Confidence

Mainly for economists

Francesco Saraceno reminds us about the days in which very important people believed in the confidence fairy (aka expansionary fiscal austerity), which are not so very far away. He also points to some recent ECB research which shows that confidence - as measured by surveys - clearly falls following fiscal austerity. The confidence fairy, rather than waving her wand to make everything alright again, may be making austerity worse. 

However, looking at the research in detail revealed some results I found at first surprising. In particular, revenue cuts have a bigger effect on consumer confidence than spending cuts. In terms of GDP impacts, theory - and most but not all empirical evidence - suggests that temporary spending cuts will have a larger impact on overall activity than temporary tax increases, if there is no monetary offset and incentive effects are not very large. Do these empirical results contradiction this?

To answer that you need to ask two further questions. First, what does consumer confidence actually measure? Second, and perhaps more interesting, what information do fiscal announcements actually reveal.

The answer to the first question seems to be a mixture of things, some of which relate to the individual household’s income, and some related to the general economic situation. To the extent that the consumer is thinking about the former, then it would make sense that a tax increase might have a larger impact on confidence than a spending cut. This would tell you very little about the economic impact of the two types of measure.

The obvious answer to the second question is that the information conveyed by an announcement of a spending cut or tax increase is just itself. If we stick to taxes, then if the announcement had not been made, the consumer would have just assumed lower taxes (for a time, or forever?). But this is naive from an intertemporal perspective, and clearly non-Ricardian. In the logic of Ricardian Equivalence, a tax increase today must imply cuts in taxes tomorrow for a given path of spending.

There are three alternative, more ‘rational’, ways of thinking about the announcement of a tax increase. Suppose the current government budget deficit is not sustainable. Taxes either need to rise today, or tomorrow after more borrowing. The announcement then tells us about the timing of the tax increase. If Ricardian Equivalence held it would have no impact on lifetime discounted income, but if for many possible reasons it did not hold, then a tax increase today could depress consumer confidence. However, to the extent that confidence depended on the general economic situation, you would expect ‘bringing forward’ expenditure cuts to have a much greater impact than bringing forward tax increases (with the caveats noted above), because of consumption smoothing. In that case spending cuts should reduce confidence more than tax increases.

A second possibility is that a tax increase could signal something about the future economic situation. Perhaps the consumer had thought the deficit was sustainable because they were optimistic about future growth, but the tax increase told them to be less optimistic. Reduced optimism could lead to reduced confidence. To the extent that the fiscal action conveys information about future pre-tax incomes, the tax increase conveys the same information as a spending cut.

A final possibility, which is generally ignored when discussing the plausibility of Ricardian Equivalence, is that the announcement of a tax increase tells consumers about the composition of any consolidation. Suppose again that the deficit is unsustainable. Either taxes have to rise or spending fall, but the consumer does not know which of these will happen. If spending is then cut, this tells the consumer that taxes will not rise, which in terms of the consumer’s own income would represent a plus. So in that case a spending cut could increase consumer confidence.

Trying to evaluate the impact of past fiscal actions is complicated, in large part because it is difficult to know what the counterfactual was, or what people thought the counterfactual was. Were changes thought to temporary or permanent? (Governments hardly ever say, and even if they did would they be trusted?) To what extent do people internalise the government’s budget constraint? If they do, are fiscal changes telling us about the timing of taxes or spending, or their mix, or something else? It seems to me that these difficulties arise whether we are trying to assess the impact of fiscal changes on confidence, or on activity itself. 

Macro teaching and the financial crisis

Some macro textbooks (not all) are a bit like extensively modified code. You can see the structure of the original code, even after extensive software development. This can mean that, as new capabilities were added to the programme, rather than rewrite the software from scratch, extra routines were just added on top. Not only is this inefficient, but the whole thing ends up looking like a confused mess.

Perhaps this is why we end up with textbooks that still have the completely out of date LM curve at their heart (and associated AD curves, plus Mundell Fleming, and even money multipliers), but additional chapters where the AS curve becomes a Phillips curve, and money targeting gives way to Taylor rules. The student ends up totally confused, if they ever get to those later chapters. And after the financial crisis, a new edition will have a chapter devoted to that crisis, but not much in earlier chapters will change.

