A New Macropolicy Assignment

With central bankers rightly pessimistic about fighting recessions, maybe it is time to give that responsibility to politicians, while keeping central banks in charge of keeping inflation at target.

At the recent Jackson Hole conference of central bankers there seemed to be a general acceptance that central bankers just do not have the tools to effectively fight a new recession. I discussed some of the reasons here. The most familiar is the lower bound for nominal interest rates, but Anna Stansbury and Larry Summers argue that even before we get to the lower bound interest rates may be an ineffective stabilisation tool when they are very low. [1]

This is not a problem specific to this period of time. Most people agree that the natural real interest rate (the real rate at which inflation is stable) has fallen with little sign that this fall will be reversed. That means nominal interest rates are likely to remain low for decades. So its not just this recession where monetary policy is impotent, but every recession in the foreseeable future.

One response is that, as I argued in my earlier piece, central bankers should aim to develop new tools that are effective in recessions. This includes differential interest rates for borrowers and savers, and helicopter money. But for whatever reason central bankers are in no hurry to do this. Instead their current view is that fiscal policy needs to take some of the burden of fighting recessions.

Unfortunately for a variety of reasons many politicians in government have not got the message. In the Eurozone they are stuck with primitive fiscal rules that assume monetary policy can always control demand. In the US and perhaps the UK they think a fiscal stimulus is giving the rich tax breaks, which is perhaps the most ineffective way of stimulating demand.

More generally we have had decades were central banks were responsible for controlling inflation and avoiding downturns, and both politicians and the media (and to some extent economists) will require something more than one Jackson hole conference to shift this expectation. Maybe another recession might do it, but the largest recession since WWII failed to do the job. Part of the problem is that central bankers will try to fight the next recession with ineffective measures like Quantitative Easing, and this appearance of activity will fool too many into thinking they have the problem in hand.

As we saw in the last recession, the danger is not just that politicians will fail to fight a recession, but they may actually do the wrong thing. In their minds and also the minds of most media commentators, the central bank is responsible for controlling demand (and therefore fighting a recession) but politicians are responsible for controlling the deficit. This leads to a perverse response in an economic downturn if monetary policy is ineffective.

Macroeconomists call a simple division of labour between monetary and fiscal policy an assignment. What I call the conventional assignment is that interest rates control demand (and therefore inflation) and politicians control the deficit. I called this assignment conventional because it had become ingrained in the minds of economists, the media and politicians. Right now the conventional assignment is not working in terms of fighting recessions.

If central banks remain conservative in developing new tools, what we need to do is give back to politicians the responsibility for fighting economic downturns. One way of doing that is to take monetary policy away from independent central banks, and give it back to politicians. This would make politicians responsible for avoiding recessions as well as controlling inflation, and they will realise that a fiscal stimulus is a more effective means of doing this than any kind of monetary policy stimulus.

I do not want to rehearse the arguments for or against central bank independence (CBI), but simply note that the popularity of CBI comes from a suspicion that politicians are unreliable when it comes to fighting inflation. And unlike supporters of MMT I see no reason to believe that interest rates chosen by independent central bankers are not effective at moderating periods of excessive inflation.

My suggestion is instead a modified assignment. Central bankers remain responsible for controlling inflation, but politicians become responsible for fighting recessions. That is two different bodies managing the same variable - aggregate demand - but at different parts of the business cycle. Think of it like a car, with independent central bankers as the brake and politicians as the accelerator.

Cars are designed so it is difficult to push the accelerator and brake at the same time. We need something similar for this assignment: some way of coordinating between politicians and central banks so they don’t try to manage demand at the same time. The obvious coordination device is the adoption of a common belief about what the NAIRU is (or something similar to the NAIRU) and a common forecast (as actions will depend on expectations of future states of the economy).

The advantage of this asymmetric assignment is that it makes politicians responsible for tackling recessions, which in turn avoids a mistaken view that in a recession they should be controlling the deficit. In other words it is an assignment that rules out austerity. Any assignment that prevents austerity has to be worth considering.

[1] I will wait to see the paper before commenting on this idea, but there is no theoretical reason why the IS curve should be linear. What we need is some empirical evidence, but unfortunately the microfoundations hegemony means that is thin on the ground.

Real wages are mainly a macro issue

What do I mean by this? Macroeconomists have many faults, but one clear positive is that we think about systems as a whole rather than just one particular component. One area where it is important to do this is in thinking about what determines economy wide real wages. Take, for example, this recent post by the Flip Chart Rick. (His posts are brilliant and I try and read every one, but unfortunately this one is too good an illustration of the problem I have in mind.) He starts with this chart from the FT that I reproduce below.

Why is the UK unique in having a combination of negative real wage growth but positive GDP growth? Now it just so happened that I had written a post about this, explaining I thought pretty well the key reasons. But Rick mentions none of these, but writes about a whole bunch of stuff related to labour market structure and trade union power that I think are largely irrelevant. I think he is making the same mistake that people make when they say immigration reduces real wages, or that we would all be better off if only unions were more powerful.

All these things are important in influencing nominal wages, and perhaps the distribution of wages between workers. But real wages also depend on prices, which are set by domestic or overseas firms depending on where goods are made. If nominal wages go up, prices are likely to go up.

