Macroeconomic innumeracy

Anthony Seldon is perhaps best known for his biographies of recent UK Prime Ministers. He had a column in the FT recently, which suggested that the Prime Minister’s team had done rather better than popular perception might suggest. Two sentences caught my attention: “Credit for sticking to the so-called Plan A on deficit reduction must be tempered by the government’s reluctance to cut more vigorously” and “Downing Street insiders can claim to have managed to steer…..the recovery of a very battered economy”.

The first sentence suggests that the government stuck to its original 2010 deficit reduction plan, but it should have cut spending by more than this plan. I disagree with the opinion in the second part of the sentence, but that is not the issue here. The problem is that the factual statement in the first part of the sentence is very hard to justify. The numbers suggest otherwise, as Steven Toft sets out here. The second sentence also indicates no acquaintance with the numbers. As the well known (I thought) NIESR chart shows, this has been the slowest UK recovery this century - including those in the 1920s and 1930s. The financial crisis certainly battered the UK, but it also hit the US pretty hard too! Yet average growth 2011-13 in the US was 2.2%, in the UK 1%. The idea that macroeconomic mismanagement left the UK economy in a peculiar mess before the financial crisis is a politically generated myth which is also divorced from the data, as I have argued on a number of occasions.

In one sense it is unfair to single Anthony Seldon out in this respect, because I hear similar mistakes all the time from UK political commentators who profess to be, and may honestly believe they are, objective when it comes to macroeconomic reporting. I suspect the problem is threefold. First, the common feature of these mistakes is that they are repeated endlessly by the government and its supporters. Second, there is group self-affirmation - what Krugman calls ‘Very Serious People’ talk to each other more often than they talk to people acquainted with the data. Third, when some of this group do look for economic expertise, they often talk to ‘experts’ in the City or read the Financial Times. Unfortunately, both sources can and do have their own agendas.

Yet in another sense it is not unfair, because Seldon is a historian, and historians stress the importance of accessing primary sources. The main positive point I want to make is that political commentators need to check the data if they want to avoid making macroeconomic statements that are factually incorrect.      

When the definition of a recession matters

The official definition of a recession in nearly all developed economies except the US is two consecutive quarters of negative growth. In the US a recession is ‘called’ by the NBER. Economists, of course, just look at the numbers. This is obviously the sensible thing to do, because a fall in GDP of 3% followed by positive growth of 0.1% is clearly worse than two periods of -0.1% growth, but only the latter is an official recession. The media on the other hand behaves differently, so we had the silly situation in the UK before 2013 when tiny revisions to GDP led to headlines like ‘UK avoids double dip recession’.

Yet this minor annoyance for people like me has been turned into an opportunity in a recent paper (pdf) by two political scientists at the LSE (HT David Rueda). Andrew Eggers and Alexander Fouirnaies look at the data to see if the announcement of a recession causes any additional impact on macroeconomic aggregates compared to what you might expect from the GDP data itself. In other words, does the announcement of a recession reduce consumption or investment in OECD countries, conditional on actual economic fundamentals? For ease I’ll call this an announcement effect.

For investment they get the answer that economists would hope for - there is no announcement effect. Firms are well informed, and just look at the numbers. However for consumption they do find a significant announcement effect, both in terms of the actual data (and the size of the impact can be non-trivial) and in terms of consumer confidence indicators. One final result they emphasise, which makes clear sense from a macro point of view, is that the impact of recession announcements on consumer spending in smaller in countries with more robust social safety nets.

There are many reasons why this is interesting, but let me focus on one that I have discussed before. In this post I pointed to a potential paradox. On the one hand I believe that for most macroeconomic problems, rational expectations rather than naive expectations is the right place to start. On the other hand I also think that media reporting can have a strong influence on the average persons view on certain highly politicised issues, like is man-made climate change a serious problem, or how important is the cost of welfare fraud. I discussed this paradox here, and argued that it could easily be resolved by thinking about the costs and benefits of obtaining information. In particular, the costs of researching climate change are significant, whereas the cost to the individual of getting their own view wrong is almost zero. (This is just a variation on the paradox of voting.)

