Debt restructuring: a proposed principle

With Greece under Syriza about to enter negotiations with the Troika, there has been much discussion of what might happen, and what should happen. This post is in the ‘should’ category. In the past I have argued that the Troika should welcome the opportunity to put right earlier mistakes. There should be a large amount of guilt, or at least regret, on their side. I will say why in a minute, but just to show that I’m not living in a dreamland, read this FT piece by Reza Moghadam, the former head of the European Division of the IMF.

In reality debt restructuring is a bargaining game, but I want to suggest a general principle that any agreement should hold to. That principle is that there should be no significant increase in unemployment above its natural rate (let’s call this excess unemployment) as a direct result of having to pay interest on any government debt. Unemployment above the natural rate when there is no excess core inflation is a waste of resources as well as being damaging to most of those unemployed, so any deal that creates such unemployment, or allows it to persist, should be regarded as the result of creditors acting against the social good. Indeed you could easily argue that it involves creditors acting against their own self-interest, because the more of an economy’s resources you waste, the less is available to pay its debts.

This is why the Troika should feel guilty, because by not allowing Greece to default on all its debt back in 2010 it helped create a situation where over half young people in Greece are unemployed. Some excess unemployment was inevitable in Greece after 2010 because the country had become very uncompetitive, and the impact of this on demand had been offset by large primary budget deficits. (This problem was made worse by pre-recession cost-cutting in Germany.) However, as I have argued in the past in the context of Latvia, the efficient way to restore competitiveness is to have small but persistent excess unemployment: a ‘short sharp shock’ is much more costly. The Troika imposed much too much austerity on Greece in a futile effort to avoid full and early default.

The process transferred the ownership of the remaining Greek government debt from the private sector to the public sector - other Eurozone governments and the IMF. The transfer to other European governments was wrong in two respects. First, it was another example of governments bailing out their own banks and other financial institutions with no costs to those institutions. Second, it made any subsequent restructuring of Greek debt much more difficult politically. If there had been full and immediate default there would have still been need for additional lending to Greece to give them time to adjust their public finances and avoid a large increase in unemployment, but that is what the IMF is for. If the Troika had not been involved, the IMF may well have gone for early and complete default.

So much for the past and guilt. What about what should happen now. The priority is for Greece to reduce unemployment as quickly as possible. That would be consistent with my principle, and so should be a priority for both sides. It could be achieved, for example, by suspending all interest payments on all Greek debt immediately, with those payments resuming on any debt not written off once excess unemployment had been eliminated. Paul Krugman shows what a positive effect no longer having to run a primary surplus to pay interest could have on the Greek economy. (As Paul Krugman observes in a separate post, and OECD data confirm, the competitive position of Greece is now back to the level it was when the Euro was created.)

What about all the ‘structural reform’ that the Troika has imposed. The new Greek government is likely to introduce plenty of structural reform of its own, so encouragement from outside is hardly necessary. If it is not the structural reform that the Troika prefers, then I’m afraid that is the price you pay for having a democratic Europe. We know that some within the Eurozone bureaucracy have little respect for national sovereignty, and it is time these people were put in their place.  

What about the backlash from voters in Northern Europe? I find arguments that say this should be (we are talking about what should happen here) a barrier to debt restructuring hard to take seriously. Northern Europe’s politicians foolishly socialised the Greek debt held by their own country’s financial institutions. To say Greece has to pay the price of this mistake seems perverse. What about other periphery countries wanting to revise the terms they were required to accept for Troika help? Well maybe they are right to do so. And finally what about the argument that this would ‘frighten the markets’ (always a good tell by the side that uses it that their argument is weak)? The markets will be unsettled far more if negotiations break down because creditors refuse to give enough.

Germany is now the third most popular country of origin for pageviews of my blog, which is something I’m very happy about. I’m sure at least some of those readers will be worrying that any renegotiation violates ‘the law’, or at least contracts that have been previously agreed. I have very little sympathy with that argument. The British government was also protecting the rule of law when it provided armed guards to ensure that shipments of grain left Ireland during the famine of the 1840s.

Even if you do not accept my argument about the role that creditors played in inflicting great harm on the Greek economy and people in the past, these creditors have a clear choice for the future. Current levels of unemployment in Greece represent a criminal waste of resources and source of unhappiness, and it should be brought to an end as soon as possible. Creditors can make this happen with a small economic cost to themselves by at least suspending all interest payments until the Greek economy has recovered. It is a cost that creditors are almost certainly going to have to pay at some point anyway. As Martin Wolf says in an excellent column, “What cannot be paid will not be paid.” It would be much better for the Greek people and Europe as a whole for the Troika to admit this now rather than later.    

Are DSGE models distorting policy? - a test case

The debate about the current state of academic macroeconomics continues, but it has reached a kind of equilibrium. Heterodox economists, some microeconomists and many others are actively hostile to the currently dominant macro methodology. Regardless, academic macroeconomists in the papers they write carry on using, almost exclusively, microfounded DSGE models. [1] Critics say this methodology was crucial in missing the financial crisis, but academic macroeconomists respond by highlighting all the work currently being done on financial frictions. I personally think missing the crisis was down to failings of a different kind, but that DSGE did hold back our ability to understand the impact of the crisis. However what I want to suggest here is a forward looking test.