This is not the case with the third textbook by Wendy Carlin and David Soskice. It has been around for a few months, but I at last got a chance to take a good look. 

I say third textbook rather than third edition because they do not do editions. This is a complete rewrite of their earlier ‘Macroeconomics: Imperfections, Institutions, and Policies’. Luckily all the features of that earlier book that I really liked are retained. For example, a supply side based on imperfect competition rather than perfect competition (although alas the price setting curve is still flat!). But most importantly, a core model (the 3 equation model) which dispenses with the LM curve, and replaces it with a ‘monetary rule’ curve, based on a central bank using interest rates to hit an inflation target. This is similar to the approach championed by David Romer. (So the 3 equations are the IS curve, the Phillips curve, and the monetary rule curve.)

There are also some major improvements compared to the second book. The open economy analysis is now fully integrated with the 3 equation model, and the remnants of Mundell-Fleming are gone. The Euler equation appears on page 22, as one of the foundations of the IS curve. It is a shame that the Phillips curve is still based on the traditional (this period’s expected inflation) rather than New Keynesian (next period’s expected inflation) version, but you cannot have everything.

But by far the most important change concerns the financial sector. After initial chapters on the demand side, supply side and 3 equation model, plus a fourth on expectations, we have three chapters on the financial sector. The first looks at the banking sector, and makes the key alteration to the 3 equation model: there is a wedge between the ‘policy’ interest rate and the interest rate relevant for the IS curve. You can see this chapter as looking at how the financial system works in ‘normal’ times, when the system is not a source of instability. The second chapter then looks at how the financial system can be a source of instability, through mechanisms like the financial accelerator or asset price bubbles. The third chapter applies this analysis to the financial crisis of 2008.

When I taught most of the finals macro course at Oxford, I used their earlier book. I did have a lecture on the financial crisis, but it was an add-on of the type I described above. This new book is almost enough to make me wish I was still teaching this course. It gives finance the position in macro that recent events suggest it deserves. Mark Gertler on the back cover writes: “This is an exciting new textbook. Overall, it confirms my belief that macroeconomics is alive and well”. That pretty well sums up my reaction.

Except to add that the front cover is a painting by Paul Klee. Perfect!

Cyclically adjusted deficits and instability

Jean Pisani-Ferry, currently advising the French government and former director of Bruegel (the Brussels-based economic think tank) has written a heartfelt plea for more stability in the Commission’s estimates of potential output. The reason is straightforward. The Eurozone’s fiscal rules require meeting targets for cyclically adjusted deficits within the next year or two. Every time estimates of potential output change, the target for the actual deficit also changes, and policy often has to respond immediately to meet the new targets.

Pisani-Ferry of course understands why this happens, and why cyclical adjustment makes sense in principle. He is not advocating returning to the days when targets ignored the economic cycle. However the problem he clearly has is in communicating to policy makers who are not economists why they need to change actual policy simply because someone in Brussels has revised their estimate of potential GDP. He writes

“Members of parliament – who are not technicians – are understandably disturbed when they are asked to pass a revised budget in response to an updated estimate. Not knowing the whys and wherefores, they end up perceiving such revisions as a source of artificial instability.”

However an obvious objection to his proposal might involve the following scenario. To meet its target the government is embarking on austerity which is also reducing GDP. The Commission gets new information which leads it to revise up its estimate of potential GDP, implying the need for less austerity. Should the Commission ignore this information for the sake of stability?

I would suggest that the ‘non- technical’ instincts of policymakers are right in this case, but the reason is more basic. Short term fixed date targets for the deficit are a source of instability. There is no economic reason to have such short term deficit targets, and there are plenty of very sound economic reasons not to have targets of this kind. In essence this is because the deficit should be a shock absorber, but by targeting it you make taxes or spending the shock absorber. Hence the perceived, and actual, instability.

It would be much better, as Jonathan Portes and I argue, to have deficit targets for 5 years ahead. Whether these should be fixed date or rolling targets would depend on how trustworthy the government was, and whether there was an independent and robust fiscal council that could provide an ‘implementation incentive’ for the government. (We would argue in addition that fiscal policy in the Eurozone needs to play a countercyclical role, both at the individual country level to correct imbalances within the zone, and at the aggregate level if interest rates are at the Zero Lower Bound.)

