Stock-Flow Consistent models: response to Jo Michell

Jo has a thoughtful and constructive response to my post discussing a recent Bank of England paper that presents a new Stock-Flow Consistent (SFC) model. One of the reasons it is constructive is because it is not tribal: too many followers of heterodox schools seem to just want to rubbish mainstream macro and suggest their particular school represents the new dawn. So I thought I might make a few points on Jo’s post that might be helpful.

1. A model that includes a lot of institutional detail is not a virtue in itself: indeed if at the end of the day these institutions do not matter too much it is an unnecessary and distracting feature. A useful way to think about modelling approaches is in terms of the validity of simplifications or short-cuts. It is for this reason that my method of theoretical deconstruction outlined and demonstrated here for large models is so important. By trying to relate large model properties to simpler models, you find out where additional detail is important or unnecessary. And of course, the answer to that problem may be context specific.
   
   
2. I hope I never said SFC modes were “accounting, not economics”, because that statement makes no sense. Any behavioural model contains some kind of theory. What I think I said was that these models often seemed ‘light on theory’, which means that they talk a great deal about the accounting and rather little about theory.
   
   For example, to say that consumers have a desired wealth to income ratio is light on theory. Why do they have such a ratio? Is it because of a precautionary motive? If it is, that will mean that this desired ratio will be influenced by the behaviour of banks. The liquidity structure of wealth will be important, so they may react differently to housing wealth and financial assets. Now the theory behind the equations in the Bank’s paper may be informed by a rich theoretical tradition, but it is normal to at least reference that tradition when outlining the equations of the model.
   
   
3. It is true that stock-flow accounting is important in modelling, in the sense that doing it stops you making silly errors. But it is not dissimilar to identities or market clearing conditions in this respect. You would never call a class of models ‘National Income Identity models’. [1] If the point is to emphasise that stocks matter to behavioural decisions about flows, then that is making a theoretical point. As Jo says, DSGE models are stock-flow consistent, but in the basic model consumers have no desired wealth ratio: it is the latter that matters. So when Jo says this absence should ring alarm bells, he is making a theoretical statement.
   
   I think Jo is right that the SFC name is unfortunate, but you can make a similar case for the name DSGE. It only matters when some people believe that stock-flow consistency is some kind of heterodox invention. Equally the label DSGE becomes a problem when economists start thinking that macroeconomists cannot do partial equilibrium any more, a point that Blanchard makes in his discussion of DSGE models.
   
   
4. When Jo tries to connect the unimportance of stocks in DSGE to the return to full employment I think he is painting with too broad a brush. Let’s take a simple example. In the baseline small open economy model of mainstream macro, a temporary shock that leads to a current account deficit will permanently reduce welfare because net assets permanently fall. The trade balance has to improve, and consumption is therefore lower. A permanent depreciation worsens the terms of trade. In that case what happens to stocks has a permanent effect. Indeed, if you alter the model by replacing the consumption function with one based on Blanchard/Yaari consumers, there would be a feedback from wealth to consumption which would mean this shock would no longer have a permanent effect.
   
   
5. In using the quote of mine about ‘not their field’ from a previous post he is rather unfair. As I go on to say, mainstream macro was at fault in neglecting finance. Pretty well every mainstream macroeconomist will say the same. The point I wanted to make was that it is not true that they all did this because they were sure it didn’t matter, the sector would regulate itself etc etc. What I have argued in this paper is that macroeconomists might well have not neglected the financial sector if they had allowed more traditional aggregate (i.e. non-microfounded) models to continue to be a legitimate area of academic research. Some might want to argue that this neglect of the financial sector reflected that mainstream macroeconomists were inherently neoliberal and believed financial markets looked after themselves. Perhaps some were, but plenty of others were not.
   
   
6. I also think it is a bit unfair to suggest that I was criticising the model in the Bank’s paper. As it represents an alternative to DSGE models it should be welcomed. (Especially so for the Bank. Many public institutions, like the Fed, have maintained their aggregate models alongside DSGE models: the Bank of England has not.) What I was criticising was (a) the emphasis in the paper on the accounting at the expense of theoretical discussion (b) that the paper ignored the non-DSGE non-Post Keynesian modelling tradition.