So what do I think accounts for the fall in real wages in the UK over the last decade? We need to start with GDP per head rather than GDP: growth in the latter has been boosted by immigration. Here is what has happened to GDP per head over the last ten years.

GDP per head fell in the recession, and then steadily but slowly recovered: the slowest recovery in at least a century. To see how that is related to real wages (using ONS average earnings divided by the CPI), which I call real consumer wages, we first need to look at an intermediary measure: real product wages. These are real wages divided by the price of UK output: the GDP deflator.

This is an interesting measure because its closely related to a simple identity relating GDP to labour income and profits. We can see that real product wages have not changed very much over this period: the recession mainly hit profits, or it created unemployment. (Real wages are wages divided the number of workers, GDP per head is GDP divided by the total population, which includes the unemployed.) But if we are comparing 2007 with 2015, real product wages were as stagnant as GDP per head.

So why did real consumer wages fall? That must be because consumer prices rose more than output prices. There are two reasons why this happened in this case: indirect taxes increased (remember the 2011 VAT hike), and a large sterling depreciation during the GFC worked its way into higher prices for imported goods. It is of course another depreciation after the Brexit vote that is cutting real wages once again right now. As I always try and stress, real GDP growth per head is not a good guide to real income growth if the price of imported goods rise or the price of UK goods sold overseas falls (what economists call a decline in the UK’s terms of trade).

Real wage growth in the UK has not been lousy because of lack of union power, immigrants or higher profits, but because economic growth (properly measured) has been stagnant, austerity included raising indirect taxes and we have now had two large depreciations in sterling. [1] That is not to say that these labour market factors are not important. At a macro level they are important in keeping inflation low, which should have allowed a more rapid expansion of GDP growth than we have actually had. That is where fiscal austerity and Bank of England conservatism come in. At a micro level labour market structure helps influence the distribution of earnings between different labour groups. [2]

What I say about the unimportance of profits is factually true for the UK over this period, but it is not always the case. In the US and elsewhere we have seen a gradual shift from wages to profits over the last few decades. But even here it is not obvious that weak nominal wage growth is the main cause, because in a competitive goods market lower nominal wages should get passed on as lower prices. One explanation that is attracting a lot of interest is the rise of superstar firms. These firms make unusually high profits, or equivalently have low labour costs, and if output is shifting towards these firms labour’s share will fall. What these firms do with their profits then becomes an important issue. More generally, it may be the case that governments have become too lax at breaking up monopolies, allowing a rise in the overall degree of monopoly.

The consequence of growing concentration, superstar firms and a rising share of profits is that income derived from profit grows faster than income from labour. I say derived from profit because I would include in this CEO and financial sector pay, which in effect extracts a proportion of profits from large firms. The net result is that most of the proceeds of economic growth are going to those at the top of the income distribution. But it would be good if we could change that by making the goods market more competitive and removing the incentive for CEOs to extract surplus from firms [3], rather than by making the labour market less competitive.

Technical appendix

For those who are lucky enough to have learnt economics using the Carlin and Soskice text, this is a classic application of wage and price setting curves. If workers become weaker, this shifts the wage setting curve towards the (perfect competition) labour supply curve, reducing the equilibrium real wage (unless the price setting curve is flat) but increasing the equilibrium level of employment. An increase in the degree of monopoly (the mark-up) shifts the price setting curve further away from the perfect competition labour demand curve, which reduces equilibrium employment as well as the real wage.

[1] One possible caveat here is that low wage growth may have encouraged firms to use more labour intensive production techniques, which has depressed investment and productivity. But if we want to incentivise firms to invest in more productive technology, increasing demand is a much better method than increasing nominal wages.

[2] Another caveat. I'm not sure where the real wage data in the FT chart comes from, but the fall in UK real wages there is greater than you get by using the ONS average earnings data (which I have used), so it may be a different and more specific measure of real wages. In which cases labour market structure might be relevant in explaining that number, and I apologise to Rick in advance if that is what he had in mind. 

[3] By, for example, applying much higher tax rates on high incomes, or imposing a maximum wage.  

Growth will be lower if the Conservatives win

The Conservatives want Brexit to be the central issue in this election. Partly as a result, the relative macroeconomic outlook under the different parties has not been discussed as much as it should, or as much as it was in 2015. The other reason it has not been discussed very much is that the economic record of the last seven years has been dire, but prospects under either Labour or the LibDems would be distinctly better. [1]

The last seven years have seen an extraordinary decline in real wages. To quote Rui Costa and Stephen Machin:

“Since the global financial crisis of 2007/08, workers’ real wages and family living standards in the UK have suffered to an extent unprecedented in modern history. Real wages of the typical (median) worker have fallen by almost 5% since 2008, while real family incomes for families of working age have just about recovered to pre-crisis levels.”

This stagnation in real wages is greater than any other advanced economy bar Greece. [2] In addition, as Laura Gardiner from the Resolution Foundation points out, current government policies imply the “biggest increase in inequality since Thatcher”. The less you earn, the more this government plans to take income away from you.

