Economic Competence Revisited

My last post was designed to show clearly that the UK has not been a strong economy since the Conservatives started running it. Now I would be the first to say that this proves nothing about how competent the Conservatives are. It may be just bad luck. My point was about the media debate. This should be about whether it is the government’s fault that we have a weak economy, or alternatively whether they have done the best they could in the circumstances. Instead of that discussion, we have mediamacro’s presumption that we have a strong economy when clearly we do not.

The political debate should really be about economic competence. Mediamacro assumes that the Conservatives are more competent at running the economy because that is what the polls say, and the polls say that in part because mediamacro assumes it. It is a self-reinforcing loop, where the last thing the media thinks of doing is asking academic economists. How would I, as an academic macroeconomist, assess competence when it comes to running the macroeconomy?

The obvious thing to do is to look at key macroeconomic decisions made by governments, and how they turned out. I would be particularly hard on governments when they chose to go against the prevailing academic consensus, and this choice did not turn out well. I have written about this before on a few occasions: see here and here for example. Let me summarise why I think, once again, it is the Conservatives rather than Labour who have a lot of explaining to do.

We can start with monetarism, which in its most basic form is setting policy according to movements in monetary aggregates (the ‘money supply’). It was a short lived failure. A particular failure was the 1981 budget, raising taxes in the middle of a recession, which was famously opposed by 364 economists. The economists were right: the recovery (properly defined) was delayed by 18 months. This is not the story told by mediamacro, but it is an account that fits the facts.

The next economic disaster was the Lawson boom of the late 1980s, which combined a monetary and fiscal stimulus that increased inflation. I was once told by someone close to decisions at the time that Lawson wanted to reduce the top tax rate to 40% in 1988, and it was thought to be politically expedient to combine this was a standard rate cut even though we were in the middle of a boom. Monetary policy involved shadowing the DM, so could not counteract the fiscal stimulus and other inflationary pressures.

By 1990, the Lawson boom was becoming a recession, and the Conservative government decided to formally fix the exchange rate. Their chosen rate was much too high, as the work I carried out with colleagues at NIESR clearly showed. Black Wednesday, when the UK was forced to abandon the fixed exchange rate regime, rightly lost the Conservatives their reputation for economic competence for some time to come.

Between 1992 and 1997 the management of the economy was better, but without any major decisions or events. Widening the definition of policy you can justifiably credit Thatcher with weakening trade union power, but her failure to emulate Norway and establish a sovereign wealth fund from North Sea Oil revenues was a clear mistake.

Under Labour there were three major macroeconomic decisions, and all three were successes. First most academics agree with central bank independence, and I think most would agree that the design of the Monetary Policy Committee in 1997 was particularly good. Second, the decision not to join the Euro in 2003 was clearly correct, which was taken after extensive economic analysis. Third, the decision to embark on fiscal stimulus after the Great Recession was correct, in much the same way as Obama’s slightly later stimulus was correct.

Should we count the financial crisis, and the failure to prevent it happening, as a clear negative against economic competence? I would argue not, as (a) the opposition argued for less financial regulation, and (b) the government did follow the consensus view at the time. If any institution is to blame, it is the Bank of England for ignoring the rise in bank leverage. As to a profligate fiscal policy, this is simply a myth.

The incoming coalition government set up the OBR, which deserves credit just as setting up the MPC under Labour does. However their decision to embark on austerity in 2010 was a huge mistake, which once again probably went against majority academic opinion, particularly as it involved cutting public investment sharply. And then we have Brexit. Although arguably mandated by a referendum, the decision to leave the Single Market and customs union are down to the Conservative government alone.

We will be able to compare the economic policies of the two parties this time when they publish their manifestos. This post is about track records. It shows clearly that Labour tend to get things right, while the Conservatives have created a number of major policy-induced disasters. As with the ‘strong economy’, mediamacro have got it completely wrong about macroeconomic competence. But I’m afraid, as was the case in 2015 and 2016, it will be mediamacro rather than reality that carries the day. That, alas, is how democracy currently works in the UK.  

