Why it’s your bloody GDP, not ours

Why does the recovery mediamacro constantly talk about seem not to apply to most people? Aditya Chakrabortty tells the story behind my title better than I did here, and picks up the important regional angle. But there is more to it than that.

First, there is the abuse of language I talked about here. I make a strong case that recovery should only be used when GDP is catching up with a past trend. Instead mediamacro use it for any non-negligible increase in GDP. They are egged on, of course, by the politicians who are partly responsible for our failure to actually recover from the Great Recession.

Second is an old favourite. Mediamacro constantly uses GDP rather than GDP per capita. This makes a big difference when an economy experiences a large increase in immigration. This chart from an article in the FT recently attracted attention, showing that the UK was the only major economy over the period 2007 to 2015 to combine growth in GDP with a fall in real wages. (I assume below the chart means growth between 2007 and 2015, rather than between 2006 and 2015.)

If we use the latest ONS data, UK GDP did indeed grow by 7% between those years (0.85% average annual growth), but GDP per head increased by only 0.8% (0.1% annual growth). It is one of the great ironies of this period, and a largely untold mediamacro secret (because mediamacro hardly ever connects dots), that the government has relied on claims about GDP growth that were in large part a consequence of the immigration which they were at the same time complaining about.

GDP per capita is of course the relevant comparison for real wages. But the claim in the FT article remains true: the UK does combine growth in GDP/capita (albeit small) with falls in real wages. The chart below uses ONS data on average earnings deflated by the consumer expenditure deflator. [1] That is the relevant deflator to use, if you want to look at the purchasing power of wages. However if instead you use as a deflator the price of GDP as a whole, the GDP deflator, then you get a very different story. As the chart below shows, that measure of real wages has increased by a similar amount to GDP per capita between 2007 and 2015.

So what has caused the price of consumer goods to increase more rapidly than the price of total output? There are a number of factors, but I emphasised two in a similar analysis I did two years ago: the depreciation in sterling in 2008, and the increase in VAT in 2011. The impact of the later is clearly evident in the chart, but so is the depreciation if you recall that there was a temporary cut in VAT in 2010, which led to a short term fall in consumer prices. The depreciation raises after a lag the price of imported goods and therefore consumer prices, relative to the price of domestic output. [2]

The disparity between GDP growth and real wages is therefore due to a combination of three factors: immigration, which boosted GDP, a rise in indirect taxes and a depreciation which both raised consumer prices. If we focus on GDP per head, as we should, then very weak GDP growth caused by the global financial crisis and austerity was translated into negative real wage growth, because of the global financial crisis (the depreciation) and austerity (the rise in indirect taxes). We are not seeing a shift from wages to profits. [3]

If there is one overall message here, it is that since the global financial crisis overall GDP growth in the UK has been terrible, and austerity plus an exchange rate depreciation has made it even worse for real earnings. That the media have not presented it that way is an important reason why it seems like your GDP, not ours. 

This disconnect in mediamacro between GDP and real wages has been very evident more recently as well. On the one hand Brexiteers have made great play about the fact that GDP in 2016 has been much stronger than some had expected. The media has also noted how inflation is increasing, and earnings growth is flat, implying a squeeze on real wages. Yet the two facts are hardly ever brought together. If they were, they might note that the 1.8% growth that the Brexiteers are so proud of in 2016 falls to 1.1% if you take out population growth (immigration). And they might also note that any growth in GDP in 2017 is likely to seem like ‘your bloody GDP’ if real earnings fall because of the Brexit depreciation. (No wonder they are in such a hurry to start negotiations.) Another message of this discussion is that the media could try a little harder to relate GDP growth to average earnings, rather than treat them as disconnected events just because the statistics are published on different dates.

[1] The fall in real wages shown in this chart is a lot less than in the FT chart, but without knowing their exact source it is difficult to know why.