The Conservative response is to point to record levels of employment, and to keep saying ‘strong economy’. But these two apparently diverse developments, high employment and falling real wages, may be related in a very simple way: workers may have been forced to price themselves into jobs by keeping real wages low, or workers who might otherwise have retired are continuing to work to earn enough for their old age. When high employment is a symptom of no growth in living standards, it is nothing to cheer about. They both reflect a weak rather than a strong economy.

The different party manifestos have been discussed at length, but one aspect that has been almost totally ignored by the media has been their different macroeconomic implications. A lot of the responsibility for this lies with the IFS. As I wrote in a recent tweet, the “problem with IFS analysis of manifestos is not just the absence of macro dimension, but their failure to acknowledge it even exists.” **

Both the Labour and LibDem manifestos amount to an increase in public investment, and an increase in public spending financed by higher taxes, compared to current government plans. Standard macroeconomics implies that both higher investment and spending will lead to an increase in GDP, unless the Bank of England raises interest rates to exactly offset this effect. With interest rates currently stuck at their lower bound, and with public investment helping aggregate supply, that last possibility is extremely unlikely. The conclusion therefore has to be that GDP over the next few years would be higher under a Labour or LibDem government than under the Conservatives.

This is why, according to Larry Elliott, Oxford Economics estimate that “the economy would be 1.9% bigger under the Lib Dem plans and 1% bigger under Labour’s plans than under Conservative plans.” The argument that this cannot be done because it would involve some more borrowing is rightly dismissed as pre-Keynesian nonsense. It is for this reason that the IFS approach of ignoring macro is so helpful for the Conservatives. I understand that the IFS does not do macro, but its failure to even mention this gap in their analysis not only encourages mediamacro, but in the current situation represents a clear bias towards the Conservatives.

This is not the only reason why living standards would be significantly higher under a Labour/Lib Dem government. Just as the IFS ignores macro, I fear Theresa May ignores economics. In this post I noted her obstinate refusal to take foreign students out of their net migration target (causing considerable damage to one of our leading export industries), but more generally her obsession with reducing immigration is likely to do further damage not just to the public finances, but output and living standards too. It is increasingly clear that while the the coalition government (and in particular George Osborne) had no intention of meeting their immigration target, May regards it as an unfulfilled commitment despite the economic damage this would do. This marks a big difference between the Conservatives and Labour.

Finally, in comparing the economic outlook under a Conservative or alternative government, we should not ignore Brexit. After my previous post outlining why May is in many ways unsuited to the forthcoming EU negotiations, some comments were along the lines that surely Corbyn would be worse. I think not, for two reasons. You have to put out of your mind the government’s and media’s framing of these negotiations as some kind of poker game or battle of wills. They are much more like a cooperative exercise involving give and take. I see clear reasons for thinking that May/Davis will be worse at this than Corbyn/Starmer. Last but not least, I think there is no chance of a No Deal outcome under Labour, but a significant chance that the Conservatives would walk away. As Ben Chu points out, what is best for the UK economy might well be rather different from what Theresa May sees as best for Theresa May.

If the last 10 days of the campaign seem to ignore the outlook for the economy, there will be a very simple reason why. As a result of the manifestos, attitudes to immigration and Brexit, the UK economy will be better off and subject to less risk if Theresa May is no longer the Prime Minister after 8th June.

[1] Implicit in these two sentences is that the Conservatives tend to dictate the issues discussed by the media during an election, as was clearly the case in 2015.

[2] See also this New York Times piece from Simon Tilford, which presents a rounded picture of our performance relative to other European countries, rather than the carefully chosen snippets beloved by the government's spin machine.

** In the original version of this post I said that the IFS analysis assumes GDP would be fixed. This is incorrect: what I had missed is that they do allow a short term impact from additional public investment on GDP (see slide headed 'Impact on the Economy' here). However this slide illustrates exactly the concern I have.
(1) It makes no sense to allow a short term impact from public investment, but no short term impact from a balanced budget increase in public spending.
(2) The slide says that the long term positive impact of this public investment on GDP will be exactly offset by the macro impact of a higher minimum wage and additional public holidays. Is this a result of detailed macro analysis, or just a convenient assumption?
(3) The slide also says that the Conservative commitment to reduce immigration would weaken growth and public finances, but despite this they assume no impact of lower immigration on growth. This makes no sense whatsoever, unless we are working backwards from the fixed long run GDP assumption. 

Attacking economics is a diversionary tactic

Forgive the numbered note form. For some reason it seems appropriate to me in this case

1. The financial crisis in the UK was the result of losses by banks on overseas assets, originating from the collapse in the US subprime market. It was not a result of excessive borrowing by UK consumers, firms or our government. As the Bank’s Ben Broadbent points out, “Thanks to the international exposure of its banks the UK has been, in some sense, a “net importer” of the financial crisis.” This overseas lending caused a crisis because banks were far too highly levered, and so could not absorb these losses and had to be bailed out by the government.
   
   
2. This is why UK macroeconomists failed to pick up the impending crisis. They did routinely monitor personal, corporate and government borrowing, but not the amount of bank leverage. Macroeconomists generally acknowledge that they were at fault in ignoring the crucial role that financial sector leverage can play in influencing the macroeconomy. There has been a huge increase in the amount of research on these finance-macro linkages since the crisis.
   