In the example from this paper, we have a standard macroeconomic problem, which is trying to assess what level of consumption to choose. The importance of the announcement effect suggests that for consumers the costs of ‘looking at the numbers’ (and, of course, interpreting them) to some extent exceeds the benefits of going beyond media headlines. If the media can have an influence on something that clearly has a significant financial pay-off for individuals, then it is bound to influence attitudes when the personal costs of making mistakes is almost zero.  

The View from Brussels

When incomplete ideas get embodied in institutions and the people in them

As I have said before, its too easy to be rude about austerity. It is harder to put yourself in the mindset of reasonable individuals who take a different view, and pinpoint exactly - in ways that they will understand - why their view is wrong. So this paper from Marco Buti and Nicolas Carnot (HT Philip Lane) is useful because it shows us that mindset. [1]

The argument in the paper is essentially this. “We recall that large adjustments are needed

in most economies to restore sustainable fiscal positions, not because of the arbitrary will of the markets or of EU institutions.” So the debate is about the precise speed of adjustment, and the Commission is trying to strike the “right balance”. In particular, it recognises the need for different speeds in different countries. I think this view characterises the position of many international organisations, including the OECD, and many in the IMF.

There is a big mistake being made here. It essentially involves the prioritisation of issues. Fiscal adjustment is seen as the overriding priority. Issues involving the state of the economy are secondary: they are one factor in judging the appropriate speed of adjustment. This is the wrong way around.

The major priority at the moment should be doing something about the demand led recession in the Eurozone (and other countries like the UK). The budgetary position of some countries is a secondary factor that may influence the country by country balance of any fiscal actions required to deal with this priority.

This point about priorities is not an expression of political preferences. It is about what basic macroeconomics tells us. The recession is a problem right now. If it is not dealt with now, the loss of resources is permanent and irretrievable, and in addition there is likely to be a more permanent scarring effect through hysteresis. Given the imbalances within the Eurozone, and the political tensions generated by creditor/debtor relationships, the costs of a recession could be greater still. Budget consolidation is a permanent, long term issue, and there is clearly a right and a wrong time to deal with it. Recessions are the wrong time, not just because it conflicts with other priorities, but because it may not even work, because of hysteresis effects, or political effects, or banking effects.

So why is this obvious to me, but not to those running policy? To repeat, my own view is in no sense about the relative importance, in some abstract sense, of deficit bias versus avoiding recessions. As regular readers will know, on deficit bias and long run goals for debt I am something of a hawk. I just do not see why we cannot avoid recessions and bring down government debt.

In some cases those running policy take a different view because of ulterior political motives, but not in all cases. I’m prepared to give those in the Commission, and other international organisations like the OECD and IMF, the benefit of the doubt on this. I believe an important influence on their mindset is that they are working in a framework in which overall demand stabilisation is not their problem. That is monetary policy, not fiscal policy. It is very revealing that in the Commission paper two phrases do not appear at all: they are  ‘zero lower bound’ (ZLB) and ‘liquidity trap’. Too few in government have recognised that when we hit the ZLB, the rules of the macroeconomic game fundamentally change, and the institutions of government - and those in them - have to adapt too.

This is hardly a novel point, but as Paul Krugman keeps stressing, it is absolutely central. It is why I get annoyed by those who insist that, if only we did monetary policy differently, all would be well - what I call ZLB denial. Few (unfortunately not all) deny the central role and importance of monetary policy in getting us out of recessions. When monetary policy fails - which it patently has, mainly [2] because of the ZLB - fiscal policy has to take its place. Countercyclical fiscal policy becomes as important as monetary policy normally is. Institutions, and habits of thinking, that are set up for normal times must adapt. The IMF recognised this in 2009, but I’m not sure the OECD or European Commission ever did.

