More on Schools of Thought

                The main task of this post is to try and answer the following question: why do schools of thought seem to fragment mainstream macroeconomics but not microeconomics? However before tackling that issue, I need to clear some ground raised by some interesting comments on my earlier posts on this issue.

                One point I did not make clear enough in my earlier discussion is a distinction between mainstream and heterodox economics. The latter might include neo-Marxists, post Keynesians, Austrians and others. My concern was about mainstream macroeconomics becoming fragmented into schools of thought. I can see why those challenging the mainstream might find schools of thought both convenient and useful. I also think it is very important that the mainstream should be continually challenged.

                I also may not have emphasised enough the downside of the microfoundations project. I do worry that it may help to exclude good ideas, as James Galbraith suggests, and have written about how this could be dangerous for policymakers who rely on the mainstream. However I still believe that microfoundations, if interpreted flexibly, bring net benefits. But that is not the focus of what I wanted to say on schools of thought.

                The success of the microfoundations project is also why I agree with Steve Williamson that academic work in macro is probably not as fragmented as it was in the 1970s. (I was not an academic at the time, so I cannot be sure.) In that sense, academic macroeconomists when doing academic work can still locate what they do within a common, mainstream framework. We all use models that abstract from many things to focus on what we think is important for some particular issue, and we receive criticism about whether those abstractions are valid or not. My concern about schools was more with the interface between academia and policy, which includes the advice academics give, what economic journalists write, and what politicians pick up.

                The kind of thing I had in mind here include politicians thinking that austerity would not increase unemployment, because those that worried that it would were from the same misguided Keynesian school that opposed Margaret Thatcher’s monetarism in 1981. Journalists who find it easier to slot every debate into one between schools rather than address issues on their merits. And academics who attempt to argue that certain views are not worthy of consideration because they were confined to the dustbin 30 years earlier. Jonathan Portes gave similar examples in his post.

                One of the interesting things about schools of thought in mainstream macroeconomics is that there does not seem to be anything similar in microeconomics. Now such a generalisation invites counterexamples. Some might point to the debate over the methodology of behavioural economics, for example. However most of my academic colleagues who I have road tested this idea on do agree that macroeconomics seems more prone to schools fragmentation than microeconomics. If this is true today, it is strange, because macroeconomics has become microfounded.

                One simple answer to this paradox is that schools of thought are associated with macroeconomic crises, and macro synthesis follows periods of calm. Keynesian theory itself was born out of the Great Depression. The first Neoclassical Synthesis arose from the period of strong growth and low inflation in the post-war period. Monetarism gained strength from the rapid inflation of the 1970s. The more recent synthesis may be a child of the Great Moderation, and now we have the Great Recession, schools of thought have returned. Because these crises are macroeconomic, and there are no equivalent crises involving microeconomic behaviour or policy, then fragmentation of the mainstream into schools will be a macro, not micro, phenomenon.

                Attractive though this account seems, I think it misses some important points. As one of the comments on my original post pointed out, the New Neo-classical Synthesis was in many ways a celebration of New Keynesian theory which was not shared by many freshwater departments in the US. Now I think there are good reasons why New Keynesian economists might have imagined that their analysis was an uncontested part of the mainstream. As I noted here, it is used in nearly all central banks as their main tool in carrying out monetary policy. With monetary policy somewhat depoliticised through central bank independence, the Great Moderation allowed this division among academic departments to remain dormant.

                On the other side, there was a belief that New Classical economics had been revolutionary: a successful counter-revolution against Keynesian ideas.  Once again there were good reasons to support this belief. Nick Rowe in his comment on my Anti-Keynesian School post noted how many Monetarist ideas, opposed at the time by many Keynesians, were now part of the mainstream. We could do the same for the battles between New Classical and Keynesian economists: on consumption, rational expectations, the Lucas critique and more, traditional Keynesians had unsuccessfully opposed New Classical ideas. Furthermore, many of the leaders of New Classical thought did not want to update Keynesian thinking, they wanted to destroy it.

                There is a lot more that could be said here, but it would lead me to the conclusion that this counter-revolution failed. It led to fundamental and largely progressive changes in Keynesian analysis, and macroeconomics more generally, and Keynesian analysis survived and prospered. Yet, for many reasons including ideological ones, the would-be counterrevolutionaries did not want to give up their counterrevolution.

