Is economics jargon distortionary?

Employees are already beset by red tape if they try to improve their working conditions. Now the UK government wants to increase the regulatory burden on them further, by proposing that employee organisations need a majority of all their members to vote for strike action before a strike becomes legal, even though those voting against strike action can still free ride on their colleagues by going to work during any strike and benefiting from any improvement in conditions obtained. Shouldn’t we instead be going back to a free market where employees are able to collectively withhold their labour as they wish?

I doubt if you have ever read a paragraph that applies language in this way. Yet why should laws that apply to employers be regarded as a regulatory burden, but laws that apply to employees are not? Labour markets, alongside financial markets, are areas where the concept of a ‘free’ market uncluttered by regulations is a myth. Here, as elsewhere, language has been distorted to suit a neoliberal agenda.

Is this also true with terminology used in academic economics? That is the argument put forward by Charles Manski in this Vox piece in the context of economists’ discussion of taxation and lump-sum taxes. He writes:

“Students of economics learn that the formal usage of the concepts 'inefficiency', 'deadweight loss', and 'distortion' in normative public finance refer to a theoretical setting where a private economy is in competitive equilibrium and a government can use lump-sum taxes to modify the endowments of individuals. In this setting, classical theorems of welfare economics show that any Pareto efficient social outcome can be achieved by having the government use lump-sum taxes to redistribute endowments and otherwise not intervene in the economy. Income taxes and other commonly used taxes logically cannot yield better social outcomes than optimal lump sum taxes but they may do worse. Deadweight loss measures the degree to which they do worse.”

The big problem with this terminology and associated research agenda, he argues, is that it presumes lump sum taxes are a feasible option, whereas in reality they are not.

“The research aims to measure the social cost of the income tax relative to the utterly implausible alternative of a lump-sum tax. It focuses attention entirely on the social cost of financing government spending, with no regard to the potential social benefits.”

Indeed, lump sum taxes (a.k.a. a poll tax) are not a feasible option precisely because they achieve non-distortion at the cost of being unfair, and in the real world taxation is as much about fairness as allocative efficiency.

The counterargument is that the idea of a lump sum tax is just a useful analytical device, which allows research to focus on the taxation side of the balance sheet, without having to worry about what taxes are spent on. It would be equally possible to look at the benefits of different types of government spending, all of which were financed by a lump sum tax. Equally the competitive equilibrium against which real world taxes are distortionary is an imaginary but analytically useful reference point - everyone knows the real world is not like this competitive equilibrium.

It is not our fault, the counter argument would go, that non-academics abuse these analytical devices. No serious economist would talk about the costs and benefits of a policy to cut a particular tax in isolation, when that cut has been financed using a lump sum tax. Governments that do that have clear ulterior motives. Equally no serious economist would talk about the benefits of reducing a tax designed in part as Pigouvian (i.e. a tax designed to offset some market externality), within the context of a model that ignores that externality. (For a recent example where the UK Treasury published a study that managed to do both of these things, see here.)

I think the key here is to clearly differentiate analysis from policy advice. I have used lump sum taxes in my research, and I often talk about taxes being distortionary. I think both general and partial equilibrium analysis is useful, and devices that allow abstraction are invaluable in economics. (I have less sympathy for the concept of Pareto optimality, for reasons discussed here. See also the excellent series of discussions by Steve Randy Waldman.) However these devices can often allow those with an agenda (including the occasional economist) to mislead, which is why economists need to be very careful when presenting their analysis to policy makers, and why they also need to have the means to alert the public when this kind of deception happens. 

Fiscal deceit

Vince Cable, the LibDem minister whose remit includes UK student finance, is apparently having cold feet about the plan to privatise the student loan book. Which is good news, because if ever there was an example of a policy designed to lose money for the public sector (or, as they say in the media, cost the taxpayer more), it was this.

As I explained in this post, if a public asset that generates income is privatised, the public gains the sale value, but loses a stream of future income. The ‘debt burden’ need not be reduced, because although future taxes will fall because there is less debt to pay interest on, they will rise because the government has also lost a future income stream.

With assets like the Royal Mail, we can debate endlessly whether the asset will become more or less efficient under private ownership. If it is more efficient, and therefore profitable, under private ownership, the private sector might be prepared to pay more for it, and so the public sector (and society) is better off selling it – unless of course the government sells it at below its market price! However in the case of the student loan book, it is pretty clear that privatisation is a bad deal for the public sector for two reasons.

