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September 08, 2010

Why Bad Economics is Like Bad Art

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It's economics bashing time again.

The latest to have a go is Gideon Rachman in yesterday's Financial Times. "Sweep economists off their throne!" he demands. He compares economists unfavourably to historians, "archive grubbers" who at least have a sense of modesty about their claims to rigour. He goes on to complain about the "brash certainties, peddled by those pseudo-scientists, otherwise known as economists." 

As an economic historian -- and I do grub around in archives -- I suppose I have some sympathy for this view. Only a year ago I was writing about the advantages of history in helping us see what's coming round the next corner.

But as a trained economist I think it misses the point.

Good economics isn't brash and doesn't make unjustified claims of predictive power. Specifically, good economics is not the handmaiden of the journalists and politicians who most want economics to support their nostrums and interventions. My Hoover colleague Paul Gregory makes a powerful case that what our first year students have been learning is still pretty much on the button in today's world. It is, above all, an economics that promotes scepticism, critical thinking, and the avoidance of Type I errors.

My point is that there is not just "economics." There is good economics and bad economics. I don't care if it is radical, liberal, conservative, or what. It's interesting that good economics of every school or tradition has more in common with the good economics of other schools than it has with bad economics of any school.

The problem is that there is always a demand for bad economics and there is also a plentiful supply of it. Why? We won't discuss good and bad physics, because that annoys too many people. Instead, think about bad art. On the supply side, untalented artists exceed the number of talented ones by a large margin. So, bad art is abundant. The same is true of economists; there are many more people like me that are writing about economics, for example, than there are Keyneses, Hayeks, and Friedmans. (I hope there's an even larger number of economists that are worse than me, but that's not for me to say.)

On the demand side, many people (myself included) are not really sure of the difference between good and bad art. Also, there are many reasons why we positively desire bad art: because it is comfortable; because it fits with the decor of the room we live in; because it promotes our fantasies without transcending them; and, particularly, because some critic tells us it is good when it's not. I'm sure I personally subscribe to at least some bad art for each and all those reasons.

The demand for bad economics is similar. In fact, just as critics and reviewers mediate the demand for bad art to the public, bad economics has a bunch of people that do the same job of telling the public to buy it. Who are they? Well, many of them are politicians and, er, journalists.

Since this is about economics, we should also think about price. Good economics is relatively scarce, difficult, and uncomfortable; it's designed for truth, not reassurance. In short, the price is high. Bad economics is abundant, soft, and easily absorbed. For all these reasons, it's cheap.

In fact, I'm fairly sure some of the journalists that are now hopping mad at economists are mad just because they themselves previously invested too much of their beliefs in bad, cheap economics. I once had a rather ill-mannered go at Anatole Kaletsky of The Times on this score. Not all of them are to blame, though, and specifically not Gideon Rachman. (I checked out what Rachman was blogging about before the crisis broke in 2007. At least, he wasn't promoting buy-to-let.)

Anyway, let's get back to sweeping the bad economists off their throne. Get rid of them; then what? Who are we going to ask about the economy? Sociologists? Some guy in the pub? Use common sense?

The trouble is, this is a surefire way of replacing bad economics with ... more bad economics. It was Keynes, himself a great economist, who wrote:

Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

July 26, 2010

The Return of Animal Spirits?

A student asked me recently if the economists' consensus is that deficit reduction should be delayed until private demand has picked up -- which might not be any time soon. My first response was to point out that, while this might easily be the impression gained by reading the pages of The Guardian, a number of distinguished economists take the view that global demand would benefit from a more rapid fiscal adjustment. My Hoover colleague John Taylor has listed some of them here.

I also considered how to explain the wide range of disagreement to my student. Model uncertainty is part of the story, reflected in divergent views about the value of the government spending multiplier. According to President Obama's advisers, a government consumption stimulus of 1% of GDP will add 1.55% to U.S. GDP over 16 quarters, i.e. every $1 of federal spending should create another 55 cents of private consumption and investment. A recent IMF paper, in contrast, estimates that the effect goes nearly to zero over the same period, i.e. the same $1 of federal spending eventually reduces private consumption and investment by an equal amount.

Just as importantly, I wondered whether, in addition to differences between models, there is also inconsistency within models -- specifically, within the Keynesian model as some are applying it currently.

Think of Keynesian economics as incorporating two key insights. One is the problem of effective demand, and the spending multiplier that augments the effect of any income shock on aggregate demand. The other is the problem of unpriced uncertainty and the human reaction to this problem, which Keynes called "animal spirits." It seems to me that Keynesians are sometimes unjustifiably selective in applying these two insights.

To simplify, the Keynesian narrative of the crisis should have both main elements. On the way down they work like this. Borrowers and lenders failed to price the uncertainty in asset markets. Animal spirits soared, then collapsed as reality struck home. When animal spirits collapsed, they took down effective demand and there was a sharp multiplier contraction. It's a coherent and interesting diagnosis. Now we have the problem of getting back up. What should the Keynesian narrative of the recovery look like? Here the prescription of leading Keynesians (I'm thinking of Paul Krugman, Brad deLong, and my Warwick colleague Robert Skidelsky) becomes curiously one sided; there's the multiplier -- and just the multiplier. Animal spirits aren't in the picture, so private demand is destined to be flat. In this view, the only thing that can get us back up off the floor is discretionary government spending. That's why, they argue, deficit reduction right now is crazy.