   
3. But supposing economists had ensured that they knew about the increase in bank leverage and had collectively warned of the dangers of excessive risk taking that this represented. Would it have made any difference? There are good reasons for thinking it would not.
   
   
4. The main evidence for this is what has happened after the crisis. Admati and Hellweg have written persuasively that we need a huge increase in bank capital requirements to bring the ‘too big to fail’ problem to an end and avoid a future banking crisis, and the work of David Miles in the UK has a similar message. I have not come across an academic economist who seriously dissents from this analysis, but it has no impact on policy at all. The power of the banking lobby is just too strong.
   
   
5. So the response of economists to the financial crisis has been as it should be. The error in neglecting bank leverage is being addressed. Economists have come up with clear proposals about how to avoid the crisis happening again. And these proposals have been pretty well ignored.
   
   
6. In terms of conventional monetary and fiscal policy, academic economists got the response to the crisis right, and policymakers got it very wrong. Central banks, full of economists, relaxed monetary policy to its full extent. They created additional money, rightly ignoring those who said it would bring rapid inflation. Many economists, almost certainly a majority, supported fiscal stimulus for as long as interest rates were stuck at their lower bound, were ignored by policymakers in 2010, and have again been proved right.
   
   
7. So given all this, why do some continue to attack economists? On the left there are heterodox economists who want nothing less than revolution, the overthrow of mainstream economics. It is the same revolution that their counterparts were saying was about to happen in the early 1970s when I learnt my first economics. They want people to believe that the bowdlerised version of economics used by neoliberals to support their ideology is in fact mainstream economics.
   
   
8. The right on the other hand is uncomfortable when evidence based economics conflicts with their politics. Their response is to attack economists. This is not a new phenomenon, as I showed in connection with the famous letter from 364 economists. With austerity they cherry picked the minority of economists who supported it, and then implemented a policy that even some of them would have disagreed with. (Rogoff did not support the cuts in public investment in 2010/11 which did most of the damage to the UK economy.) The media did the rest of the job for them by hardly ever talking about the majority of economists who did not support austerity.
   
   
9. The economic costs of Brexit is just the latest example. Critics have focused on the most uncertain and least important predictions about Brexit, made only by a few, to attack all Brexit analysis. The fact that this prediction involved an unconditional macro forecast, while the assessment made by a number of groups about the long term cost involves a conditional projection based largely on trade equations, seems to have completely escaped the critics. More important, the fact that the predicted depreciation in sterling happened, and is in the process of already causing a large drop in living standards, is completely ignored by these critics.
   
   
10. Attacking economists over Brexit is designed to discredit those who point out awkward and uncomfortable truths. Continuing to attack economists over not predicting the financial crisis, but failing to ignore their successes, has the effect of distracting people from the group who actually caused this crisis, and the fact that very little has been done to prevent a similar crisis happening in the future.
    

Competitiveness: some basic macroeconomics of monetary unions

From comments on an earlier post, it is clear how many people do not understand how a monetary union works. Thinking about it, I also realise that while the macroeconomics involved is entirely straightforward and uncontentious, it may only be obvious to someone who is used to working with models. As I do not want to restrict my readership to those with such knowledge, I thought a brief primer might be useful.

We need to start with the idea that for a country with a flexible exchange rate, you will not increase your international competitiveness by cutting domestic wages and prices. The reason is that the exchange rate moves in a way that offsets this change. This is what economists might call a basic neutrality proposition, and there is plenty of evidence to support it. The Eurozone as a whole is like a flexible exchange rate economy. So if wages and prices fall by, say, 3%, then the Euro will appreciate by 3%.

So what happens if just one country within the Eurozone, like Germany, cuts wages and prices by 3%. If Germany makes up a third of the monetary union, then overall EZ prices and wages will fall by 1%. Given the logic in the previous paragraph, the Euro will appreciate by 1%. That means that Germany gains a competitive advantage with respect to all its union neighbours of 3%, plus an advantage of 2% against the rest of the world. Its neighbours will lose competitiveness both within the union and to a lesser extent against the rest of the world.

That may seem complicated, but to a first approximation it is in fact very simple. The Eurozone as a whole gains nothing: the gains to Germany are offset by the losses of its union neighbours. For the union as a whole, it is what economists call a zero sum game. Germany gains, but its EZ neighbours lose.

One of the comments on this earlier post said that there was nothing in the ‘rules’ to prevent this, the implication being that therefore it was somehow OK. But it must be obvious to anyone that this kind of behaviour is very disruptive, and hardly compatible with Eurozone solidarity. An idea sometimes expressed that it represents healthy competition is wide of the mark. The only incentive it provides is for other countries to try and emulate this behaviour. If they all achieved that, nothing would be gained. The Eurozone inflation rate would, other things being equal, be lower, but other things would not be equal: the ECB would cut rates to try and get inflation back to its target.

The reason there are no formal rules about all this is straightforward: you cannot legislate about national inflation rates. What you could do, to incentive governments, is establish fiscal rules based on inflation differentials of the kind described here. That would have meant that as relative German inflation rates fell, the government would have been obliged to take fiscal (and perhaps other) measures to counteract it. Once again, this is a symmetrical case to what should have happened in the periphery countries. But if rules of this kind had been on the table when the Euro was formed, I’ll give you one guess about which country would have objected the most.