First, as Martin Wolf has pointed out, the revenues from student loan repayments are very long term, and pretty uncertain. Any private sector firm that might buy this book is likely to discount these revenues quite highly, and so will not be prepared to pay the government enough to compensate the government for the lost revenue. Second, as Alasdair Smith points out, the main efficiency issue is collecting the loan repayments. Here the government has clear advantages over the private sector, because loan repayments are linked to income, and the government has all the information on people’s income, and an existing system for collecting money based on income.

So selling the student loan book is an almost certain way of increasing the ‘debt burden’ on current and future generations. As Alasdair Smith reports, George Osborne justified the sale by saying that it helped the government with a ‘cash flow issue’. As Alasdair rightly says, the government does not have cash flow issues. This kind of ludicrous policy either comes from ideological fundamentalism (the government shouldn’t own assets) or the need to meet ridiculously tough deficit targets. Whichever it is, every UK citizen loses money as a result.

George Osborne is hardly the first finance minister to play tricks like this, so how do we stop future governments from doing the same? I’m glad to see more journalists, like Chris Cook, making the points I make here. However it would be better still if an independent body, set up by the government to calculate its future fiscal position, was charged with a statutory duty to make these points. At present the OBR does not have that duty, and it feels naturally reluctant to go beyond its remit and pick fights with the government. However, if it became more of a public watchdog, with a remit to flag government proposals that appeared to lose money for the public sector in the long term, that might just stop future governments doing this kind of thing.

What annoys me about market monetarists

I missed this little contretemps between Nick Rowe and Paul Krugman. Actually this appears to be a fuss over nothing. The main point Paul was trying to make, it seemed to me, was about how far the Republican base were on monetary policy from anything reasonable, and so what he called the neomonetarist movement did not have much chance with this group. By implication, neomonetarism was something more reasonable, although he had well known problems with its ideas. So a sort of backhanded compliment, if anything.

Nick responded by pointing out that what he called neofiscalists (those, like me, who argue for fiscal stimulus at the Zero Lower Bound (ZLB)) hadn’t done too well at finding a political home recently either. Which, alas, is all too true, but I think we kind of knew that.

What interests me is how annoyed each side gets with each other. Following my earlier posts, I will use the label market monetarist (MM) rather than neomonetarist. It seems to me that I understand a little why those in the MM camp get so annoyed with those like me who go on about fiscal policy. Let me quote Nick:

“We don't like fiscal patches that cover up that underlying problem. Because fiscal policy has other objectives and you can't always kill two birds with the same fiscal stone. Because we can't always rely on fiscal policymakers being able and willing to do the right thing. And because if your car has alternator trouble you fix the alternator; you don't just keep on doing bodge-jobs like replacing the battery every 100kms.”

I’ll come back to the car analogy, but let me focus on the patches idea for now. In their view, the proper way to do stabilisation policy outside a fixed exchange rate regime is, without qualification, to use monetary policy. So the first best policy is to try every monetary means possible, which may in fact turn out to be quite easy if only policymakers adopt the right rule. Fiscal policy is a second best bodge. MM just hates bodgers.

As I explained in this post, the situation is not symmetric. I do not get annoyed with MM because I think monetary policy is a bodge. I have spent much time discussing what monetary policy can do at the ZLB, and I have written favourably about nominal GDP targets. But, speaking for just myself, I do get annoyed by at least some advocates of MM.

Before I say why, let me dismiss two possible reasons. First, some find MM difficult because there does not seem to be a clear theoretical model behind their advocacy (see this post from Tony Yates for example). I can live with that, because I suspect I can see the principles behind their reasoning, and principles can be more general than models (although they can also be wrong). Second, I personally would have every right to be annoyed with some MMs (but certainly not Nick) because of their debating style and lack of homework, but I see that as a symptom rather than fundamental.

To understand why I do get annoyed with MM, let me use another car analogy. We are going downhill, and the brakes do not seem to be working properly. I’m sitting in the backseat with a representative of MM. I suggest to the driver that they should keep trying the brake pedal, but they should also put the handbrake on. The person sitting next to me says “That is a terrible idea. The brake pedal should work. Maybe try pressing it in a different way. But do not put on the handbrake. The smell of burning rubber will be terrible. The brake pedal should work, that is what it is designed for, and to do anything else just lets the car manufacturer off the hook. Have you tried pressing on the accelerator after trying the brake?”