                So, perhaps unlike the first (post-war) neoclassical synthesis, the New Neoclassical Synthesis was partial in terms of its coverage among academics. This incompleteness was not apparent during the Great Moderation, because the synthesis was applied in nearly every central bank. The fault lines only became apparent when monetary policy became relatively impotent at the zero bound after the Great Recession, and fiscal stimulus was used both in the US and UK. Once that happened, what I called the Anti-Keynesian school re-emerged.

                This back story is important, because it raises the possibility of an optimistic (from a Keynesian point of view) way forward. This is that the New Neo-Classical synthesis becomes complete. (For possible signs that this has already begun, see here.) The microfoundation of macroeconomics does logically imply that mainstream macro should be as free from alternative schools as microeconomics. This would require freshwater macroeconomists to recognise that New Keynesian models are essentially RBC models plus sticky prices, and that the addition of price rigidity was not that offensive. All would recognise that the conditions in which fiscal policy was a major stabilisation tool were either rather unusual (the zero bound), or geographically remote (monetary union), and so not something to get so worked up about. Freshwater economists would come to realise that demand denial  just did not make academic sense.

                I fear a more realistic conclusion is that the Keynesian/Anti-Keynesian division is always going to be with us, because it reflects an ideological divide about state intervention. (For some supporting evidence, see here.) That divide occurs all the time in microeconomics, but because it involves arguing about many different externalities or imperfections it does not lend itself to fragmentation into schools. In macro, however, there is one critical externality to do with price rigidity, and so disagreements about policy can easily be mapped into differences about theory. Demand denial is attractive because it gives a non-ideological justification for what is essentially an ideological position about economic policy.

Budget deficits: changes, levels and risks

                One reasonable response to arguments that the UK, or US, needs less austerity and more fiscal stimulus is ‘deficits are already large’. Now there is an obvious trap here, which is that deficits in a recession are large because of the automatic stabilisers. However it remains the case that in many countries budget deficits are large even when they are cyclically corrected. Cyclical correction is a non-trivial task, and involves making judgements about output gaps which are far from easy at present, but it is better to try than to ignore the issue. The chart below plots ‘underlying’ budget deficits as calculated by the OECD in their end November 2011 Economic Outlook. (More accurately, they are the financial balance of general government as a percent of GDP corrected for the cycle and ‘one-offs’.)

Underlying budget deficits, OECD Economic Outlook Nov. 2011

                Cyclical adjustment takes a bit more than 2% of GDP off the 2010 deficit for the UK and the US, reflecting a view that the output gap was around 3.5% that year. So in 2010 cyclically adjusted budget deficits were still very large in both countries, reflecting in part a deliberate policy of fiscal stimulus. The chart also shows the underlying deficit projected for 2013. (Projected changes over these three years are smooth enough not to make the choice of particular years important.) In terms of withdrawing stimulus, or instituting austerity, the Euro area is expected to do more than the UK, and the US less than the UK. This raises a simple question: in judging the direction of policy, should we be looking at levels or changes?

The first thing to say is that we have to be careful relating budget deficits to the stance of fiscal policy because of forward looking behaviour. Suppose the government permanently increases spending, and finances this initially through debt, but Ricardian Equivalence holds. In that case we would get a budget deficit, which generates a matching private sector surplus because consumption falls, and there is no stimulus to aggregate demand. Perhaps a more relevant example in the current situation might be that the government promises to gradually reduce spending, making the current level of taxes eventually sustainable, but the private sector does not believe this, and instead expects taxes to be raised in the future. In this case consumers would save more to help pay for the expected increase in taxes. Once again there is no stimulus, this time because the government is not believed.

                For the sake of argument let’s put those concerns to one side, and assume in the case of the UK that long term plans to reduce spending without raising taxes are credible. We have a large private sector surplus not because consumers are saving to pay for future tax increases, but because they are increasing their precautionary saving, or because those that want to borrow cannot do so because banks are restricting lending. In that case, the question about levels or changes in deficits depends on what is likely to happen to private sector demand. If the private sector is expected to continue to save in this way, then we have the same demand gap, but less of it is filled by the public sector, so aggregate demand and output fall. In that sense fiscal policy is restrictive because deficits are falling. However if the increase in private saving is expected to come to an end, which it should at some point, then it is appropriate that the public deficit also declines at some point.