[2] If you are wondering how real wages managed to ride out the recession, there are two main factors involved. The recession reduced the share of profits in national income (as recessions generally do), and in addition there was a large increase in unemployment.

[3] The labour share (of GDP at market prices) did fall by over 1% over this period, but the profit share also fell. The share that increased was taxes, reflecting the VAT increase already noted.  

Does democracy require implementing the referendum result?

We all know the EU referendum was not legally binding on parliament. That is not true of all UK referendums: the referendum on using AV did require parliament to enact whatever voters decided. Despite the lack of a legal requirement, there remains a powerful political argument that parliament was nevertheless duty bound to implement the referendum result. It is an argument that is often invoked by both government and opposition MPs. Now I have no doubt that in reality other motives are important, perhaps decisive, but because political arguments can be persuasive, it is important to debate this one.

The clearest argument along these lines comes from a post from Richard Ekins, who is a Professor of Law at Oxford University. He writes

“Parliament made clear that the decision about whether to leave the EU was to be settled by the referendum. There were good reasons, outlined above, why Parliament should not permit Brexit otherwise than by way of a referendum. Even if one denies all this, one should still accept that a referendum once held settles what should be done. For the decision to proceed thus is itself an important public decision that fairly governs how we jointly are to decide. That is, Parliament having decided to hold the referendum, and the public having participated fully in it, the result should be respected and not undone.

Political fairness and democratic principle require one to respect the outcome of the referendum even if one is persuaded that Brexit would be a very bad idea. One might think it wrong to hold the referendum, but it was held – and Parliament invited the people to decide this question. ... In short, the important constitutional question of whether Britain should remain in the EU was fairly settled by public vote.

The proposal to ignore or undo the vote is unjust. It bears noting that the relatively powerless in our polity – the poor – overwhelmingly supported exit. Ignoring the referendum would be particularly unfair to them.”

Note that this does not say that people like me should shut up about the harm that this action will cause. Instead it says that parliament, having invited people to decide, should respect that verdict. To do otherwise would be highly undemocratic, and would be particularly unjust to those who, for well known reasons, might justifiably claim that they are not well represented by the sovereignty of parliament. Arguing that the Leave campaign told lies, or that voters were deceived, does not seem to be a compelling argument against this, as exactly these charges can and are made after general elections

To help see why Ekins is wrong, it is useful to look at his discussion of the claim by Ken Rogoff that the “real lunacy of the United Kingdom’s vote to leave the European Union was not that British leaders dared to ask their populace to weigh the benefits of membership against the immigration pressures it presents. Rather, it was the absurdly low bar for exit, requiring only a simple majority.” But Ekins’ response strikes me as particularly weak. He essentially says parliament could do this because it has done it before. He goes on to say that there is “nothing at all perverse in Parliament choosing to make provision for a clear decision on point by way of a single referendum, inviting and encouraging public deliberation that culminates in a moment of clear and authoritative decision.”

This strikes me as completely ignoring Rogoff’s point. How can a 51.9% vote on one particular day represent a “clear and authoritative decision”. If a general election is close in terms of seats, that is reflected in the balance of parliament, and governments with small majorities and independently minded MPs face constraints on what they can do. What Rogoff is saying is that a referendum which only requires in theory a majority of only a single voter can never be clear and authoritative. Those who lost can justifiably claim that if the vote had been taken a day later or earlier the result could have been different, and we know they could be correct. The fact that UK governments have made this mistake in the past does not make it right. Remember we are talking about what is right politically, not what is right in law, so precedent is far less compelling.

Much the same point applies to the issue of a second referendum. He says: “Parliament having chosen already the decision-making procedure, it is not legitimate now to say that this should be set aside. The time for arguing for a two referenda requirement, or majority support in each part of the UK, was before this referendum was held.” He is certainly right that those who had won would think it is unfair to apparently change the rules of the game after the event, much as those who have lost think the whole process is deeply unfair and unjust. I also think that Ekins’ appeal to those who are otherwise unrepresented resonates with many Labour supporters, who feel that such a move would look just like the elite overriding the wishes of the people. (See Owen Jones, who questions Corbyn’s leadership but not his Brexit line.)