OK, that last one is unfair, but you get my point. When you have a macroeconomic disaster, with policymakers who are confused, conflicted and unreliable, you do not obsess over the optimal way of getting out of the disaster. There will be a time and place for that later. Instead you try and convince all the actors involved to do things that will avoid disaster. If both monetary and fiscal policymakers are doing the wrong thing given each other’s actions, and your influence on either will be minimal, you encourage both to change their ways.

MM agrees that fiscal stimulus will work unless it is actively counteracted by monetary policy. Nick says we can't always rely on fiscal policymakers being able and willing to do the right thing. But since at least 2011 we have not been able to rely on monetary policymakers in the Eurozone to do either the right thing, or consistently the wrong thing. So why is anyone with any sense saying that austerity is not a major factor behind the second Eurozone recession? That is just encouraging fiscal policymakers to carry on doing exactly the wrong thing, in the real world where monetary policy is set by the ECB rather than some MM devotee.

A short note on tobacco packaging

About a year ago I published a post that was off my macro beat, about whether banning advertising was paternalistic or freedom enhancing. It was prompted by the UK government appearing to kick the idea of enforcing ‘plain packaging’ of cigarettes into the long grass. Subsequently the government seemed to change its mind, and asked paediatrician Sir Cyril Chantler to review the Australian experience, where plain packaging had been introduced more than a year earlier. In April this year the UK government announced that it would go ahead with plain packaging, after a ‘short consultation’.

The standard argument against actions of this kind is that they are paternalistic. Most economists are instinctively non-paternalistic, although personally I think paternalism can be justified in a small number of cases, like the compulsory wearing of seat belts. Furthermore, I think as behavioural economics progresses, economists are going to find themselves becoming more and more paternalistic whether they like it or not.

However my argument on advertising was rather different. Most advertising is not ‘on-demand’: we have to go out of our way to avoid it. Examples would be television advertising, magazine advertising or billboard advertising. A lot of advertising also has no informational content, but instead tries to associate some brand with various positive emotions - a mild form of brainwashing. A ban on this kind of advertising enhances our freedom, making it less costly to avoid being brainwashed. Banning advertising allows us to avoid unwanted intrusion by advertising companies. It enhances rather than detracts from our freedom. Of course it restricts the freedom of companies, but companies are not people.

What appears on a packet of cigarettes is different, because it is ‘on-demand’ - only those buying the product view it. However it is almost invariably of the non-informative kind. In contrast, ‘plain packaging’ is actually informative, about the health risks being faced by the smoker. So in this case, the smoker receives more information under plain packaging, so will be better off. Arguments by the industry that this represents a ‘nanny state’ are nonsense, and are akin to potential muggers arguing that policemen represent a gross violation by the state of the rights of the mugger.

The UK decided in April to adopt plain packaging because the evidence from Australia was that it was having a positive impact. More recently, the Financial Times reports that the latest National Drugs Strategy Household Survey shows a sharp decline not only in the number of cigarettes smoked per week, but also a large rise in the age at which young people smoke their first cigarette. (The cigarette industry and their apologists argue that smoking has in fact increased as a result of the ban, so strangely they are against it!)

This shows how in at least one respect Australia is helping lead a global improvement in peoples’ lives. Alas the new Australian government has also just abolished their carbon tax, which unfortunately means we need to be selective in following an Australian example!

  

Further thoughts on Phillips curves

In a post from a few days ago I looked at some recent evidence on Phillips curves, treating the Great Recession as a test case. I cast the discussion as a debate between rational and adaptive expectations. Neither is likely to be 100% right of course, but I suggested the evidence implied rational expectations were more right than adaptive. In this post I want to relate this to some other people’s work and discussion. (See also this post from Mark Thoma.)

The first issue is why look at just half a dozen years, in only a few countries. As I noted in the original post, when looking at CPI inflation there are many short term factors that may mislead. Another reason for excluding European countries which I did not mention is the impact of austerity driven higher VAT rates (and other similar taxes or administered prices), nicely documented by Klitgaard and Peck. Surely all this ‘noise’ is an excellent reason to look over a much longer time horizon?

