said “Central banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy.”

These ideas are in conflict with the message on fiscal policy coming from the central bank’s own models. In the UK and US, this contradiction is partly resolved by an excessive optimism about unconventional monetary policy. But it can also be resolved through overoptimistic forecasts, given that inflation targeting is in reality targeting future inflation. Although both these mechanisms come with a limited shelf life, they only need to operate for as long as austerity and the liquidity trap last.

The story I like to use about the Great Recession is that it exposed an Achilles’ heel with the consensus assignment that helped give us the Great Moderation. Yes, it was best to leave monetary policy to independent central banks, but the Achilles’ heel is that this would not work if interest rates hit their lower bound. In that situation fiscal policy had to come in as a backup for monetary policy. But if the analysis above is right the creation of independent central banks may have helped make that backup process much more difficult to achieve. By concentrating macroeconomic received wisdom in institutions that were predisposed to worry far too much about budget deficits, a huge spanner was thrown into the (socially efficient) working of the knowledge transmission mechanism.

  

Policy, risks and public discourse

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

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

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

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

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

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