Except that is nonsense. If those who voted to Leave cannot get a simple majority in a second referendum when we have a lot more information about what leaving entails then that indicates something very wrong with the initial vote, and not some plot by the elite to cheat them. It is hardly undemocratic to hold a second referendum because the situation has become much clearer. As I have said before, when politicians argue that allowing a second vote is going against ‘the will of the people’ you know that you are in real trouble.

Is that unfair to one side? Of course not, because it is how politics works. Take the Scottish referendum, where Remain won by 55.4%. Just a few years later, and we could well see another referendum. To say that is different because something crucial has changed actually plays into the arguments for a second EU referendum. Unless voters perfectly anticipated the nature of the exit deal with the EU, that deal in itself is a huge and crucial change.

It seems to be neither politics nor fairness dictates that something poorly done in the past should dictate what politicians do in the future, when there is no legal constraint on them changing their minds. Holding further votes when the situation has changed cannot be undemocratic or unfair to anyone. [1]

I think all this is a useful perspective when we go back to the original question of whether parliament is obliged in some way to enact the result of the referendum we have had. Recall that Ekins says: “Parliament made clear that the decision about whether to leave the EU was to be settled by the referendum.” Now I have said in the past that I can understand why an individual MP, who has pledged to let the referendum decide their vote, should feel duty bound to keep their word. But I do question how exactly ‘parliament’ made such a pledge. An obvious way for a parliament to make such a pledge is to embed it into the terms of the referendum itself, as was done with the AV referendum. This was not done on this occasion.

It seems to me, therefore, well within the rights of any MP or Party to say that they do not regard a vote this close as binding on how they should vote. Indeed I would go further. Any MP or Party who thinks, based on the knowledge they have, that those voting Leave will over time regret their decision, has a duty to vote based on his or her judgement, rather than be tied by some vague notion around parliamentary commitment. 

But all this assumes that the Article 50 vote was just about implementing the referendum. It clearly was not just about that. Any sane discussion of the referendum has to recognise that voting Leave gave no guidance to politicians about how to leave. The referendum was not about the Single Market, the customs union etc. What the Prime Minister should have done was to allow parliament to debate the issue of how to leave, which is critical for the future of the UK. No doubt they would have given parliament a lead, but triggering Article 50 could have waited until that discussion had taken place. [2] Theresa May decided not to allow parliament that discussion.

As a result, the vote on Article 50 was not just about deciding to start the leaving process, but it also effectively became the last chance for MPs to express any view on how we should leave. That in effect made the vote a decision to leave the way May had decided, or might decide without recourse to parliament. The moment the Prime Minister did that, any obligation an MP might have felt regarding the referendum became null and void.

This is the crucial difference between 1975 and 2016, and another reason why arguments that appeal to precedent are wrong. In 1975, voters had a clear idea about what both In and Out involved. In 2016 what Leave meant was completely unclear, not least to those campaigning for it. That meant in practice that voters decided on the basis of the form of Leave they expected to happen, or perhaps were promised would happen, rather than the form of Leave the government would eventually choose.

It is for this reason that we appear to have a decidedly undemocratic result. If the referendum had set remaining against leaving for the type of hard Brexit that we are almost certain to have, it seems extremely unlikely that a majority would have voted for that. Yet those who argue that the referendum obliged MPs to vote for triggering Article 50 are in effect arguing for exactly that result. That is neither democratic, fair or indeed wise.

[1] I am sure many would argue that a referendum which came with the promise of a later referendum where you could change your mind would be too great an invitation to those who simply wanted to exercise a protest vote. I will leave that and similar arguments for others.