                It is all a question of timing, which of course is uncertain. However this uncertainty gives us a very strong argument for not reducing the size of public sector deficits too quickly. If high levels of private savings continue in the short term, then the appropriate policy is to maintain large deficits. But what if the private sector starts spending again? Will that not mean we have too much demand? Two points here. First, when there is a large degree of spare capacity, we can probably tolerate quite rapid growth in demand for a time, without this being inflationary. In fact it is a good thing, because we get rid of unutilised resources sooner. Second, if demand growth is too rapid and inflation rises (and we cannot cut government spending quickly enough because of well known institutional and implementation lags), then we can use monetary policy to cool things down.

We have an asymmetry of risks. If fiscal policy is too expansionary, we have monetary policy as a fall back. However, because of the zero bound for interest rates and uncertainty over the effectiveness of Quantitative Easing, we do not have a similar insurance policy if fiscal policy is tightened too quickly.

                This is why I think the speed of fiscal tightening implied by the chart above is too rapid. In the UK in 2010, for example, there was a clear risk that private sector demand would not pick up in 2011. The risk coming from the Eurozone was also apparent. In these circumstances, the prudent policy option was not to scale back public spending too rapidly, because there was no insurance policy in place if these risks materialised. They did materialise, and UK growth stalled. The Eurozone is making exactly the same mistake, in perhaps a bigger way.

                Now I have not mentioned the risks associated with rising debt, which is something I’ve discussed elsewhere. However one simple point is worth making again and again. If the recession reflects additional net saving by the private sector, they want to hold more assets. Furthermore, given the character of the recession, they want to hold relatively safe assets. There is a literature on the current shortage of safe assets. Budget deficits provide those assets, but still interest rates on debt are falling outside the Eurozone because there are not enough of them. This too points to budget deficits being cut too quickly. 

When growth returns: a prediction

                No, I’m not about to get into the forecasting game – I did enough of that when young. What I am prepared to predict is the reaction of some when growth does return (as it may be in the US, and as it might one day in the UK and the Eurozone). My prediction is that some people will say that growth shows those Keynesian prophets of doom were all wrong. Look, the patient has recovered just fine without the need for any fiscal stimulus medicine.

                If people do say this, they will be wrong on two counts. First, there are good reasons for believing that aggregate demand will start to recover at some point without any additional monetary or fiscal stimulus. One of the main reasons for the recession was the need to repair balance sheets, which for consumers meant less borrowing and more (precautionary) saving, and for banks building up capital by reducing lending. Once this process is complete, demand will begin to recover. Once it does so, firms will stop delaying new investment. There is a lot more that could be said about the dynamics of demand following the Great Recession, but a return to growth at some stage is almost inevitable.  

                Second, the argument was never about growth, but about the level of activity, and unemployment. Put simply, those of us who argue for more fiscal (and monetary) action want growth to come sooner and quicker, so that unutilised labour resources can get back to work. Unemployment is not only a waste of resources but also a major cause of unhappiness (see, for example, this paper by Blanchflower). Worse still, there is the likelihood that prolonged involuntary unemployment may lead to much more permanent reductions in supply, as workers become discouraged and deskilled (see, for example, this paper by Laurence Ball). 

                So that is my forecast. In one sense I cannot wait to see if it comes true.

P.S. The above has nothing to do with this from Tyler Cowen: Tyler can do no wrong after recently listing my blog. Those interested in that particular post should see Noah Smith.

Euro Deja Vu?

                I was giving a talk about the Euro crisis this week, and in preparation I looked at the new Treaty. Like Antonio Fatas I had that feeling that I had been here before. I remember reading the original Stability and Growth Pact (SGP) and wondering why the focus seemed to be entirely on debt ceilings, with no discussion of using fiscal policy as a countercyclical tool. Much the same could be said about this Treaty.

                To recap, this matters because there are two crises in the Eurozone at present: a debt crisis and a competitiveness crisis. General austerity might deal with the first, but because it includes austerity in Germany it makes the second worse: we have ‘competitive austerity’ that will lead to recession and will test the cohesion of the Eurozone. (For example, read Tim Duly and follow the links.) Both crises might have been avoided, or at least mitigated, if many non-German economies had undertaken much more aggressive fiscal tightening before 2007 as they saw their inflation rates exceed those in Germany. It is possible that the SGP itself may have discouraged such tightening, partly because politicians thought that if they were within the pact’s limits things were OK, and perhaps because of reasons I explore below.

                I cannot see anything in the new Treaty that encourages countries to think about their relative inflation and cyclical positions. If this Treaty had been in place in 2000 rather than the SGP, it seems likely that the crisis in competitiveness would still have emerged. Not only is the new Treaty unlikely to prevent such crises happening again, but it makes the current crisis worse, because there is no pressure on Germany to expand its economy by fiscal means.

