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.
Sunday, 16 December 2012
Saturday, 15 December 2012
Delegation and accountability
Ian Mulheirn of the UK's Social Market Foundation uses lots of evocative phrases in a recent post on the OBR’s role in the Autumn statement: he talks about the wizard of OZ, economic high priests handing down prognostications on tablets of stone, Robert Chote (director of the OBR) as a kind of Pope, and more. But behind all this is a crucial point about the delegation of key economic judgements to experts. Ian expresses a feeling that is shared by many, but which I think is mistaken.
First a brief recap. As I explained here, given the Chancellors fiscal mandate, the extent of UK austerity depends crucially on the judgement of the UK’s independent fiscal council about what the output gap is. Now, its the Chancellor’s choice to pursue this path, and as I argue here, it is not a good path in the current circumstances. But having set these parameters, the OBR’s judgement is critical in determining the medium term fiscal stance. Unfortunately, given the recent behaviour of UK productivity, no one has much of a clue what the current output gap is. Until the Autumn statement the OBR had been following a consistent approach, based on survey evidence, but this time it found that approach produced results it found unbelievable. So it is now, like everyone else, making it up as it goes along.
Ian does not disagree with this move, and as he notes others have gone further than the OBR in discounting the survey evidence. But nevertheless he says of this change: “ The loss of consistency and the sudden wholesale re-evaluation of its approach makes the OBR’s processes opaque and unpredictable for outsiders.” This is true, but would he rather the OBR stuck to an approach to measuring the output gap that it, and most others, no longer believe - just for the sake of consistency?
I think his real complaint is about accountability. To quote again: “Back in 2010, the case for the OBR was that independent economic experts would yield better judgments about crucial things such as the structural deficit than politicians. What that argument overlooked was that politicians are at least accountable for their judgments at the ballot box.” Now I think many feel the same way, so lets explore just what is meant by accountability here.
A political party is accountable at the ballot box for everything it does, all at once. And I can safely say that you will find it very hard to discover a voter who will say in 2015: I’m not voting for the Conservatives because the Chancellor got his calculations about the output gap wrong. By contrast, Robert Chote's reputation will depend in large part on the judgements he makes on this issue. Partly for that reason, I know who I’d prefer making these judgements, even though I cannot vote for or against him.
There is also a certain naivety in the way even some macroeconomists talk about evaluating these judgements. If we are talking about a forecast, they suggest the judgement is simply based on whether the forecast is right or wrong. Yet anyone who knows anything about macro forecasts knows this is silly. To test the ability of a macro forecaster by results, you need a large number of forecasts to separate luck from judgement, by which time the forecaster is safely drawing their pension. The only short term criteria we really have to make a judgement is the quality of their analysis, as judged by other experts.
This is why it is very important that an institution like the OBR or a central bank is accountable in a clear public manner to those with expertise in the area. If that institution starts taking judgements that clearly deviate from what outside experts regard as reasonable, there should be mechanisms by which the leadership of that institution can be changed. The way the Treasury Select Committee works in the UK, while far from perfect, provides accountability along these lines. The absence of similar mechanisms in the Eurozone is a real concern. Where such accountability exists, I think it is superior to any appeal to the ‘judgement of the ballot box’.
As I have argued before, there are structural flaws in getting politicians to make judgements that involve technical expertise, which the ballot box does not resolve. Delegation to independent institutions can avoid these flaws. However these institutions will invariably have to tread a careful path, because their advice has political implications. Here I do have a little sympathy for Ian’s point of view. There is no doubt that the current government has taken every opportunity it can to use the OBR as cover. In his Autumn Statement speech the Chancellor again used analysis the OBR has done about its forecast errors to suggest that the UK’s second recession had nothing to do with austerity. This is a simple case of economic deceit.[1] If my judgement had been misused in this way, I would want to make that misuse as clear as possible in a very public manner, because I had a reputation to protect. Whether the OBR has done that in this case I leave as an exercise for the reader.
[1] Austerity in itself will depress the economy, but a forecast that included it could still be optimistic because of other factors. If these other factors do not materialise, the forecast will be wrong for that reason, but austerity has still depressed the economy. Now whether some of the OBR’s forecast error is due to underestimating the impact of austerity is another matter, so I will not comment on it here, as others have already done so.
First a brief recap. As I explained here, given the Chancellors fiscal mandate, the extent of UK austerity depends crucially on the judgement of the UK’s independent fiscal council about what the output gap is. Now, its the Chancellor’s choice to pursue this path, and as I argue here, it is not a good path in the current circumstances. But having set these parameters, the OBR’s judgement is critical in determining the medium term fiscal stance. Unfortunately, given the recent behaviour of UK productivity, no one has much of a clue what the current output gap is. Until the Autumn statement the OBR had been following a consistent approach, based on survey evidence, but this time it found that approach produced results it found unbelievable. So it is now, like everyone else, making it up as it goes along.
Ian does not disagree with this move, and as he notes others have gone further than the OBR in discounting the survey evidence. But nevertheless he says of this change: “ The loss of consistency and the sudden wholesale re-evaluation of its approach makes the OBR’s processes opaque and unpredictable for outsiders.” This is true, but would he rather the OBR stuck to an approach to measuring the output gap that it, and most others, no longer believe - just for the sake of consistency?
I think his real complaint is about accountability. To quote again: “Back in 2010, the case for the OBR was that independent economic experts would yield better judgments about crucial things such as the structural deficit than politicians. What that argument overlooked was that politicians are at least accountable for their judgments at the ballot box.” Now I think many feel the same way, so lets explore just what is meant by accountability here.