What do macroeconomists know anyway?

In an article in the Independent today I argue that what goes for a ‘credible’ economic policy among politicians and the media is often very different from what an academic economist might describe as credible. Which invites the obvious response: who cares, what do academic economists know anyway? So I look at what I regard as the three major macroeconomic policy disasters in the UK over the last 35 years, and one success.

The success was the decision not to join the Euro in 2003. It is pretty clear that this was the right decision, and it was made after what may have been the most extensive academic consultation ever undertaken by the Treasury, coupled with substantial macro analysis. (I talk more about this here.) The Prime Minister Tony Blair was initially in favour of joining, but the analysis helped persuade him otherwise.

The first failure was Mrs. Thatcher’s monetarism, which was famously opposed by 364 economists. Those on the right have tried to spin this as a failure by the economists, but the actual policy framework of money supply targets was a complete disaster and was quickly abandoned, never to be tried again. (Here is a discussion, and here is an account from one of the two movers behind the letter.)

Current austerity we all know about: if not, read this.

The third disaster was the UK’s entry into the European Exchange Rate Mechanism (ERM) in 1990 at an overvalued exchange rate, and the subsequent recession and forced exit in 1992. My argument that this went against macroeconomic analysis needs some justification. At the time I was in charge of macroeconomic research at the National Institute (NIESR) in London, and I undertook with colleagues what was easily the most extensive analysis of the consequence of entry into the ERM at different exchange rates. This was subsequently published in 1991, but all the material was first presented before we entered the ERM.

We concluded that the UK’s actual entry rate was 10-15% above the equilibrium rate. The implication was unavoidable: either we would be forced out, or trying to stay would lead to a recession as part of an ‘internal devaluation’. I remember Sam Brittan, one of the main writers at the FT at the time, saying that he thought we had won the intellectual argument, but that his instinct was still that we should enter at a high rate.

After entry into the ERM the UK entered a recession, and we were then forced out just two years later. Our analysis was vindicated. It is true that the whole system eventually collapsed as a consequence of the tight monetary policy that followed German unification, but it is no accident that the UK was the first to go (Black Wednesday). On leaving the ERM sterling depreciated by 10%, and the UK recovered quickly from recession.

There is no doubt that had the Treasury taken our advice and entered at a lower rate, less jobs would have been needlessly lost. I have often wondered if I could have done things differently to make a more persuasive case. But honestly I doubt it: the almost macho appeal of entering at a ‘strong’ rate was too great, together with the idea that the market knew best. As I say in The Independent, macroeconomists are far from perfect, but the UK evidence suggests that you ignore their advice at your peril.

Economic credibility

The UK’s Labour leadership election has become a two horse race: Jeremy Corbyn on the left, versus ABC. I must admit that it took me a bit of time before I realised who ABC was - it is Anyone But Corbyn. It is quite an achievement not only to become the candidate everyone is talking about, but also to be able to define your opponent as well. The last time I can remember that happening was - well, the 2015 UK general election maybe!

Anyway, a constant refrain of ABC is that Labour can only win if it has economic credibility, with the implication that Corbyn’s economics are a bit wacky. As I argued here, some of Corbyn’s macro proposals are misconceived, and if the implication of them is that the Bank of England would lose its independence then they also go against the view of most mainstream macroeconomists. That, by the way, is why I did not sign this letter, even though I agree wholeheartedly that “his opposition to austerity is actually mainstream economics”.

In the last paragraph I played a little trick that I hope most of you would not have noticed, and that is to equate ‘economic credibility’ with ‘mainstream (macro)economics’. If that seems reasonable to you, think about the following. In 2009, most of the world was following mainstream economics in undertaking a fiscal stimulus to combat the impact of the financial crisis. But in the UK a certain politician decided to ignore ‘economic credibility’, and instead proposed doing the opposite: what has subsequently become known as austerity.

What was the intellectual basis of his departure from economic credibility? Could it have been that fiscal contractions were actually expansionary, an idea that certainly qualifies a whacky. Was it the idea that the central bank, by using a completely untried and untested instrument, had everything under control? Or was it something else. The honest answer is we do not know, which is interesting in itself. But what is absolutely clear, based on surveys and other evidence, is that his advocacy of fiscal contraction in 2009 went against what most macroeconomists thought were the implications of their discipline.

You know the rest of the story. By departing from mainstream macroeconomics, George Osborne arguably won not one but two elections. Does his example show that there is nothing wrong with departing from ‘credible economics’ - it could even win you elections? That is perhaps the lesson some in the Corbyn camp would like to draw. It certainly suggests that there is very little relationship between policies that have ‘economic credibility’ and mainstream economics. Economic credibility, as used by politicians and the media, seems to be something rather different. As Chris Dillow suggests, it can mean acceptable to the Westminster-media Bubble, but that in turn may derive from some concoction of views that serve dominant political interests, and in macro the views of the financial sector and central banks.