Would such targets need to be cyclically adjusted? In the context of an economy with its own monetary policy we would argue not, because within five years the central bank should have eliminated any output gap (in expectation). Whether cyclical correction via competitiveness effects works so quickly is less clear, and if it does not cyclical correction would still be required. However I suspect that if targets were for five years ahead, revisions caused by new estimates of potential would be less problematic, because the need for an immediate policy change would be reduced. (As an example, when the OBR first revised its estimate of potential in the UK, Osborne’s response was to extend austerity into the next parliament, rather than intensify current austerity.)

The key point is that targets for the deficit just one or two years ahead are foolish things to have, and cyclically correcting the target only makes them slightly less foolish. Indeed, I would go so far as to say they are primitive in macroeconomic terms. It is like telling consumers that they shouldn’t smooth their consumption, but instead vary their spending or income to keep their wealth at some fixed target level. You would only want to do that to a child, and policymakers should not be treated as children.

How can Labour say it didn't crash the economy

If my memory serves me correctly, one of the rounds of applause received in the UK election debate on Thursday was when Clegg said that Miliband should have apologised for crashing the economy when they were in office. That suggests that a significant number of people (I suspect not including Nick Clegg, but that may be optimistic) think it is true that Labour should apologise for crashing the economy. Are they right?

You can see why they might think this, because much of the press keeps saying they did. In addition, the more non-partisan parts of mediamacro hardly ever challenge members of the governing parties when they make the claim that Labour crashed the economy.

The difficulty here is that ‘Labour crashed the economy’ is not complete fiction. If the accusation was that Labour crashed the economy through fiscal profligacy (which it sometimes is), that is a straightforward falsehood, and it is easy to show it is a lie. The economy crashed because of the global financial crisis. But if fiscal profligacy is not mentioned, the claim cannot be dismissed as completely wrong. This is because the Labour government, like their Conservative predecessors, brought about or tolerated a regulation regime and a financial sector that allowed the global financial crisis to have a particularly damaging effect on the UK economy.

 

That is I guess why Ed Miliband seemed to respond to this accusation by saying something like: “yes we did get financial regulation wrong, but …”. That may be an honest reply, but it is not very effective, because many will read it as admitting Labour caused the recession. A better reply would be: “everyone knows that the recession was caused by the global financial crisis and insufficient regulation, but the recession would have been worse if the Conservatives had been in power.” As Mervyn King says “the real problem was a shared intellectual view right across the entire political spectrum and shared across the financial markets that things were going pretty well”, a view which he of course shared. I think the claim that the recession would have been worse if the Conservatives had been in government can be justified on two grounds. First, the Conservatives did accuse Labour of too much financial regulation, not too little. Second, they were against Labour’s fiscal stimulus in 2009.

Why is it important that Labour combat this charge effectively? Because it seems to me, being as impartial as I can be, that when it comes to a contest of macroeconomic competence between the last Labour government and the current coalition, Labour wins hands down. That is not so much because Labour were so good (although they got some important things right, like not joining the Eurozone, setting up the Monetary Policy Committee, and fiscal stimulus in 2009), or because the coalition has been all bad (setting up the OBR was clearly a positive move). It is because the coalition made such a bad mistake with austerity, a mistake that very many warned them about. Losing the equivalent of at least £4,000 per household is a big deal, with no obvious equivalent in my professional lifetime. Even if we were prepared to forgive this as a genuine mistake, to plan to make exactly the same mistake again either suggests a complete inability to learn, complete incompetence, or a duplicitous pursuit of ideology over social welfare.

On a more positive note, if you want a detailed assessment of the coalition’s record on a whole range of economic issues, look both here and at the Coalition Economics website. The latter is by the same team that made an assessment of economic policy under Labour for the Oxford Review, and that issue is also available on the website, so even if the authors do not make an explicit comparison between the two governments, you have the information to do so. Some excellent articles are already there (including one on financial regulation), and more are to follow.