A political party is accountable at the ballot box for everything it does, all at once. And I can safely say that you will find it very hard to discover a voter who will say in 2015: I’m not voting for the Conservatives because the Chancellor got his calculations about the output gap wrong. By contrast, Robert Chote's reputation will depend in large part on the judgements he makes on this issue. Partly for that reason, I know who I’d prefer making these judgements, even though I cannot vote for or against him.
There is also a certain naivety in the way even some macroeconomists talk about evaluating these judgements. If we are talking about a forecast, they suggest the judgement is simply based on whether the forecast is right or wrong. Yet anyone who knows anything about macro forecasts knows this is silly. To test the ability of a macro forecaster by results, you need a large number of forecasts to separate luck from judgement, by which time the forecaster is safely drawing their pension. The only short term criteria we really have to make a judgement is the quality of their analysis, as judged by other experts.
This is why it is very important that an institution like the OBR or a central bank is accountable in a clear public manner to those with expertise in the area. If that institution starts taking judgements that clearly deviate from what outside experts regard as reasonable, there should be mechanisms by which the leadership of that institution can be changed. The way the Treasury Select Committee works in the UK, while far from perfect, provides accountability along these lines. The absence of similar mechanisms in the Eurozone is a real concern. Where such accountability exists, I think it is superior to any appeal to the ‘judgement of the ballot box’.
As I have argued before, there are structural flaws in getting politicians to make judgements that involve technical expertise, which the ballot box does not resolve. Delegation to independent institutions can avoid these flaws. However these institutions will invariably have to tread a careful path, because their advice has political implications. Here I do have a little sympathy for Ian’s point of view. There is no doubt that the current government has taken every opportunity it can to use the OBR as cover. In his Autumn Statement speech the Chancellor again used analysis the OBR has done about its forecast errors to suggest that the UK’s second recession had nothing to do with austerity. This is a simple case of economic deceit.[1] If my judgement had been misused in this way, I would want to make that misuse as clear as possible in a very public manner, because I had a reputation to protect. Whether the OBR has done that in this case I leave as an exercise for the reader.
[1] Austerity in itself will depress the economy, but a forecast that included it could still be optimistic because of other factors. If these other factors do not materialise, the forecast will be wrong for that reason, but austerity has still depressed the economy. Now whether some of the OBR’s forecast error is due to underestimating the impact of austerity is another matter, so I will not comment on it here, as others have already done so.
Thursday, 13 December 2012
Monetary Policy Innovations
It is always interesting to compare the Fed, ECB and Bank of England. For both the Fed and ECB it has been quite a year for innovation. At the Fed the most recent announcements in terms of forward guidance can be seen as just a development of how it began the year, by publishing its own forecasts for interest rates. Once you tell others how you expect policy to develop given one (central) projection of how the economy will go, it is natural to say how it might develop in other circumstances. Just as it seemed to me the first development was eminently sensible (but others disagreed), so I think recent moves are as well.
Do they mark a substantial shift in policy? Brad DeLong thinks so, but Paul Krugman is more downbeat. I think the answer depends on the timespan you are looking at. In terms of the very recent developments, they are perhaps not a huge shift, although I agree with Mark Thoma that raising the inflation target from an ‘apparent 2%’ to a ‘definitely at least 2.5%’ is significant. Seen over the year as a whole, and including the idea of continuing QE, I think it is an important change.
The ECB has also had an innovative year, but from a different starting point. OMT was a big deal not in terms of central bank practice - it just allows the ECB to do what others are doing already, but with a much more limited remit and under conditionality - but it was a big deal in terms of the mindset of the ECB. However, whereas I think the Fed has been consistently building one innovation on top of another, it seems as if OMT was such an effort for the ECB that they want a rest for at least a year or so. But the Eurozone is starting a new recession, while the US is at least growing. So in terms of what is needed, the ECB is looking at least as out of touch with reality as they did a year ago.
Which brings us to the UK. Now it was only a Christmas Party, but Stephanie Flanders’ account of Bank reactions to the Fed moves sound depressingly plausible. I remember hearing similar reactions to Fed policy as the financial crisis began (‘they will regret cutting rates so quickly’), and to their publication of interest rate forecasts (‘a rod for their backs’). Now if everything was hunky dory in the UK such conservatism might be forgiven, but its not. So it seems that if you want innovation at the Bank, it needs to be imposed from outside.
Which is why this recent speech from Mark Carney has attracted a lot of interest. It has been interpreted by some as arguing for NGDP targets, but I think it is more nuanced than that. Carney clearly argues that forward guidance is useful, but it is much more useful for a country like the US which does not have an overriding inflation mandate than it could ever be for the UK which does. The Bank of England, whoever is Governor, will never say that they will not think about raising interest rates until inflation goes beyond 2.5% because they would be clearly going outside their remit.
On NGDP targets, Carney is quite equivocal about their use in normal times, but sees clear advantages as a device for dealing with the Zero Lower Bound (ZLB). So one interpretation of his remarks is that, yes, they might have been useful back in 2008/9, but they are less useful today. However I think its also possible to take a more optimistic view. As long as we do not treat the survey evidence too seriously, acknowledging that there is a significant output gap (x% say) implies that any NGDP path has to start at a point x% above current NGDP. So even if the long term desired NGDP growth rate is 4% (2% real + 2% nominal), the target for NGDP growth for the year the policy begins will be 4%+x%, which implies a much more aggressive monetary expansion than we have at present.
To get this aggressive monetary stimulus for the UK, I still prefer my suggestion of moving temporarily to a 4% earnings growth target. (Latest number 1.3%.) There are two reasons. First, this puts no upper limit on GDP growth. If in fact the output gap is y% rather than x%, where y is much higher than x, a 4% earnings path will not stop us closing that gap quickly, whereas a NGDP path based on x% might. Second, I take a pessimistic view that x% will be chosen very conservatively, as a price for what will be seen by the indigenous Bank as a radical move. I can also see it taking time to come, because the new Governor will want to persuade, rather than impose his views. If, indeed, these are his views, which as I suggest above the speech leaves open.
