Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 28 September 2016

Why was austerity once so popular?

Duncan Weldon asks whatever happened to deficit bias, and why was austerity so popular when it seems to hurt two crucial groups of electors. They are both excellent questions.

First, a quick recap of Duncan’s arguments. The standard view among economists before the financial crisis was that economies were prone to deficit bias: a tendency for government budget deficits and debt (as a share of GDP) to slowly increase. [1] Although there are a number of theories about why deficit bias occurs, several involve voters being at best unconcerned about it, and at worst conniving in it. Such theories are miles away from an electorate giving strong support to a government campaigning on reducing the deficit.

Second, austerity keeps interest rates low. So not only does austerity hit wages and profits, but it also hits those who rely on interest income to supplement their pension, a group who in case you need reminding have a high propensity to vote. Although asset values have gone up as well, many in this group will be reluctant or unable to turn this into income.

I try and answer both questions in this paper. As with many things, I think the answer lies in the financial crisis. Popular concern about government deficits will be much greater if these deficits are at 'record levels', which they inevitably were following the deepest global recession since WWII. A recession initiated by a financial crisis is also likely to see consumers reducing their own borrowing, and so (erroneous) analogies between governments and households resonate. A recession initiated by a financial crisis also makes the public receptive to the potential power of these markets, and therefore to claims by those ‘close to the markets’ that national disaster is just one more large deficit away. Arguments from economists that rational markets would not be concerned about government default when the central bank can create money are met with a widespread belief that the recent crisis shows markets are not necessarily rational. Markets become like a powerful god who can only be appeased by the sacrifices prescribed by its priests.

This is how, in the case of the UK, George Osborne was able to redefine the goal of macroeconomic policy from the normal desire to see higher living standards into the need to reduce the deficit. His motives for doing so may have involved a desire to reduce the size of the state, what I call deficit deceit, but uppermost in his mind was that his strategy was popular. So popular, both among the electorate and the media, that the Labour opposition eventually gave up on arguing that there was an alternative.

A key corollary of all this is that the popular appeal of austerity has a sell by date. Once people have stopped paying off their own excess debt, market panic becomes a more distant memory, and the need to control the government’s deficit seems less compelling. The underlying factors that created deficit bias can resurface. Quite when that sell by date will be depends on particular national circumstances. In the UK the game was up when the country voted for Brexit, but I suspect even without that austerity would not have won the Conservatives two elections. So the popularity of austerity is short term.

As to the political economy question, I think that be a genuine puzzle if austerity was a long term phenomenon. But as it is not we need to bring in (hopefully) short term failures of knowledge and information. I have not noticed campaigns to ‘save our savers’ also arguing for less austerity, and I suspect the reason is because they just do not see the connection. Who makes that connection for them? Here is Chris Dillow complaining that the media just does not do this kind of thing. Central banks should, but for their own reasons rarely do. People may not act in their own self-interest if they do not know what is in their own interest, and in the short term at least this knowledge may not be made available to them.


[1] To preempt the usual MMT comments, this bias relates to economies where monetary policy takes care of output and inflation stabilisation.  

Monday, 26 September 2016

The total failure of the centre left

We have already begun to hear laments that Corbyn’s second victory means the end of Labour as a broad church. This is nonsense, unless that church is one where only people from the right and centre of the party are allowed to be its priests. Alison Charlton (@alicharlo) responded to my tweet to that effect by saying “It's the soft left, like me, who shouldn't be priests. We're rubbish at it.”

That I think captured my thoughts this last weekend. As Steve Richards writes “The so-called shadow cabinet rebels must be the most strategically inept political group in the history of British politics.” And although they were never the tightly knit group of coup plotters that some Corbyn supporters imagined, their collective thinking was completely flawed. It was self-indulgent folly by the minority group that I call the anti-Corbynistas to constantly spin against Corbyn from the start: as I predicted, it was totally counterproductive. But it was equally naive of centre-left MPs who nominated Owen Smith to believe that all they needed to do was adopt the leadership’s economics policies.