Monetary Impotence in context

Mainly for macroeconomists

There are a significant group of people who think that monetary policy must be the right answer even in a liquidity trap because of the centrality of money in macroeconomics, and because of ‘basic’ ideas like money neutrality. Call them market monetarists if you like. They dislike fiscal stimulus because - in their view - it just has to be second best, or a fudge, compared to monetary policy. Their view is not ideological, but essentially based on macro theory. Now it may not be very relevant to the real world, but for many holding the theoretical high ground is important, because it colours their view of the real world.

That is the group that Paul Krugman has been arguing with recently, and why the point he made in his post yesterday is so critical. It is set in an idealised two period world where Ricardian Equivalence holds, but that is entirely appropriate for the task in hand. If people believe something because of (in their view) basic theory, and you think they are wrong in terms of basic theory, then that is the level on which to argue.

The argument is that in a liquidity trap, when prices are sticky, temporarily expanding the money supply - even if it involves helicopter money (i.e. money financed tax cuts) - will not do anything to get you out of the trap. Another, and more modern, way of saying the money supply increase is temporary is saying that the inflation target is unchanged, so the long run price level is unchanged. (Long run money neutrality does hold in this world.) I will not go through Paul’s argument in detail - I have gone through the same logic before. The basic point is that the temporary increase in money is saved, not spent, because agents know it is temporary. Short run money neutrality does not hold, and not because prices are sticky, but because of Ricardian Equivalence.

It is exactly the same reason why the Pigou effect is no longer discussed. Ricardian Equivalence killed the Pigou effect as a fundamental theoretical idea. If the inflation target is unchanged, when prices fall today the future price level must fall pari passu, reducing the future nominal stock of money. There is no wealth effect. As I noted here, even allowing money to be special in not being redeemable does not get the Pigou effect back, because with irredeemable money any wealth effect comes from the long run stock of money.

Money is not a hot potato in this world. The potato has gone cold because of the liquidity trap, and the money is happily saved to pay the future tax increases that will be required to keep the long run money stock (and price level) constant. 

While in this largely frictionless world money is impotent, additional government spending is a foolproof way of expanding demand. So is raising the long run price level, which means at some point raising the inflation target.

All I really wanted to do in this post was make an observation. The theoretical point that Paul makes depends crucially on thinking in an intertemporal manner, which gives you Ricardian Equivalence. Just as price rigidity kills short run monetary neutrality, so does Ricardian Equivalence in an inflation targeting liquidity trap world. So here is modern microfounded macroeconomic theory providing support to increasing government spending rather than monetary policy in a liquidity trap. Modern theory is not inherently anti-Keynesian. .  

Left, Right and Macroeconomic Competence

The title of one of my recent posts was a bit of a cheat. It was meant to surprise, because it contradicted the prevailing view, but the post didn’t actually try to answer the question the title posed. This post does try to assess whether a political party’s place on the left-right spectrum might influence its macroeconomic competence.

It should be obvious that, for any individual country, looking at some macro outcome (like growth) and drawing some conclusion can be meaningless. For example, growth under Republican presidents has been far worse than under Democratic presidents, but that could so easily be down to luck rather than judgement. To make headway we need to think of mechanisms and particular instances when they applied.

In the US, for example, there is a belief on the right that cutting taxes will increase tax revenue, a belief that is also clearly wrong. So you would expect Republican administrations that acted on that belief to run up bigger budget deficits than their Democratic counterparts, and that seems to be what they do. That may not be the whole story, but at least it is a mechanism that seems to fit. However it seems like a story that is rather specific to the US, at least for the moment.

Just now you could argue that parties of the right are more prone to austerity, because they want a smaller state than those of the left, and austerity can be used as a cover to undertake policies that reduce the size of the state. In a situation where interest rates are stuck at zero that has the damaging macroeconomic consequences that we are seeing today. However this is a story that is specific to liquidity traps.

An alternative source could be different views about the relative costs of inflation and unemployment. You might expect governments of the left to have higher inflation and those of the right to have higher unemployment. While that mechanism loses much of its force when you have independent central banks, it can resurface in a liquidity trap.

A final left/right difference that might impact on macroeconomic outcomes is different views on the need for state intervention. Those on the right might favour less intervention, leading them to favour simple rules, and to argue against the use of fiscal policy for macroeconomic stabilisation.