I want to end by returning to the general theme of central bank innovation, and the lack of it in the UK. In the reaction on the Carney speech, one report suggested that the Chancellor was open to new ideas that might come from the new Governor. I think this tells you a lot about the current Chancellor. Even though he is in charge of the monetary policy framework and the target itself, he still waits for any suggestion of change to come from the Bank. I cannot imagine Gordon Brown, or indeed Alistair Darling or Nigel Lawson, waiting to hear from the Bank before thinking about changing macroeconomic policy. Perhaps the curtains of No.11 are closed while others do all the hard work?
Do they mark a substantial shift in policy? Brad DeLong thinks so, but Paul Krugman is more downbeat. I think the answer depends on the timespan you are looking at. In terms of the very recent developments, they are perhaps not a huge shift, although I agree with Mark Thoma that raising the inflation target from an ‘apparent 2%’ to a ‘definitely at least 2.5%’ is significant. Seen over the year as a whole, and including the idea of continuing QE, I think it is an important change.
The ECB has also had an innovative year, but from a different starting point. OMT was a big deal not in terms of central bank practice - it just allows the ECB to do what others are doing already, but with a much more limited remit and under conditionality - but it was a big deal in terms of the mindset of the ECB. However, whereas I think the Fed has been consistently building one innovation on top of another, it seems as if OMT was such an effort for the ECB that they want a rest for at least a year or so. But the Eurozone is starting a new recession, while the US is at least growing. So in terms of what is needed, the ECB is looking at least as out of touch with reality as they did a year ago.
Which brings us to the UK. Now it was only a Christmas Party, but Stephanie Flanders’ account of Bank reactions to the Fed moves sound depressingly plausible. I remember hearing similar reactions to Fed policy as the financial crisis began (‘they will regret cutting rates so quickly’), and to their publication of interest rate forecasts (‘a rod for their backs’). Now if everything was hunky dory in the UK such conservatism might be forgiven, but its not. So it seems that if you want innovation at the Bank, it needs to be imposed from outside.
Which is why this recent speech from Mark Carney has attracted a lot of interest. It has been interpreted by some as arguing for NGDP targets, but I think it is more nuanced than that. Carney clearly argues that forward guidance is useful, but it is much more useful for a country like the US which does not have an overriding inflation mandate than it could ever be for the UK which does. The Bank of England, whoever is Governor, will never say that they will not think about raising interest rates until inflation goes beyond 2.5% because they would be clearly going outside their remit.
On NGDP targets, Carney is quite equivocal about their use in normal times, but sees clear advantages as a device for dealing with the Zero Lower Bound (ZLB). So one interpretation of his remarks is that, yes, they might have been useful back in 2008/9, but they are less useful today. However I think its also possible to take a more optimistic view. As long as we do not treat the survey evidence too seriously, acknowledging that there is a significant output gap (x% say) implies that any NGDP path has to start at a point x% above current NGDP. So even if the long term desired NGDP growth rate is 4% (2% real + 2% nominal), the target for NGDP growth for the year the policy begins will be 4%+x%, which implies a much more aggressive monetary expansion than we have at present.
To get this aggressive monetary stimulus for the UK, I still prefer my suggestion of moving temporarily to a 4% earnings growth target. (Latest number 1.3%.) There are two reasons. First, this puts no upper limit on GDP growth. If in fact the output gap is y% rather than x%, where y is much higher than x, a 4% earnings path will not stop us closing that gap quickly, whereas a NGDP path based on x% might. Second, I take a pessimistic view that x% will be chosen very conservatively, as a price for what will be seen by the indigenous Bank as a radical move. I can also see it taking time to come, because the new Governor will want to persuade, rather than impose his views. If, indeed, these are his views, which as I suggest above the speech leaves open.
I want to end by returning to the general theme of central bank innovation, and the lack of it in the UK. In the reaction on the Carney speech, one report suggested that the Chancellor was open to new ideas that might come from the new Governor. I think this tells you a lot about the current Chancellor. Even though he is in charge of the monetary policy framework and the target itself, he still waits for any suggestion of change to come from the Bank. I cannot imagine Gordon Brown, or indeed Alistair Darling or Nigel Lawson, waiting to hear from the Bank before thinking about changing macroeconomic policy. Perhaps the curtains of No.11 are closed while others do all the hard work?
Sunday, 9 December 2012
Some Thoughts on Fiscal Rules
In one area macroeconomic policy in the UK is well ahead of the
US or the Eurozone: the use of fiscal rules. The US seems to
prefer cliffs to rules - yes, I know that is a cheap jibe, but you know what I
mean. In the Eurozone fiscal rules now come in packs, the individual parts of which are of
variable quality and may not be consistent with each other. By contrast, the
surviving UK fiscal rule (or ‘mandate’) makes some limited sense, as did Gordon
Brown’s predecessors. It says the government should
achieve structural (cyclically adjusted) balance, excluding investment
spending, within five years - where that five year period rolls forward.
What is good about this rule? Its main advantage is that, by
having a rolling target, nothing is adjusted too quickly. One thing that stands
out from the literature is that, as long as you are able to
sell debt, fiscal adjustments should be slow, and the government’s deficit
should act as a shock absorber. The analogy with consumption smoothing is
pretty close. Now it is true that a rolling target could allow a government to
keep delaying adjustment, but that is hardly a problem right now.
Two additional features of the UK rule are the use of the
cyclically adjusted deficit and the exclusion of investment. Although cyclical
adjustment gets talked about a lot, for this particular rule
it would in normal times be largely irrelevant, because we would expect to have
a zero output gap in five years time anyway. Right now it is not irrelevant,
but I will have more to say about the current conjuncture below. Whether it is
right to exclude spending on investment is a difficult question, which I will
leave for another post.