[1] It may well be that the models I quoted, like the 1970s Treasury model, were SFC because of the influence of Godley, but they would have thought that this was just good modelling, and not a defining aspect of what they were doing. 

The UK goes back to the 1950s

I have always felt that the British were slightly obsessed by anniversaries, particularly if it involves anything to do with the two world wars. It seemed unhealthy, perhaps encouraging beliefs that should have died with our empire. And perhaps more generally it encourages an unhealthy nostalgia.

One of the clear dividing lines in the EU referendum between those voting Leave and those voting Remain was how they felt about the past. Asked if life in Britain was better or worse than it was 30 years ago, those voting Remain had a 46% balance saying better, while Leave voters had a 16% balance saying worse. While those on the left tend to see this as a protest by a working class left behind by de-industrialisation, it was also a protest by social conservatives who like to think of England as cricket on the village green.

The Brexit vote takes us back not to the 1970s when we joined, but back to the 1950s. Britain first tried to join the EU in 1961, but was rebuffed by De Gaulle in 1963. Theresa May’s call for the return of Grammar schools (selection into different schools at the age of 11) also takes us back to the 1950s. One of the major achievements of the Labour government of the 1960s was to largely phase out selection at 11.

The pretext May uses for reintroducing grammar schools is that it will help increase social mobility. The evidence is clear: it does not. A few local authorities did manage to retain grammar schools, and the evidence from them is also clear. The following graph is taken from a post by Chris Cook.

FT points are a measure of educational attainment. The graph clearly shows that while the very rich might do slightly better in areas where grammars remain, the poor do very much worse.

In short, reintroducing grammar schools is simply reactionary. We are going back to a time where class divisions were far more entrenched than they are now. It is possible that this can be avoided, but it requires those in the Conservative party who prefer living in this century to the last to say no to their Prime Minister. They could not stop the UK voting for Brexit, but they can stop this.

Voters making big mistakes

In the last year we will have seen three occasions where large numbers of people voted in ways that seem to fly in the face of expert advice. I’m talking of Brexit of course, where 52% of voters chose a course of action which will make them worse off. The choice of Donald Trump as the Republican’s candidate for President, a con man and egotist who is not fit to hold public office. And finally Labour party members, who are about to elect as leader someone who seems almost certain to badly lose the next election.

The experts were different in each case: economists in the case of Brexit, people with knowledge of government for Trump, and political scientists plus psephologists for Corbyn. Now of course some people who voted for Brexit wanted it even if it cost them, but most did not. Some people think a con man and egotist would work well as President, and some Labour party members are quite happy to lose elections. But I think in every case those people are in a minority.

Why have experts been ignored in these cases? Politicians ignore experts all the time, but that is because of their own self interest or ideology. In the three cases above the experts are advising or have advised that actions will amount to self harm.

I’ve included the Corbyn case because it puts in doubt an explanation for the first two that I have seen elsewhere. It is technically known as the Dunning-Kruger effect, but I like to think of it as Springfield and the Monorail. Basically the idea is that people who know little are unaware of their ignorance, and can be easily conned. The reason this explanation is sometimes invoked is that support for both Brexit and Trump is stronger among those without college degrees. It is an explanation that leads to advocating meritocracy and questioning democracy. But that explanation cannot work for Corbyn supporters, who on average are very politically aware.

One obvious point to make is that in all three cases the expertise gets diluted in three related ways. All three disciplines are ‘inexact’. In all three, you more often see people without expertise talk about these issues in the media. And in all three some experts are subject to political or ideological bias. All that helps, but is not enough to explain self harm.

Another striking commonality is that expertise has become associated with elites who were once trusted and where voters now feel their trust has been betrayed. I talked here about how the Brexit vote was the result of combining two large minorities: those that felt they had been left behind socially, and those that had been left behind in terms of prosperity. I remember on the occasions I have written about the Conservatives continuing drift to the right, I have had comments which in essence say ‘nonsense: gay marriage’. When it came to the referendum the betrayal was the failure to control the social change implied by immigration. More directly concerned with economics were those left behind economically. I’ve been told of one meeting where the response to the argument that EU membership had increased GDP was ‘maybe your GDP but not my GDP’. This association of experts with an elite that has helped leave a whole section of society behind is discussed in this perceptive article by Jean Pisani-Ferry.

