Defining austerity redux

This is a rather dull post about definitions

In a previous piece I talked about how there is no clear definition of what we mean by austerity, and how different people mean different things. In the context of my ‘General Theory’ paper, I attempted a definition which made precise one strand of common usage. However, if you look at the comments to that post, others were not convinced.

Some recent exchanges on twitter have convinced me that we still need a clear definition, but that my own earlier attempt could be improved. In that earlier post I argued that equating austerity with one type fiscal consolidation - public spending cuts - was inadequate for two reasons. First, why not use ‘public spending cuts'! But second and more important, it would equate such consolidation taken at the height of a boom that did no damage to the economy with cuts in the depth of a recession.

The definition (call it Def A) I suggested was

“fiscal consolidation that leads to a significant increase in involuntary unemployment, or pwerhaps more formally but less colloquially as leading to a noticeably more negative output gap”.

If people wanted to restrict the definition to spending cuts, simply replace ‘fiscal consolidation’ with ‘cuts to government spending’.

One minor change I would now want to make is to remove the reference to involuntary unemployment. For a start unemployment may lag output, and conceivably unemployment could be avoided by workers pricing themselves into jobs, but this does not negate the fact that fiscal consolidation has reduced output and wasted aggregate resources.

However rephrasing the definition (Def B) to

“Fiscal consolidation/cuts to public spending that leads to a significantly more negative output gap”

still involves the problem that the output gap is poorly measured. For example, some think the UK output gap is currently zero, but I would want to apply the term austerity to the current fiscal consolidation. Replacing ‘negative output gap’ by ‘economic downturn’ does not help, and saying ‘in a recession’ actually makes it very restrictive given the formal definition of a recession. Another possibility would be to simply say (Def C) that austerity was

“Fiscal consolidation/cuts to public spending that leads to a significant fall in output”

The trouble with this is it allows austerity to be in some cases entirely appropriate: for example if spending was too high in a boom. Indeed that is the obvious problem with simply denoting austerity as cuts in public spending. There should I think be some connection with the other meaning of austerity i.e. hard times. Reducing spending in a boom is hardly that.

Let me go back to why I had a problem with definition B i.e. why would I want to apply the term austerity to current cuts in spending. The answer is that interest rates are at their lower bound. That suggests an alternative definition (Def D):

“fiscal consolidation/spending cuts that have a negative impact on aggregate demand which monetary policy is unable to offset.”

I prefer definition D to B because it gets to the heart of why austerity is a problem. The key idea is not that fiscal consolidation in some form is always bad or inappropriate, but that it should not take place when monetary policy is unable to offset its impact on output.

One of the criticisms of my original definition B, which also applies to D, is that it rules out the possibility of ‘expansionary austerity’. Instead we would have to call it expansionary fiscal consolidation. Once again, if we want this meaning of austerity to have some connection to hard times, then expansionary austerity seems a misnomer anyway.

I did warn you it was dull, but I really would be interested in comments on all this. Perhaps I should end on one reason why I think it is important. Suppose I asked what part of Labour's 2017 manifesto was anti-austerity? I think many would say the proposed increases in current government spending, but if you take the manifesto at its word that is not anti-austerity, because the spending increases are tax financed. What is anti-austerity, if you accept my definition, are the increases in public investment and the fiscal credibility rule.

Could independent central banks be advisory?

With fiscal councils (or Independent Fiscal Institutions) now commonplace in advanced economies, a natural question arises. Why are all these councils advisory, while independent central banks have control over monetary policy? For fiscal policy we seem to have delegated advice [1], while for monetary policy we have delegated control. In this post I want to focus on control over how policy instruments are changed, and not control of the goals of policy. For clarity assume that governments still control the ultimate goals of monetary policy (e.g. an inflation target) and fiscal policy (e.g. a target for the deficit in 5 years time).

As fiscal councils are the less familiar, it is natural to try and answer this question by asking why fiscal councils are not given control over fiscal policy. I am, of course, not talking about controlling the detail of government spending or taxes, but instead setting a target for the projected deficit which governments should aim to achieve in a budget. There are lots of potential answers to that question, which I have written about elsewhere.