Where the rule is more problematic is the focus on the deficit,
and the idea that ‘balance’ for the current deficit is a meaningful target.
Ultimately we are concerned about government debt. We want to stop debt rising
relative to GDP, and then we want to get it down. The speed at which that is
done will imply a path for deficits, but these deficits will almost certainly
be varying over time, and there is no magic in zero (i.e. balance). The rule
that an economist would naturally think of (and which is commonly used in academic work) is to adjust instruments in
proportion to the difference between actual debt and its target level. However, a zero deficit over the medium run will imply a reduction in debt
(as the OBR shows), so at least its moving us in the right direction.
While for the macroeconomist as scientist there is plenty of
scope for exploring these issues, I think they miss the two major problems that
the macroeconomist as engineer has to deal with. The first is whether we are
designing rules for a (roughly) benevolent government, or for a government that
departs from benevolence in particular ways. Second, good rules will inevitably
involve making guesses about the future, and many people find it difficult to
get their head around this.
As an example, we only need to look at the reaction to the
Autumn Statement in the UK. Whether the measures taken by the Chancellor are
sufficient to meet his rule depends on where you think the economy will be in
five years time. Given the current uncertainty about the output gap, the
Chancellor could be being too optimistic or embarking on unnecessary austerity.
(See Ian Mulheirn on the implications of
alternative assumptions.) Commentators, particularly those political
commentators for whom the long run is after the next election, but also in my
experience some macroeconomists, yearn for rules or targets that are not
conditional in this way. Why cannot we have something straightforward like an
inflation target? I mention all this not because I think these concerns are
legitimate (I have argued against unconditional inflation
targets), but because if fiscal rules are to command public confidence, they
may need to take this into account. Perhaps concerns like these explain
why most rules focus on deficits rather than debt.
However, there is one point that has to be made if we are
discussing fiscal rules in relation to current events, and that is that all the
discussion above presumes that monetary policy is unconstrained, and in
particular that interest rates are not at the Zero Lower Bound (ZLB). This is a
very familiar point, that Paul Krugman has made again and again: at the ZLB things are very different. Monetary policy has lost much of its
power, and it has certainly lost its claim to predictability and superiority.
We need fiscal policy to help in eliminating excess supply. In this situation, if we need a fiscal rule at all it is more likely to look like a Taylor rule than a rule involving a debt or deficit target. However, when
there is no danger of hitting the ZLB, there is no need for fiscal policy to be
concerned about the output gap or inflation at all - if we are talking about an
economy with a floating exchange rate. The conventional assignment can apply.
Some fiscal rules attempt to address this point by having terms
in both debt stabilisation and output gap stabilisation. Now while this might
make sense under fixed exchange rates, it is a
pointless compromise under flexible rates. If the effectiveness of monetary
policy is quite different at the ZLB, then optimal fiscal policy is also bound to be very different at the ZLB. So the main problem with the UK
government’s fiscal mandate has nothing to do with cyclical adjustment or any
of the other things discussed above. It is just inappropriate for the
situation we are now in.
Friday, 7 December 2012
Delegating to the wrong people: the strange case of interviewing undergraduate candidates at Oxford
This post starts off talking about something rather parochial, but it then moves to a wider point about decision making in a particular type of large organisation.
This is a strange time of year at Oxford University. Very few UK universities interview prospective undergraduates to help select who should be admitted, but both Oxford and Cambridge do. As a result, all but the most senior academics will generally spend at least two solid days interviewing something like 3 times as many undergraduate candidates as there are places. The personal and social cost of this is pretty high - quite a few research papers will not get written as a result, and maybe the odd important discovery will be delayed by years. Yet Oxford and Cambridge are also relatively unusual among UK universities in still allowing academics considerable control over the way the institution is run. Is this a paradox?
Now all this might make sense from a social point of view if interviewing meant we clearly got much better students at Oxford than we would otherwise. However all the evidence I have ever seen on interviews is that they are pretty unreliable as a selection procedure. In this particular case, there are well known biases: those from certain schools or families will be practiced at giving a good impression in such situations, whereas others will not. We (and I think I’m justified in using that collective pronoun) do our very best to get round those biases, but it is hard. We can fail to compensate, or over compensate. We all think we can judge someone by talking to them for 30 minutes, but in reality our ability to assess academic potential that way is pretty small. Indeed, even if information gleaned from interviews contains some useful information, I strongly suspect those making decisions give this information far more weight than it deserves. My suspicions receive some local support from Bhattacharya et al (2012)[1].
So, if there is no clear evidence that students are much better selected as a result of interviews, why do we continue with them? One familiar idea is that this is a form of concealed class bias, but I suspect this is not the general case. The evidence from Bhattacharya et al suggest that for PPE at Oxford, the marginal student from an independent (private) school faces significantly higher admission thresholds than those from state schools. A slightly less politically charged version of this argument is that we want to select students who are easy and interesting to teach, and as the interviews are like mini tutorials they achieve this goal. This would also explain why interviewing is largely confined to the two universities that still have a traditional tutorial system (teaching in small groups of two to four).
Even if there is some truth in this, there still seems to be a puzzle. From the self-interested point of view of the research oriented and highly competitive academic, the effort involved in interviewing seems out of proportion to any gain in getting more congenial students. I spend the equivalent of 12 full days a year teaching in tutorials, so spending 2+ days each year in a process that might make those 12 days slightly easier is just not worth it.
One of the other unusual aspects of Oxford and Cambridge is that they remain - in theory at least - self-governing. The individual colleges that make the admission decisions certainly are run by the academics.[2] So why are Oxford academics so attached to interviewing, when it just does not seem to be in their interests?