Many of the difficult choices in conducting monetary (and sometimes fiscal) policy involve trade-offs between inflation and unemployment. We saw this in the UK particularly after the crisis, with inflation going well above target during the depth of the recession. What you do in those circumstances depends critically on the costs of excess inflation compared to the costs of higher unemployment. Is 1% higher unemployment worth more or less than 1% higher inflation to society as a whole?

What do New Keynesian DSGE models say about this trade-off? They do not normally model unemployment, but they do model the output gap, which we can relate to unemployment. Their answer is that inflation is much the more important variable, by a factor of ten or more. One reason they do this is that they implicitly assume the unemployed enjoy all the extra leisure time at their disposal. I have discussed other reasons here.

Empirical evidence, and frankly common sense, suggests this is the wrong answer. Thanks to the emergence of a literature that looks at empirical measures of wellbeing, we now have clear evidence that unemployment matters more than inflation. Sometimes, as in this study by Blanchflower et al, it matters much more. Another recent study by economists at the CEP shows that “life satisfaction of individuals is between two and eight times more sensitive to periods when the economy is shrinking than at times of growth”, which as well as being related to the unemployment/inflation trade-off raises additional issues around asymmetry.

So the DSGE models appear to be dead wrong. Furthermore the reasons why they are wrong are not deeply mysterious, and certainly not mysterious enough to make us question the evidence. For example prolonged spells of unemployment have well documented scarring effects (in part because employers cannot tell if unemployment was the result of bad luck or bad performance), which may even affect the children of the unemployed. So it is not as if economists cannot understand the empirical evidence.

Does that mean that the DSGE models are deeply flawed? No, it means they are much too simple. Does that mean that the work behind them (deriving social welfare functions from individual utility) is a waste of time? I would again say no. I have done a little work of this kind, and I understood some things much better by doing so. Will these models ever get close to the data? I do not know, but I think we will learn more interesting and useful things in the attempt. The microfoundations methodology is, in my view, a progressive research strategy.

So academics are right to carry on working with these models. But many academic macroeconomists go further than this. They argue that only microfounded DSGE models can provide a sound basis for policy advice. If you press them they will say that maybe it is OK for policymakers to use more ‘ad hoc’ models, but there is no place for these in the academic journals. In my view this is absolutely wrong for at least two reasons.

First, models that are clearly still at the early development stage should not be used to guide policy when we can clearly do better. In this particular case we can easily do better just by using ad hoc social welfare functions on top of an existing DSGE model. (The Lucas critique does not apply, which is why I like this example.) Yes these hybrid models will be ‘internally inconsistent’, but they are clearly better! Second, to confine academics to just doing development work on prototype experimental models is stupid: academic economists can have many useful things to say starting with aggregate models (as here, for example), and this is not something that policymakers alone have the resources (or sometimes the inclination) to do. (We also know that academics will give policy advice, whatever models they use!) Analysis using these more ad hoc but realistic models should be scrutinised in high quality academic journals.

Let’s be even more concrete. Take the debate over whether we should have a higher (than 2%) inflation target (or some other kind of target), because of the risks of hitting the zero lower bound. If this debate just involves micofounded DSGE models which clearly overweight inflation relative to unemployment, then these models will be guilty of distorting policy. This is not a matter of running some variants away from microfounded parameters (as in this comprehensive analysis, for example), but adopting realistic parameters as the base case. If this is not done, then microfounded DSGE models will be guilty of distorting this policy discussion.

[1] A few elderly bloggers, who use both DSGE and more ‘ad hoc’ models and think the critics have a point, are regarded by at least some academics as simply past their sell-by date.

US savings behaviour, and empirical research strategies

In this post I want to look at a paper by Chris Carroll, Jiri Slacalek and Martin Sommer for two reasons. The first is for what the paper tells us about US consumption behaviour, and potentially consumption behaviour in any advanced economy. The second thing I want to use it for is as an example of different ways of doing empirical research in a microfoundations world.

The mainstay of modern macroeconomics is the consumption Euler equation, where consumption is proportional to the sum of financial wealth and human wealth, where human wealth is the discounted present value of future labour income. This model implies consumption aims to smooth out erratic movements in income through borrowing and saving. In this model periods of high saving can reflect periods of temporarily higher income, or temporarily high real interest rates. Adaptations of this model that are commonplace are to assume that some proportion of consumers are liquidity constrained, and therefore consume all their income, or that consumption is subject to ‘habits’, which generates additional inertia. This model with or without these adaptations is not very helpful in explaining why savings rose sharply in the Great Recession.

Rather more worrying is that this model is not very good at explaining US savings behaviour before the Great Recession either. As I noted here, US savings rates fell steadily for about twenty years from the early 1980. You might think that explaining such a large and important trend would be a sine qua non of any consumption function routinely used in macromodels, but you would be wrong. Consistency with the data is not the admissibility criteria for a microfounded macromodel.

The Carroll et al paper finds two explanations for the pre-recession trend and the increase in savings during the recession. The first is easier credit conditions, and the second is employment uncertainty. The mechanism through which both work is precautionary savings. If the risk increases that your income will fall sharply because you will lose your job, you need to build up some capital to act as a buffer. The easier credit is to obtain, the less precautionary savings you need.