If you want a non-macro example, consider the minimum wage. Setting the right level for this is a delicate balance, requiring all the empirical knowledge that labour economists have gleaned. In the UK we have an institution, the Low Pay Commission, to get this judgement right. That same George Osborne threw all that aside in his last budget because it was politically convenient to do. Did he get berated from all quarters for not following ‘credible economics’? Of course not.

Unfortunately, I think ABC are right that something called economic credibility matters a great deal when it comes to winning elections. Also unfortunately, I think they do not realise that economic credibility is something that gets defined in a complex social and political process, and can (and currently does) have very little to do with the economics taught in universities. Right now, in the UK and elsewhere, I think the political right understands that, but the political left of whatever variety does not.

The trouble with macro

Diane Coyle, writing in an FT blog, says

 “There are two tribes of economists, the macro and the micro. I’m one of the latter group. We have our empirical controversies, of course – much of our applied research concerns public policy choices in areas such as education and health, so vigorous disagreement is inevitable. But I think it’s fair to say that few of the micro disagreements compare in intensity to the all-out war of words between different macroeconomists about the effects of fiscal stimulus or austerity.”

She goes on to say that it is macroeconomists’ “certainty that’s astonishing”. Her comments could be summarised as asking why macroeconomists are so sure and shrill compared to their micro colleagues.

Now it could be that there is something odd about those who choose macro rather than other types of economics, but I’m not sure I’ve noticed any character traits more evident in macro people. (But who am I to judge - an open invitation for microeconomists to comment!?) It could be something to do with the nature of the theory and empirics involved, but since macro became microfounded that seems unlikely. I think the problem is in a way much more straightforward.

I think you only need to look at the recent UK election to understand the problem. One of the central themes of the Conservative’s attack on Labour involved their alleged incompetence at running the macroeconomy when they were in power. For whatever reason, macro rather than micro policy issues become central in political debates. That makes macro unusual for various reasons.

One immediate consequence is that many beyond the tribe of macroeconomists think they can write with authority of macroeconomic issues. As a recent example of a shrill macro debate Diane cites Krugman vs Ferguson. But this is not to compare like with like. On one side you have an economics Nobel Prize winner who has made important contributions to macroeconomics, and as a result is careful about what he writes. Both data and theory are respected. On the other side … well I’ve said what I think in an earlier post.

To take another politically charged topic, I have seen plenty of debates between climate change scientists and deniers who are not scientists. Often the scientist will go into detail to get the facts straight, and say how uncertain everything is, while their opponent by contrast will be confident and clear. A scientist will not be fooled by this confidence, but many others will be. When one side argues out of conviction or ideology or political bias rather than knowledge, it is difficult for someone who does have that knowledge not to respond in kind if they want to be convincing.

There is a deeper reason for shrillness, however. The debate over austerity is not a normal academic discussion about the likely size of parameter values. Here Diane is mistaken in saying that the key issue is whether the multiplier (the size of the impact of cuts in government spending on output) is greater or less than one. In talking about UK austerity, I have typically quoted OBR figures which assume a multiplier below one, which gives me the £4000 per average household cost of UK austerity. My own best guess would be that the multiplier has been larger than one, which gives me significantly higher costs, but I have never suggested that I know with certainty what the size of the multiplier has actually been. However there has, to my knowledge, been no public debate on these terms.

Instead supporters of austerity typically want to suggest that the multiplier is close to zero. They want to suggest that sacking nurses and cutting back on flood defences will be very rapidly met by an increase in private sector labour demand and investment. Although theoretically possible via various different mechanisms, the evidence and recent experience overwhelmingly suggests this does not normally happen in the kind of situation we are currently in. For much of the time those arguing for the virtues of current austerity seem to be doing so from a position of faith or political convenience rather than evidence.

Why is it important to recognise this? Because there is a danger that microeconomists may misdiagnose the problem, and suggest that macro contains some fundamental flaw which undermines eighty years of intellectual endeavour. This provides useful cover to those who have an ideological or political agenda, and want policymakers to ignore the bits of the discipline that clearly work. Sometimes microeconomists seem to think that if only they could disassociate themselves from macro, economics would become a better and more respectable subject. That is an illusion: the ideological and political forces that cause such problems for macro are not unique to it.

So I’m not sure that academic macroeconomists suffer from an excess of certainty compared to their micro colleagues. Instead I think the trouble with macro is that it is prone to ideological and political influence: like all economics, but just more so.

Misunderstanding macroeconomic models

The first half of this post is meant for non-economists, but it ends with a couple of points on OLG modelling

I recently wrote a post on the Eggertsson and Mehrotra paper on secular stagnation, because I thought the paper was interesting. A much more critical post from Unlearning Economics (UE) has just appeared in Pieria. UE says it “helps to illustrate the troubles faced by contemporary macroeconomics”. One of UE’s complaints seems to reflect a misunderstanding, often shared by non-economists, about what much academic macromodelling is designed to do.

UE objects to the fact that the model assumes that the amount the young can borrow (the degree of leverage) is exogenous, which means that there is no attempt to explain where this constraint on the borrowing of the young comes from. UE also complains that the model contains no banks, and no investment in physical capital. In other words, the model is much too simple. It is a natural enough idea: to explain what might be currently going on, you need a more complex model that includes everything that could be important.