But maybe this is not the right question. Perhaps the majority of Oxbridge academics would happily give up interviewing, but for some reason this preference is not getting realised. I could at this point talk about the peculiarities of decision making at Oxford (and peculiar is the right word), but I think there may be a more general issue here.
Decision making in large organisations like universities is often run through committees, or through delegation to ‘volunteers’. Most academics, even though they may enjoy teaching students, are primarily interested in research (either intrinsically, or because it determines future career prospects). As a result, they will tend to avoid taking positions where they have to think about non-research related issues (like being on department or university teaching committees), and try and avoid administrative duties more generally. However a minority will have different priorities, and so they will take those positions. They may as a result take decisions which divert academics away from research, given their own interests and responsibilities. It may be these people who are taking decisions about interviewing, and not your more typical research focused academic.
Some of my former (non-Oxford) colleagues wrote a paper about this general issue some time ago [3], and although they did not apply it to universities, I suspect it may have been their inspiration. In many organisations this problem is dealt with by a strong central authority, but universities often do not have that, and Oxford and Cambridge certainly do not. So even if the majority of academics did want to stop interviewing, they cannot exercise this preferences, because they have delegated decision making to others who have different interests and priorities. Who knows if this is right, but maybe I have just thought up a good interview question!
[1] Bhattacharya, Kanaya and Stevens (2012), Are University Admissions Academically Fair? Oxford University Discussion Paper No. 608. Note (Table 2) that interview scores are very significant in deciding who is admitted, but have a weaker correlation with first year exam results compared to other pre-admission evidence.
[2] For UK universities, research performance is the key incentive, because of the UK’s research assessment exercise. So I suspect a strong, top down central authority would quickly decide that interviewing was a non productive distraction.
[3] Bulkley, G., Myles, G.D. and Pearson, B.R. (2001), On the Membership of Decision-Making Committees, Public Choice, 106, 1-22.
This is a strange time of year at Oxford University. Very few UK universities interview prospective undergraduates to help select who should be admitted, but both Oxford and Cambridge do. As a result, all but the most senior academics will generally spend at least two solid days interviewing something like 3 times as many undergraduate candidates as there are places. The personal and social cost of this is pretty high - quite a few research papers will not get written as a result, and maybe the odd important discovery will be delayed by years. Yet Oxford and Cambridge are also relatively unusual among UK universities in still allowing academics considerable control over the way the institution is run. Is this a paradox?
Now all this might make sense from a social point of view if interviewing meant we clearly got much better students at Oxford than we would otherwise. However all the evidence I have ever seen on interviews is that they are pretty unreliable as a selection procedure. In this particular case, there are well known biases: those from certain schools or families will be practiced at giving a good impression in such situations, whereas others will not. We (and I think I’m justified in using that collective pronoun) do our very best to get round those biases, but it is hard. We can fail to compensate, or over compensate. We all think we can judge someone by talking to them for 30 minutes, but in reality our ability to assess academic potential that way is pretty small. Indeed, even if information gleaned from interviews contains some useful information, I strongly suspect those making decisions give this information far more weight than it deserves. My suspicions receive some local support from Bhattacharya et al (2012)[1].
So, if there is no clear evidence that students are much better selected as a result of interviews, why do we continue with them? One familiar idea is that this is a form of concealed class bias, but I suspect this is not the general case. The evidence from Bhattacharya et al suggest that for PPE at Oxford, the marginal student from an independent (private) school faces significantly higher admission thresholds than those from state schools. A slightly less politically charged version of this argument is that we want to select students who are easy and interesting to teach, and as the interviews are like mini tutorials they achieve this goal. This would also explain why interviewing is largely confined to the two universities that still have a traditional tutorial system (teaching in small groups of two to four).
Even if there is some truth in this, there still seems to be a puzzle. From the self-interested point of view of the research oriented and highly competitive academic, the effort involved in interviewing seems out of proportion to any gain in getting more congenial students. I spend the equivalent of 12 full days a year teaching in tutorials, so spending 2+ days each year in a process that might make those 12 days slightly easier is just not worth it.
One of the other unusual aspects of Oxford and Cambridge is that they remain - in theory at least - self-governing. The individual colleges that make the admission decisions certainly are run by the academics.[2] So why are Oxford academics so attached to interviewing, when it just does not seem to be in their interests?
But maybe this is not the right question. Perhaps the majority of Oxbridge academics would happily give up interviewing, but for some reason this preference is not getting realised. I could at this point talk about the peculiarities of decision making at Oxford (and peculiar is the right word), but I think there may be a more general issue here.
Decision making in large organisations like universities is often run through committees, or through delegation to ‘volunteers’. Most academics, even though they may enjoy teaching students, are primarily interested in research (either intrinsically, or because it determines future career prospects). As a result, they will tend to avoid taking positions where they have to think about non-research related issues (like being on department or university teaching committees), and try and avoid administrative duties more generally. However a minority will have different priorities, and so they will take those positions. They may as a result take decisions which divert academics away from research, given their own interests and responsibilities. It may be these people who are taking decisions about interviewing, and not your more typical research focused academic.
Some of my former (non-Oxford) colleagues wrote a paper about this general issue some time ago [3], and although they did not apply it to universities, I suspect it may have been their inspiration. In many organisations this problem is dealt with by a strong central authority, but universities often do not have that, and Oxford and Cambridge certainly do not. So even if the majority of academics did want to stop interviewing, they cannot exercise this preferences, because they have delegated decision making to others who have different interests and priorities. Who knows if this is right, but maybe I have just thought up a good interview question!