                Is there anything positive to say about the Treaty? Maybe one thing. The idea of an automatic correction mechanism if deficits stray from the cyclically adjusted balanced budget rule is modelled on the Swiss and German debt brake idea. This mechanism has some attractions (see this paper by Charles Wyplosz), although I think the devil is in the detail. A debt brake with conditionality related to relative inflation rates might work, as some research I was involved with a few years ago suggests.

                The other big problem (besides ignoring countercyclical fiscal policy) which I have with the Treaty is the continuing emphasis on imposition ‘from above’. One thing that we have clearly learnt from the crisis is that it is in each country’s national interest to have adequate budgetary control. In contrast, a key idea behind the original SGP was that without it individual countries would free ride on the union, and that therefore union level control was required. This seems much less relevant today. The danger with control on individual countries coming from the union is that it becomes a ‘them and us’ game. If it is in the national interest to free ride at the union’s expense, then activities such as fiddling the figures may also be seen as in the national interest, when clearly they are not. If austerity is imposed from above rather than from within, the political dangers to the Eurozone itself are obvious. It would, in my view, be much better for individual countries to take ownership of the control of their own national budgets. This could be done through a combination of national institutional reform and nationally determined fiscal rules. Calmfors and Wren-Lewis (2011) show how this combination is becoming increasingly popular. I do not think forcing countries to pass laws to follow balanced budgets really qualifies as taking national ownership!

Chris Giles on UK Austerity

According to Chris Giles in today’s Financial Times, “..the area in which Britain still leads the international debate is fiscal policy”. This might come as a surprise to many, such as Paul Krugman. I should emphasise that Chris does make one point which I totally agree with. Gordon Brown was quick to recognise the need for fiscal stimulus in 2008, and he applauds that. So, unlike some, the argument is not that fiscal stimulus is always and everywhere wrong. Instead it is that fiscal stimulus was appropriate in the downturn, but that once a recovery began, it was necessary to switch sharply from stimulus to austerity. This argument has of course been made for other countries, including the US, as well as the UK.

                Chris gives some arguments against austerity that he says range from ‘mad to bad’. The first, which he attributes to Labour politicians, is the suggestion that austerity is entirely responsible for the recent downturn in UK growth. Well, if anyone said this, they are obviously wrong (although not quite mad): there are other important deflationary forces, of course. But it is equally wrong to infer that austerity has little or nothing to do with the recent poor performance. I know of no evidence to suggest that is likely. Indeed it would be rather strange if stimulus had been effective in moderating the downturn, as Chris acknowledges it was, but that withdrawing that stimulus (and more) had no impact.

                The second argument against austerity which he describes as ‘bad’ is that low borrowing rates imply that we can “go on a spending spree”. Let’s forget about the ‘spending spree’ language. What I do take exception to is the suggestion that this is a bad argument. It could be wrong, but the idea that the market price might tell you something about demand and supply is hardly bad. What Chris and others seem to have in mind here is a rather unusual demand curve. Lenders want lots of UK debt under current austerity plans, but if these plans were moderated or delayed, or if a temporary stimulus package was laid on top of them, they would suddenly panic. It is possible that they might behave this way, but I think it is unlikely for various reasons.

                The source for this sudden panic idea is of course the Eurozone. However I think it is generally accepted now, among economists if not coalition politicians, that the Eurozone is different, because individual countries do not have their own central banks, and the ECB’s attitude is ambivalent. Certainly market panic does seem to be confined to the Eurozone. Indeed, with Quantitative Easing in place, the UK is in a particularly good position to respond to any market panic, as I argued here. We also have some evidence that, outside the Eurozone, the market does not panic at the first suggestion of stimulus. This does not seem to have happened in Denmark, as David Blanchflower noted, and it has not happened in the US. Also, as Olivier Blanchard of the IMF said recently, if we are concerned about market psychology we should be worried about growth as well as debt. 

It is far from clear why the current government’s rapid move to austerity is just sufficient to avoid market panic, but anything more moderate (like the previous government’s plans) would send them into a tizzy. The reduction in UK interest rates on debt that we have seen is part of a worldwide trend, and not an indication that the UK leads the world in finding the appropriate policy stance. Meanwhile, the UK recovery has stalled in a major way, and the scale of unutilised labour resources is large and growing. The view exemplified by Chris’s article that we should wait and see what happens, and hope that Quantitative Easing might yet do the trick, is much too complacent. It was wrong two years ago, and it is even more wrong today.