Is any of the above helpful in looking at UK policy since 1979? I use this place and period as a case study because I am most familiar with it. In the past I have talked about three major macroeconomic policy errors over this period, all of which occurred when the Conservatives were in power. However that alone proves nothing: Labour was in power for fewer years and might have been lucky. [1] 

The period starts with Margaret Thatcher and the brief experiment with monetarism. Here you could use the inflation/unemployment contrast - the policy succeeded in getting inflation down very rapidly, but at high costs in terms of unemployment, which persisted because of hysteresis effects. A secondary question is whether, given any particular preferences between inflation and unemployment, the policy was inefficient because it attempted to run monetary policy according to a simple rule which failed. Many at the time argued it was, because it put far too much of the burden of lost output on the traded sector, which in turn was because the policy generated Dornbusch type overshooting effects (i.e. a large appreciation in the exchange rate).

The 1990 recession can also be linked to left/right influences. The rise in inflation that preceded the recession (and to some extent made it necessary) was partly down to Nigel Lawson’s tax cuts. I have been told by one insider that the key wish at the time was to cut the top rate of tax, but it was felt that to do this alone would be politically damaging, so tax cuts were made across the board. That was not the only reason for the late 80s boom - there was also the decline in the aggregate savings ratio that in my view had a great deal to do with financial deregulation - but it was a factor.

The macroeconomic failure that everyone knows about from that period was the forced exit from the ERM in 1992, and that was costly because it made monetary policy too tight beforehand. Although you could say fixing the exchange rate is a simple rule that the right might prefer, that would be stretching things: ERM entry was favoured by Labour as well (although with the notable exception of Bryan Gould). According to my own and colleagues analysis at the National Institute the entry rate was too high, which might follow from a preference for low inflation, although it could just have been a choice based on poor macroeconomic analysis.

Inflation targeting followed the ERM debacle, and it was augmented by central bank independence at the start of the Labour government of 1997. One major decision that, if it had gone the other way, we might be scoring as a major error would have been if the UK had joined the Euro in 2003. I have argued that the decision not to was based on an intelligent and well researched application of current academic knowledge (subsequently vindicated by additional but related problems that academics did not anticipate), rather than any left/right policy preference.

Which brings us to George Osborne. I have just finished the first draft of a paper that appraises the coalition’s macroeconomic policy, and an interesting question that arises from that is why the coalition went for austerity despite the liquidity trap. While the 2010 Eurozone crisis might explain the change of mind of the minority partners in the coalition, it does not explain Conservative policy, which was against fiscal stimulus in 2009. If you look at some of Osborne’s speeches (and I’m not sure there is much else to go on), the rationale for austerity was a belief that monetary policy was sufficient to stabilise the economy, even in a liquidity trap (see the second part of this post). At the time that represented a minority view amongst macroeconomists. It could be explained in left/right terms in various ways: a dislike of additional state intervention, taking a risk that would lead to higher unemployment rather than higher inflation, or a devious way of reducing the size of the state.

So we have three major UK macroeconomic policy errors: the monetarist experiment of Thatcher, ERM entry and exit (and the boom that preceded it), and current austerity. In all three cases it is possible to link these to some extent to right wing political preferences. It may be equally possible to go back further and link the increased inflation of the 1970s to a left wing dislike of unemployment, but I cannot do that from memory alone so it would require some additional work going over the detailed history of that period.

However one additional point strikes me. Two of these three errors can be attributed to following a minority academic view. That monetarism was a minority academic view in the UK in the early 1980s became clear with the famous letter from 364 economists in 1981. In UK right wing mythology that episode represents the triumph of Thatcher over the academics. I have also noted that the Labour/Brown period perhaps represented a high point in the influence of academic economists within government, and the analysis behind the 2003 entry decision was an example of that. A belief that fiscal policy is not required in a liquidity trap is a minority academic view.

It may seem odd to some that those on the right might be more disposed to ignore mainstream academic opinion within economics, but of course academic economics can be described as the analysis of market failure. No one looking at debate in the US would dispute that minority academic views, or a more general anti-intellectualism, finds an easier home on the right than the left at the moment. Of course you can also find anti-intellectualism on the left - see here for a recent UK example - and my distant memories of the UK in the mid 1970s suggest that during this period they might have been at least as prevalent as those on the right. What may have happened over the last few decades is that what is currently called the left has become ideology light, and therefore more receptive to academic expertise and evidence based policy.