There is certainly a place for this kind of more elaborate model. Christiano, Eichenbaum and Trabandt in this paper want to argue that a model based on New Keynesian theory can track what has happened over the last ten years. Their model has 40 equations. If I was trying to do a similar exercise, I would want to augment the standard New Keynesian framework with at least the following: nominal wage stickiness as well as price stickiness, a financial sector that endogenised both the cost and rationing of credit, a model of consumption which allowed for credit constraints and precautionary saving, a housing market, a model of the labour market that combined matching with rationing (as here), and something that allowed recessions to have long lasting (hysteretic) impacts on labour supply and technical progress. However large models like this will involve many macroeconomic ‘mechanisms’, and it will generally be unclear which mechanisms are important at driving particular results or explaining particular facts. We do not want to treat the elaborate model as a black box, but instead we want to understand its properties.

To understand complex models, we need much simpler models. (I once - in this paper - called the process of relating complex models to simpler models ‘theoretical deconstruction’.) In fact it is often sensible to start with the simpler model. For example, a particular issue with secular stagnation is to show how the natural real interest rate can be negative for decades rather than years (i.e. beyond the Keynesian short term)? What mechanism can do this? As I explained in my post, neither a standard representative agent model nor a standard two period overlapping generations model (OLG model, where the two generations are those earning and those retired) will give you that result. What Eggertsson and Mehrotra show is that a very simple three period OLG model (which adds a young generation that borrows) where borrowing by the young is constrained (they would like to borrow more but cannot) can provide just that mechanism.

That is a key point of the paper. The paper is not designed to explain where borrowing constraints come from: there is now a big literature on that. Thankfully the authors do not feel compelled to microfound these constraints. Instead the paper simply offers and explores a mechanism whereby an increase in these borrowing constraints could move the natural interest rate into negative territory, and for it to stay there. Having established that result, it is for subsequent work (which the authors intend to do) to see if that mechanism survives complicating the model, by for example adding investment.

Suppose the endeavour is successful, and a more complex but realistic model is able to provide an account of secular stagnation that includes other important mechanisms and which is based on a realistic set of parameter values. That would be a success, but those not familiar with all the work would ask: why does this model allow real interest rates to be negative when the standard models we know do not. The reply would be that the three period OLG structure was critical, and to see why have a look at the original, simple model.

Now you might say the authors should wait until they have built the more realistic model before creating what could turn out to be a research path that might fail to achieve its goal. That would be quite wrong, because the more debate there is within the academic community when ideas are at their early stages the better. I want to give an example of this, but here I will go into territory that will probably only interest macroeconomists.

It might be the case, for example, that the authors intuition that their results will survive introducing other assets like physical capital can be shown to be wrong very quickly. Indeed, Nick Rowe has already made such a claim, arguing that the presence of land as an asset ensures a positive real interest rate. If Nick was right this could be enough to kill the research programme, without any more time being wasted. Whether he is right is another matter: this paper by Rhee may be relevant in that respect.

Here I just want to add a final thought. Within an OLG framework, it may not be necessary to establish the existence of a steady state with negative real interest rates. The typical period in an OLG model lasts two or more decades. So if the dynamics of such a model involved some overshooting, it might be possible to generate prolonged periods (in years) of negative interest rates even if the steady state real interest rate was positive. To be honest I’m not sure what might give rise to overshooting of this kind, but that may just reflect my inadequate imagination.  

Banks, economists and politicians: just follow the money

Economics rightly comes in for a lot of stick for failing to appreciate the possibility of a financial crash before 2007/8. However it is important to ask whether things would have been very different if it had. What has happened to financial regulation after the crash is a clear indication that it would have made very little difference.

There is one simple and straightforward measure that would go a long way to avoiding another global financial crisis, and that is to substantially increase the proportion of bank equity that banks are obliged to hold. This point is put forcibly, and in plain language, in a recent book by Admati and Hellwig: The Bankers New Clothes. (Here is a short NYT piece by Admati.) Admati and Hellwig suggest the proportion of the balance sheet that is backed by equity should be something like 25%, and other estimates for the optimal amount of bank equity come up with similar numbers. The numbers that regulators are intending to impose post-crisis are tiny in comparison.

It is worth quoting the first paragraph of a FT review by Martin Wolf of their book:

“The UK’s Independent Commission on Banking, of which I was a member, made a modest proposal: the proportion of the balance sheet of UK retail banks that has to be funded by equity, instead of debt, should be raised to 4 per cent. This would be just a percentage point above the figure suggested by the Basel Committee on Banking Supervision. The government rejected this, because of lobbying by the banks.”

Why are banks so reluctant to raise more equity capital? One reason is tax breaks that make finance using borrowing cheaper. But non-financial companies, that also have a choice between raising equity and borrowing to finance investment, typically use much more equity capital and less borrowing. If things go wrong, you can reduce dividends, but you still have to pay interest, so companies limit the amount of borrowing they do to reduce the risk of bankruptcy. But large banks are famously too big to fail. So someone else takes care of the bankruptcy risk - you and me. We effectively guarantee the borrowing that banks do. (If this is not clear, read chapter 9 of the book here.  The authors make a nice analogy with a rich aunt who offers to always guarantee your mortgage.)