With Trump the elite in question are the elder statesman of the Republican party. For fifty years they have pursued a “southern strategy” that made elections about race and culture, and had used this strategy to enact economic policies that were certainly neoliberal but in particular favoured those who were already extremely well off. The cost of this strategy was that Republicans gradually became the party of the white, non-college educated working class which had no interest in lining the pockets of the economic elite. As Lee Drutman so clearly explains, this contradiction could only be disguised by upping the rhetoric that “allowed the party to keep its donor-class activists happy by obscuring these donors' deeply unpopular policy goals under the guise of something else.” The inevitable conclusion of that process was Donald Trump. The warnings against his candidacy by Republican leaders were discounted by an electorate who felt these leaders had given them nothing in economic terms and had failed to stop a black US president.

The Labour party under and after Blair had a model where it tried to occupy the centre ground by being just to the left of the Conservatives (triangulation). From 2010 George Osborne used this to pull Labour this way and that, and then leapfrogged over them with policies like hiking the minimum wage. In contrast the Conservative’s strategy was smarter in terms of winning votes. (A lot of it was imported from the Republicans in the US.) Play on people’s fears after the recession by going on about public debt, and use that as a lever to reduce the size of the state. Reduce welfare payments by demonising claimants as workshy and feckless. This was not triangulation. Corbyn’s election was the understandable reaction to Labour’s fruitless drift to the right. Yet it brought with it a complete distrust of not just of the PLP, but also the language and thinking that had been used by the PLP. The language of needing to be electable, and the means of deciding whether you were achieving that goal, had become tainted by its previous users. It is as if the problem with triangulation was not that it was the wrong model, but just thinking about developing strategies to win votes is wrong.

A key lesson in all cases is that what we saw, or are seeing, is a reaction to failures by an elite. Not entirely: I cannot see that much can be done about people who think gay marriage is a sign that the Conservative party has swung to the left, nor would I want to pander to racism. But the consequences of allowing sections of society to be left behind in terms of prosperity or economic dynamism are clear. Equally it is clear what happens to a political party when the elite lose touch with not just their membership, but also the consequences of profound economic change.

One final commonality is that the people who are rejecting experts are being conned. With Brexit it was the idea that leaving the EU and controlling immigration will make lives better rather than worse for those that have been left behind in economic terms over the last few decades. The people who really mattered in playing that con were not a few bumbling politicians but the right wing press. With Trump they are being conned by the notion that one rich man who is full of himself can turn things around to their advantage, a con perpetrated by both the man himself and the media outlets that give him support.

Labour party members are being conned not by a person or group of people, but by a set of ideas. The idea is that this leadership contest is a battle for democracy, and the most important goal is to create a party whose leadership and MPs reflect members views. The idea that all MPs should all agree with the majority of members, which effectively stops Labour being a broad church. The idea that it is more important to build a social movement than an effective parliamentary party (and to imagine that they are building that movement). The idea that no credence should be given to how voters perceive leaders (see here and here), because the decline in neoliberalism will ensure eventual victory. These are ideas that will destroy the party as an effective political force.  

Labour elections: a response to Chris Dillow

Chris Dillow’s post today is so concise, comprehensive and in my view largely correct that I cannot help responding to it.

The case against Corbyn

I only have two comments on this, which go in different directions

C1) A case can be made that Corbyn needs to stay in control for as long as it takes to change the voting procedures for leaders so the PLP can no longer block left candidates. He is, in that sense, a placeholder. That is why I suggested Smith commit to make similar changes, and he has not. The only caveat to that argument is that Corbyn’s popularity may mean he carries on too long: a placeholder who cannot give up his place.

C2) I am much less dismissive than Chris of the polling information we have on Corbyn. I have not found anyone who studies these things who gives Corbyn any chance at all, and they are not all politically biased when they say that. It is hardly a precise science, but there are regularities there that should not be dismissed. There is also for me the killer common sense point: why would anyone who is not a politics geek vote for a leader that 80% of his MPs had no confidence in.