The reason why precautionary savings represents a significant departure from the basic Euler equation model is intuitive. If you want to hold a certain amount of precautionary savings, you have a target for wealth. A wealth target pulls in the opposite direction to consumption smoothing. If you have a one-off increase in income, consumption smoothing says you should consume it very gradually, perhaps only consuming the interest. The marginal propensity to consume that extra income is tiny. But this leaves wealth higher for a very long time. If you have a wealth target, your marginal propensity to consume that additional income will be larger, perhaps a lot larger.

Now for the methodology part. These empirical results are in sections 3 and 4 of their paper. They call their empirical results in section 4  ‘reduced form’, because they come from a regression relating saving to wealth, credit constraints and expected unemployment. However the authors feel that this is not enough. In section 2 they discuss a structural theoretical model. Because modelling labour income uncertainty is very difficult, their microfounded model assumes that once someone becomes unemployed, they become unemployed forever. Section 5 then estimates this structural model.

The authors describe a number of reasons why directly estimating the structural model may be better than estimating the reduced form. But in order to get their structural model they have to make the highly unrealistic assumption noted above. The reduced form, on the other hand, does not have this assumption imposed on it. So I do not think we can say that the results in Section 5 are more or less interesting than those in Section 4, which is why both are interesting, and why both are included in the paper. There does not seem to be any compelling reason to elevate one above the other.

OK, a last  - perhaps wild - pair of questions. Is it the case that, compared to a few decades ago, there are far fewer papers in the top journals that simply try and explain historical time series for a single key macro aggregate (like consumption or saving)? If that is the case, is this due to the difficulties in getting microfounded models to fit, or something else?  

Why strong UK employment growth could be really bad news

Some of the better reporting and interviews with George Osborne yesterday did try and put the strongish 2014Q2 output growth in context. Yet the much stronger growth in UK employment continues to be greeted by many as unqualified good news - even by some who should know better. So, rather than trying to be satirical, let me attempt to be as clear as I can. Those who already understand the problem can skip the next three paragraphs.

By identity, strong employment growth relative to output growth means a reduction in labour productivity. In the short term when unemployment is above its ‘natural’ (non-inflationary) level, falling labour productivity is good news. It means that a given level of output is being produced by more people, so there are less people unemployed. This is good news because our evidence is that the costs of being unemployed are very high. Of course if more workers are producing the same amount of stuff, their real wages will fall, but that just means that the cost of a recession is being evenly spread rather than being concentrated among the unemployed.

Now lets move on until unemployment has fallen to its natural rate. It is what happens next that is crucial. If labour productivity starts increasingly rapidly, such that we make up all or nearly all of the ground lost over the last five years, that will be fantastic. Rapid productivity growth will bring rapid growth in real wages, meaning that much of the unprecedented fall in real wages we have seen in recent years is reversed. After a decade or so, UK living standards will end up somewhere around where they would have been if there had been no recession. The UK ‘productivity puzzle’ will have been a short term affair that economists can mull over at their leisure. Analysis will not look kindly on the policies that allowed output to be so low for so long, but - hysteresis effects aside - that will be history.

The alternative is that labour productivity does not make up lost ground. If this happens, the average UK citizen will be 15-20% poorer forever following the Great Recession. Living standards in the UK, which before the recession appeared to be growing at least as fast as those in other major established economies, will have fallen back substantially relative to citizens in the US and Europe. This is the alternative that most forecasters, including the OBR (see chart reproduced here), are assuming will happen. 

So the absence of labour productivity growth is good in the short term, but is potentially disastrous in the long term. The problem is that the absence of growth in labour productivity since the recession is unprecedented (see chart below): nothing like this has happened in living memory. The reason to be concerned is that the rapid growth in productivity required to catch up the ground already lost is also unprecedented for the UK, which is why most economists assume it will not happen. Which brings me to another puzzle.

As long as I can remember, UK governments have been obsessed by long term productivity growth, and its level relative to the US, France and Germany. They have put considerable effort into understanding what influences this growth, and what policies can help increase it. This was true when UK labour productivity was steadily increasing at a slightly slower rate than in other countries, or increasing at a slightly faster rate. Given this, you would imagine that the UK government would be frantic to know what was currently going on. Why has UK productivity stalled, why are we falling behind our competitors at such a fast rate?

GDP per hour worked: source OECD

Instead this government seems strangely indifferent. If they have an explanation for the absence of UK productivity growth, I have not seen it. You generally need to understand something before you know what to do about it. Instead the Prime Minister and Chancellor would seem to prefer not to talk about it, because it ‘feeds into’ the opposition’s complaints about low wages. This really is irresponsible. Is it simple arrogance? - they know what is good for the economy, even if they do not understand it. Or is it indifference? - we do not care too much about long term UK prosperity, as long as you keep voting for us. Or is it just too embarrassing to admit that the most calamitous period for UK living standards since the WWII has happened on their watch.

Confusing levels and rates of growth

It was entirely predictable. Once growth returned to the UK economy, those with a political axe to grind, but also some who do not, and even some who should know better (uneconomical has a good detailed response), will start saying that any aggregate demand problems have gone away. The simplest argument suggesting otherwise is NIESR’s well known chart, the latest version of which is reproduced below.