Forget all you read about Smith not being experienced enough, or about how he made gaffes (journalists just love gaffes), how he could have run a better campaign and so on. This is stuff and nonsense. Just as with Sanders in the US, Corbyn’s support is the result of a financial crisis the after effects of which we are still suffering from and where the perpetrators have got away largely unscathed. The crisis came as a complete surprise to the political centre, and only those on the left had warned about growing financialisation. Yet these warnings went unheeded by the Labour party, in part because the left had become marginalised. That is why politicians like Sanders and Corbyn can talk about the financial crisis with a conviction that others cannot match, and their supporters see that. The constant UK refrain about entryism is, frankly, pathetic.

In those circumstances Owen Smith had a mountain to climb. I wrote on 1st August a list of things he needed to do to win. Crucially he failed to back reducing the number of MPs required to nominate a candidate for leader, which in practice excluded any successor to Corbyn from the left being able to run. I wrote “If Smith wants Labour members to trust him, he has to show that he also trusts them in the future.” I also suggested he should now offer John McDonnell the job of shadow chancellor to show he meant to unify the party. How naive I was, some retorted: didn’t I know McDonnell was hated by much of the PLP. Of course I knew, which was partly why it was a good idea: at least I was trying to show some imagination that seemed absent from the PLP. Team Smith even seemed unable to acknowledge McDonnell’s positive achievements, like the Economic Advisory Council (EAC) and the fiscal credibility rule. No wonder he lost.

There is no getting away from the fact that the vote of no confidence is going to be fatal to Labour’s chances at the General Election. Of course Corbyn’s performance had been extremely poor, and he ran a deeply flawed Brexit campaign. But the no confidence vote was a do or die act, and the chances of it succeeding were always minimal. That is political ineptitude: sacrificing your party’s election chances for slender odds. All MPs can do now is help minimise the scale of that defeat, and if some feel that given all that they have said about the leadership that is best done from the backbenches Corbyn supporters should respect that. They should use the spare time to think about how to revitalise the centre left, but keep these and other thoughts out of the public eye. Talk of sacrificing being part of the single market so we can end freedom of movement is not a good start. As Chris Dillow argues, they are not even worthy of the label Blairite.

What Corbyn needs to do is clearly set out by Owen Jones here. To say he has a mountain to climb is an understatement. He carries the weight of the no confidence vote. Even if the PLP now unites behind him, much of the media will act as if it does not. He risks being outflanked in the traditional heartlands by UKIP: if voters think their problems really would be reduced with less immigration (and which politicians are telling them otherwise?), they will vote for the party that talks about little else. In the new heartlands of London and other cities, anti-Brexit feeling may well find LibDem clarity on the issue attractive. (Corbyn’s margin of victory in London was small.) Corbyn's ridiculing of warnings about the economic cost of Brexit (despite the advice of his EAC) does not set him up well to capitalise on any bad economic news.

In short, if he manages to defeat the Conservatives in 2020 it will be one of the most remarkable achievements in UK political history. Even to come close would be a great success. For what it is worth I hope he does, if only because it would force the centre-left to finally recognise their failure since the financial crisis.

Saturday, 24 September 2016

What is so bad about the RBC model?

This post has its genesis in a short twitter exchange storified by Brad DeLong

DSGE models, the models that mainstream macroeconomists use to model the business cycle, are built on the foundations of the Real Business Cycle (RBC) model. We (almost) all know that the RBC project failed. So how can anything built on these foundations be acceptable? As Donald Trump might say, what is going on here?

The basic RBC model contains a production function relating output to capital (owned by individuals) and labour plus a stochastic element representing technical progress, an identity relating investment and capital, a national income identity giving output as the sum of consumption and investment, marginal productivity conditions (from profit maximisation by perfectly competitive representative firms) giving the real wage and real interest rate, and the representative consumer’s optimisation problem for consumption, labour supply and capital. (See here, for example.)