We can see how this failure to change priorities influences the subsequent discourse by looking at two issues that are covered by the paper: OMT and Germany. The paper recognises the importance of OMT in altering market expectations. But they then say “As is clear as well however, the OMT announcement per se does not address the underlying sustainability concerns.” Of course OMT does not directly change the outlook for future primary balances. However it is a game changer in allowing periphery countries to change priorities. When you cannot sell your debt, this has to take priority over recession concerns (although fiscal consolidation can still be designed to try and avoid recession). What OMT allows countries to do is change priorities. If it had been implemented earlier, priorities could have been changed earlier. The paper does not see this, because for them fiscal consolidation remains the key priority.

The paper says “In Germany, the fiscal stance is now broadly neutral [3], hence consistent with

the call for a differentiated fiscal stance according to the budgetary space”. Which makes perfect sense (albeit using the rather tortured language of international organisation space), except at the ZLB. At the ZLB we need overall fiscal expansion in the Eurozone. The differentiation point still stands, so from an overall Eurozone perspective the Commission (and the OECD, and the IMF) should be arguing for substantial fiscal expansion in Germany. However, if your priority is fiscal consolidation, advocating doing nothing can seem quite radical and brave.

Right at the end there is a hint of recognition, but in a way that reinforces my point. To quote in full:

“A dedicated stabilisation fund could improve the conduct of fiscal policies throughout

the cycle by enforcing tighter policies in good times and providing additional leeway for cushioning downturns. Such a tool could strengthen the existing automatic

stabilisers while maintaining a credible rule-based framework. It would be particularly useful in the current predicament characterised by large cyclical differentials across the zone as well as a not insignificant average output gap. However, according to the Commission blueprint such a tool should only be considered in the longer term in the context of full fiscal and economic union.”

In other words countercyclical policy at the overall Eurozone level would be useful right now, but it needs to wait until we have the institutional change that can accommodate it. [4] Which tells me that those in the Commission think institutions are very important, but it does not tell me why existing institutions (and those within them) have to be behave in such a blinkered way.

[1] This can be seen as a companion piece to two others that looked at the power austerity has over politicians, and why some economists are suspicious of Keynesian fiscal stimulus. This post is about economists working in policy institutions.

[2] Unfortunately the ECB often gives the impression that as long as consumer price inflation is around about 2%, then nothing else (like other measures of inflation, or a recession) has anything to do with them. However I doubt very much that if the ECB had done what the Fed is now doing, a Eurozone recession would have been avoided.

[3] Whether this is true is another matter: see here for example. The latest OECD Economic Outlook has the German debt to GDP ratio falling steadily since 2011, despite a widening output gap.

[4] That institutional change will come too late for the current recession. I take a critical view of whether fiscal union for the Euro is either feasible or desirable here.

Causing recessions

If a car driver falls asleep at the wheel of his car, do we say they caused the accident that follows? Of course we do: it would be absurd to say otherwise. We take it as given that it is the driver’s responsibility to keep control of the car.

Now imagine that the Fed or the MPC had kept interest rates at their pre-recession levels from 2008 onwards. Would we say that monetary policy had made the recession worse. Of course we would. We expect monetary policy to do everything it can to bring the recession to an end. That is exactly what Milton Friedman thought about the Great Depression.

Yet when it comes to fiscal policy, it seems people suddenly take a different view. Some ‘neutral’ path for government spending and taxes is defined, and only if they differ from these paths do we say fiscal policy made the recession worse. Has austerity reduced UK GDP by 2.5%, as the IMF suggest, or by 1.4%, as the OBR suggest? But this asks the wrong question. The right question is why has fiscal policy not been used to help end the recession. That is the question Keynes posed in the General Theory following the Great Depression.