However we could ask the question the other way around, and I cannot remember anyone asking it this way. Why are there no independent advisory central banks? In the UK, for example, imagine having the MPC meeting, and then immediately advising (in secret for a short time) the Chancellor of their recommendation for interest rates. The Chancellor would very quickly (within an hour or day?) decide whether to accept that recommendation or do something different. After that, the decision and the MPC’s recommendation would be announced.

Two straightforward points. First, a system of that kind could only work in the US if Congress gave the President the power to accept the Fed’s recommendation or impose the President’s own decision: perhaps not something we would want to contemplate right now. In the Eurozone the ECB would have to give recommendations to Ecofin, which might make it both impractical and perhaps undesirable. Second, this form of delegation is obviously weaker than giving complete control to the central bank, and that in itself may be a reason why it is not adopted.

Nevertheless, for a country like the UK, it would be a mistake to underestimate the political pressure the Chancellor would be under to accept the central bank’s public advice. The Chancellor or Treasury minister would be entirely responsible from deviating from the recommendation given to them, and if it went wrong they would incur a considerable political cost. In these circumstances, it would be understandable for governments to reason that there was little to be gained from having the power to overrule central bank advice. They would get it in the neck if they overruled this advice and turned out to be wrong, but equally if the MPC make mistakes they would also have ultimate responsibility for accepting this advice. If in practice nearly all of the time they are going to accept the central bank’s recommendations, why not give them complete control so that at least you are not implicated when things go wrong.

If this reasoning is correct, it raises a difficult question for those who argue against central bank independence but still accept monetary policy’s primary role in stabilising the economy outwith the ZLB. Of course many governments used to be happy to control monetary policy, as long as the advice they were getting was secret. But if that advice is public, as surely we all agree it should be, would even formally advisory central banks start to in effect control monetary policy because governments would never incur the risk of going against their advice? In which case, why so much fuss about independent central banks that do control monetary policy being undemocratic? I stress again that I’m talking about control of month to month interest rate changes, and not the goals of monetary policy (inflation targets or NGDP targets). I think those should be democratically decided (as in the UK, but not the US or EZ), and that central banks should be accountable in a meaningful way if they do not achieve these goals. But for the day to day business of setting rates, I cannot see that much would be gained by putting those under democratic control. 

[1] In the absence of delegating advice to an independent institution, advice would come from the the internal civil service. 

Why Brexit has led to falling real wages

This might seem easy. The depreciation immediately after Brexit, plus subsequent declines in the number of Euros you can buy with a £, are pushing up import prices which feed into consumer prices (with a lag) which reduce real wages. But real wages depend on nominal wages as well as prices. So why are nominal wages staying unchanged in response to this increase in prices?

Before answering that, let me ask a second question. Why hasn’t the depreciation led to a fall in the trade deficit? Below are the contributions to UK GDP from the national accounts data. Net exports are very erratic, but averaging this out they have contributed nothing to economic growth since the Brexit depreciation.

The belief that the depreciation should benefit UK exports is based partly on the idea that exporters will cut their prices in overseas currency terms, making them more competitive. Yet at the moment UK the majority of exporters seem to be responding to the depreciation not by cutting prices but by taking extra profits. If they keep their prices constant in overseas currency terms (from currency denomination data almost as many exports are priced in overseas currency as imports), sales will stay the same but profits in sterling will rise.

While this helps account for the lack of improvement in net trade, it increases the puzzle over why nominal wages are not responding to higher import prices. If exporting firms profits are rising because of the depreciation, why not pass some of that on to their workers?

One perfectly good answer is that the labour market is weak, and what has stopped real wages falling further is that firms do not like to cut nominal wages. In these circumstances there would be no reason for exporters to share their higher profits with their workforce. So the immediate impact of the depreciation has not been a decline in the terms of trade (export prices/import prices), but instead a shift in the distribution between wages and profits. But many people believe that, with unemployment falling rapidly, the labour market is not weak.

There is another reason why exporters might be increasing profits but not sales, and not passing higher profits on to higher wages, which goes back to a point I have stressed before. We need to ask why the depreciation happened in the first place. To some extent the markets were responding to lower anticipated interest rates set by the Bank of England, but there is more to it than that. Brexit, by making trade with the EU more difficult, will reduce the extent of UK-EU trade. Furthermore there are two reasons why Brexit is likely to reduce UK exports by more than UK imports.