[2] The more people argue that such an arrangement would not have been practical, the more they illustrate how badly designed the original referendum was. Instead of debating and voting on a specific way of leaving (which could have been chosen jointly by those who wanted to leave) relative to remaining, we got a decision which was far too open ended. As a result, Leave campaigners said during the campaign that voting Leave did not imply leaving the Single Market. Once again, it seems odd to argue that parliament should not try and rectify past mistakes like this for the sake of some imagined commitment.   

A self-fulfilling expectations led recession?

The only two lectures on Oxford’s core undergraduate macro course that I still teach, and which I have just taught, are the last two on fiscal policy. I use the privilege of the last lecture to end on a reflective note. I acknowledge that macro rightly got a lot of stick by largely ignoring the role of finance, but I also point out that the poor recovery has involved a vindication of the core macro model: austerity is a bad idea at the ZLB, QE was not inflationary and interest rates on government debt did not rise but fell.

So far so familiar. But I end by showing them my this chart.

And I say that we really have no idea why there has been no recovery from the Great Recession, so there are plenty of mysteries left in macro. The puzzle is sharpest in the UK because the pre-crisis trend is so stable, but something similar has happened in most places. I think it is a suitable note of humility (and perhaps inspiration) on which to end the course. 

A mechanical way to explain what has happened is to bend the trend: to suggest that technical progress has been slowing down for some time. This inevitably means that the pre-crisis period is transformed into a boom. I have been highly skeptical about that story, but I have to admit part of my skepticism comes in part from traditional ideas about what inflation would do in a boom.

However another explanation that I have always wondered about and which others are beginning to explore is that perhaps we remain in an extended period of demand deficiency. Keynesian theory is very suggestive that such a possibility could occur. Suppose that firms and consumers came to believe that the output gap was currently zero when it is not, and that they erroneously believed that the recession caused a step change both in potential GDP but also possibly its growth rate. Suppose also that unemployed workers priced themselves into jobs by cutting their (real) wage or disappearing by no longer looking for work. The former could happen because firms could choose more labour intensive production techniques: scrapping the car wash machine for workers with hoses.

In that situation, how do we know that we are suffering from demand deficiency? The traditional answer in macroeconomics is nominal deflation: falling wages and prices. But because workers have already priced themselves into jobs, nothing more will come from the wages route. So why would firms cut prices?

If the pre-crisis trend still applies, it means that there are a large number of innovations waiting to be embodied in new investment. With this new more efficient capital in place, firms would either increase their profits on selling to their existing market or try to expand their market by undercutting competitors. We would get an investment led recovery, accompanied by rising productivity and perhaps falling prices.

But suppose the innovations are just not profitable enough to generate an increase in profits that would justify undertaking the investment, even though borrowing costs are low. Maybe a far more dependable motivator for embodied technical progress to take place is the need to satisfy an expanding market. The firm needs to install new capacity to satisfy growing demand for its product, and then it is obvious to investment in equipment that embodies new innovations. The accelerator remains a very successful empirical model of investment. (On both points, see this discussion by Caballero.) But if beliefs are such that the market is not going to expand that much, because firms believe the economy is ‘at trend’ and trend growth has now become pretty small, then the need to invest to meet an expanding market largely goes away.

This idea goes right back to Keynes and animal spirits of course. Others have more recently reformulated similar ideas, such as Roger Farmer. This is a little different from the idea of adding endogenous growth to a Keynesian model, as in this paper by Benigno and Fornaro for example. I’m assuming in this discussion that potential output has not been lost, because innovation has not slowed, but it is simply not being utilised.

It is this possibility which is the reason that I have always argued central banks and governments should have been much more ambitious about demand stimulation after the Great Recession. As I and others have pointed out, you do not have to attach a very high probability to the scenario that demand will create supply before it justifies a policy of ‘testing the water’ by letting the economy run hot. Every time I look at the data above, I ask whether we have brought this on ourselves by a combination of destructive austerity and timidity.