What is the really big problem with this model? Not problems along the lines of ‘I would want to add this’, but more problems like I would not even start from here. Let’s ignore capital, because in the bare bones New Keynesian model capital does not appear. If you were to say giving primacy to shocks to technical progress I would agree that is a big problem: all the behavioural equations should contain stochastic elements which can also shock this economy, but New Keynesian models do this to varying degrees. If you were to say the assumption of labour market clearing I would also agree that is a big problem.

However none of the above is the biggest problem in my view. The biggest problem is the assumption of continuous goods market clearing aka fully flexible prices. That is the assumption that tells you monetary policy has no impact on real variables. Now an RBC modeller might say in response how do you know that? Surely it makes sense to see whether a model that does assume price flexibility could generate something like business cycles?

The answer to that question is no, it does not. It does not because we know it cannot for a simple reason: unemployment in recessions is involuntary, and this model cannot generate involuntary unemployment, but only voluntary variations in labour supply as a result of short term movements in the real wage. Once you accept that higher unemployment in recessions is involuntary (and the evidence for that is very strong), the RBC project was never going to work.

So how did RBC models ever get off the ground? Because the New Classical revolution said everything we knew before that revolution should be discounted because it did not use the right methodology. And also because the right methodology - the microfoundations methodology - allowed the researcher to select what evidence (micro or macro) was admissible. That, in turn, is why the microfoundations methodology has to be central to any critique of modern macro. Why RBC modellers chose to dismiss the evidence on involuntary unemployment I will leave as an exercise for the reader.

The New Keynesian (NK) model, although it may have just added one equation to the RBC model, did something which corrected its central failure: the failure to acknowledge the pre-revolution wisdom about what causes business cycles and what you had to do to combat them. In that sense its break from its RBC heritage was profound. Is New Keynesian analysis still hampered by its RBC parentage? The answer is complex (see here), but can be summarised as no and yes. But once again, I would argue that what holds back modern macro much more is its reliance on its particular methodology.

One final point. Many people outside mainstream macro feel happy to describe DSGE modelling as a degenerative research strategy. I think that is a very difficult claim to substantiate, and is hardly going to convince mainstream macroeconomists. The claim I want to make is much weaker, and that is that there is no good reason why microfoundations modelling should be the only research strategy employed by academic economists. I challenge anyone to argue against my claim.




Friday, 23 September 2016

Inequality under the Labour government

In the last few months I have sometimes been told that the last Labour government did nothing to reverse the rise of inequality seen under the previous Conservative administration. It is a serious charge, given the harm that inequality creates. But it is also incorrect, and here is a nice chart that shows why.


The Gini coefficient measures inequality. The black line looks at incomes, but the grey line looks at full time earnings. It shows that inequality in earnings was rising throughout the period, including when Labour was in power. Inequality of incomes was flatter while Labour was in power.

The chart is taken from a paper by Mike Brewer and Liam Wren-Lewis (short summary here). The authors use microdata to explain these divergent trends in the 1990s and 2000s. They find four factors at work.
“First, inequality between those with different employment statuses has fallen, primarily due to a fall in the number of unemployed. Second, employment taxes have played a larger role since 1991 in mitigating the increase in inequality of gross employment income than they did before 1991. Third, investment income has contributed less to total income inequality since 1991, largely due to the decline in its importance as an income source. Finally, a rise in the relative incomes of pensioners and households with children under five – both groups that benefited from reforms to welfare benefits and tax credits during the 1990s and (especially) 2000s – has pulled inequality down. Overall, since 1991 these four factors have almost entirely offset the impact on income inequality of the inequality-increasing changes in the distribution of earnings and self-employment income.”

Some of these factors may not have owed much to government policy, but others clearly did. The bottom line is that the last Labour government did quite a lot to reduce inequality. Only once you recognise that can you be realistic about what it would take to do more. Here are some ideas from Tony Atkinson, and I personally would be even more radical in one particular area. 