The case against Smith

S1) I’m less worried about the ‘mis-speaking’: you cannot at the same time appear authentic and not do this, and the importance voters place on this is wildly exaggerated. It was trying to avoid this that got us Labour politicians who seem to speak in gaff proof platitudes. 

S2) I am more worried on the policy and judgement side. Alas, I see few politicians you do appreciate the big difference the financial crisis has made. I think the point about Corbyn and clocks is correct: part of the Owen Jones cri de coeur was about this. But equally I have seen little from Smith on any overarching political or economic vision. He has said nothing on the Economic Advisory Committee or fiscal rules: small things but so easy to do I wonder why he hasn’t done them. The one point I would make in Smith’s favour is he has Brexit right. Ironically it is here that Corbyn and his supporters sound like triangulators: we must not be too pro single market/freedom of movement because that will antagonise the traditional heartlands.

S3) The generational divide point is overrated. Also for the reasons I’ve already given Smith is likely to do much better in a general election than Corbyn.

Overall judgement

The way to look at this election is in terms of disaster avoidance. Corbyn risks a split left and a wipe out at the general election. I can see a path where a split is avoided and someone takes over from Corbyn in time and with the qualities required to bring the party back, but that will not happen until after 2020 so we are talking a Tory government for the next decade at least. But there are so many obstacles on this path, like boundary changes, or the absence of a strong successor in the Corbyn group, that I give it a very low probability. In other words a disaster of one kind or another is pretty likely. In short, so much of this is something I have already lived through once before.

One disaster with Smith is a return to triangulation and a drift back to the ways of 2010-2015. But it will not be the same as 2010-2015, mainly because the Conservatives will not put deficit reduction at the heart of their strategy. Brexit has changed that, which is something many Corbyn supporters fail to see. Brexit also stops appeasement on immigration. Partly as a result I think there is a good chance that the centre left have now learnt the right lesson from 2015. Another disaster will be more personal - he is just not up to the job, and Labour will do almost as badly at the polls as they will with Corbyn. Again possible but unlikely: he has passed the Today test. To sum up, I cannot by any stretch of the imagination get these two combined to come close to the likelihood of a disaster under Corbyn.

Which is basically it. If you think that something like the Blair/Brown government was little better than the Tories, and therefore want to shoot for the moon, it is clear what you do. If you do not think that, and want to avoid a disaster for the left, you do the opposite. Doing nothing, to be honest, is a cop out.

Connecting the dots

John Harris has an excellent article in the Guardian, listing the number of politicians in the UK and EU who have retired to lucrative jobs, often in the financial sector. He links that directly to popular distrust of our ruling elite. I want to make the same connection, but via a slightly more elaborate but perhaps more worrying route.

First, let’s think about the financial crisis. The damage caused by that crisis has been huge, and not just because of the recession it caused. In many countries it seems to have permanently reduced the growth in productivity, meaning that compared to a world in which it did not happen we are permanently poorer by a large and growing amount.

Now as an economist I get a lot of stick about my profession failing to predict this crisis. But economists have not been reticent in thinking about how to prevent the next one. The fundamental weakness of the financial sector is the relative absence of capital (equity) compared to other companies. But the adjustments forced on banks since the crisis have been marginal, and certainly not enough to prevent another crisis.

It is natural to ask why. You might think that getting very tough with banks would have been politically popular? Measures could have been phased in to avoid any short term damage to lending. So why have politicians, and the senior civil servants who advise them, been so tentative? (For that matter, why don’t we change the way multinationals are taxed?)

Or if we go to the Eurozone, the decision to stop Greece defaulting in 2010 was the result of fear that the European banking system was too weak to cope. The consequence was crippling austerity for Greece, and bailing out European banks by the back door using Troika loans to Greece. You might think that European politicians would as a result be particularly keen to ensure that this kind of thing would never happen again, but there too action has been very limited.