One answer is given in this recent JEL paper by Mavroeidis, Plagborg-Møller and Stock. As Plagborg-Moller notes in an email to Mark Thoma: “Our meta-analysis finds that essentially any desired parameter estimates can be generated by some reasonable-sounding specification. That is, estimation of the NKPC is subject to enormous specification uncertainty. This is consistent with the range of estimates reported in the literature….traditional aggregate time series analysis is just not very informative about the nature of inflation dynamics.” This had been my reading based on work I’d seen.

This is often going to be the case with time series econometrics, particularly when key variables appear in the form of expectations. Faced with this, what economists often look for is some decisive and hopefully large event, where all the issues involving specification uncertainty can be sidelined or become second order. The Great Recession, for countries that did not suffer a second recession, might be just such an event. In earlier, milder recessions it was also much less clear what the monetary authority’s inflation target was (if it had one at all), and how credible it was.

How does what I did relate to recent discussions by Paul Krugman? Paul observes that recent observations look like a Phillips curve without any expected inflation term at all. He mentions various possible explanations for this, but of those the most obvious to me is that expectations have become anchored because of inflation targeting. This was one of the cases I considered in my earlier post: that agents always believed inflation would return to target next year. So in that sense Paul and I are talking about the same evidence.

Before discussing interpretation further, let me bring in a paper by Ball and Mazumder. This appears to come to completely the opposite conclusion to mine. They say “we show that the Great Recession provides fresh evidence against the New Keynesian Phillips curve with rational expectations”. I do not want to discuss the specific section of their paper where they draw that conclusion, because it involves just the kind of specification uncertainties that Mavroeidis et al discuss. Instead I will simply note that the Ball and Mazumder study had data up to 2010. We now have data up to 2013. In its most basic form, the contest between the two Phillips curves is whether underlying inflation is now higher or lower than in 2009 (see maths below). It is higher. So to rescue the adaptive expectations view, you have to argue that underlying inflation is actually lower now than in 2009. Maybe it is possible to do that, but I have not seen that done.

However it would be a big mistake to think that the Ball and Mazumder paper finds support for the adaptive expectations Friedman/Phelps Phillips curve. They too find clear evidence that expectations have become more and more anchored. So in this sense the evidence is all pointing in the same way.

So I suspect the main differences here come from interpretation. I’m happy to interpret anchoring as agents acting rationally as inflation targets have become established and credible, although I also agree that it is not the only possible interpretation (see Thomas Palley and this paper in particular). My interpretation suggests that the New Keynesian Phillips curve is a more sensible place to start from than the adaptive expectations Friedman/Phelps version. As this is the view implicitly taken by most mainstream academic macroeconomics, but using a methodology that does not ensure congruence with the data, I think it is useful to point out when the mainstream does have empirical support.

Some maths

Suppose the Phillips curve has the following form:

p(t) = E[p(t+1)] + a.y(t) + u(t)

where ‘p’ is inflation, E[..] is the expectations operator, ‘a’ is a positive parameter on the output gap ‘y’, and ‘u’ is an error term. We have two references cases:

Static expectations: E[p(t+1)] = p(t-1)

Rational expectations: E[p(t+1)] = p(t+1) + e(t+1)

where ‘e’ is the error on expectations of future inflation and is random. Some simple maths shows that under static expectations, negative output gaps are associated with falling inflation, while under rational expectations they are associated with rising inflation. If we agree that between 2009 and today we have had a series of negative output gaps, we just need to ask whether underlying inflation is now higher or lower than in 2009. 

Public Investment and Borrowing Targets

Often fiscal rules, designed to keep a lid on public deficits or debt, exclude borrowing for public investment from any deficit target. This is true of the UK government’s fiscal mandate, which seeks to achieve a cyclically-adjusted current budget balance within five years. The idea, in simple language, is to only borrow to invest. What could be wrong with that?

Most of the time public investment is not like private investment. A successful private investment will generate future income which can pay back any borrowing. A successful public investment project may raise future output, and this may increase future taxes, but there is no sense in which we would only undertake the project if we could be sure of paying off the borrowing with these extra taxes. A public investment project should be undertaken if discounted future social benefits exceed its costs. This cost has to be paid for by higher taxes at some point, so the question is simply when taxes will increase to do so.