Annoying Anti-Stimulus Arguments: Numbers 1 and 2

Unfortunately this may be the beginning of a series. I will try and keep it short and to the point. I will also avoid mentioning anyone in particular who has made these arguments – you know who you are! These arguments are annoying because they keep being made, despite the fact that they have shown to be inadequate over and over again.

No. 1   Arguments that ignore the zero lower bound for interest rates.

                There are good arguments for saying that if monetary policy is free to do its job, then countercyclical fiscal policy is both unnecessary and welfare reducing. I have written on the subject. But having written those papers, I could see immediately the importance of that proviso about monetary policy. At the zero lower bound for interest rates (in a liquidity trap), monetary policy is clearly not free to do its job, and so different conclusions apply. See Eggertson and Woodford (2004). If the argument assumes that, despite the zero bound, monetary policy can do all that is required, then this should be said so explicitly, because it is somewhat counterfactual.

                For exactly the same reasons, these arguments against countercyclical fiscal policy do not apply to individual countries in a monetary union. If monetary policy is set by the ECB, it cannot ensure output is at its natural level (‘full employment’) in each individual Eurozone country. There is a large literature on this, which I have contributed to, but a standard reference would be Gali and Monacelli (2008). There, as in most of this literature, countercyclical fiscal policy in the face of country specific shocks is welfare improving.

No.2    Arguments that say stimulus is just Econ 101, and the profession has moved on.

                I have in the past been very critical of the gap between undergraduate teaching in macro and teaching at masters/PhD level. I think it is quite wrong to teach things to undergraduates that we then tell graduate students are incorrect. But the analysis of fiscal stimulus is not one of these. I know this because my work on fiscal policy uses microfounded New Keynesian models of the type Woodford and others analyse. It is not the same as old fashioned Keynesian analysis, but it can give similar answers for similar reasons. I gave an example here.

                So when I teach Keynesian theory to undergraduates, I am not thinking ‘this is nonsense, as they may find out when they are older’. I’m teaching them simple, non-microfounded models that are a rough approximation to many more advanced, microfounded models. If the argument is that these approximations do not hold in the case of fiscal stimulus, then the argument should be explicit about why. It is just not good enough to say we have better models now, without saying what those models are, and why they make a difference. 

If the argument is that New Keynesian models are wrong, say so, and say why. If the argument is that New Keynesian models would give different answers to Econ 101 reasoning, be specific about which models, and say why they give different answers. If the argument is that state of the art New Keynesian analysis does not support fiscal stimulus at a zero lower bound, then it is simply false: again, see Eggertson and Woodford (2004).

It is time the Bank of England started publishing interest rate forecasts

                In an earlier post I celebrated the announcement that the US Federal Reserve intended to publish interest rate forecasts. It has now done so. Here is the key chart.

The vertical axis in the level of expected interest rates. On the horizontal axis we have four points in time: the end of 2012, 2013, 2014 and the long run. Each dot represents the expectation of one of the FOMC members (roughly the equivalent of members of the Monetary Policy Committee in the UK).

                This tells us some important information that could only be guessed at beforehand. The majority of FOMC members expect interest rates to stay at almost zero for the next two years. Every member of the FOMC expects interest rates to be below their long run level (i.e. they expect monetary policy to be expansionary) in three years time. (We know it is expansionary because we also have FOMC inflation forecasts, so we can work out what real interest rates will be.) Now these forecasts are not necessarily better than others, but that is not the point. What they tell us is what these individuals are likely to decide to do if events (inflation, growth etc) turn out as they expect, and if they are being consistent. (More formally, this makes it easier for a central bank to demonstrate its credibility in the face of potential time inconsistency: see my earlier post for an example of what this means.)

                The Federal Reserve example also weakens two of the standard arguments against the Bank of England doing the same. The first argument is how you get all the MPC members to agree a forecast. As the above shows, you do not. Each member of the MPC says what they think. The second argument is that the public will confuse conditional forecasts with commitments. However, unless every MPC member has the same forecast (which seems unlikely), what you get is alternative opinions, so clearly this is not some kind of unconditional target for interest rates.

                The central bank of New Zealand has been doing this for years, and those of Sweden and Norway for some time now. Those central banks have not decided it was a horrible mistake because the public did not understand what it was doing. However, these were relatively small economies, so the Bank of England could brush their experience to one side. Now that the US has followed in their footsteps, I believe the Bank has to move in the same direction.