Do not underestimate the power of microfoundations

Mainly for economists

Brad DeLong asks why the New Keynesian (NK) model, which was originally put forth as simply a means of demonstrating how sticky prices within an RBC framework could produce Keynesian effects, has managed to become the workhorse of modern macro, despite its many empirical deficiencies. (Recently Stephen Williamson asked the same question, but I suspect from a different perspective!) Brad says his question is closely related to the “question of why models that are microfounded in ways we know to be wrong are preferable in the discourse to models that try to get the aggregate emergent properties right.”

I would guess the two questions are in fact exactly the same. The NK model is the microfounded way of doing Keynesian economics, and microfounded (DSGE) models are de rigueur in academic macro, so any mainstream academic wanting to analyse business cycle issues from a Keynesian perspective will use a variant of the NK model. Why are microfounded models so dominant? From my perspective this is a methodological question, about the relative importance of ‘internal’ (theoretical) versus ‘external’ (empirical) consistency.

As macro 50 years ago was very different, it is an interesting methodological question to ask why things changed, even if you think the change has greatly improved how macro is done (as I do). I would argue that the New Classical (counter) revolution was essentially a methodological revolution. However there are two problems with having such a discussion. First, economists are usually not comfortable talking about methodology. Second, it will be a struggle to get macroeconomists below a certain age to admit this is a methodological issue. Instead they view microfoundations as just putting right inadequacies with what went before.

So, for example, you will be told that internal consistency is clearly an essential feature of any model, even if it is achieved by abandoning external consistency. You will hear how the Lucas critique proved that any non-microfounded model is inadequate for doing policy analysis, rather than it simply being one aspect of a complex trade-off between internal and external consistency. In essence, many macroeconomists today are blind to the fact that adopting microfoundations is a methodological choice, rather than simply a means of correcting the errors of the past.

I think this has two implications for those who want to question the microfoundations hegemony. The first is that the discussion needs to be about methodology, rather than individual models. Deficiencies with particular microfounded models, like the NK model, are generally well understood, and from a microfoundations point of view simply provide an agenda for more research. Second, lack of familiarity with methodology means that this discussion cannot presume knowledge that is not there. (And arguing that it should be there is a relevant point for economics teaching, but is pointless if you are trying to change current discourse.) That makes discussion difficult, but I’m not sure it makes it impossible.

Silly questions or silly economics

On cue to confirm what I wrote yesterday, Ryan Bourne at the Institute of Economic Affairs complains about the BBC coupling the Telegraph business leaders story with the CFM economists survey. [1] Mr. Bourne’s main gripe is that the CFM question on austerity was silly. The question was “Do you agree that the austerity policies of the coalition government have had a positive effect on aggregate economic activity (employment and GDP) in the UK?”

Why was it silly? To quote: “the overwhelming majority of even supporters of austerity would disagree with the question, because in the short-term they would also believe that cutting spending and raising taxes would dampen growth. Indeed, the OBR and others factored this into their models. It is well known.” And later on: “these proponents of austerity were willing to make a trade-off: slightly slower growth today, in order to achieve other objectives.” [2] So they would be forced to disagree with the statement, even if they agreed with austerity. 

This tells us two things. First, it emphasises something I and others have occasionally said, which is how far austerity supporters have lost the intellectual debate. I remember not that long ago the arguments being about expansionary austerity, or how monetary policy could (would) offset any impact that fiscal policy might have on activity. Or it was about how we had to have austerity, because without it there would have been market panic. Apparently not - it was really all about current sacrifice for future gain.

Second, it illustrates the gulf between what most economists understand and mediamacro. In mediamacro, austerity was necessary because without it terrible things would happen (or at least there was a good chance of them happening). Not sometime in the future, but pretty soon. To quote the Prime Minister: “Britain was on the brink“. This of course is why some of the non-partisan media found the CFM survey interesting.

There is a huge amount in Mr. Bourne’s post that I could take issue with [3], but let me just focus on one point. He says: “Certain commentators are keen to claim that employment growth has only been strong because the productivity performance of the economy has been weak. This is an utterly bizarre claim.” He mentions this, of course, because the government is making great play over the number of jobs ‘they have created’.

To say that this is a bizarre claim is, frankly, bizarre? Let me explain why. No one disputes that our labour productivity performance over the last five years has been terrible. Here is a chart from the latest ONS release.

