Letter wars, and how policy is made

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

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

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

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

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

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

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

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

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

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

Spain, and how the Eurozone has to get real about countercyclical policy

Matthew Klein has a good account of how Spain’s macroeconomic fortunes are improving, but only from a very bad place. I’m not that knowledgeable about the Spanish economy, so I cannot add any detail. However I do want to pick up on one point, which he and others (including Martin Wolf - see below) have made, which I think is wrong and misleading.

Before I do that, I just want to make a general point about the current recovery. At its heart it is export led, which is exactly what you would expect. Just as this post which compares Greece to Ireland shows, the Eurozone does have a natural correction mechanism when a country becomes hopelessly uncompetitive as a result of a temporary domestic boom (whatever its cause). The mechanism is a recession and what economists call ‘internal devaluation’: falling wages and prices. The problem with this correction mechanism is that, on its own, it is slow and painful, particularly when Eurozone inflation is so low.

So the key question is what could Spain have done to avoid having such a painful period of correction. The cause of the problem was the excess private sector borrowing of the pre-crisis period, and the associated capital inflows. This was part of an unsustainable property boom that led to a large current account deficit and rising inflation. (I liked the point that Matthew Klein made about how export orientated firms have recently increased their borrowing. Extra borrowing is not bad if the investment is sound.) What could Spain have done to cool things down? As Matthew Klein points out, Spain already had some sensible macroprudential monetary policies, and it seems likely that more of the same would not have been enough.

Which brings us of course to fiscal policy, and it is here that so many commentators go wrong. They say, correctly, that Spain’s problem was never a profligate government. They say, correctly, that the actual budget was in surplus from 2005-2007. Of course the relevant number is the underlying (cyclical adjusted) balance, and the IMF now thinks that shows a persistent although small deficit. But as Martin Wolf points out, again correctly, the IMF in 2008 thought very differently. As I have said many times in the case of the UK, ex post numbers for pre-crisis cyclically adjusted deficits can be very dodgy because of the depth and persistence of this recession.

The mistake everyone here makes is to judge the appropriate fiscal policy by the size of the deficit. That is like saying that a bigger fiscal stimulus in the US in 2009 was impossible because the deficit was already very large. For an individual country in a currency union the deficit is not the appropriate metric to judge short term fiscal policy. Unless there are very good reasons for believing the economy is too competitive, the appropriate metric is national inflation relative to the Eurozone average. From 2001 to 2007 the GDP deflator (the price of domestically produced goods) for the Eurozone as a whole increased at an average rate of just over 2%. In Spain it increased at an average rate of nearly 4%. 2% excess inflation over 7 years implies a 15% loss in competitiveness. So forget the actual budget deficit or any cyclically corrected version, fiscal policy was just not tight enough.

I have been told so many times that for Spain to have a tighter fiscal policy before the crisis was ‘politically impossible’. If that really is true, then Spain has little to complain about when it comes to the subsequent recession. If you cannot do any better, you have to leave the natural correction mechanism to do its slow and painful work. But I suspect what is ‘politically impossible’ is in part a reflection of the Eurozone’s flawed Stability and Growth pact itself, which focused entirely on deficits.

It seems more than likely that the existing monetary but not fiscal/political union is here to stay for some time. Many in Europe’s political elite plan to move quickly to greater union (see Andrew Watt here), but there are serious obstacles in their path. The current system can be made to work better, and strong countercyclical fiscal policy is an obvious part of that. Combining this with medium term deficit reduction is technically trivial. Just how many years and recessions does it take before what is obvious textbook macroeconomics can become politically acceptable?

Corbyn, QE and financial interests

Although this uses UK events as a spur, the point about QE is universal

Labour leadership candidate Jeremy Corbyn has shown some flexibility on his idea of People’s QE. That is perhaps a good sign for the future (if he wins), in terms of responding to informed criticism. As I have written before, the original proposal took two perfectly good ideas (we can do better than current QE, and the need for a National Investment Bank) and combined them in an unfortunate way. I was annoyed that this proposal had been made public with so little consultation, and that as a result it might discredit both of the two good ideas. Perhaps more optimistically it will instead spark a debate on each individually.

Here I want to talk about Quantitative Easing (QE). The basic idea behind QE is that by buying long term assets at a time when their price is high (interest rates are low) to make their price even higher (interest rates even lower) in the short term, and selling them back later when asset prices are lower (and interest rates higher), you could stimulate additional demand. At first sight it seems not too dissimilar to a central bank’s normal activities in changing short rates. There are however two major differences. The first, which in principle does not matter too much, is that the amount of money you create to ensure short term interest rates fall is modest. The amount of money you have to create to have any significant impact on long rates is much greater.