[1] If you want to call the gradual liberalisation of financial controls that facilitated the financial crisis a macroeconomic policy error that would make four, but I do not think anyone would seriously argue that this occurred under Labour because they were more predisposed to market liberalisation than the Conservatives.

Simplistic theories of inflation

After I wrote this I saw that Frances Coppola has a post that covers some of the same ground, but the point I want to make is different.

One of the things that made monetarism so popular until governments actually tried it was its simplicity. You can express this simplicity in many ways, but most involve the idea that there is a stable demand for the real value of money (M/p), so if you can control M you must control p. Never mind that the immediate influences on inflation were much more complicated: if you knew what M was, you would know what p would be. If you controlled M you would eventually control p.

There are lots of problems with this idea. I talked about the difficulty in explaining prices by just using money in this post. The difficulty of finding the ‘right’ definition of money is not a technical problem but a feature: because money can be saved as well as buy goods (the medium of exchange is also a store of value) focusing on its role in buying goods (‘hot potatoes’) is misleading. But even if there was a stable long run demand for money for some definition, the usefulness of this becomes questionable if we cannot say what the future quantity of money will be.

This becomes blindingly obvious if money is base money and we think about Quantitative Easing. Printing base money under quantitative easing does not imply hyperinflation because the expansion in the monetary base will be reversed once the recession is over. Knowing what base money is becomes useless as a tool for saying what future prices will be. (For those more technically minded who still think there is a Pigou effect, I discussed why the Pigou effect has disappeared from modern macro here. It is based on the same point.)

The Fiscal Theory of the Price Level is potentially another simplistic theory of inflation. This works from the identity that the real value of government debt must equal the discounted value of primary surpluses (taxes less government spending). It also can be used in a naive way: treat future primary surpluses as fixed, and any increase in nominal government debt must lead to higher prices. But, as Chris Sims explains in this nice exposition at Lindau, future primary surpluses are not fixed. If debt increases, future primary surpluses can increase to pay the interest on that additional debt, and more.

There may be some that say that we cannot trust politicians to do that. To which I say which planet have you been on for the last five years? As Brad DeLong reminds us for the US, this recession has been unusual in the zeal that governments have shown in rapidly reducing primary deficits, and of course in the Eurozone this zeal - embodied in the fiscal compact - has led to a second recession. Chris Sims raised the possibility that so great has this zeal been that even though nominal debt has risen, the price level might fall to make the identity hold.

One lesson I would draw from this is that the Fiscal Theory of the Price Level, like monetarism, is not a terribly helpful way of thinking about future inflation. The idea that we can take one variable, or one equation, and distil from that the future price level is a fantasy. What is surprising is that this fantasy has been, and still remains, so attractive for some economists.

Reduced form macro

Mark Thoma has a reflective post on the ability of evidence to move us forward in macro. Noah Smith also has interesting things to say. I just want to add the following thought.

If you think about some of the recent disputed empirical results (the 90% debt to GDP, expansionary austerity, cutting spending rather than taxes, multiplier sizes), they all involve relating policy variables directly to outcomes. And if we think about some of the reasons these apparent relationships turned out not to be empirically robust, it was because they failed to think about other things that might matter for outcomes.

Lets be specific. Fiscal multipliers are bound to depend on what monetary policy is doing. In principle monetary policy can offset the impact of fiscal changes on output, but if monetary policy is constrained in some way, it cannot. So any empirical study of the impact of fiscal policy must control for what is happening to monetary policy. I have often written about why high debt may be damaging to growth, but these effects work through raising real interest rates, or discouraging labour supply. It just seems foolish to apply them to a situation where real interest rates are unusually low, and output is hardly constrained by a shortage of labour.

These are simple, obvious points, but its amazing how often they are ignored. It is if some in the profession are desperate to find universal (and perhaps convenient) simple truths, in the face of the obvious fact that the macroeconomy is complex. This is not a new phenomenon. I’m afraid what follows is a personal anecdote, but it is topical.