  

Note that a fall in productivity during a recession is not unusual. What is unusual is what has happened during the period of the coalition government. (See more on UK productivity from Ken Mayhew at the coalition economics site.)

Labour productivity is just output divided by employment (or hours worked). Why is stagnant productivity a problem? Because over the long term (across booms and recessions) the level of employment is essentially tied down by how many people want to work and how many hours they want to work, so productivity growth means output growth. Improving living standards depend on improving productivity. So if over the last four years we have lost productivity growth that we are not going to get back for some time, this will mean lower average UK prosperity.

Does this not also imply that had productivity growth been stronger over the last four years, output would have been higher and employment growth much the same? No, because coming out of a recession caused by a collapse in demand, most economists see output as being determined by aggregate demand: how much people want to spend, how much firms want to invest, and how internationally competitive UK firms are. That is exactly why austerity hurts output, a point which Mr. Bourne seems happy to concede. It therefore follows that if productivity growth had been stronger, output would have been much the same because aggregate demand would have been much the same, but employment growth would have been weaker. Over the last five years strong employment growth and weak productivity growth is much the same thing. Which is why celebrating strong employment growth is effectively celebrating poor productivity, which does seem silly.

[1] Mr. Bourne will have been pleased to note that, at least from what I saw, none of the evening news bulletins covered the CFM survey, while the business leaders’ letter retained its top spot. I’d love to know the reason for this change.

[2] Mr. Bourne gave three reasons why sacrifice now would lead to later gains: (a) lower borrowing costs, (b) preparing for the next recession, and (c) a smaller state increases productivity. As I have argued before, there is no evidence that at the beginning of 2010 interest rates on UK debt involved any noticeable default premium. I have discussed at length how we might be better prepared for the next recession, but strangely sacrificing large chunks of GDP today was not on my list. As for (c), look at the record on productivity.

[3] For example, the question Mr. Bourne would have rather seen is whether fiscal policy was the main cause of weak growth from 2010 to 2012, or whether external factors were more important? He does not say why this is a much better question. Of course the question Mr. Bourne would really like is why the economy did worse than the OBR expected, because the OBR were always expecting austerity to reduce growth. Personally I find questions like what impact did government policy have on the economy rather relevant, particularly coming up to an election.  

Economists vs. Business Leaders?

Today illustrated very clearly why the monthly CFM survey of mainly academic, mostly macro UK economists was such a good idea. (And something that I should have included in this discussion.) I have often written that I thought austerity was only supported by a small minority of UK macroeconomists, but my evidence for this has been much thinner than I would like. Today CFM published their latest survey which asked: “Do you agree that the austerity policies of the coalition government have had a positive effect on aggregate economic activity (employment and GDP) in the UK?”

The response was clear: 15% agreed, 18% neither agreed nor disagreed, and 66% disagreed. As CFM reported: “Ignoring those who sat on the fence, 19% agree and 81% disagree with the proposition. This ratio is unaffected by confidence weighting.”

That was welcome confirmation of my prior, but what was much more important is that the survey came out on the same day as the Daily Telegraph published a letter from 100 business leaders saying exactly the opposite. To quote: “We believe this Conservative-led Government has been good for business and has pursued policies which have supported investment and job creation.” Now of course a letter (organised by whom?) is not a survey, and it is hardly news that Labour has policies that are unpopular with business leaders. Yet the letter was nevertheless the lead item on BBC news today.

However in at least some of the reports I heard that led on the letter ‘news’, the CFM survey was also mentioned. I myself participated in Radio 4’s World at One (about 11 minutes in) as a direct result of the survey. Robert Peston went as far as to ask: “Who to trust - business leaders or economists?” I liked the way he introduced his post:

“Neither business leaders nor economists have a monopoly of wisdom on what's good for Britain or are free from political bias. But it is perhaps therefore all the more important to remember that those paid to think about how best an economy should be run don't necessarily agree with those paid to run companies.”

He might have also added that, probably without exception, we are paid a lot less than business leaders, so the danger that our opinions might be influenced by Labour policies like reintroducing the 50p income tax rate or introducing a mansion tax is perhaps also smaller!