Thursday, 22 September 2016

Explaining macroeconomics to the Swabian housewife

Matthew Bishop has a nice simple post at SPERI suggesting how the ‘economy is like a household’ idea can be tackled. He is correct that this analogy has tremendous power, to the extent that I doubt we would have seen so much UK austerity without it. He uses an exchange between Yanis Varoufakis and a member of the Question Time audience to suggest that attempts to simply explain the economics are ineffective. He suggests that the “problem, as Jonathan Hopkin and Ben Rosamond have suggested (here and here), is that you cannot fight ‘political bullshit’ with facts”.

I want to make some observations, in ascending order of importance.
  1. I think he is right that economists can usefully point out that households do not always balance their budgets. But all the examples he gives help explain why it may make sense for the government to borrow to invest. Indeed he could have added comparisons between governments and firms in this respect. That is why it is easy for economists to now argue that governments should be borrowing more to invest. I’m sure most economists would use exactly these analogies: after all most do try to teach this stuff.

  2. However these analogies do little for the issue the audience member thought we were dealing with. He thought the analogy was exactly the case of spending too much on excessive drinking, and needing to sober up financially. While the examples Matthew quotes get you over the simplistic idea that governments should never borrow, they do not explain why (a) it is OK in principle to keep the ratio of government debt to GDP constant (governments live forever), and (b) why it makes sense for governments to borrow a lot more in a recession (the automatic stabilisers), or even (c) why the government should go out of its way to borrow even more in a recession when interest rates are at the Zero Lower Bound. We can try and get these ideas across as simply as we can, as I have tried many times (and suggestions on how to do it better are always welcome), but it is very difficult to do so in a minute or two on Question Time. It is sufficiently difficult that before the General Theory it was not understood by most economists.

  3. I think the suggestion that economists are too busy trying to be correct and therefore too scornful of simple analogies is a little unfair. Only a little: in a live public appearance there is always the concern about what your colleagues in the department will say afterwards. Economists are also aware, as Chris Dillow points out, that partial analogies used in one context can easily backfire in others. However I doubt very much that most economists do the equivalent of mocking “every grammatical error made by friends practising their holiday Spanish”.

  4. The big difference between economists and scientists at CERN is not that economists are less respectful of lay people’s mistakes. It is (a) they have politicians repeating false analogies about their subject as if they were facts, and (b) large sections of the print media doing the same, and (c) most of the rest of the media too clueless to challenge these falsehoods.

  5. This is why, for an evidence based discipline like economics, the response ‘economists know that the economy is not like a household in important respects and here is why’ is not at the end of the day arrogant or dismissive. If Brian Cox was asked on Question Time ‘what is all this about the Earth moving: it is obvious that everything moves around the Earth’ we would not blink an eyelid if he replied ‘No, scientists know that is not true and it only seems that way to you because..’.

  6. What austerity tells us, just as the climate change denial tells us, is that in today’s world respect for science is fragile. In the US public opinion about climate change is sharply divided along political lines, despite the near unanimity among scientists. It is this that should really worry us, and not how climate change scientists can better communicate with the public, desirable though that might be in itself. A world where the scientist has to compete on equal terms with the ignorant polemicist is not a healthy world.



Wednesday, 21 September 2016

The Treasury and Brexit

I pointed out two days ago that the real costs of Brexit are long term, which unfortunately means that those who argued for Brexit will never be held responsible in political terms for the damage it will do. As John Springford argues, that also strengthens the hand of those arguing for a hard Brexit (aka maximum damage). So who will speak for the 48%+ who want to limit the damage?

Potentially the majority of MPs do. We have united opposition from the SNP and LibDems. The great majority of Labour MPs also oppose Brexit. Polly Toynbee suggests this should become their unifying cause whatever the leadership does. And of course around half of Conservative MPs probably voted, in a personal capacity, to Remain. That has to be a worry for Theresa May, which is why she has made it clear that MPs will have no effective say in the Brexit negotiations.