The first is specialisation. Because countries tend to specialise in what they produce, they may not have firms that produce alternatives to many imports, making substitution more difficult. The EU produces many more varieties of goods than the UK, so they are more likely to be able to substitute their own goods to replace UK exports. The second is the importance for UK exports of services, and the key role that the Single Market has in enabling that. On both counts, to offset exports falling by more than imports after Brexit we need a real depreciation in sterling. Exporters will have to cut their prices in overseas currency terms, and a depreciation allows them to do this.

Of course Brexit has not happened yet. We still get a depreciation because otherwise holders of sterling currency would make a loss. So firms do not need to cut their prices in overseas currency yet, allowing them to make higher profits. But these higher profits will be temporary, disappearing once Brexit happens. It would therefore be foolish to raise wages now only to have to cut them later when Brexit happens (no one likes nominal wage cuts). To restate this in more technical language, when Brexit does happen the UK’s terms of trade will deteriorate as a response to export volumes falling by more than import volumes. Firms are in a sense anticipating that decline in the terms of trade by not allowing nominal wages to rise to compensate for higher import prices.

So before Brexit happens we are seeing a distributional shift between wages and profits, but once Brexit happens profits will fall back and we will all be worse off. For Leave voters who think this is all still just ‘Project Fear’, have a look at the national accounts data release that the chart above came from. It shows clearly that UK growth in the first half of this year has been slower than that in the US, Germany, France, Italy and Japan by a wide margin. What Leave campaigners called Project Fear is real and it is happening right now, but do not expect your government or some of your newspapers to tell you that. 

Would Remain win a second referendum?

I think it unlikely that we will have a second referendum before we leave in 2019. [1] Brexiteers fear losing it and Labour fears fighting it. So why ask the question? It will become clear.

I think if a second referendum was just a rerun of the first, then Remain would win comfortably. It is now pretty clear there will be no £350 million a week for the NHS, and instead as the OBR suggests there will be less money if we leave the EU. The economic concerns that the Leave campaign so effectively neutralised with ‘Project Fear’ are now becoming real: we had a depreciation (as predicted), real wages are falling, and GDP per head in the first half of the year is almost stagnant. I could go on, but this is enough for many Leavers to change their minds.

Partly because of this, a second referendum would not be a rerun of the first. Leave would have a new theme, which they would plug away at relentlessly. They would argue that the very existence of a second referendum was an attack on democracy. The people had already decided, and a second referendum was an attempt by MPs to take power away from the people. The people needed to take back control from MPs as well as the EU. They would argue that you should vote to Leave again to preserve democracy.

The simple point that people should be allowed to change their mind would be met by lots of rhetoric that sounds convincing. If a second, why not a third? Referendums are meant to last a generation, and not to be held every few years. (Quotes from David Cameron saying similar things from the last campaign would be trotted out.) We know from the polls that this argument has power, as many people who voted Remain think that nevertheless we should respect ‘the will of the people’. Many think that on a constitutional issue like this, a referendum should override the views of MPs, and will feel that by voting Leave they will be upholding this principle. In this sense it would be like the Labour leadership election in 2016, which Corbyn won in part because members felt MPs were trying to take members power away.

If your reaction to this is to say ‘what nonsense’ or ‘who would be so idiotic to fall for this tactic’ then you are who I’m writing this post for. The view that Remain lost and that result should be respected is a perfectly valid point of view. Furthermore, as Owen Jones has pointed out, the polls suggest there are many besides himself who take that view. It does the Remain cause no good whatsoever to suggest that people who hold this view are in any sense stupid. (The opposite is also true - the Re-Leavers view is also not obviously right, and needs to be argued. Is parliament overriding the referendum result really a 'coup against the popular will' when people realise they were duped and so no longer support Leaving?)

In addition, Remain campaigners just saying a majority of the electorate didn’t vote for Leave because some people did not vote will not convince anyone. Simply asserting that the original Leave campaign was based on lies is also not sufficient, because all election campaigns involve politicians telling lies of some kind. We need much better arguments than this if we are going to convince Remainers who think the original referendum result should stand.