In thinking about when to raise taxes, the obvious principle is tax smoothing. If taxes are distortionary, it is better to spread the pain. So if we need some additional public spending for just this year, one way to pay for it is to borrow, and use higher taxes just to pay the interest on that borrowing. That smooths the distortion over time. This is true whether the public spending involves consumption or investment. In contrast, if we are planning to raise public spending permanently, taxes should be raised by the amount of the increase in spending, and no borrowing should take place. Again this is true whatever the form of the additional expenditure. Now it is true that public investment projects tend to be temporary, while additional public consumption can be permanent, but the principle here is how taxes are distributed, rather than the nature of the spending.

This simple application of tax smoothing takes no account of distributional issues. If we believe that government consumption only benefits those paying taxes at that time, we might want taxes to rise with a temporary increase in government consumption rather than being smoothed. Why should future generations pay for the consumption enjoyed by the current generation? Here public investment would be different if it benefits both current and future generations. So from a distributional point of view, it might make sense to treat government consumption and investment separately. There are two problems here though. The first is that the distinction between public investment and consumption in the statistics does not necessarily follow this distributional logic. Education is classed as consumption. Second, how in practical terms do you allocate taxes paid to benefits received from public investment? (I touch on this here.)

One of the key points that Jonathan Portes and I stress in our discussion of fiscal rules is that rules have to balance optimality when governments are benevolent against effectiveness when they are not. One feature of periods of austerity is that public investment often gets hit hard. The reason this happens may also reflect intergenerational issues. To the extent that public investment benefits future generations, they are unable to complain when it is cut.

This can be one reason why rules sometimes use current balance targets rather than targets for the overall deficit. If public investment does not influence the target, it need not be cut. (This does not seem to have worked with George Osborne, as the victims of flooding found out!) However such rules are inevitably incomplete, because they say nothing about the overall level of public debt. In the case of the last Labour government, there were two rules: one involving the current balance over the cycle (only borrow to invest), and one specifying a total debt ceiling. There was an implicit target for public investment implied by the conjunction of the two rules, but it is unclear how sensible that implicit target was.

Jonathan and I suggest that the simpler and perhaps most effective way of preventing public investment being squeezed in times of austerity is to have a specific target for the share of public investment in GDP. Of course this target should also influence any overall deficit target, but if you want to protect public investment, it seems best to do so explicitly. If you do that, then it makes more sense to have just one target for the overall deficit (primary or total) that includes borrowing to invest, rather than a target for just the current balance.

French macroeconomic policy improvisation

I’m confused about macroeconomic policy under François Hollande. When he came to power in 2012 he made deficit reduction a priority. The chance to lead some opposition to the dominant policy of austerity was lost. However where French policy did seem to differ from some other Eurozone countries was that tax increases rather than spending cuts would play a prominent role in deficit reduction. As I noted in this post, the Commission’s austerity enforcer, Olli Rehn, was not pleased.

However policy in France now seems to have taken a rather different turn. In January Hollande announced cuts to social charges paid by business. Many outside comments declared that this was a move ‘to the centre’. His speech also seemed to imply that he had become a convert to Say’s Law. But maybe there was a more modern logic to this policy: by reducing employment costs, perhaps the government was trying to engineer an ‘internal devaluation’.

Yet more recently, Hollande has appeared to pledge tax cuts to middle class voters. With non-existent growth and a rising budget deficit, the macroeconomic logic behind this policy escapes me. Many taxpayers will quite reasonably assume that any tax cuts will turn out to be temporary and will therefore save a good proportion of them, so the impact on demand will be weak compared to the cuts in public spending required to pay for them. A deflationary balanced budget cut in spending is the last thing you want with an estimated negative output gap of 3% or more. On a more positive note, he also appears to be trying to form alliances to loosen the eurozone fiscal straightjacket, although what success he will have remains to be seen.

The latest OECD forecast predicts a gradual pickup in growth, despite a sharp fiscal contraction, although this fiscal contraction is not enough to stabilise the debt to GDP ratio by 2015. The danger is the by now familiar one: that fiscal contraction will inhibit growth by more than forecasters expect, which will generate pressure to undertake additional fiscal contraction. Is there a clear strategy to avoid this outcome, or is Thomas Piketty correct when he says: "What saddens me is the ongoing improvisation of François Hollande.”