[1] Bhattacharya, Kanaya and Stevens (2012), Are University Admissions Academically Fair? Oxford University Discussion Paper No. 608. Note (Table 2) that interview scores are very significant in deciding who is admitted, but have a weaker correlation with first year exam results compared to other pre-admission evidence.
[2] For UK universities, research performance is the key incentive, because of the UK’s research assessment exercise. So I suspect a strong, top down central authority would quickly decide that interviewing was a non productive distraction.
[3] Bulkley, G., Myles, G.D. and Pearson, B.R. (2001), On the Membership of Decision-Making Committees, Public Choice, 106, 1-22.
Wednesday, 5 December 2012
Some thoughts on the Autumn Statement
1) As the snow that I can see outside my window as I write this testifies, the Chancellor’s Autumn statement is misnamed - but it does have a winter’s feel about it. Yet again we have low growth that from the survey evidence looks structural. To quote from the OBR:
Now on this occasion the OBR has balked at following this evidence, and instead it has assumed that most of the slow growth has been cyclical rather than structural. Nevertheless their estimate of trend output has fallen, so as a result prospective UK austerity has now been increased and extended one more year (see Gavin Davies here). But you have to ask, if the survey information is not credible this year, has it been credible in previous years?
2) The Chancellor’s headline grab was to cancel the proposed increase in petrol duty. This cements his reputation as being decidedly anti-green. When the history books are being written in a hundred years time as the world struggles with average temperatures 4 degrees centigrade higher, George Osborne’s name will be on the list of people who helped that happen.
3) The statement included £5 billion extra in public investment, mainly paid for by reducing government consumption elsewhere. When I talked about rearranging the deck chairs, I thought I was using a metaphor and not a simile. Now it is probably true that the net effect of this on demand will be positive, when it happens. But if building a 100 new schools is such a great idea now, cancelling the project to repair existing schools two and a half years ago was clearly a very bad idea. As they say in the media nowadays, I think we deserve an apology.
4) One of the policy changes is a huge increase in investment allowances for small businesses. I really do not understand why this was not done earlier, and why it is limited to small firms. When I gave a talk at the Treasury in the summer I said I thought there was lots of scope for introducing incentives of this kind to get firms to bring forward investment plans. But why direct this to smaller firms, who may not be able to get the loan from the bank, when it is larger firms that have all the cash? [Edited from original, which complained that the measure did not have an expiry date. It does - it only lasts for two years. The hazards of reacting quickly to partial information!]
5) No doubt a lot of political capital will be made from the fact that the Chancellor has had to delay for a year meeting one of his fiscal rules. The opposition can say that at least Gordon Brown’s rules lasted for 10 years, while one of George Osborne’s has not lasted beyond two. Yet this ‘supplementary target’ was always rather silly, as it was vulnerable to a negative demand shock of the kind the UK has suffered. The main fiscal mandate, which is to achieve cyclically adjusted balance on the budget excluding investment, involves a rolling five year period. Now the criticism of a rule of this type is that it allows a government to keep putting adjustment off, but its advantage is that it allows flexibility in response to shocks. Obviously in the current situation I think the latter is more important.
6) We got the usual nonsense about austerity not causing the second recession. Luckily Chris Dillow makes the points, so I do not have to go over this again. Paul Krugman gets exasperated by having to play the ‘fiscal policy can have a big impact on demand’ record once more, just as I did here. Perhaps denial of this kind is understandable from politicians who do not want to admit mistakes, but less understandable when coming from good macroeconomists.
7) The FT asked me to write 300 words. Unfortunately the style didn’t match the other pieces they had, so there was a rather hasty re-edit, but here is the original which I rather like:
In a parallel universe somewhere....
Mr. Speaker
I commend this statement to the House.
"Business and consumer surveys ... imply that the output gap had narrowed since the end of 2011 despite actual output being roughly flat over this period and much weaker than expected in March. This in turn would imply that the weakness in output over this period was structural and that trend total factor productivity (TFP) had contracted."
Now on this occasion the OBR has balked at following this evidence, and instead it has assumed that most of the slow growth has been cyclical rather than structural. Nevertheless their estimate of trend output has fallen, so as a result prospective UK austerity has now been increased and extended one more year (see Gavin Davies here). But you have to ask, if the survey information is not credible this year, has it been credible in previous years?
2) The Chancellor’s headline grab was to cancel the proposed increase in petrol duty. This cements his reputation as being decidedly anti-green. When the history books are being written in a hundred years time as the world struggles with average temperatures 4 degrees centigrade higher, George Osborne’s name will be on the list of people who helped that happen.
3) The statement included £5 billion extra in public investment, mainly paid for by reducing government consumption elsewhere. When I talked about rearranging the deck chairs, I thought I was using a metaphor and not a simile. Now it is probably true that the net effect of this on demand will be positive, when it happens. But if building a 100 new schools is such a great idea now, cancelling the project to repair existing schools two and a half years ago was clearly a very bad idea. As they say in the media nowadays, I think we deserve an apology.
4) One of the policy changes is a huge increase in investment allowances for small businesses. I really do not understand why this was not done earlier, and why it is limited to small firms. When I gave a talk at the Treasury in the summer I said I thought there was lots of scope for introducing incentives of this kind to get firms to bring forward investment plans. But why direct this to smaller firms, who may not be able to get the loan from the bank, when it is larger firms that have all the cash? [Edited from original, which complained that the measure did not have an expiry date. It does - it only lasts for two years. The hazards of reacting quickly to partial information!]
5) No doubt a lot of political capital will be made from the fact that the Chancellor has had to delay for a year meeting one of his fiscal rules. The opposition can say that at least Gordon Brown’s rules lasted for 10 years, while one of George Osborne’s has not lasted beyond two. Yet this ‘supplementary target’ was always rather silly, as it was vulnerable to a negative demand shock of the kind the UK has suffered. The main fiscal mandate, which is to achieve cyclically adjusted balance on the budget excluding investment, involves a rolling five year period. Now the criticism of a rule of this type is that it allows a government to keep putting adjustment off, but its advantage is that it allows flexibility in response to shocks. Obviously in the current situation I think the latter is more important.