The moment that monetary policy hit the zero lower bound, fiscal policy should have been used to first limit the size of the recession, and then bring the recession to an end. The former happened under the previous Labour government in the UK and Obama in the US, and it worked. My quarrel with what happened afterwards is not that fiscal policy was restrictive compared to some neutral path, but that it did not continue to do whatever was necessary to sustain the recovery. Quite simply, when monetary policy could no longer do the job, fiscal policy should have taken on the stabilisation role. [1]

I’m reminded of this point by Robert Chote’s letter to the Prime Minister. Stephanie Flanders says that “in the most important arguments with Labour - over the role of austerity in thwarting recovery, and the scope to boost growth in the short term with higher borrowing - the OBR is still on the coalition's side.” If you were to take from this statement that the OBR had sided with the government on the policy debate over austerity, then I think you would be dead wrong. 

Why do I think you would be dead wrong? Why I am pretty sure that the OBR have never said anything about ‘the scope to boost growth in the short term with higher borrowing’ in such an unqualified way? I can be pretty sure of this, because the OBR are not allow to examine alternative policies to those of the government. So they cannot take sides in the way suggested. [2] I know this because, when the OBR was set up, I argued strongly - with Treasury officials, the Treasury Select Committee and others - against this restriction on what the OBR can do. (The argument is set out here.)

While I disagree with this restricted OBR remit (which I hope will change in time), it does have a silver lining - it allows the OBR in its infancy to focus on the other things it has to do, and avoid getting sucked into a political debate. It is unfortunate that Stephanie Flanders in this post suggests the OBR is taking sides on policy when its mandate precludes it from doing so. [3]

Often the questions we ask are more revealing than the answers we give. Questions like “was it the Eurozone crisis rather than fiscal policy that really caused the UK double dip”, or “is the weak US recovery down to greater uncertainty or restrictive fiscal policy”, or “budgets were in surplus in Spain and Ireland before the recession so what more could they do” in my view miss the point, much as the statement “it was oil prices rather than monetary policy that caused 1970s inflation” would miss the point. Whatever shocks have caused weak demand in this recession, if monetary policy is constrained, fiscal policy should be trying to offset these shocks. [4] In these situations, the presumption should be that fiscal policy is countercyclical. If it is not, that is a failure of policy. The driver is falling asleep at the wheel.

[1] Inflation could well have been higher for a while as a result, but as I argued here for the UK, that would have been an acceptable cost.

[2] They can of course comment on the scope for additional borrowing while maintaining the government’s fiscal mandate, but that is quite a different thing.

[3] I hesitate to suggest that such a good journalist as Stephanie Flanders might have been misleading here, but I'd also hate to think she was only criticised from one side, and hopefully I'm being a little more polite. In addition,  when the government criticised her for not celebrating the slow growth in UK productivity, she was of course completely right and they were completely wrong.

[4] Of course I also understand that fiscal policy can be incapacitated just like monetary policy can be. If you cannot sell government debt, or interest rates on that debt are high and rising, then debt financed fiscal expansion is just not possible. But fiscal policy is potentially a lot more flexible than monetary policy: there is balanced budget fiscal expansion, or changing the tax mix to create intertemporal incentives. If monetary policy cannot do the job, fiscal action is second best, but it is a quite versatile second best.

UK Deja Vu?

Jonathan Portes has a nice chart comparing this recession to previous downturns in the UK. The most eye catching implication is the similarity between this recession and the 1930s. Although it appeared as if we were recovering more quickly, thanks to the rapid reduction in interest rates and fiscal stimulus immediately following the recession, additional austerity brought in by the new coalition government has coincided with a much slower recovery. Whether this is causal we cannot be sure, but in my view it would be very surprising if the additional austerity was not at least partly to blame.

I want to focus on a different comparison, between now and the recession of the early 1980s. These recessions were both severe, but their immediate causes were quite different. The recession that started in 1980 was the consequence of a very tight monetary policy designed to reduce inflation. RPI inflation averaged 18% in 1980, but came down to 5% by 1983. GDP fell by over 2% in 1980, and very slightly in 1981, but an unusual feature of the recession was that it was concentrated in the traded sector: manufacturing output fell by 15% over those two years. One possible explanation is ‘Dornbusch overshooting’: using monetary policy to reduce inflation in an open economy leads to a temporary loss in competitiveness that hits the traded sector.