Of course this does not prove that the UK still has an aggregate demand problem. Perhaps something unprecedented has happened to UK supply over the last five years. After all, consumer price inflation (CPI) is still above target. Well, as I pointed out here, CPI was above target in 2008, and 2009, and 2010 ….. so unless you want to suggest that the UK never had an aggregate demand problem, the behaviour of the CPI today is not very reliable evidence.

The main point, however, is that aggregate demand problems are about the level of GDP, not its rate of growth. In a demand induced recession, aggregate demand will fall: consumers start saving more; firms reduce the level of investment etc. As a result, resources are underutilised, the clearest indication of which is an increase in unemployment. We start a recovery when aggregate demand starts rising again at a rate that exceeds the rate of growth of underlying supply (labour force growth and technical progress). That might have just started in the UK.  GDP growth in the last quarter was 2.4% at an annual rate, which if you were pessimistic might be above trend. The chart shows the recovery started in 2010 but then stopped, but better late than never.

However that is just the start of a recovery. As the chart again shows, we should really be looking for rates of GDP growth of 4% or more if we are going to start utilising those resources which are currently being wasted (i.e. if we want to reduce unemployment). The aggregate demand problem only disappears when those resources are utilised again, and unemployment goes back to its non-inflationary rate (NAIRU). (And no, CPI inflation does not tell us that has already happened - average earnings are increasing at rates well below CPI inflation, which strongly suggests unemployment is well above the NAIRU.) As yet, falls in UK unemployment have been tiny relative to the increase that occurred during the recession.

UK Unemployment

If this all sounds too ‘Old Keynesian’, we can retell the story in New Keynesian terms. In a recession the natural real rate of interest falls below the level the actual rate can reach. Whatever shock caused the fall in the natural real interest rate (initially a need to adjust balance sheets, later compounded by fiscal austerity and a Euro recession), that shock can gradually dissipate, allowing the economy to grow. However, the aggregate demand problem only disappears when the natural real interest rate rises to equal the actual real interest rate. We should know when that happens because unemployment will fall to the NAIRU. Recessions do not just last as long ‘as it takes prices to adjust’, because we are at the zero lower bound.

The reason why this is so important is that it may be too easy to settle into a political equilibrium, where the economy is growing roughly at trend, but unemployment is not falling. It is a political equilibrium because the unemployed have very little political voice, and sections of the media encourage politicians (I’m being as polite as I can here) to label the unemployed as workshy. This may not have happened in the US since the war, but with fiscal policy being tightened as a result of Tea Party fundamentalism it could well do this time. In the UK there are some similarities with the 1980s, when unemployment stayed above 10% until near the end of that decade. Luckily no one in the UK has started arguing that current levels of unemployment are ‘structural’, but given the rhetoric about strivers vs skivers it will not be long before they do, and of course if you wait long enough to reduce unemployment you are in great danger of creating a structural problem.

So we will stop having an aggregate demand problem when unemployment falls to near pre-recession levels, and (assuming rational monetary policy) nominal interest rates start rising significantly. It would be great if that happened very quickly because of rapid growth, and while I can think of reasons why that might be unlikely, I know enough about forecasting to know it is also quite possible. However that will have no impact on the costs of austerity that have already been incurred, which is why I wrote my ‘final verdict’ on the current Chancellor six months ago.

Even earlier, over a year ago, I wrote this: “come 2015, the spin “we have done the hard work and the strategy has worked” will accord with (relatively) strong growth, while talk of output gaps and lost capacity will have less resonance. True, unemployment will still be high, but not many of the unemployed are Conservative voters, and the immunising spin about lack of willingness to work can be quite effective.” Paul Krugman described this post as ‘remarkably cynical’. I fear it will be one of my better forecasts.  

Unemployment, the output gap and wage flexibility

This post is about the impact of nominal and real wage flexibility on unemployment and the output gap. It starts in an academic, abstract sort of way, but the policy implications do follow. I try and make the analysis as accessible as I can to non-economists.

Start with an economy with a zero output gap (defined below) and no involuntary unemployment. Everything in the economy is just fine, which is a non-technical way of saying it is efficient. Then a ‘crisis’ happens that leads consumers to consume less and save more, so aggregate demand falls. Normally in these situations the central bank cuts nominal and real interest rates sufficiently to restore aggregate demand. Once this has happened, call everything in this economy ‘natural’, so the real interest rate that restores demand is the natural rate of interest. The natural level of output may not be the same as the pre-crisis level, because for example the new natural rate of interest can have knock on effects on how much people want to work. [1] However the natural level is the level of output that policymakers should aim for. [2]

In the Great Recession this mechanism did not work because nominal interest rates hit zero, and maybe also because monetary policy put a cap on inflation expectations. As a result, actual real interest rates are above the natural level. In addition, fiscal policy is in the hands of people who know nothing about macroeconomics, so there is no help from there. However monetary policymakers still think they could do something ‘unconventional’, so they want to know what to aim for. The answer is that, as long as what they do does not seriously distort the economy, they should try to get to the natural level of output, because that produces an efficient economy.