The state guarantee is a huge, and ongoing, public subsidy to the banking sector. For large banks, it is of the same order of magnitude as the profits they make. We know where a large proportion of the profits go - into bonuses for those who work in those banks. The larger is the amount of equity capital that banks are forced to hold, the more the holders of that equity bear the cost of bank failure, and the less is the public subsidy. Seen in this way it becomes obvious why banks do not want to hold more equity capital - they rather like being subsidised by the state, so that the state can contribute to their bonuses. (Existing equity holders will also resist increasing equity capital, for reasons Carola Binder summarises based on the work of Admati and Hellwig and coauthors.)

This is why the argument is largely a no brainer for economists. [1] Most economists are instinctively against state subsidies, unless there are obvious externalities which they are countering. With banks the subsidy is not just an unwarranted transfer of resources, but it is also distorting the incentives for bankers to take risk, as we found out in 2007/8. Bankers make money when the risk pays off, and get bailed out by governments when it does not.

So why are economists being ignored by politicians? It is hardly because banks are popular with the public. The scale of the banking sector’s misdemeanours is incredible, as John Lanchester sets out here. I suspect many will think that banks are being treated lightly because politicians are concerned about choking off the recovery. Yet the argument that banks often make - holding equity capital represents money that is ‘tied up’ and so cannot be lent to firms and consumers - is simply nonsense. A more respectable argument is that holding much more equity capital would translate into greater costs for bank borrowers, but David Miles suggests the size of this effect would not be large. (See also Simon Johnson here, John Plender here and Thomas Hoenig here.) In any case, public subsidies are bound to be passed on to some extent, but that does not justify them. Politicians are busy trying to phase out public subsidies elsewhere, so why are banks so different?

There is one simple explanation. The power of the banking lobby (and the financial industry more generally) is immense, from campaign contributions to regulatory capture of various kinds. It would be nice to imagine that the UK was less vulnerable than the US in this respect, but there are good reasons to think otherwise. [2] As a result, the power and influence of banks and bankers within government has hardly suffered as a result of the Great Recession that they played a large part in creating.

So to return to my original question, would it really have made much difference if more mainstream economists had been fretting about the position of the financial sector before the crisis? I think they would have been ignored then even more than they are being ignored now. The single most effective way of avoiding another financial crisis is to reduce the political influence of the banking sector.      

[1] The optimum amount of equity is not 100%, in part because some (subsidised) borrowing does increase discipline on bankers. For a good discussion of other measures that might reduce the too big to fail problem, see this speech from Andy Haldane. An alternative to the state picking up the bill is to inflict losses on depositors, but the economic problems with this are pretty obvious. Nicolas Véron discusses the difficulties the Eurozone has got itself into with this following the Cyprus crash: see also Simon Johnson here.

[2] In Europe, we had what Mark Blyth describes as the biggest bait-and-switch operation in modern history, where a banking crisis involving private sector debts was turned into a public sector debt crisis. While I would be the last person to defend the macroeconomics status quo, I also think there is an element of bait and switch in the ‘macroeconomics in crisis’ idea. Macroeconomic theory tells us a lot of useful things about how to get out of the recession, if only politicians would take some notice.  

Macroeconomic Theory and the Multiplier

I agree with most of what John Quiggin says in his post on fiscal multipliers, but I started having problems towards the end when he writes:

“To sum up, despite the thousands of papers published every year in the field, macroeconomic theory is incapable of giving even a qualitative answer to the most basic questions about fiscal policy[3]; at least, not one that would not elicit dissent from a substantial, and well-credentialled group of leading experts.”

The footnote reads

“[3] While writing this, I wondered what would happen if you put this question to a group of DSGE theorists as a pop quiz. I suspect most would give some variant of “the question is ill-posed” and the rest would be all over the place. But, if any DSGE theorists are reading, I’d be keen to get their views.”

OK, I have written a fair number of published DSGE papers on fiscal policy over the last decade, so here is my response. New Keynesian theory, and therefore the New Neoclassical synthesis, provides pretty clear answers to the multiplier question. I have talked about this before so I will not repeat these answers here. Macroeconomic theory is ‘all over the place’ on many issues, but this is not one of them. I would go further. If policymakers had paid more attention to theory, and less to a well known piece of empirical work, they would have been less likely to have made the mistakes they have.

The problem is not ambivalent theory, but the fact that a large section of macroeconomists choose to ignore or discount the relevant theory. Now this is actually consistent with the sentence from John Quiggin’s post that I quote above, because of the part that says ‘at least ....’. So in that sense it is a quibble. But I think it is an important quibble. There is a great deal of difference between suggesting that theory is all over the place, and saying that a large body of theory – the theory used by nearly all monetary policymakers – is pretty clear, but that a significant group of economists do not accept it.

The difference comes in the following paragraph, where he says “It really is hard for me to see how the economics profession can recover from its current rotten state, at least as regards macro..” If a large section of the profession (perhaps even a majority) subscribes to the New Neoclassical synthesis framework, and that framework is sound (if far from perfect), then we still have a problem, but one that does have solutions.