Monetarism was the centrepiece of Mrs Thatcher’s first government. Following Friedman, policy was based around the idea that there was a predictable causal relationship from the money supply to prices. Lags might be long and variable, but an x% change in the money supply would within a year or two lead to an x% change in prices. Parliament asked the new government to come up with evidence for this assertion. They agreed to, but for some reason I cannot remember, they promised to produce a working paper by a named Treasury economist, rather than some anonymous Treasury document.

At the time I was working in the Treasury, and my job was to help forecast prices. So they chose me to produce this paper. I was to report each week to Terry Burns on progress. Terry Burns had been recently appointed as Chief Economic Advisor and he was one of the architects of the government’s new macroeconomic strategy. The first meeting went fine: I reported that if you regressed prices on the government’s chosen monetary aggregate, you got exactly the relationship they were looking for. However I had remembered some of the econometrics I had been taught. I was worried about omitted variables, and the fact that the two time series were dominated by one particular episode. [1] To cut a long story short, the relationship fell apart if you either took that episode out, or added other explanatory variables like oil prices. Despite Terry and my best efforts, we could not rescue the relationship once you went beyond that first simple regression. To be honest I was not that surprised or unhappy about this, but for the government it was rather embarrassing.

I learnt two things from that episode. The first was to be always extremely distrustful of simple correlations between policy instruments and outcomes. The second occurred after my paper was published. As I was the named author, I was free to write what I thought was an unbiased but purely factual account of my findings, with (to Terry Burns’ credit) no pressure to spin the results to suit the government. Yet despite it being obvious to any objective reader that the results gave no support to the government’s policy, at least one well known city economist cherry picked the results to suggest it did. [2]

Pretty much all the econometric work I did subsequently involved more structural relationships rather than these simple reduced forms. I think we have learnt a great deal from estimating equations that at least try and get close to underlying behavioural relationships, whether its using cross section, time series or panel regressions. A carefully structured VAR may also tell us something. Perhaps an exhaustive robustness analysis running countless single equation regressions can reveal insights - as for example in Xavier Sala-i-Martin's AER paper 'I just ran two million regressions' trying to explain economic growth. But if the empirical evidence involves little more than a regression of outcome x on instrument y, be very very aware.

[1] Just in case anyone is interested, the expansion in M3 caused by the Competition and Credit Control reforms in 1973, and the increase in inflation associated with higher oil prices in 1975.

[2] What happened at that point is a story that I will tell publicly one day. It is probably of no interest except to those who were involved in UK policy at that time, but it reminds me of one of the nicest and most interesting acquaintances I made during my time at the Treasury who is greatly missed.

On Major Macroeconomic Policy Mistakes

            I have spent the last week on a farm south of Matera in the Basilicata region of Italy. Wonderful scenery, sun, hospitality and food, but no internet access. Returned to find a very wet UK, and that the economy has officially entered a second recession.

When UK GDP fell in the last quarter of 2011, I wrote that the 2010 Budget should rank as one of the major UK macroeconomic policy errors since the war. A number of comments on that post and since have asked why I single out fiscal policy rather than monetary policy for such criticism? This is a good question, which has much more general applicability than to just the UK.

There are three charges that could be made against recent monetary policy.

1)                          That it could have done something to prevent the financial crisis itself, by raising interest rates by more in the middle of the last decade.

2)                          Following the crisis, central banks could have cut rates more quickly, or done more in terms of ‘unconventional’ monetary policy.

3)                          Policy should have moved to some form of price level or nominal GDP target. 

Let me take each in turn.

            Policy was clearly at fault in allowing the financial excesses that preceded the crisis. There is also a strong case that monetary policy should have reacted to excess leverage, as my recent post summarising Woodford’s new NBER paper suggests. There is plenty to debate about who should have seen the danger signals and ‘shouted from the rooftops’ about them. However I see the financial crisis as primarily a failure of financial regulation, and not conventional monetary policy. A laissez-faire attitude to the financial sector, rather than the setting of interest rates, was the major policy failure here.

            The second criticism is also probably valid. If the Bank of England had cut interest rates as rapidly as the US Fed, or if it had tried to orientate its Quantitative Easing policy to where the credit constraints were most acute, then this might have improved things somewhat. However I’m reluctant to label this a major policy error. Monetary policy, in contrast to fiscal policy, did move in the right direction. My view would be different if the UK had followed the ECB in raising interest rates in 2011, as they nearly did. 