The difference between the actual level of output and the hypothetical natural level is called the output gap. The traditional way of defining the output gap was the difference between actual output and ‘productive potential’, which was the amount that could be produced if all factors of production were fully utilised. That is still how the gap is often measured in practice, although the measurement problems can still be huge, as Paul Krugman notes here. The problem at a conceptual level is that this approach downplays considerations of optimality, so nowadays theoretical macroeconomics uses the natural level of output to define the output gap. This has the advantage that we know what policy should be aiming to do: achieving the natural level of output.

Now imagine three almost identical economies where an output gap exists because nominal interest rates have hit zero. The level of real interest rates that would eliminate the output gap is the same in all three economies (i.e. they have the same natural levels of output). In the first economy, workers resist nominal wage cuts, so this puts a floor on how much unemployment reduces real wages. (Equally firms may be reluctant to impose wage cuts, as this research suggests - HT Kevin O’Rourke.) If nominal wages stop falling, at some point firms will stop cutting prices to protect their profits. We settle down to a new lower level of demand deficient output, high unemployment, but stable wages and prices. There is plenty for unconventional monetary policy to do, even though inflation is not falling.

In the two other economies nominal wages carry on falling. In the second economy prices get cut pari passu, so real wages remain unchanged, while in the third they do not, so real wages fall. So in the second economy inflation is lower than in the first, but real wages are the same. Does this lower rate of inflation increase or decrease the output gap? That depends only on whether actual output falls or increases because of lower inflation: the natural level of output involves a hypothetical economy which is unaffected by whether nominal wages fall or not in the actual economy [3]. Actual output may fall if negative inflation makes debtors spend a lot less but creditors not much more - this and other mechanisms are discussed in Mark Thoma’s post here. However, if monetary policymakers have been inhibited from doing much because inflation was not falling (which would be one interpretation of UK policy, for example), then as David Beckworth says, lower inflation may raise actual output by encouraging expansionary unconventional monetary policy.

How about the third economy, where real wages have fallen? Suppose firms respond to lower real wages by substituting labour for capital, and this process continues until all those who want to work can find a job. So in the third economy involuntary unemployment goes away. But is the output gap any lower? Once again, the natural level of output has not changed. (It was set in our hypothetical economy where real interest rates fell to their natural level.) So the key question becomes whether lower real wages and lower unemployment reduces or increases aggregate demand, and therefore actual output. It could go either way. So it is perfectly possible that both actual output and therefore the output gap is exactly the same in all three economies, even though unemployment has returned to its natural rate in one, and the other two have very different inflation rates. 

This comparison suggests that those who say unemployment in the first two economies is caused by wage inflexibility kind of miss the point. The basic problem is lack of aggregate demand. You could argue (I would) that the third economy is better off than the other two, because the pain of deficient demand is evenly spread (everyone has lower real wages), rather than being concentrated among the unemployed. But the first best solution is to raise aggregate demand, because that gets rid of the pain.

I started writing this post because of a recent study by Pessoa and van Reenan, who argue that the mysterious decline in UK labour productivity that I have talked about before can in large part be explained by unusually slow growth in UK real wages. The mechanism they have in mind is entirely traditional: if real wages are low firms substitute labour for capital. This in turn may explain (see Neil Irwin here for example) why UK unemployment originally rose by less than in the US (see first chart), even though the UK’s output performance was worse. On this issue looking at consumer price based measures of real wages will be misleading, so below is a very simple measure of real product wage growth in the two countries: compensation per employee less the GDP deflator. Real wage growth in the UK has noticeably fallen since the recession, whereas the fall has at least been less abrupt in the US (2013 is a forecast).

Unemployment in the US and UK: Source ONS and BLS

Growth in compensation per employee less GDP deflator: OECD Economic Outlook

In terms of just the UK economy, whether Pessoa and van Reenan are right is debatable. When I discussed this in an earlier post I referenced a Bank of England paper by MPC member Ben Broadbent, which argued that for the factor substitution story to explain most of what we have seen in the UK, investment should have completely collapsed, which it has not. This difference in view reflects a number of nitty gritty issues, like how you measure the capital stock, and whether the substitution elasticity is one (as implied by the Cobb Douglas production function), or nearer one half.

However most seem to agree that some of this factor substitution is going on in the UK. So my hypothetical discussion above suggests that, by spreading the pain of deficient aggregate demand further, this ‘real wage flexibility’ in the UK has been a good thing, but it does not mean the aggregate demand problem has decreased. If anything, it suggests that looking at unemployment underestimates the size of the output gap. Monetary policy makers please note.

[1] New Keynesian economists sometimes call the natural economy the outcome when all prices are completely flexible. That is OK, as long as we note that flexible prices here has to include the possibility that nominal interest rate can go negative, which in the real world it cannot.

[2] Opinions may differ on whether the crisis itself is a necessary correction for past errors, or whether it is itself a distortion. For example, was risk undervalued before the crisis, or is it overvalued now. In other words, was the pre-crisis economy efficient, or would there be a distortion in the post-crisis economy even without an aggregate demand problem? These are important complications compared to the story I tell here, but they will have to wait for another post.