6) We got the usual nonsense about austerity not causing the second recession. Luckily Chris Dillow makes the points, so I do not have to go over this again. Paul Krugman gets exasperated by having to play the ‘fiscal policy can have a big impact on demand’ record once more, just as I did here. Perhaps denial of this kind is understandable from politicians who do not want to admit mistakes, but less understandable when coming from good macroeconomists.
7) The FT asked me to write 300 words. Unfortunately the style didn’t match the other pieces they had, so there was a rather hasty re-edit, but here is the original which I rather like:
In a parallel universe somewhere....
Mr. Speaker
The OBR, using tried and tested methods, tell me that there is very little spare capacity. Apparently the UK has suffered an unprecedented decade of low productivity growth, for no obvious reason. We therefore need yet more fiscal consolidation.
But there is another possibility. Firms may be underreporting their capacity. Inflation is not falling because of commodity price shocks and rigidities when inflation is low.
But there is another possibility. Firms may be underreporting their capacity. Inflation is not falling because of commodity price shocks and rigidities when inflation is low.
I have no idea which explanation is correct. But a good Chancellor considers the consequences of mistakes they might make. I failed to do that in 2010, and I will not do so again.
The danger in following the OBR’s path is self-fulfilling pessimism. By tightening policy today, demand falls, and supply appears to fall with it. It may be years before we realise that the economy could have safely produced much more, and we will never get that output back.
That is why I am announcing today that there will be no further austerity. Instead, to test what the economy can sustain, I’ve agreed a £25 billion increase in public investment, funded by a combination of borrowing and higher taxes. Furthermore, I have told the Bank of England for the next three years to replace their current target with a nominal earnings growth target of 4%, and I’ve sanctioned unlimited Quantitative Easing in order to achieve it. I have asked the Treasury Select Committee to investigate possible longer term changes to MPC objectives, like a nominal GDP target.
Perhaps my policy will fail to produce extra growth and just give us higher inflation. But I know the MPC will act quickly to counteract this. At least I would have tried. The far greater danger is that by continuing down my previous course each UK citizen would end up losing thousands of pounds forever.
I commend this statement to the House.
Sunday, 2 December 2012
How to try and get more inflation quickly
The following is written in the UK context, but the proposal I make would work in the US and the Eurozone as well.
Wednesday will be Autumn Statement day in the UK: one of the two times a year the Chancellor makes big fiscal announcements. Yet this post will not be about fiscal policy: current policy looks too much like rearranging the deck chairs, and so I will just be repeating myself in saying that the strategy is all wrong. Instead this post is about monetary policy. How come - that is the MPC at the Bank of England surely? I think not - they are just rearranging the deck chairs too. The big picture on UK monetary policy is down to the Chancellor.
The MPC’s mandate, set by the Chancellor, is to hit 2% for CPI inflation ‘within a reasonable time period’. In the past I and others thought the phrase reasonable time period would allow the MPC in practice to minimise a combination of excess inflation and the output gap, which is what most macroeconomists assume monetary policy is all about. I think this was true, within limits. In the UK these limits were surpassed following the Great Recession, where we had a large negative output gap but above target inflation. We are at the ZLB, and have had Quantitative Easing (QE), because the MPC looked at the output gap as well as inflation, and thought that a large output gap would mean inflation would come tumbling down. It did not, so now they are just targeting CPI inflation (and rather conservatively at that).
What we need is for UK monetary policy to be as expansionary as it can be, and we are not going to get that under the current system, even with a new man running the Bank. I have talked to enough MPC members to know that they take the mandate they are given very seriously. They certainly believe they do not have the discretion to follow a different strategy while still paying lip service to the current set up. The system can only be changed by the Chancellor. Now some would like him to move to nominal GDP targets, and I’d be happy with that. However I cannot see him doing that overnight: the move to include output and go from changes to levels is probably too much for something that is not widely discussed in the UK . The best we can hope for (and hope is the word) is for him to launch some kind of inquiry into this (and other) possibilities - I have suggested in the past that the Treasury Select Committee could do this.
So for the next year or two we are almost certainly stuck with inflation targeting. He could announce an increase in the inflation target, which he has the discretion to do as part of the current system. But he will not, because it plays terribly in terms of politics. As Noah Smith laments, what we as economists understand as inflation is not what everyone else understands by inflation. The number of people in the UK who would be prepared to defend raising the current CPI inflation target to 4% (which I would) is probably less than the number of economics departments in the UK.
However, why not change the measure of inflation being targeted? The GDP deflator is the obvious alternative, but there is a better candidate if the aim is produce a significant but temporary rise UK inflation (and thereby to start a proper recovery in UK output). My suggestion is that 2% CPI inflation is replaced by a target for 4% growth in average earnings. In normal times 4% earnings growth and 2% CPI inflation would be quite compatible (because real wages grow with productivity), but currently average weekly earnings inflation is below 2%.[1] So moving wage inflation from 2% to 4% is a real challenge for monetary policy. To help with this challenge, the Chancellor could at the same time sanction unlimited QE, and could suggest this goes beyond just buying gilts.
If monetary policy still has some power despite the ZLB, then this move would have a significant effect in reducing real interest rates. It would also play well politically. “In the last few years hard working families have seen the real value of their earnings fall, as wage growth has been held back while the Bank of England has failed to keep consumer price inflation on target. It is time that we changed things so that the rewards from working increased rather than decreased over time. That is why I am announcing today ….” Rhetoric that is nonsense in terms of economics, but no worse than much of the rhetoric the government currently uses.