So is this just going to amount to a lot of despairing and angry complaints as the Brexiters do their worst. Not quite. There is one source of opposition left standing (in the sense of having some power): Philip Hammond and H.M.Treasury. The Treasury has always been the job Hammond wanted, and not because he wanted to radically change that institution. It should also not be forgotten that it was Treasury economists who wrote the analysis suggesting the long run impact of Brexit on the UK economy could be very large, and the larger the further away from the single market we ended up being. Some will think this was a stitch-up job to please Osborne, but I think that is extremely unlikely. After all the Treasury analysis was pretty close to other estimates, and it was overseen by Charlie Bean who is excellent at judging what is academically kosher.

It is for this reason that we are already seeing headlines talking about Hammond blocking Brexit ‘progress’. How much power he has to do this will depend on the Prime Minister. If Theresa May sides with her Brexit ministers against Hammond, as it seems increasingly likely (see Martin Wolf here), this will mark the end of a long period where the Treasury has dominated economic policy in the UK.

That dominance started after a meeting in an Islington restaurant, where Gordon Brown extracted the maximum price for standing aside in favour of Tony Blair. The Treasury under Brown not only stopped Tony Blair from adopting the Euro, but also exerted a control over the economic aspects of other departments that had not been seen before. Under the Coalition government Osborne and Cameron worked very closely together, and the austerity strategy - supported by key Treasury civil servants - dominated the domestic agenda. If May sidelines Hammond over Brexit, the Treasury will have moved from dominance to playing second fiddle very quickly indeed.



Tuesday, 20 September 2016

Paul Romer on macroeconomics

It is a great irony that the microfoundations project, which was meant to make macro just another application of microeconomics, has left macroeconomics with very few friends among other economists. The latest broadside comes from Paul Romer. Yes it is unfair, and yes it is wide of the mark in places, but it will not be ignored by those outside mainstream macro. This is partly because he discusses issues on which modern macro is extremely vulnerable.

The first is its treatment of data. Paul’s discussion of identification illustrates how macroeconomics needs to use all the hard information it can get to parameterise its models. Yet microfounded models, the only models deemed acceptable in top journals for both theoretical and empirical analysis, are normally rather selective about the data they focus on. Both micro and macro evidence is either ignored because it is inconvenient, or put on a to do list for further research. This is an inevitable result of making internal consistency an admissibility criteria for publishable work.

The second vulnerability is a conservatism which also arises from this methodology. The microfoundations criteria taken in its strict form makes it intractable to model some processes: for example modelling sticky prices where actual menu costs are a deep parameter. Instead DSGE modelling uses tricks, like Calvo contracts. But who decides whether these tricks amount to acceptable microfoundations or are instead ad hoc or implausible? The answer depends a lot on conventions among macroeconomists, and like all conventions these move slowly. Again this is a problem generated by the microfoundations methodology.

Paul’s discussion of real effects from monetary policy, and the insistence on productivity shocks as business cycle drivers, is pretty dated. (And, as a result, it completely misleads Paul Mason here.) Yet it took a long time for RBC models to be replaced by New Keynesian models, and you will still see RBC models around. Elements of the New Classical counter revolution of the 1980s still persist in some places. It was only a few years ago that I listened to a seminar paper where the financial crisis was modelled as a large negative productivity shock.

Only in a discipline which has deemed microfoundations as the only acceptable way of modelling can practitioners still feel embarrassed about including sticky prices because their microfoundations (the tricks mentioned above) are problematic . Only in that discipline can respected macroeconomists argue that because of these problematic microfoundations it is best to ignore something like sticky prices when doing policy work: and argument that would be laughed out of court in any other science. In no other discipline could you have a debate about whether it was better to model what you can microfound rather than model what you can see. Other economists understand this, but many macroeconomists still think this is all quite normal.