[3] The idea is that the economies are identical except for the extent of nominal inertia in goods and labour markets. In economy 1 wages are sticky, in economy 3 prices are sticky but wages are flexible, and in economy 2 the degree of wage and price stickiness is such that real wages do not change. 

On the economic achievements and failures of Margaret Thatcher

I was not going to write anything on Mrs T, but then I just happened to read yesterday a journal article that says something important about her legacy today. I also decided to write something to challenge some of the myths and taboos created by the political right and left. The right in the UK tends to mythologise Margaret Thatcher, in a similar way I think the right in the US does with Ronald Reagan. So its worth pointing out two major macroeconomic errors that were made while she was Prime Minister. The left is less inclined to hero worship its own Prime Ministers (generally it does the opposite), but it has its own taboos when it comes to macroeconomic history.

What was the journal article? It is a paper [1] that looks at the causal impact of fathers' job loss on their children's educational attainment and later economic outcomes. The place and time is the UK recession of the early 1980s. The study concludes: “Children with fathers who were identified as being displaced did significantly worse in terms of their GCSE attainment than those with non-displaced fathers.” Not a very surprising result, but further evidence of the long term damage done by high and prolonged unemployment (what macroeconomists call hysteresis effects).

The UK recession at the beginning of the 1980s was the worst since the second world war. UK unemployment increased dramatically, from below 6% to nearly 12%, and stayed high until the end of the decade. The chart below boxes the Thatcher years. (Unemployment would have been higher still if the government had not encouraged the unemployed to register as disabled, as John Van Reenen relates and even George Osborne admits.)

UK Unemployment

Did the government led by Margaret Thatcher intend for this to happen? Almost certainly not. Their plan involved replacing traditional macroeconomic policy by monetarism, which meant gradually declining targets for the growth of a particular monetary aggregate. As Chris Dillow points out, they expected this would lead to a steady decline in inflation, with a minor and temporary dislocation in terms of output.

Many thought that a foolish thing to believe at the time, but in macroeconomic terms Mrs Thatcher’s administration were revolutionaries who despised conventional wisdom. When presented with Treasury forecasts telling them with unusual accuracy what would happen, they rubbished the Treasury advice. As unemployment rose rapidly, and many in her party urged her to change course, she gave her famous ‘this lady’s not for turning’ speech that is so eulogised by some Conservatives today.

The attempt to hit their monetary targets failed dismally: 81/80 target money growth 7-11%, actual 19.1%, 82/81 target growth 6-10%, actual 13.7%. After that monetary targets were effectively abandoned. One of the biggest experiments in UK macroeconomic policy turned out to be a disastrous failure. As GDP fell by over 2% in 1980, and remained flat in 1981, and manufacturing output fell by 15% in two years, it is not surprising that inflation fell rapidly, although too many on the left believed it would not.

Yet, as I have noted before, this period is regarded by many as Mrs. Thatcher triumphing over doubters, including most academic economists. This myth may be partly responsible for the current government's obstinacy about austerity. So how can it be regarded as a triumph? Output did recover - well of course it did, but as the chart shows unemployment stayed persistently high, with the long run costs that I noted above. Inflation came down rapidly, but far more rapidly than was intended.

Was this unintended cold turkey cure in any sense optimal? I think that is highly unlikely for many reasons. One is that the traded sector bore the main cost of the recession. The period coincided with North Sea oil coming on stream, which in itself would have led to an appreciation in sterling and a movement of resources away from the traded sector. In these circumstances, embarking on a policy that produced a further appreciation in classic Dornbush overshooting style led to the very uneven recession. Now the Dornbusch analysis was fairly new, so perhaps the government can be forgiven for not anticipating that this would happen, but by 1980 it was all pretty clear what was going on, and that was the point at which the lady refused to turn.

But the key point remains that this skewed, cold turkey policy to reduce inflation was never part of the plan. The plan itself was a complete failure, and if you think the outcome was optimal (which I do not) then that is down to luck rather than judgement.  

The second failure involved North Sea oil. I have compared how the UK and Norway responded to additional government revenue from North Sea oil before. The Norwegian government created a sovereign wealth fund, so that the gains from North Sea oil could be enjoyed by future generations. The UK government thought the people should make that choice, and so cut taxes. The people, for one reason or another, do not appear to have invested that money to replicate what a sovereign wealth fund would do. So Mrs Thatcher made the wrong choice, and whether it was for ideological reasons or more base electoral considerations is secondary. It was a major mistake that current and future generations will pay for.

Those are two major failures, but what about the successes? The Thatcher era saw the implementation of supply side reforms that ended and then reversed the relative decline of UK productivity. As Paul Krugman has pointed out, the lags here need to be long, but I think we have good reason to believe that they are. As Nick Crafts outlines here, and John Van Reenen here, this improvement came about partly through increased goods market competition, but of course it also reflected a reduction in union power that was one of the major aims of government policy. The taboo on the left is not to admit (at least publicly) that UK trade unions had grown too powerful in the 1970s, and that any benefits this had were outweighed by inefficiency and often severe dislocation.

The battles of the 1980s, and the path Mrs Thatcher took,  were not inevitable, and it is possible that the UK could have moved to something like the German model where unions retain a strong presence. However the path followed by the UK is at least partly the responsibility of the left as well as the right: some of the proposals later introduced by Mrs Thatcher were first tabled by the 1969 Labour government and Barbara Castle, and were defeated by the Trade Union Congress and the later Labour Prime Minister Jim Callaghan.