On top of that are the politicians and the journalists. There is a lot of Keynesian-inspired "never again" publicism around at the present time. This might be stretching it a bit, but the spirit of it is pretty much: Animal spirits got us into this mess -- never again! Animal spirits are bad -- let's kill them off, once and for all! We need rules that will put a stop to irrational behaviour! Let's appoint sensible people to take charge and just not let that happen any more!

This is absolutely not the spirit of Keynes. Keynes did not say that animal spirits are a bad thing or that we should get rid of them. He said that animal spirits are a source of instability, and they are hard to manipulate; but they are also the driver of capitalist enteprise and we cannot get away from them or do without them. Here I'm going to quote a few sentences from Keynes's General Theory of 1935 (which is on line here). First, Keynes suggests that enterprise relies on animal spirits as much as business calculation:

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits — of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come.

When animal spirits falter, so does enterprise:

Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die; — though fears of loss may have a basis no more reasonable than hopes of profit had before.

Without animal spirits there is no progress:

It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death.

Policy makers must legitimately reckon with the effects of politics and policy on animal spirits:

This means, unfortunately, not only that slumps and depressions are exaggerated in degree, but that economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average business man. If the fear of a Labour Government or a New Deal depresses enterprise, this need not be the result either of a reasonable calculation or of a plot with political intent; — it is the mere consequence of upsetting the delicate balance of spontaneous optimism. In estimating the prospects of investment, we must have regard, therefore, to the nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity it largely depends.

It's Keynes's last point that so-called Keynesians should pay more attention to. Reckoning with animal spirits does not mean that we are now somehow ruled by "the markets," as Robert Skidelsky suggested recently. It does mean giving thought to how policy can encourage animal spirits to revive -- and how policy mistakes can do further damage.

At the core of today's policy dilemma is this question: How does the government's budgetary policy influence animal spirits? It's a difficult question because it cuts both ways. Deficit spending by the government is good for animal spirits, other things being equal, because it floods the economy with demand and floats us all upwards. But other things are not equal. The deficit adds to the debt. Public debt must be financed, and a growing debt implies a rising tax burden that, looking to the future, must depress animal spirits.

So, there are two effects: deficits are a positive, but debt is a negative, and you cannot have the deficit without adding to the debt. Of the two effects, which today is the greater? It's hard to be sure, because animal spirits are as incalculable as the uncertainty to which they respond. In fact, we don't really know. On top of that, when policy outcomes are uncertain, and we fail to make a clear choice, we have policy uncertainty. As Robert Higgs has shown looking at the Great Depression, policy uncertainty is more bad news for animal spirits.

In short, there exists a Keynesian argument for decisive fiscal retrenchment now -- and it is more coherent and truer to Keynes than the positions adopted by some latter-day Keynesians. Deficit reduction is likely to take away from demand now via the spending multiplier (which may however be small, or become small or even go to zero over a few years). At the same time deficit should add to demand to the extent that it slows the accumulation of debt and encourages business confidence in the future, and also because a clear choice in favour of enterprise also builds confidence.

Contemplating deficit reduction, can we be sure of the results? No. Past behaviour gives us only rough averages as a guide; for example, Reinhart and Rogoff suggest that the median long term growth penalty for pushing debt above 90% of GDP is 1% a year. There's a lot of variation around that figure, which reduces the predictability of the outcome. So, is there an element of gamble in debt reduction now? Absolutely. But is there a safe or low-risk alternative? No.

The jobs and welfare of hundreds of millions of people are at stake in the fiscal policy game being played out now in the capitals of the West. But it's not a game we can refuse to play.

May 17, 2010

Fear of Floating

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It was intriguing to read in the FT (May 11) about Eurozone resentment at Britain's lack of participation in the Greek bailout. In fact, it goes beyond that:

Charles Grant, director of the Centre for European Reform, said there was increasing anti-British feeling across the EU, fuelled by the belief that Britain had allowed its currency to depreciate to gain a competitive advantage.

I wondered what to think about this. It's true that sterling has depreciated quite substantially since the beginning of the crisis. Without that, the UK economy would be in much worse shape today, with still higher unemployment and a bigger budget deficit. So, it is true that the eurozone has been feeling some of our pain.

On the other hand, the reason Britain didn't join the euro in the first place, rightly or wrongly, was to retain the some insulating flexibility in the sterling-euro exchange rate if things went wrong. It wasn't compulsory for us to join the Euro, any more than Greece or Portugal were forced into it. They chose to and we didn't. Now this choice has proved correct, it's hard to understand why we shouldn't be permitted to benefit from it.

Some Europeans believe, apparently, that to benefit from a currency depreciation is morally wrong. In that case, what about the euro itself? The euro has a flexible exchange rate vis à vis the rest of the world. If the euro depreciates against the dollar or the yuan, then the entire eurozone will gain a competitive advantage over American and Chinese producers. In fact, in the last month the euro has depreciated by about 10 per cent against the dollar.

If it's right to avoid competitive depreciation, I expect to see the ECB intervening in the markets to sell euro denominated bonds and drive the value of the euro back up again. But actually ... Oh! I think they're doing the opposite-- on an unprecedented scale.

That's probably a good thing, at least in the short term, for Europe as a whole, even if it will do little for the long term solvency and prospects of the countries that are hurting most -- Greece, in particular.

As Barry Eichengreen and Doug Irwin have shown, in the Great Depression the countries that came off the Gold Standard earlier recovered quicker; those that prioritized exchange rate stability found little alternative to the policies of protectionism and regional autarky that eventually destroyed the global economy.

April 30, 2010

Poor Greece — Poor Us?