A good place to start is a post by Richard Ekins, a Professor of Law at Oxford University, who argues “Political fairness and democratic principle require one to respect the outcome of the referendum even if one is persuaded that Brexit would be a very bad idea”. His arguments are strong and they need to be addressed (as I tried to do in March). We need to argue that the chosen electorate for the first referendum was not fair, and to allow just a simple majority to decide such an important and potentially irreversible event is not democratic, even after the event. We need to argue, as I tried to do, that the lies told by the Leave campaign went well beyond what normally happens in an election. In these circumstances a referendum result is not something to respect, but something you resist with all your power.

Remain campaigners also need to be politically realistic. To say, as some do, that Labour’s commitment yesterday (to staying in the Single Market and Customs Union during the transition period) means nothing and is “not good enough” because it still involves leaving the EU in 2019 completely misunderstands political realities. Brexit is not going to fall apart of its own accord. As George Eaton argues (see also Stephen Bush), the best bet for reversing Brexit is through a Labour government. Given this, to suggest that Labour would campaign against Brexit if it wasn’t for Jeremy Corbyn is both misdirected (it ignores many MPs in Leave voting constituencies who think Labour have to support Brexit) and counterproductive (if Brexit is reversed, it will likely be by a Labour government under Jeremy Corbyn).

When Owen Jones described ‘Hard Remainers’ online as increasingly resembling a cult, I was both shocked and surprised. I am, after all, someone who argues online that the referendum vote should not ‘be respected’. By cult he meant those he encountered who were

“Intolerant, hectoring, obsessively repeating a mantra that doesn’t convince outside of their bubble, subjecting any who dissent from their hardline stance to repeated social media pile-ons, engaging in outright abuse and harassment, saying that people who voted Remain aren’t really Remain supporters and are heretics.”

Now I like to think I do none of those things, and I know some of those campaigning to Remain who do not do these things either, but I can also see that others might take a much more aggressive and purist approach. This is a strange but I think real phenomenon: the less likely something is to happen, the more some demand that only it will do. The reality is that staying in the Single Market and Customs Union outside the EU permanently is a lot more likely than simply staying in the EU, and less costly that leaving either. Because it is obviously inferior to staying in the EU it may be how rejoining the EU eventually happens. Those campaigning to Remain are in no position to be aggressive or absolutist.

[1] A referendum where Remain is an option, and assuming we leave in 2019 and the Conservatives remain in power until then.  

Medicine and the microfoundations hegemony in macroeconomics

Mainly for economists

I’m beginning to think I should have made much more of analogies between economics and medicine in discussing what I call the microfoundations hegemony: the idea that the only ‘proper’ macroeconomic models are those that have all their equations consistently derived from microeconomic theory. The analogy I have in mind is that biology represents microfoundations, and statistical analysis linking, say, smoking to lung cancer are the non-microfounded models. (I've used the analogy in other contexts.)

I was thinking about this in the context of a paper I have just finished which uses a diagram that Adrian Pagan used to describe different types of macromodels. The diagram, which you can find in an earlier post, has ‘degree of empirical coherence’ and ‘degree of theoretical coherence’ on the two axes. Particular macromodels can be placed within this space. At one extreme involving the highest theoretical coherence but weaker empirical coherence are microfounded DSGE models. At the other are VARs: statistical correlations between a group of macro variables with no theory-based theoretical restrictions imposed. In the middle are what I call Structural Econometric Models and Blanchard calls Policy Models, which use an eclectic mix of theory and econometric evidence.

If you have a simple view of the hard sciences, this diagram looks very odd. Theories either fit the facts or they do not. But I think a medic could make sense of this diagram by thinking about medical practice based on biology (for example how cells work and interact with various chemicals) and practice based on epidemiological studies. Ideally the two should work together, but at any particular moment in time some medical ideas may borrow more from one side or the other. In particular, statistical studies could throw up links which do not have a clear and well established biological explanation.