This post is not meant to be comprehensive: I have said nothing about the rise in poverty under Mrs Thatcher (briefly mentioned here), inequality more generally and the role that taxation had in increasing that (of which the poll tax was just one example), selling off state assets or under investing in what was left. (Van Reenen gives more detail on some of these.) A second major UK macroeconomic disaster also occurred right at the end of her premiership. The UK entered into the European Exchange Rate Mechanism at an overvalued exchange rate, which led to another major recession. That story, and my own very small part in it, will have to wait for another time.

   

[1] Gregg, P., Macmillan, L. and Nasim, B. (2012), The Impact of Fathers' Job Loss during the Recession of the 1980s on their Children's Educational Attainment and Labour Market Outcomes. Fiscal Studies, 33: 237–264

Mistaking models for reality

In a recent post, Paul Krugman used a well known Tobin quote: it takes a lot of Harberger triangles to fill an Okun gap. For non-economists, this means that the social welfare costs of resource misallocations because prices are ‘wrong’ (because of monopoly, taxation etc) are small compared to the costs of recessions. Stephen Williamson takes issue with this idea. His argument can be roughly summarised as follows:

1) Keynesian recessions arise because prices are sticky, and therefore 'wrong', so their costs are not fundamentally different from resource misallocation costs.

2) Models of price stickiness exaggerate these costs, because their microfoundations are dubious.

3) If the welfare costs of price stickiness were significant, why are they not arbitraged away?

I’ve heard these arguments, or variations on them, many times before.[1] So lets see why they are mistaken, taking the points in roughly reverse order.

Keynesian recessions arise because of deficient demand. If you want to think of this as being because some price is wrong, in my view that price is the real interest rate. Now flexible wages and prices might get you the right real interest rate, either because they encourage monetary policy to do the right thing (by changing inflation), or because a particular monetary policy combines with inflation expectations to generate the appropriate real interest rate. However when nominal interest rates hit zero and there are inflation targets, flexible prices may not be enough (as argued here), so there may be no flexible price solution that gets rid of the costs of recession. At the very least, that suggests that recessions are a bit different from, say, the costs of monopoly or distortionary taxation. It also tells you why they cannot be arbitraged away by the actions of individuals.(See also Nick Rowe on this.)

What we have in a recession is a coordination problem. If everyone were to spend more, the additional output would generate incomes that matched the spending. If monetary policy cannot induce that coordination, then individuals could try and persuade someone with a great deal of spending power who could borrow freely and very cheaply to embark on additional spending. The obvious someone is the government, and the real puzzle is why governments have been so reluctant to arbitrage away recessions in this way.  

The second point is horribly wrong, and it explains the title of this post. The problem with modelling price rigidity is that there are too many plausible reasons for this rigidity - too many microfoundations. (Alan Blinder’s work is a classic reference here.) Microfounded models typically choose one for tractability. It is generally possible to pick holes in any particular tractable story behind price rigidity (like Calvo contracts). But it does not follow that these models of Keynesian business cycles exaggerate the size of recessions. It seems much more plausible to argue completely the opposite: because microfounded models typically only look at one source of nominal rigidity, they underestimate its extent and costs.

I could make the same point in a slightly different way. Lets suppose that we do not fully understand what causes recessions. What we do understand, in the simple models we use, accounts for small recessions, but not large ones. Therefore, large recessions cannot exist. The logic is obviously faulty, but too many economists argue this way. There appears to be a danger in only ‘modelling what we understand’ that modellers can go on to confuse models with reality.

Lets move from wage and price stickiness to the major cost of recessions: unemployment. The way that this is modelled in most New Keynesian set-ups based on representative agents is that workers cannot supply as many hours as they want. In that case, workers suffer the cost of lower incomes, but at least they get the benefit of more leisure. Here is a triangle maybe (see Nick Rowe again.) Now this grossly underestimates the cost of recessions. One reason is  heterogeneity: many workers carry on working the same number of hours in a recession, but some become unemployed. Standard consumer theory tells us this generates larger aggregate costs, and with more complicated models this can be quantified. However the more important reason, which follows from heterogeneity, is that the long term unemployed typically do not think that at least they have more leisure time, so they are not so badly off. Instead they feel rejected, inadequate, despairing, and it scars them for life. Now that may not be in the microfounded models, but that does not make these feelings disappear, and certainly does not mean they should be ignored.

It is for this reason that I have always had mixed feelings about representative agent models that measure the costs of recessions and inflation in terms of the agent’s utility.[2] In terms of modelling it has allowed business cycle costs to be measured using the same metric as the costs of distortionary taxation and under/over provision of public goods, which has been great for examining issues involving fiscal policy, for example. Much of my own research over the last decade has used this device. But it does ignore the more important reasons why we should care about recessions. Which is perhaps OK, as long as we remember this. The moment we actually think we are capturing the costs of recessions using our models in this way, we once again confuse models with reality.