Greece at the mercy of "the markets." Hundreds of thousands faced with job cuts, lower salaries, and longer to work until retirement. It's hard not to feel sorry.

Equally, it's easy to understand the wrath of many Greeks: why should foreign bond holders have such power over the domestic policies of a sovereign state? Why should they accept the diktats of the IMF?

There is a simple answer. For many years, the Greek government spent far more than it raised in taxes. Why? It was the easiest way to buy votes. The problem was that the Greek government could not do it without the cooperation of others: those willing and able to lend it it.

Some of these were Greek financial institutions such as pension funds. But 80% of the Greek debt is held abroad, much of it with German and French banks. But these have walked away, taking the ball with them.

Now that the markets have called an end to the game, those who want to stand up for the entitlements of the Greek workers have to ask where the money will come from. Here are the options:

  • Continue to borrow on the market -- but who will lend? The Greek debt is already at or beyond the margin of sustainability (on which more below). It is not an attractive prospect.
  • If not borrow, then take. One option for the Greek government is to take from the lenders that previously enabled the years of pleasure and are now causing the pain. Taking without permision is normally called taxation. In this case it is called default. For Greece, default is all the easier because most of the lenders are abroad; they do not vote and are unlikely to throw rocks. Unilateral default has one problem: you can only do it once. After that, there is the same problem as before: if the voters want the Greek government to spend more than it raises in taxes, they must borrow. But who will lend?
  • If neither borrow nor default, then print money. For most sovereign states, printing money would fix several things at once. The new money would cover the budget deficit. Then there would be inflation, but inflation would erode the real value of the debt. After that there would be a disaster, but hey ... But Greece cannot go down this road, even if it wants to. When it joined the euro, Greece gave away the right to print its own money.
  • If neither borrow, nor default, nor print money, then ... raise taxes and cut spending, because there is nothing else that can be done.

These are Greece's options. In fact, the conditions that the EU and the IMF are "imposing" on Greece -- to raise taxes and cut spending -- are just what Greece must to do anyway, because there are no other choices that don't end in disaster.

Even that might not be enough. Government revenues are currently around one third Greece's GDP. If the debt heads for 140% of GDP and then stops, and must be refinanced at 10%, it follows that in future taxation must transfer 14% of GDP annually to bondholders in interest payments, and these alone will use up around 40% of Greece's limited tax capacity. Moreover, around 80% of Greek debt is held abroad, so those interest payments must shift more than a tenth of Greek GDP abroad each year -- just to cover the service on the debt, not to reduce it. The currrent EU-IMF bailout assumes that Greece's problem is liquidity. But what if it is solvency?

In that case, the future still holds the possibility of default. Given more time there will perhaps be an organized, agreed default. A rescheduling of repayments agreed with Greece's creditors will not kill Greece's credit ratings for ever, provided Greece adheres to the conditions imposed upon it.

One way of thinking about the Greek government yesterday, if not today, is that it stood at the centre of a web of obligations: legal obligations to bondholders, moral obligations to public sector employees and pensioners, and political obligations to voters. What the world has found, adding these up, is that they total far more than Greece's available resources. Something must give.

Greece holds one card, and it is an important one. If Greece goes down, so do its foreign bondholders. The German government has faced the choice between bailing out Greece and bailing out its own banks. It is interesting, and not inevitable, that the German administration has chosen in favour of Greece rather than to let Greece go and pick up its own pieces afterwards. This illustrates two things: the importance of politics, and the well known saying widely attributed to Keynes: "If I owe you a pound, I have a problem, but if I owe you a million, the problem is yours."

In all modesty, how far from Greece are we? Expectations of the British government, and what it can do for lenders, employees, the young, the old, the sick, and voters at large, have also become overstretched. Like Greece, the UK has a government that overspends, with a budget deficit of similar size relative to GDP. As in Greece, public spending is much more important to the UK economy than it should be. Even before the crisis, its importance was rising steadily; public spending accounted for nearly half of the entire increase in GDP over the period of the Blair-Brown government from 1997 to 2007. Since the start of the crisis, the growth of public spending has accelerated. Right now, public spending amounts to more than half of the UK's GDP.

In some other important ways, we are much better placed than Greece. Our aggregate debt is smaller relative to GDP, with less need for near-term refinancing. More significantly, the UK has a much greater fiscal capacity than Greece, with better coverage of tax raising institutions and less avoidance. We will be able to raise the taxes we need to finance the debt we have. And we will raise them, for another important reason: more of our debt is held at home, so lenders are also voters.

Finally, and crucially, we are not part of the eurozone. That matters, not because it will let us print money, but because it will let us recover from fiscal adjustment. The coming squeeze on spending and tax increases will put a cramp on jobs and demand from the public sector, but further depreciation against the euro and dollar will eventually rebalance the economy, allowing exports and private spending to take its place.

If there is a parallel with Greece it is not in the national picture but the regional one. For the UK as a whole, the ratio of government spending to GDP is currently a little over one half. For Ireland, Wales, and the Northeast it is between 60 and 70 percent. These regions are not only hugely dependent on public subsidies but they have no chance of renewed competitiveness through currency depreciation because, like Greece, they belong to a currency union -- in their case, the United Kingdom. What keeps them going is an unconditional year-on-year bailout from central government revenues.

My vote is not yet decided, but these are some of the reasons why I am taking seriously what the conservatives have to say about the economy today. Darling called the first phase of the crisis far more astutely than Osborne, and labour deserves credit for that. I am not convinced that more of the same will take us into a recovery.

April 16, 2010

Privatized Keynesianism: Rebirth After a Life That Never Was?