Now imagine the microfoundations hegemony in macroeconomics applied to medicine. Statistical longitudinal studies in the 1950s showed a link between smoking and lung cancer, but the biological mechanisms were unclear. The microfoundations hegemony applied to this example would mean that medics would argue that until those biological mechanisms are clearly established they should ignore these statistical results. The investigation of such mechanisms should remain a top research priority, but for the moment advice to patients should be to carry on smoking.

OK, that is perhaps a little harsh, but only a little. That some macroeconomists (I call them microfoundations purists) can argue that you should model and give policy advice based not on what you see but on what you can microfound represents something that I cannot imagine any philosopher of science taking seriously (after they had stopped laughing).        

The BBC and Patrick Minford

Over the last few days the BBC has given considerable publicity to Patrick Minford’s new report published by the ‘Economists for Free Trade’. I have looked at both the BBC News website entry and listened to the Radio 4 Today programme’s discussion. They are both classic ‘2 sided controversy’ formats, with Monique Ebell from the National Institute of Social and Economic Research (NIESR) providing the main opposition.

So why was this coverage something the BBC should be deeply ashamed about? There are two main reasons, but first let me make a more general point which applies to journalism more generally. There is no quality control in most of the media when it comes to giving publicity to a report like this. There is a very simple reason for this, and that is the primacy given to immediacy. In a better world, when a report like this came out, journalists would spend a few days ringing around to see what the reaction of other experts were, or nowadays just look at reactions on twitter.

In this particular case such a strategy would have thrown up some apparently large errors, and this should have led journalists to question whether they should give the report any publicity. They might at the very least have waited until the full report was published next month.

Let me give an analogy. Suppose a report of a medical trial had suggested a miracle cure for some serious disease. The report had not been peer reviewed, and its author had connections to a drug company that stood to benefit from the alleged cure, but the BBC had decided to give it considerable publicity nevertheless. Within days it became clear that there were serious problems with the report, and that there were other existing papers that came to a completely different conclusion. The BBC would then look very foolish, and many sufferers from this disease would have been given false hope. I suspect for that reason the BBC would be much more cautious. Yet if the report is about a subject matter with any political implications this caution appears to go out of the window.

Now let me get to the two reasons why the BBC should be ashamed in this case. First, Patrick Minford is no expert in international trade. He is a macroeconomist, who in his younger, less obviously political, days served as something of a role model for me. He published a very similar argument about the benefits of unilateral trade liberalisation during the referendum campaign. It was heavily criticised by individuals or groups that are experts in international trade. So we have already had the quality control, yet the BBC decided to ignore that. Returning to my analogy, it is as if there had been earlier claims of miracle cure that had been thoroughly debunked by medical experts and the BBC had ignored these.

Second, at no point in either of the two items I looked at is there any mention that the overwhelming consensus among academic economists is that Brexit would be harmful to the economy. We just have reports that give two opinions, with no context whatsoever about which opinion is the consensus view and which is the maverick. It is exactly equivalent to giving considerable publicity to a report from some climate change denial outfit, and including a response from one or two climate scientists with no mention of what the consensus among climate scientists is. Again to draw on my analogy, it is like reporting a miracle cure and failing to say that nearly all doctors thought this was rubbish.

This last point about ignoring the clear consensus touches a particular nerve for me, because it is exactly what the BBC appeared to many of us to do during the referendum campaign. Yet when the Royal Economic Society complained about this, they were told that the economic consensus had been mentioned in this and that bulletin. Whether this was cherry picking by the BBC is not easy to establish after the event. [1] Well here is an example where it was not mentioned, and I would like to hear from the BBC why this information was not thought to be useful to convey to its audience. [2] 

On both counts, this is very bad journalism, even if you do not think economics has the same standing as medicine. The BBC may have thought they had brushed off complaints from economists, but here is a specific example where they really do have a serious case to answer. As Ben Chu rightly says: “The legitimate news story around Minford’s work is how bad science can survive and thrive when it supports the desires and prejudices of powerful people in our society … the BBC ... has become part of the problem.” Brexit is the Emperor's New Clothes, and no one - including the BBC - dares say that the Emperor has no clothes.

[1] Not easy but not impossible: it would cost a few thousand pounds in research time for someone to go through the main news reports during the Brexit campaign and establish how many times the economic consensus was mentioned.