If we were talking about the United States, the answer to why the financial sector is treated with kid gloves despite the problems it has caused would be obvious: the financial sector provides a huge amount of funding for politicians to spend getting elected/re-elected. In Europe that does not happen so much. But the expectation of financial reward for good behaviour in the form of employment after a politician retires may be just as effective an incentive. 

So any distrust that people have in our ruling elite and the political system that supports them is not some irrational form of envy. Politicians retiring to lucrative jobs is not inevitable and largely harmless. It is a form of corruption. It strikes at the heart of why we had a financial crisis which has made almost all of us a great deal poorer, and why little has been done to prevent another. The main beneficiaries of the public's reaction to economic hardship and elite corruption may be the likes of Donald Trump and Marine Le Pen.      

Why does anyone listen to Nigel Lawson?

The Financial Times let’s him write an op-ed which extols the benefits of a quick and hard Brexit. The reason they published it is presumably the one provided by Lawson himself in this piece:

“I was a member of the Thatcher government of the 1980s that transformed the British economy, an achievement acknowledged throughout the world at the time.”

That is indeed the received wisdom in much of the media, but of course they have axes to grind. If you look at the most basic measure of national prosperity, GDP per head, the underlying trend is remarkably constant from the 1960s until the financial crisis (see here). Now that itself does not prove anything, but it means there is no obvious sign of a transformation.

However we have to add, in this context in particular, that the UK had two things going for it during the Thatcher period which should have led to a more rapid growth in prosperity. The first is North Sea oil coming on stream. The second is being a member of the EU. Let me quote some recent analysis by Nick Crafts, perhaps the best economic historian in the UK today. (You will remember it from the extensive coverage it had in the media during the Brexit campaign. What, you missed it?)

“Joining the EU membership raised the level of real GDP per person in the UK compared with the alternative of staying in EFTA. The deeper economic integration that EU membership entailed increased trade substantially and this had positive effects on income. Using a variant of the standard methodology pioneered by Frankel and Romer (1999) suggests that the impact was an annual gain equivalent to about 10 per cent of GDP. This far exceeded the ‘membership fee’ required in terms of the net budgetary contribution and net costs of regulation which have totalled about 1.5 per cent of GDP.”

Given the lags involved, a substantial part of that benefit would have accrued in the 1980s.

I have a post looking at some of the failures and successes of the Thatcher era here. One failure I highlight was the 1980 recession. The scale and rapidity of that recession undoubtedly did some permanent damage to a large section of the UK population. However on this occasion the government was warned by economists in the Treasury that their policies would have this result, and these civil servants were ignored. One of the Treasury ministers at the time who arrogantly dismissed these warnings of a recession was Nigel Lawson.

Finally we come to climate change. In 2009 he founded an organisation dedicated to arguing against measures to tackle climate change (details here). That alone should mark him out as someone who is misguided, wrong and dangerous. Indeed just the character traits that help you become an advocate of a hard Brexit.

Fiscal rules and MMT

What I call the ‘consensus assignment’ in modern macroeconomics is that monetary policy keeps output stable at a level that leaves inflation at target over the medium term, and fiscal policy stabilises the ratio of government debt to GDP. Most mainstream macroeconomists understand that assignment does not work at the Zero Lower Bound (ZLB), but a few disagree. To those that follow MMT fiscal rules that target the deficit are wrong because they think fiscal policy should do the job monetary policy is supposed to do in the consensus assignment, even outside the ZLB. They do not think monetary policy is predictable or reliable enough to do the job the consensus assignment gives it. That is a perfectly legitimate view, but one I and mainstream macro do not agree with. I discussed all this here in March.

Contrast this simple one paragraph explanation to this post, which takes 14 paragraphs to miss this basic point. Instead it says

1. I assume that output is constant (my italics)
   
   
2. I prefer models about how the world should work rather than how it works
   
   
3. I am “a static kind of man living in a dynamic world”
   
   
4. I am “a proponent of waste”
   
   
5. People should question my veracity when I make my arguments

The first three are mistakes I can understand, because for some reason he has failed to grasp the point about monetary policy and has tried to come up with other rationalisations. But the final mistake is going too far: just because you cannot understand another point of view does not mean the other person must be lying. Is this acceptable discourse within MMT?