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"Privatised Keynesianism: An Unacknowledged Policy Regime," published in the British Journal of Politics & International Relations11:3 (2009), pp. 382-399  by my Warwick colleague Colin Crouch, has been deservedly recognized and cited by scholars and journalists. The paper starts from the idea that it is a problem to maintain stability and consumer confidence under capitalism. These were secured for thirty years after the war by Keynesian demand management. After that, Crouch writes:

In those countries where capitalism was moving into full partnership with electoral democracy, it was acquiring a new vulnerability. In a fully free market, wages and employment were likely to fluctuate; would workers, who were dependent on their incomes for their level of living and lacked the cushion of wealth of propertied classes, be confident enough to consume at levels adequate to enable capitalists themselves to sustain confidence to invest and maintain profit levels? Would the very characteristics of the market that constituted its strength—flexibility, especially of labour—undermine its own ability to thrive? It should be noted that we are not here talking of the market producing social problems of insecurity in workers’ lives—that might be dealt with by an adequate welfare state—but of its producing problems for itself through its own dependence on workers’ willingness to maintain and increase their consumption. It can be assumed that the level of living at which social policy will sustain purchasing power will be below that needed to sustain an expanding, consumption-driven economy.

And he continues:

In the 1940s it had seemed that only state action could solve this problem for the market. But now, absolutely in tune with neo-liberal ideology and expectations, there was a market solution. And, through the links of these new risk markets to ordinary consumers via extended mortgages and credit card debt, the dependence of the capitalist system on rising wages, a welfare state and government demand management that had seemed essential for mass consumer confidence, had been abolished. The bases of prosperity shifted from the social democratic formula of working classes supported by government intervention to the neo-liberal conservative one of banks, stock exchanges and financial markets.

I have thought about this a lot recently, partly because my students love it -- and reproduce it for me in their essays! I have to say I don't buy it -- at least not in this form. Why am I sceptical? Well, Crouch's argument seems to be that capitalism is vulnerable to underconsumption. From 1945 through the 1970s, the argument goes, the British government ensured demand was sufficient. After the 1970s, Crouch suggests, government retreated and banks stepped in. In his eyes, British capitalism survived on credit.

The big thing here that is clearly true is that as the public debt declined, household debt rose. My problem is with the counterfactual. Implicitly, without government spending in the first phase, and credit expansion in the second, there would have been a problem: not enough demand. In the first phase, that is for most of the period up to the 1970s, it's clear that British capitalism actually suffered from too much demand; that's why there was rising inflation. In the second phase, after the 1970s, the government didn't so much step out of the picture as try to limit demand more fiercely (and hamfistedly at first), eventually delegating the job to the Bank of England. In this phase I don't really see any evidence that British capitalism was going to fall into decline if we hadn't been able to lend lots of money to the workers that they couldn't afford to pay back.

With less household borrowing and less equity realization, what would have happened? Most likely, interest rates and the exchange rate would have been a little lower, and exports would have been a little higher. With more export competitiveness, our manufacturing sector would have declined a little more slowly (and our universities might have expanded a little more). That's about it. Oh, and I guess we would be in slightly better shape today.

Ironically it is only now, in the current recession, after a huge credit crunch and collapse of private demand, that privatized Keynesianism has truly come to life. Hence, in my view, its rebirth, after a life that never was. Here is some evidence, which you'll note is tri-partisan:

  • BBC, July 23, 2009: Chancellor Alistair Darling has urged banks to lend more to small firms, during a meeting with banking bosses ... Alistair Darling has said he is "extremely concerned" that banks may be charging firms too much for loans.
  • Reuters, October 26, 2009: British retail banks should stop paying big cash bonuses and use the money instead to support new lending and contribute to an economic recovery, opposition Conservatives’ finance spokesman George Osborne said on Monday.
  • The Guardian, February 23, 2010: A new government should tear up "ineffectual" lending agreements with Britain's taxpayer-owned banks and force them to lend billions of pounds more to small and medium sized businesses, Liberal Democrat Treasury spokesman Vince Cable said today.

Thanks to Colin Crouch, we know what to call it: Privatized Keynesianism. It is Keynesian because it uses debt finance to add to aggregate demand. It is privatized because the debt is private and stays off the government's books.

Now, the question is: Is privatized Keynesianism a good idea for today? Hmm. Why are we in the mess we are in? I think it might have been that we had too much private debt in the first place, so banks lent too much to firms and households that had no chance of repaying their debts unless house and stock markets floated ever upwards; and because banks did not keep enough in reserves. Where are we now? House and stock prices are still too high, and they are rising. And the solution these politicos favour is ... more private debt! The bankers are letting us down! They should be out there trying to persuade us to take out more loans! They should be keeping less in reserves! 

You couldn't make it up, could you?

At this point I am going to offer one of those dire aphorisms that runs: "The only thing worse than X is -X." I apologize in advance, but there is no alternative, so here it is:

  • The only thing worse than having bankers making lending decisions is to have politicians making lending decisions.

This does not mean I am complacent about the need for better financial regulation. Politicians have a role to play, and it is in setting prudential rules, limiting guarantees to retail depositors, and removing the incentives for banks to grow "too big to fail." That is a lot, but that is all. Politicians should not be making lending decisions! That is the bankers' job; let them do it.

April 01, 2010

On the Floor: What is Stopping Our Economy Falling into the Basement?

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A couple of months back, John Taylor made the point that the U.S. recovery is being led by the private sector. The vaunted $787 billion fiscal stimulus package passed by Congress has played no role. This is for a simple reason: it hasn't happened yet. This led Taylor, rightly, to wonder what will happen when it does come on stream, most likely in the middle of the recovery.