The second more important point is predictability. The central bank can have a large and fairly predictable influence on short term rates in the market. The impact of any amount of QE on long rates is much more uncertain, both in theory and in practice. Worse still, because its impact depends on certain institutionally specific market segmentation, or some very time specific signalling, and may also be quite non-linear, there is no reason to believe that any knowledge gained this time round will still be relevant the next time the instrument is used. In short, it is a lousy instrument.

That should mean that everyone is looking around for a better way of doing things when short rates hit their lower bound. Fiscal stimulus is the obvious candidate, but we know the political problems there. If you want to be kind, you can say that they illustrate the difficulties of apparently delegating stabilisation policy to a central bank, and then telling politicians that just when stabilisation is most needed they have to do it themselves. For that reason helicopter money is not just fiscal stimulus by the back door (and if the central bank is always underwritten by the fiscal authority, that could be all it is), but a means of giving the central bank the tools to do its job effectively whatever the size and sign of shock.

In the absence of an appropriate government fiscal policy, I find the logic for helicopter money compelling and the arguments against it pretty weak. But just as with fiscal policy, just because something makes good macroeconomic sense does not mean it will happen. I have always been reluctant to pay too much attention to the distributional impact of monetary policy, because it seemed like one of those occasions when even well meaning attention to distribution can mess up good policy. Yet in terms of the political economy of replacing QE, perhaps we should.

It is more likely than not that QE will lead to central bank losses. By this I mean that the central bank will have less money than if they had not undertaken the policy: whether they actually have to be recapitalised by the government is not the key issue here. After all, they are buying high, and selling low. That is integral to the policy. Who gains from these losses. Where does the money permanently created because of these losses go? To the financial sector, and the owners of financial assets (who are selling to the central bank high, and buying back low). In that sense, likely losses on QE will involve a transfer from the public to the financial sector.

If QE was the only means of stabilising the economy in a liquidity trap, because fiscal policy was out of bounds for political reasons, then so be it. The social benefits would far outweigh any distributional costs, even if the latter could not be undone elsewhere. But if QE is a highly ineffective instrument, and there are better instruments available, you have to ask in whose interest is it that we stick with QE?      

Going backwards on fiscal rules

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

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

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

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

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

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

The day macroeconomics changed

It is of course ludicrous, but who cares. The day of the Boston Fed conference in 1978 is fast taking on a symbolic significance. It is the day that Lucas and Sargent changed how macroeconomics was done. Or, if you are Paul Romer, it is the day that the old guard spurned the ideas of the newcomers, and ensured we had a New Classical revolution in macro rather than a New Classical evolution. Or if you are Ray Fair (HT Mark Thoma), who was at the conference, it is the day that macroeconomics started to go wrong.

Ray Fair is a bit of a hero of mine. When I left the National Institute to become a formal academic, I had the goal (with the essential help of two excellent and courageous colleagues) of constructing a new econometric model of the UK economy, which would incorporate the latest theory: in essence, it would be New Keynesian, but with additional features like allowing variable credit conditions to influence consumption. Unlike a DSGE it would as far as possible involve econometric estimation. I had previously worked with the Treasury’s model, and then set up what is now NIGEM at the National Institute by adapting a global model used by the Treasury, and finally I had been in charge of developing the Institute’s domestic model. But creating a new model from scratch within two years was something else, and although the academics on the ESRC board gave me the money to do it, I could sense that some of them thought it could not be done. In believing (correctly) that it could, Ray Fair was one of the people who inspired me.

I agree with Ray Fair that what he calls Cowles Commission (CC) type models, and I call Structural Econometric Model (SEM) type models, together with the single equation econometric estimation that lies behind them, still have a lot to offer, and that academic macro should not have turned its back on them. Having spent the last fifteen years working with DSGE models, I am more positive about their role than Fair is. Unlike Fair, I want “more bells and whistles on DSGE models”. I also disagree about rational expectations: the UK model I built had rational expectations in all the key relationships.

Three years ago, when Andy Haldane suggested that DSGE models were partly to blame for the financial crisis, I wrote a post that was critical of Haldane. What I thought then, and continue to believe, is that the Bank had the information and resources to know what was happening to bank leverage, and it should not be using DSGE models as an excuse for not being more public about their concerns at the time.

However, if we broaden this out from the Bank to the wider academic community, I think he has a legitimate point. I have talked before about the work that Carroll and Muellbauer have done which shows that you have to think about credit conditions if you want to explain the pre-crisis time series for UK or US consumption. DSGE models could avoid this problem, but more traditional structural econometric (aka CC) models would find it harder to do so. So perhaps if academic macro had given greater priority to explaining these time series, it would have been better prepared for understanding the impact of the financial crisis.