[2] Channel 4 News did put the point to Minford that many economists thought his work was flawed, to which he responded by saying “all these trumped up economists and the consensus they are all hired hands”‘. A very political answer from a very political economist, and therefore very revealing, but not a question the BBC apparently thought worth asking.  

Brexit remains an exercise in deception

I talked last week about how the Leave campaign involved lies at its centre. Not the occasional exaggerations of the Remain campaign, but claiming things that were the opposite of the truth. Like there will be more money for the NHS, when in fact there will be less. That particular lie probably swung the result, according to the man who organised the Leave campaign.

Labour people tell me that public opinion on Brexit will turn once these lies become apparent, and at that point Labour can safely take up the Remain cause. What this overlooks is that the managing of information characterised by the Brexit campaign continues. The Tory tabloids continue to distort the truth, and the Telegraph acts in a very similar fashion. The UK government appears more interested in saying stuff to please its UK audience than actually negotiating with the EU, and its studies of the impact of Brexit remain secret [1].

Meanwhile the opposition give no hint of the costs that Brexit will involve, and by design or conflicted confusion are just a tiny bit less pro-Brexit than the government. The broadcast media, and particularly the BBC, appear hopeless at questioning the facade that both main parties and supporting think tanks have erected. I have never heard a politician pulled up for saying we must retain access to the Single Market: all countries have access to that market! (This is the kind of journalism we should be seeing.) Individual MPs are intimidated into silence by the power of the Tory tabloids.

When I talk to Leave voters, all they tell me is how the economic ‘catastrophe’ predicted by Remain did not come to pass, or other Leave nonsense talking points like the exchange rate was overvalued anyway. They are often unaware that falling real wages are the direct result of the Brexit depreciation, and as a result the economy hardly grew in the first half of this year. They, and many people who voted Remain, do not realise that the government’s position papers are largely fantasy and that the EU is in a position to dictate terms. This is not because these voters minds are closed. They just get their information from sources that go along with the government’s Brexit fantasy, unless they are fortunate enough to read the Financial Times. No wonder there has been no major change in public opinion since the referendum.

Those in the Labour party should realise more than most how the media can present a one-sided reality which many non-political voters accept, until they see for themselves the other side during a general election campaign. The problem with a ‘wait and see’ attitude to Brexit is that its major economic cost will not become apparent until years after we actually leave the Single Market. Few realise that the original Treasury study, with the central estimate of an average annual cost of £4,300 per household (6.2% of GDP) was not some piece of Remain spin but a perfectly reputable study, which economists at the LSE said was “overly cautious”. Instead we get nonsense like this reported by the BBC. [2]

Some time ago I calculated a conservative estimate for the cost of austerity, and it was £4,000 per household. Ironically it was based on OBR estimates that the MSM largely ignored, just as they ignore the OBR’s estimates for the short term cost of Brexit. But my austerity cost estimate was a total cost, over all the years of austerity. The Treasury estimate is a cost each year. There is therefore a strong liklihood that Brexit will be far far worse than austerity in terms of lost resources, and unlike austerity there is no way of avoiding these costs once we are outside the Single Market.

For Labour party members and MPs I would put it this way. Imagine winning the next election but having to accept continuing austerity. Winning an election after leaving the Single Market will probably be much worse, and of course the media and voters will blame it all not on Brexit but on Labour’s ‘far left’ policies. Winning an election after Brexit is a poisoned chalice.

[1] Here is Mike Galsworthy on this and the earlier 'Balance of Competences' reviews that the government kept very quiet about before and during the referendum.

[2] I’ve talked to people at the BBC, including their economics editor, about why they cannot apply the BBC Trust’s recommendations on science coverage to economics. (The Trust’s conclusion, in summary, is that in controversial areas the BBC should go with the overwhelming scientific consensus. In other words recognise scientific knowledge, and not treat it as just an opinion.) I think a summary of their response to my question is that economics should not be regarded as a science: there is no economic knowledge, just opinions. What that attitude means in practice is that the public do not hear from the many experts in international trade we have in the UK (and there are many), but instead they hear from Patrick Minford.