Now that the 2009 Q4 figures are available, it is interesting to ask the same question of the UK economy. Recovery has started, or at least the decline has stopped. Where is the improvement coming from? Is it coming from private demand or public spending? Is it coming from home or abroad?

The chart shows the changes in the main components of GDP, in real terms, since 2008 Q1:

Changes in main components of UK GDP since 2008 Q1

Source: ONS. G is general government consumption, NX is net exports, DInvent is the change in inventories, C is household consumption, and GFCF is gross fixed capital formation. Omitted are final consumption not by households, and net acquisitions of valuables.

The main picture is clear. Domestic private demand has collapsed. Until recently our economy was being held up partly by government consumption -- and even more so by foreign demand. (You might be surprised by that, given recent doom and gloom about the UK balance of trade. And there is a downside, which we'll come to.) The fact is that, from mid-2008 to mid-2009, the biggest support for the UK economy came from net exports.

Right now, however, government consumption is what is holding the economy up. I think the John Taylor question for the UK would be: Is the action on public spending currently any more than was already in the pipeline before the crunch? In other words, is active intervention or passive drift at work? This question is answered by the next chart, which strongly suggests active intervention:

Real government consumption over the current Parliament

Source: ONS. G is general government consumption. The trend is log-linear, calculated over 2005 Q1 (i.e. the last quarter of the previous Parliament) to 2007 Q4 (i.e. the last quarter before the GDP decline set in).

The chart shows clearly that, from the onset of the crisis, public spending began to move sharply upward from the trend established over the previous quarters going back to the last general election.

Another question is: How can we account for the net stimulus from trade, at a time when global demand was collapsing as fast as or faster than demand at home? There are two candidates: the foreign fiscal stimulus, and the domestic monetary stimulus. The deciding factor here is the real exchange rate. If global demand did the trick, boosted by the foreign fiscal stimulus that the G20 coordinated from the G20 last year, then the improved real trade balance should have been accompanied by an unchanged or rising real exchange rate. If it was quantitative easing pursued by the Bank of England, then we should see a declining real exchange rate. In the latter case, we saved ourselves by grabbing more than our share of global demand through competitive devaluation.

The next chart shows it was the Bank of England and competitive devaluation that did it. Sterling since 2008 Q4

Source: Bank of England. The series plots the broad sterling effective exchange rate monthly average.

The 30% decline in the real exchange rate through 2008 implies UK monetary policy was doing the larger share of the work. We grabbed a lifebelt, while others were beginning to drown -- Greece, lashed fast to the Euro, among them.

At the end of 2008, however, the depreciation of sterling came to an end. As a result, we are now even more dependent than we were a year ago on public consumption to hold up the economy. As the first chart shows, since the recovery began, the contribution of the trade balance has ceased to be positive. While household consumption and inventories are now showing small positive contributions, fixed investment is falling again. It's not a good picture.

What does this mean, given the public spending cuts now in prospect, whoever wins our coming elections? In principle, the real effect of public spending cuts on aggregate demand should not be entirely negative; lower government consumption should bring down interest rates and this should stimulate Britain's export sector through further currency depreciation. The trouble is that interest rates are already close to zero, and cannot fall further. Like the real economy itself, interest rates are on the floor but, unlike the real economy, cannot fall into the basement. For this reason it's hard to see how public spending cuts will translate quickly into improved prospects for recovery.

I understand that Britain has already too much public debt, of course, and will have to add to it in order to maintain public spending. We cannot do this without the cooperation of the lenders! This is why it is essential to plan for deficit reduction over the medium term.

At the same time, it is clear that the spending cuts in prospect are likely to cause double pain: not only a reduction in the level of public services, but also damage to the recovery of the real economy. Whatever government is in power, these are reasons to be very, very careful.

September 23, 2009

The Essence of Keynes and the Value of Macroeconomics

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Reviewing Keynes: The Return of the Master, by Robert Skidelsky (Allen Lane), in The Observer on August 30, 2009, Paul Krugman remarked that Keynes himself at one time considered the core of his theory to be the rejection of Say's Law (that income is always spent);

Say's Law [Krugman writes] isn't true, because in a monetary economy people can try to accumulate cash rather than real goods. And when everyone is trying to accumulate cash at the same time, which is what happened worldwide after the collapse of Lehman Brothers, the result is an end to demand, which produces a severe recession.

At another time, however, Keynes suggested that the core lay in

uncertainty that cannot be reduced to statistical probabilities, what the former US defence secretary Donald Rumsfeld called "unknown unknowns". This irreducible uncertainty [Keynes argued and Krugman writes] lies behind panics and bouts of exuberance and primarily accounts for the instability of market economies.

Krugman noted that Skidelsky himself has moved closer to the second view.

Observationally, these two views are excellent markers today for positive and negative judgements of the field of modern macroeconomics. Those that emphasize uncertainty as the fundamental problem are likely to excoriate professional economists for the false precision of their mathematical modelling, and their inability to foresee the crash of 2008.

In contrast, those that emphasize the broken relationship between supply and demand as the core insight of Keynes are likely to commend many of the same economists for their prompt reaction to the same financial crisis; they were as good as their word, speedily putting in place the massive fiscal and monetary interventions that have saved us from a repeat of the Great Depression.