The similarity with today lies in fiscal policy. In the 1981 budget, income tax allowances were not raised, despite rapid inflation. To put the same point using a bit of jargon, in 1981 the ‘automatic stabilisers’ provided by fiscal policy were switched off. Despite high and rising levels of unemployment, fiscal policy was tightened, as it was in 2010.

At the time I was working as a relatively junior economist in the UK Treasury, in charge of using the Treasury’s macroeconomic model to assess the economic impact of the budget. This sounds very important, but in practice it was not, because those in charge of policy did not believe the analysis that the model produced. Traditionally after every budget, the chief economic advisor, who was then Sir Terry Burns, presided over a discussion of all Treasury economists about the issues raised. Sir Terry began by presenting his analysis of why fiscal policy had to be tightened: the large budget deficit was in danger of making it difficult to hit (broad) money supply targets. When he finished, there was silence in the room. Given my role at the time, I felt I could not let this pass. I delivered a little speech suggesting the budget was totally inappropriate. It is what happened next that was noteworthy. It was like opening the floodgates: suddenly everyone wanted to speak, and with few exceptions the verdicts were equally damning. Sir Terry looked increasingly uncomfortable.

This pattern was mirrored in public through the publication of a famous letter to the Times signed by 364 academics. We are more used to such things today, but in 1981 this was a very unusual event, and to get so many distinguished academics (mostly economists) to express such a strongly critical view of government policy was a big deal. The 364 included Amartya Sen and the current governor of the Bank of England, Mervyn King. To look at the exact text of the letter is a bit of a distraction, as it included many statements which look decidedly odd today, and which I am sure many of the signatories at the time did not fully agree with. They signed it because they thought the policy was wrong.

I think it is therefore reasonable to use this letter as a proxy for the 1981 budget itself. In 2006 a number of journalists and commentators marked the 25^th anniversary of the letter. Here I want to quote from the end of a piece written by Stephanie Flanders, because I think she is a reliable guide to what the verdict at that time was on the 364.

And the letter itself? Well, unfairly or not, the letter became something of a joke on the economics profession, as Lord Howe [Chancellor at the time] confirmed. "I've actually produced a definition of economists as a result: that an economist is a man who knows 364 ways of making love, but doesn't know any women."

Was it right, given hindsight, to switch off the automatic stabilisers in 1981? In very simplistic terms you can argue both ways. Growth did pick up after 1981. Inflation came down rapidly, perhaps more rapidly than was intended. Unemployment stayed very high for the rest of the decade, clearly suggesting that the deflationary shock in 1980/1 was so sharp that it generated hysteresis, raising the natural rate for some time. This is the point emphasised by Steve Nickell, who probably has done more work on the UK unemployment/inflation trade-off over this period than anyone else. However in one crucial respect 1981 was not like 2010, in that monetary policy was still operating freely. If switching off the automatic stabilisers in 1981 had allowed an easing of monetary policy, and given how uneven the impact of monetary policy had been, then perhaps it made sense. However the conventional view today is that monetary policy should do all the work if it can, and that fiscal policy should just allow the automatic stabilisers to operate.

                So it seems to me that the question of whether the 1981 budget, or the 364 economists’ protest, was right or wrong remains an interesting question. However the point I want to make here is that the view on the political right is quite clear. This piece by Phillip Booth in the Daily Telegraph from 2006, based on editing a collection of essays on the issue published by the Institute of Economic Affairs, is headlined ‘How 364 economists got it totally wrong’.

                So my speculative question is this. Was this verdict on the 1981 budget influential (explicitly or implicitly) when the Conservative party in opposition decided that more austerity was needed? (I have focused elsewhere on the role of Greek default in changing the policy consensus worldwide, but the Conservative Party opposed Gordon Brown’s countercyclical policy from the start of the recession.) Did the verdict on the 364 embolden the view that it was OK, and possibly even desirable, to go against conventional (in the UK at least) academic opinion? If this verdict on history was important in influencing policy in 2010, was it appreciated that being at the zero lower bound today made the two periods crucially different?