Now of course plenty of people will complain that this is returning us to the 1970s, losing all the gains in inflation credibility that we have carefully built up etc etc. But their arguments can be easily countered. If CPI inflation does rise, this helps get round the ZLB, and so should stimulate a recovery. Yet it cannot ‘open the floodgates’, because all that has happened is that the definition of the inflation target has been changed. There is no further change in definition that can lead to yet higher inflation. In the longer term 4% wage inflation is pretty compatible with 2% price inflation, unless you believe that UK productivity growth can never grow again at levels that were thought normal before the recession. Finally I do not think there is anything in the academic literature which says that the CPI index is a significantly better measure to target than an earnings index.
In an ideal world, would I be suggesting this change? Almost certainly not. Do I think it is better than nominal GDP targeting? Probably not. However, we are not in an ideal world, and we need some action right now. Otherwise there is a great danger that we continue down a road of self-fulfilling pessimism, with all the misery and loss of resources that this entails.
[1] That wage inflation is currently well behind price inflation plus underlying productivity growth is not just a UK phenomenon - it applies in the US and Eurozone as well. To that extent this proposal is not just of relevance to the UK, although elsewhere central banks have the power to make this change, whereas in the UK they do not.
Wednesday will be Autumn Statement day in the UK: one of the two times a year the Chancellor makes big fiscal announcements. Yet this post will not be about fiscal policy: current policy looks too much like rearranging the deck chairs, and so I will just be repeating myself in saying that the strategy is all wrong. Instead this post is about monetary policy. How come - that is the MPC at the Bank of England surely? I think not - they are just rearranging the deck chairs too. The big picture on UK monetary policy is down to the Chancellor.
The MPC’s mandate, set by the Chancellor, is to hit 2% for CPI inflation ‘within a reasonable time period’. In the past I and others thought the phrase reasonable time period would allow the MPC in practice to minimise a combination of excess inflation and the output gap, which is what most macroeconomists assume monetary policy is all about. I think this was true, within limits. In the UK these limits were surpassed following the Great Recession, where we had a large negative output gap but above target inflation. We are at the ZLB, and have had Quantitative Easing (QE), because the MPC looked at the output gap as well as inflation, and thought that a large output gap would mean inflation would come tumbling down. It did not, so now they are just targeting CPI inflation (and rather conservatively at that).
What we need is for UK monetary policy to be as expansionary as it can be, and we are not going to get that under the current system, even with a new man running the Bank. I have talked to enough MPC members to know that they take the mandate they are given very seriously. They certainly believe they do not have the discretion to follow a different strategy while still paying lip service to the current set up. The system can only be changed by the Chancellor. Now some would like him to move to nominal GDP targets, and I’d be happy with that. However I cannot see him doing that overnight: the move to include output and go from changes to levels is probably too much for something that is not widely discussed in the UK . The best we can hope for (and hope is the word) is for him to launch some kind of inquiry into this (and other) possibilities - I have suggested in the past that the Treasury Select Committee could do this.
So for the next year or two we are almost certainly stuck with inflation targeting. He could announce an increase in the inflation target, which he has the discretion to do as part of the current system. But he will not, because it plays terribly in terms of politics. As Noah Smith laments, what we as economists understand as inflation is not what everyone else understands by inflation. The number of people in the UK who would be prepared to defend raising the current CPI inflation target to 4% (which I would) is probably less than the number of economics departments in the UK.
However, why not change the measure of inflation being targeted? The GDP deflator is the obvious alternative, but there is a better candidate if the aim is produce a significant but temporary rise UK inflation (and thereby to start a proper recovery in UK output). My suggestion is that 2% CPI inflation is replaced by a target for 4% growth in average earnings. In normal times 4% earnings growth and 2% CPI inflation would be quite compatible (because real wages grow with productivity), but currently average weekly earnings inflation is below 2%.[1] So moving wage inflation from 2% to 4% is a real challenge for monetary policy. To help with this challenge, the Chancellor could at the same time sanction unlimited QE, and could suggest this goes beyond just buying gilts.
If monetary policy still has some power despite the ZLB, then this move would have a significant effect in reducing real interest rates. It would also play well politically. “In the last few years hard working families have seen the real value of their earnings fall, as wage growth has been held back while the Bank of England has failed to keep consumer price inflation on target. It is time that we changed things so that the rewards from working increased rather than decreased over time. That is why I am announcing today ….” Rhetoric that is nonsense in terms of economics, but no worse than much of the rhetoric the government currently uses.
Now of course plenty of people will complain that this is returning us to the 1970s, losing all the gains in inflation credibility that we have carefully built up etc etc. But their arguments can be easily countered. If CPI inflation does rise, this helps get round the ZLB, and so should stimulate a recovery. Yet it cannot ‘open the floodgates’, because all that has happened is that the definition of the inflation target has been changed. There is no further change in definition that can lead to yet higher inflation. In the longer term 4% wage inflation is pretty compatible with 2% price inflation, unless you believe that UK productivity growth can never grow again at levels that were thought normal before the recession. Finally I do not think there is anything in the academic literature which says that the CPI index is a significantly better measure to target than an earnings index.
In an ideal world, would I be suggesting this change? Almost certainly not. Do I think it is better than nominal GDP targeting? Probably not. However, we are not in an ideal world, and we need some action right now. Otherwise there is a great danger that we continue down a road of self-fulfilling pessimism, with all the misery and loss of resources that this entails.
[1] That wage inflation is currently well behind price inflation plus underlying productivity growth is not just a UK phenomenon - it applies in the US and Eurozone as well. To that extent this proposal is not just of relevance to the UK, although elsewhere central banks have the power to make this change, whereas in the UK they do not.
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