In truth and logic, these insights complement each other. If Say's Law held, uncertainty would not matter. Depressions are possible because Say's Law does not hold, but it is unpredictable animal spirits that trigger them. Thus both insights are essential to Keynesian macroeconomics

That being the case, it appears that macroeconomic policy makers did not completely lose sight of what matters most. Macroeconomic theory -- well, that's another story.

July 27, 2009

Rationalising the Macroeconomy

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In The Financial Times on July 21, Paul de Grauwe published the best comment I have read so far about the crisis in macroeconomic policy. If your time is scarce, don't read on; click the link and read him.

De Grauwe makes a fundamental argument, which I will summarize in four steps.

  • Today, macroeconomists are distributed along a spectrum from "Keynesian" at one end and "Classical" at the other. They tend to clump at the extremes so there are many passionate Keynesians and passionate Classicals, as well as less passionate scholars in between.
  • The Classical macroeconomists expect the macroeconomy to bounce back quickly from a major disturbance (for example, a credit crunch) on its own accord; government intervention is more likely to hinder than help. The Keynesians believe the opposite.
  • For practical purposes, both schools model the behaviour of the people in the macroeconomy as follows: their behaviour is based on expectations of the future that are guided by the model, whether Keynesian or Classical. Classical macroeconomists assume that people's behaviour is based on the expectation that the outcome of the Classical model will be fulfilled, and Keynesian macroeconomists similarly.
  • In both models, these expectations are self-fulfilling.

De Grauwe's punch line:

So what? Does it matter that economists disagree so much? It does. Take the issue of government deficits. If you want to forecast the long-term interest rate, it matters a great deal which of the two camps you believe. If you believe the first [Classical] one, you will fear future inflation and you will sell long-term government bonds. As a result, bond prices will drop and rates will rise. You will have made a reality of the fears of the first camp. But if you believe the story told by the second [Keynesian] camp, you will happily buy long-term government bonds, allowing the government to spend without a surge in rates, thereby contributing to a recovery that the second camp predicts will follow from high budget deficits.

In short, in a Keynesian model, the agents are assumed to expect that a credit crunch will have lasting adverse consequences. As a result they will rein in consumption (because households expect lower incomes) and investent (because firms expect depressed markets). The economy will stay depressed until government action flips the economy back to normal. But in a Classical model, the agents are assumed to expect that a credit crunch will soon be overcome, provided markets are allowed to work normally. Do nothing, and any damage to confidence will soon be restored. Unnecessary government action, however, by enlarging public spending and debt, will depress long term expectations and so inhibit the restoration of confidence.

This point is not new. I'm not sure who made it originally. It has been around a long time. I checked my notes from 1998/99, the first year I lectured to first year undergraduates at Warwick on this particular topic. I found the following passage:

We’re trying to explain a state of the world in which at least some unemployment is involuntary, money isn’t instantly neutralised by price change, and business cycles last anywhere between 5 and 9 years. The fundamental problem of the RE [rational expectations] approach is that it proves this state of the world can’t exist. Underlying this are some basic conceptual faultlines.  Learning from experience may be more difficult than RE theory assumes. Large experiments are rarely if ever repeated under controlled conditions (e.g. joining, then leaving the ERM). Large shocks (e.g. oil shocks, monetary shocks) make it hard to discern the underlying things which remain the same.  What is the true model of the macroeconomy? RE theorists tend to assume that most people adhere to a Classical philosophy. But since economists have such difficulty decided how best to model the economy, it’s not clear why rational non-economists should be different. Policy demonstrably does affect the real economy, so why should rational people believe it won’t?  This is particularly important since the outcomes of actions based on RE tend to force the world to conform to the model, not the other way round. What is created here is a "guessing the winner" problem: what’s important in forming rational expectations is not "how does the economy work?"; nor even "how does the economy work in my opinion?"; but "how does the economy work in most people’s opinion", bearing in mind that in forming their opinions they are all asking themselves the same question.

I claim absolutely no credit for this; I was not saying anything original. I got the argument from somewhere or someone else. My point is that the basic paradox in rational expectations has been understood for a long time, but the horrendous policy implications are perhaps only now fully apparent.

How bad does that make economists? Ten years ago I told my students that the idea of rational expectations, although not wrong, contained a paradox. I had no idea how to resolve it, however. One route the profession has taken has been to consider that, just as economists learn, so do non-economists. As a result, macroeconomic models have been developed that incorporate heterogeneous expectations -- when different people in the macroeconomy start out with different models of how the economy works and so different forecasts of the future -- and model how they might then learn from experience. A recent review by George W. Evans and Seppo Honkapohja is here.

This takes me well outside my comfort zone. I thought about it, however, when a friend forwarded some lines from an internet discussion including the suggestion:

Until the "science" of economics detaches itself from econometrics and unilateral modelling and realises that humans are "rationalising beings", not "rational beings", then the predictions and opinions stemming from its adherents should be treated with caution.

In the context I took the gap between "rationality" and "rationality" to reflect some falling short of cognition or computation. It wasn't that I disagreed; the suggestion seemed almost trivially true (apart from the reference to econometrics, which seemed silly). What it made me think is this: If humans are "rationalising beings," then so too, being human, are economists. All economic models have cognitive and computational limits. They model reality; they don't and can't reproduce it. 

In the often misquoted words of George Box and Norman Draper (from Empirical Model-Building and Response Surfaces, New York: John Wiley 1987, p. 63):

All models are wrong; the question is how wrong do they have to be to not be useful.

April 14, 2009

The Other Enemy

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Looking back on the G20, there seems little to say that has not been said better by Willem Buiter in his recent blog. I'm going to address a related question: Are our leaders now doing too much, or too little?