What about the claim that only internally consistent DSGE models can give reliable policy advice? For another project, I have been rereading an AEJ Macro paper written in 2008 by Chari et al, where they argue that New Keynesian models are not yet useful for policy analysis because they are not properly microfounded. They write “One tradition, which we prefer, is to keep the model very simple, keep the number of parameters small and well-motivated by micro facts, and put up with the reality that such a model neither can nor should fit most aspects of the data. Such a model can still be very useful in clarifying how to think about policy.” That is where you end up if you take a purist view about internal consistency, the Lucas critique and all that. It in essence amounts to the following approach: if I cannot understand something, it is best to assume it does not exist.

A sense of identity

Denis Snower has a provocative (at least for me) piece in Süddeutsche Zeitung in which he writes as follows:

“When the American economist and Nobel laureate Paul Krugman says that the Eurogroup requirements for Greece go “beyond harsh into pure vindictiveness, complete destruction of national sovereignty, and no hope of relief”, he does not derive his judgment from some firmly established economic theorem. When Joseph Stiglitz, another American Nobel laureate, says “What has been demonstrated is a lack of solidarity by Germany”, this is not an implication from some piece of analysis in his textbook. When five leading economists (Thomas Piketty, Jeffrey Sachs, Dani Rodrick, Heiner Flassbeck and Simon Wren-Lewis) write an open letter to Chancellor Angela Merkel, saying that “Right now, the Greek government is being asked to put a gun to its head and pull the trigger,” their perception does not come from rigorous theoretical and empirical analysis. Rather they are all expressing their feelings, which arise from their implicit sense of identity.”

Speaking for myself, I would disagree with the idea that our sentiments, however forcefully put, do not come from rigorous theoretical and empirical analysis. Greece is not the first country to borrow too much. As Jeffrey Sachs sets out here [1], examples from history (involving Latin America, Poland, Russia and Germany herself) show that “believing that indebted sovereign governments should always service their debts is a good working principle nine-tenths of the time, but can be a disaster the tenth time around. We must not push societies to the breaking point, even when they have only themselves to blame for their indebtedness.”

The theoretical analysis comes from not seeing this as just a zero sum game: as just a distributional struggle between Greece and her creditors. As a result of austerity, for every extra Euro that the creditors obtain right now from Greece, Greece loses resources that could amount to 4 Euros. (See here, footnote 2.) There are good macroeconomic reasons for believing that if this transfer to creditors is postponed, the cost to Greece will be much less. As is often the case with the austerity that the Troika demands, it is not evenly spread among the population, and the physical and mental health of Greek citizens has suffered as a result. Perhaps that knowledge influences the language that I and others have used, but it is a big mistake to believe that this passion is not firmly grounded in macroeconomic analysis and evidence.

Snower wants to play the sensible centrist. Unfortunately the current situation is not symmetrical. One side has all the power. One side has been dictating what has happened in Greece for the last five years. When we wrote “Right now, the Greek government is being asked to put a gun to its head and pull the trigger” I think that is a pretty accurate description of the politics. Should the five of us who sent an open letter to Merkel have done the same to Tsipras? What would it have said exactly: best to give in now because the longer you resist the more you will be punished by the Troika?

In the media outside Greece, the discussion is always portrayed as the Eurozone governments lending Greece yet more money. Yet Greece is now in approximate primary surplus, so the negotiations were really all about how quickly the Troika should be paid back. If economists can do nothing else, they should at least make this point in public.

I understand that it is difficult for some economists to go against the nationalist feeling in Germany and other countries. But if your investment advisor had encouraged you to buy some overseas financial asset that later turned out to be worthless, would you refrain from criticising them just because they shared your nationality? Economists in Germany and elsewhere need to start asking awkward questions of their politicians. Why was it necessary for these politicians to use their voters money to bailout the banks and others who had foolishly lent to previous Greek governments? Why, when it was obvious to everyone in 2015 that Greece could not repay all its debt, did the Eurozone group refuse to allow debt relief to be part of the negotiations? And of Schäuble in particular, is it really right that Greece is used as an example so that he can impose his financial will on other Eurozone countries?

Dennis Snower may be correct that what I write about Greece expresses my identity. It reflects my identity as a macroeconomist, and hopefully my humanity in understanding the serious damage that bad macroeconomic decisions can have.

[1] Sachs is writing following a response to our original letter to Merkel from Dr. Ludger Schuknecht, senior economist at the German Finance Ministry.

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.