The most serious charge against current monetary policy is that it is being too conservative in sticking to low inflation targets rather than moving to some form of price level targeting with, for a time, an implicitly higher inflation target. In 2009 or even 2010 such a change would have been seen as radical, but there now seems to be a growing weight of academic opinion (for example here) behind such a move. However, in the UK there is very little pressure to make any change. In part this is because – unlike the US - any move to price level or nominal GDP targeting would have to come from the government rather than the Bank of England. The government sets the Bank’s mandate, which has the 2% inflation target at its centre. Most academic expertise on UK monetary policy works through the Bank. One possibility would be to ask the Treasury Select Committee to take up this issue. If any UK academics reading this blog feel this would be a worthwhile thing to try and do, please contact me.

            So in retrospect the failure to move to some form of price level targeting may come to be seen as a major policy error. However, at least in the UK, in the absence of any great pressure from either academic economists or the opposition to make such a change, this error may reflect ignorance as much as anything. This was not the case with fiscal austerity in 2010.

            As I have noted before, the Conservative Party opposed the government’s countercyclical fiscal policy following the recession. They bought the idea of expansionary austerity, which many have pointed out contradicts basic macroeconomic theory in a liquidity trap. There can be no excuse that the right policy was new, untried and radical – the appropriate policy was simple and well understood. When a government chooses to ignore mainstream academic theory, and the economy suffers as a result, it has made a major error and it should be held to account for that.

            Does this make me a closet old fashioned Keynesian? Well for the record I think there have been only two errors of similar magnitude in the UK over the last 30 years, and both have involved monetary policy. The more recent was the decision in 1990 to enter to Exchange Rate Mechanism (ERM) at an overvalued exchange rate of 2.95 DM/£. Although an economic downturn in the early 1990s was probably inevitable given the overheating in the late 1980s, joining the ERM at an overvalued exchange rate made the recession unnecessarily sharp. On that particular occasion I really can say that ‘I told you so’. The other was the brief adoption of money targeting in the early 1980s. Once again, tightening of policy was required to reduce inflation, but the adoption of money targets led to deflation that was both too sharp and uncontrolled, and the hysteresis effects of the resulting large rise in unemployment blighted the rest of the decade. (The fiscal contraction in the 1981 budget that I have written about here was a mistake given the very tight monetary policy at the time, but a more optimal policy would probably have involved fiscal tightening and a looser monetary policy.)

            A common feature of all three episodes is that they caused increases in unemployment that were unnecessary, at a time when unemployment was already high. For reasons I have noted here, this implies a major decline in social welfare. Why have I not included any examples of errors that led to higher inflation? Well if I had gone back further then clearly the rise in inflation in the 1970s was a major policy error. The rise in UK inflation in the late 1980s was the result of policy errors, but I am being generous here because to some extent the consumer boom at the time was unexpected. (I discussed this briefly here.)

            Is it a coincidence that all three major errors were made by Conservative Chancellors? Perhaps. The catastrophic rise in inflation in the 1970s largely took place under Labour. The increase in government spending by Labour around 2005 was underfunded, but I would not call this a major policy error because I do not think it led to a large decline in social welfare.

            These three errors all had a uniquely national element. The US flirtation with money targets was briefer and much less damaging. Although German unification was the prime cause of the temporary collapse of the ERM, joining at an overvalued rate was the UK’s choice. Whereas many Eurozone countries have been forced into austerity by the markets and a lack of coordination by the ECB, the UK was never under similar pressure because it is not part of the Eurozone.    

            At least one characteristic connects all three episodes. They all get some of their appeal from simplistic macroeconomics. In 1980, it was the idea that there is a simple and reliable link between some measure of money and inflation. In 1990, it was that the medium term equilibrium real exchange rate is always equal to the PPP rate. And most recently, that private sector demand will automatically replace public sector demand (Says Law), or perhaps that monetary policy in the form of inflation targeting is always capable of stabilising demand. Most of the time I do not think sound macroeconomic policy is very complicated, but it is not that simple either.