Here are some people who think president Obama and prime minister Brown are doing too much: The British (Conservative) and United States (Republican) oppositions, and the governments of France, Germany, Ireland, and the Czech Republic. In varying terms, they fear the same enemy. Fiscal action to combat the Great Recession will cause very large increases in the public debt. In the medium term there will have to be a heavy settling of fiscal accounts. One risk is that governments that have started to enjoy their wider powers will try to pass the burden onto others through inflation or default. Even if they deny themselves this pleasure, they will have to enact tax increases that risk causing large market distortions. Persistent damage to market institutions could ensue, justifying further expansion of the role of government. This is what people mean when they refer to creeping collectivism or socialism.

As I have said before (but Buiter says it better), there is genuine reason here for concern. But those of our leaders that have lined up in the "too much" camp are facing the wrong way. In doing as much as Obama and Brown have been prepared to do, we risk creating one enemy. But the other enemy is the one we will cede power to by doing too little. And this enemy is the more dangerous of the two.

By doing too little, we will give up the political middle ground to populists and pressure groups of left, right, and middle England: protectionists, advocates of self-sufficiency and economic isolation, nationalists, xenophobes, and proponents of extra-parliamentary politics and direct action. I do not meant that such people are all the same; they are not. But whether they fight side by side or against each other, they are capable of destroying confidence in representative democracy. This would give away far more power to arbitrary government than a little gentle Keynesianism.

No one can be 100% sure, but I don't believe our leaders have done too much. They may have done too little. By doing too little, we risk a future governed by those that want to weaken the market economy permanently, or even destroy it, not fix it.

To try to do nothing in the face of the Great Recession is not even desirable. The unnecessary ruin of hundreds of thousands of businesses and households, and the consignment of a similar number of young people to unemployment, would be a great social crime. Bad as it will be to burden our children with a larger public debt in the future, it would be worse to burden them with a Great Depression in the present. The current wave of layoffs and bankruptcies is already under way, and nothing can now stop that, but we can and should do all we can to mitigate its extent and duration.

To try to do nothing will eventually fail, because our society will not tolerate complete inaction on the part of its leaders. Remedial intervention in the economy is inevitable. This means that, in the next few years, there will inevitably be more public spending, debt, and regulation. Just as most medications have harmful side effects, remedial intervention that is guided by the best intentions and the best judgements will have harmful spillovers and unintended consequences.

I would like to see remedial intervention carried out by politicians who do not relish it, but understand it as a necessary but temporary expedient, to be reversed in the medium term. I would apply this even to banking regulation: clearly, the regulatory framework must change, but it should not leave a permanently greater role for political action.

Maybe that's too much to ask. But it is what our future demands.

The alternative is to give up the keys of the city to the other enemy: to allow the remedial instruments to fall into the hands of state-building entrepreneurs who will use them enthusiastically to accumulate power, build persistent economic and political monopolies, and gradually acquire the means and motives to suppress criticism and opposition.

April 02, 2009

War and the Great Recession: Some Thoughts

A while back, an American journalist wrote to me:

We ... are trying to determine how big of a war we would need to have in order to drive the US out of this recession.  It is common belief that WWII was a major factor in invigorating US economy which had been decimated during the Great Depression.  I was wondering if it would be possible to make a projected estimate for our current situation using that era as a model. 

This question got me thinking and I put quite a lot of effort into some answers, which they did not use. So, I thought I would update them and share them here.

Basically, the question sees the problem back to front and upside down. The problem we should be thinking about today is not how to start a war that can help pull us out of recession. The real problem is that, if we don't pull ourselves and others out of recession fairly rapidly by peaceful means, we will face growing risks of war -- and that could end in a catastrophe for everyone.

So, it is a trick question. Sometimes, however, it is interesting to take trick questions at face value and work out what is wrong with them by seeing where they lead. This is what I did.

  • Is the situation of the U.S. economy today comparable with the Great Depression?

At the moment, the situation of the U.S. economy over the next year or two looks bad compared with the recent past, but it is still way better than it was in the 1930s. Economists often work in terms of what is called the "output gap," the proportion of potential output that is unrealized because there is not enough demand in the economy. The Congressional Budget Office currently expects the output gap over the next two years to average almost 7 percent.

There are various ways of calculating the output gap of the U.S. economy before World War II, and it varied a lot from year to year, but any reasonable estimate would be far above 7 percent. At the bottom of the depression, in 1932, the gap was probably around one third. At the end of the first recovery, in 1937, around one fifth of potential output was still not being realized, and in 1938 and 1939 the output gap widened again. It had got back to relatively normal levels by 1941.

So the good news is that, on present forecasts, the fiscal stimulus that is required to fix the U.S. economy is much less than was called for in the 1930s. What everyone should worry about, though, is that if things play out badly in the world as a whole there is plenty of scope for present forecasts to prove optimistic.

  • What size of war would be required to provide an equivalent fiscal stimulus?

U.S. GDP is currently around $15 trillion a year, and so an output gap of 7 percent means about $1 trillion a year of lost production. Since, in the U.S. economy, an extra dollar of public spending should give rise to about an extra $1.50 of total (public plus private) spending, a stimulus of around $700 billion a year would be needed to stimulate $1 trillion a year of extra output.