[1] A classic example comes from Robert Lucas. This includes the rather unfortunate statement that the “central problem of depression prevention has been solved”, but I don’t think that should be used as evidence against the more substantive claim of the paper, which is that the gains from stabilising the business cycle are relatively small. This assertion has been criticised even if we stick with New Keynesian representative agent models (see this paper by Canzoneri, Cumby and Diba), but the problems I outline below are more fundamental.

[2] For non-economists: twenty years ago most Keynesian analysis measured the success of policy (social welfare) by how well it stabilised inflation and the output gap, and the relative importance of inflation compared to output was a ‘choice for policy makers’. Since work by Michael Woodford, a similar measure of social welfare can be derived from the utility of individual agents, often using pages of maths, but the importance of output compared to inflation is then a function of this utility and the model’s structure and parameters.    

On Hidden Motives

                Chris Dillow has a nice follow-up to my earlier blog on balanced budget fiscal expansion. I first read the Kalecki paper when I was at Cambridge, but for better or worse this is not part of the macro lectures I give at Oxford. We all miss Andrew Glyn a lot.

                Is this what I had in mind when I said that if the government argued against all the possible balanced budget spending and tax measures that might stimulate the economy, we might suspect other motives? Before trying to answer that, I should say that part of my complaint was that such policy ideas are not part of the public debate, so we do not know what the government’s response would be. (We could infer, from the fact that none of these policies are being pursued, that they would be against them). I should also note that the FT suggests that the Liberal Democrats are thinking about tax switches, although I have my doubts about whether raising the £10K tax threshold would be particularly effective at stimulating demand.

                When I drew parallels in an earlier post between the current UK situation and 1981, I mentioned by way of anecdote a little speech I made at the internal meeting of Treasury economists at the time. What I did not report was that at that meeting I made exactly the argument Kalecki puts forward. (Needless to say Kalecki was not normally quoted in discussions about budgets in the Treasury! - I was young, and probably knew I was going to leave fairly soon.) I think what Kalecki says made a good deal of sense in that particular context: as we were to find out, part of the Thatcher agenda was to take on the power of organised labour.

                Whether it makes sense in the current context I’m less sure. Some of the factors identified by Chris in a later post could simply be attempts to deflect sympathy for the unemployed (which in turn would translate into criticism of the government) rather than the more strategic design he suggests. What I probably had more in mind on this occasion were two things.

                The first involves the point about ideology which I have mentioned several times. If your ideological perspective is that ‘government is always the problem’ and that the private sector is best left alone, then blaming all our ills on the excesses of the previous government (rather than the financial system), and pursuing austerity by government as the means of correcting those ills fits well with that perspective. To use government intervention as a way of correcting a problem with the private sector (insufficient demand) does not.

The second is that nearly all the fiscal proposals I suggest involve redistributing money from the rich to the poor. This makes macroeconomic sense, because the poor are more likely to be credit constrained than the rich. It would also make sense from an equity point of view: the poor are suffering most as the result of austerity, as the chart below from the IFS illustrates. Unfortunately it does not make political sense for the current government.

                  There is also a familiar but important point here about political influence and recognition. Issues to do with debt and financial markets are reported daily and major players in this area have almost guaranteed access to politicians – from whatever party. They tend to be rich, and will complain about being taxed at 50%. The young unemployed, who now make up nearly a quarter of the 16-24 age group, have by comparison very little political voice. Even when they are talked about when monthly figures are released, we are likely to get stories about motivation and how to brush up your CV, rather than recognition that with many times more people looking for a job than there are vacancies no amount of self help will make the problem go away. (See this by Zoe Williams.) These are the political reasons why the ‘counsels of despair’ that Jonathan Portes rightly complained about are able to endure.

When growth returns: a prediction

                No, I’m not about to get into the forecasting game – I did enough of that when young. What I am prepared to predict is the reaction of some when growth does return (as it may be in the US, and as it might one day in the UK and the Eurozone). My prediction is that some people will say that growth shows those Keynesian prophets of doom were all wrong. Look, the patient has recovered just fine without the need for any fiscal stimulus medicine.

                If people do say this, they will be wrong on two counts. First, there are good reasons for believing that aggregate demand will start to recover at some point without any additional monetary or fiscal stimulus. One of the main reasons for the recession was the need to repair balance sheets, which for consumers meant less borrowing and more (precautionary) saving, and for banks building up capital by reducing lending. Once this process is complete, demand will begin to recover. Once it does so, firms will stop delaying new investment. There is a lot more that could be said about the dynamics of demand following the Great Recession, but a return to growth at some stage is almost inevitable.  

                Second, the argument was never about growth, but about the level of activity, and unemployment. Put simply, those of us who argue for more fiscal (and monetary) action want growth to come sooner and quicker, so that unutilised labour resources can get back to work. Unemployment is not only a waste of resources but also a major cause of unhappiness (see, for example, this paper by Blanchflower). Worse still, there is the likelihood that prolonged involuntary unemployment may lead to much more permanent reductions in supply, as workers become discouraged and deskilled (see, for example, this paper by Laurence Ball). 

                So that is my forecast. In one sense I cannot wait to see if it comes true.

P.S. The above has nothing to do with this from Tyler Cowen: Tyler can do no wrong after recently listing my blog. Those interested in that particular post should see Noah Smith.