As far as I am aware from press reports and so on, the total U.S. budgetary appropriation for the global war on terror (Afghanistan, Iraq, and the protection of U.S. embassies abroad) has reached around $1 trillion in total, spread over the entire period from 9/11 to the present. I am not certain what the annual cost is currently, and I believe that not all of it is explicitly funded (i.e., the GWOT has been partly funded by the Defense Department taking resources from elsewhere.) For the sake of argument, suppose the net budgetary cost of the GWOT has recently been of the order of $200 to 250 billion a year. To provide a stimulus of $700 billion a year, therefore, the required war would have to be the equivalent of three additional global wars on terror, waged on the scale of the recent past.

How does that compare with the fiscal stimulus package that went through Congress recently? The package is $700 billion spread over two years, and much of it is tax cuts rather than public spending, which will have a lesser impact because tax cuts can be saved rather than spent privately. It is one half or one third of the stimulus that would halt the slide, so it runs the risk of being too little, too late.

One reason for the modest size of the package is that President Obama is restrained by conservative opponents of big government in Congress. I suppose someone could argue that a war might help to overcome such constraints. I think that would be a bad argument. It amounts to saying that we should whip up nationalism in order to stigmatize the people we disagree with as unpatriotic and crush them. That is not unheard of, but it does not appeal to me.

  • How good for the U.S. economy would it be to have another war?

History should make us very skeptical. Here are five reasons. First, it is true only in small part that World War II pulled the U.S. out of the depression. In fact, 1940 was the first year after 1919 when U.S. military spending rose above 2 percent of the national income. The fiscal stimulus from New Deal spending was also modest. The main driver of the U.S. recovery up to 1940 was private investment. If World War II had not broken out, this natural recovery process would have continued.

Second, it is true that the wartime period saw a huge further increase in the total output of the U.S. economy. In the three years from 1941 to 1944 the GDP rose by about two thirds. The main element in this was Federal outlays on national defense that brought about a vast increase in the mass production of standardized machinery and equipment for combat and transportation. Because of mobilization and wartime controls, patriotic national feeling, and mass production and the associated efficiency gains, the U.S. economy could temporarily produce far above peacetime norms -- effectively, there was a negative output gap. But the extra output did not make anyone better off; it was mainly in the form of ships, planes, and guns that achieved victory, not higher living standards.

After the war, most of the extra output disappeared and the economy fell back, not towards depression, just towards normal peacetime operation. So the wartime "production miracle" did not bring about lasting gains. The U.S. economy was much more prosperous after 1945 than before 1941, but this was not because of the war. It was because of the return to normal working combined with underlying productivity advances that had continued through the Great Depression, but were temporarily overwhelmed by the lack of demand.

Third, it is true that millions of U.S. citizens had a good war, economically speaking. Many people would previously have expected to live out their lives in poverty in the South and Mid-West. They moved to the industrialized, urbanized North and found new lives there. Many young men gained new skills and experiences by joining the military and fighting or supporting the war effort overseas. You might ask whether there were cheaper ways of achieving the same goals without having to fight a war. I don't mean that American involvement in that particular war was wrong; it was clearly in America's own national interest. But if you want to achieve a more mobile, equal society, and war is not forced upon you, there are cheaper ways.

Fourth, it needs to be said out loud that war is costly to society in terms of death and disability. I looked up what Michael Edelstein has to say in his chapter on “War and the American Economy in the Twentieth Century,” in The Cambridge Economic History of the United States, vol. 3 (published in 2000), on pages 342 and 349. He measures the budgetary cost of war as the cost of defense above normal peacetime operations, and the social cost is the capitalized value of lost earnings of the killed and injured. Everything is in constant 1982 prices. Edelstein’s estimates are: WW1, budgetary cost $378 billion and social cost $25 billion, WW2 $2,460 billion and $202 billion, Korea $206 billion and $27 billion, and Vietnam $313 billion and $46 billion.

You can see a couple of things. One is that, on this measure, the social costs were relatively small. Why? Mainly because the United States could fight all these wars at a distance against much less well equipped enemies. In World War II, U.S. battle deaths in Europe and the Pacific were around 350,000. In contrast, Red Army battle deaths on the Eastern Front were around 8.7 million.

Another thing is that, on the same figures, the ratio of social to budgetary costs rose continually from war to war. As a share of the combined total, the human costs were around 6% in WW1 rising to 12% for Vietnam. Why? I think, mainly because there was rising productivity, so human life got relatively more expensive. In their book on the costs of the Iraq and Afghanistan conflicts, Joseph E. Stiglitz and Linda J. Bilmes come up with various figures but their “realistic moderate” scenario (The Three Trillion Dollar War, published in 2007, page 112) suggests about 12% for social costs as a share of the total of budgetary plus social costs combined. (Stiglitz and Bilmes include items of veterans’ welfare costs that Edelstein I think does not, but these appear on both the budgetary and social sides of the balance.)

What does this mean? Well, if you want $700 billion a year of fiscal stimulus through going to war, you’d better factor in that, for every year at war, the U.S. economy will also lose a future income stream with a capitalized value of $100 billion, because of troops killed and injured. That does not seem like a good idea.

Fifth, a war today would bring huge costs in further disruption of the international economy. In 1941 international trade was a small fraction of its pre-1913 volume, so there was little to lose. The world today is much more interdependent than it was in the 1930s. Stiglitz has pointed up the billions of dollars lost to the U.S. economy because the war in Iraq triggered higher oil prices. You need to factor that in too.

Maybe I should finish this bit by quoting Edelstein again (on page 349):

It is absurd to think that the methods and perspectives of economic history come anywhere near to comprehending the meaning of human losses from war. We are far better served by the speeches and letters of Lincoln or the poetry of Sassoon, Brooke, Owen, Graves, and Seager.

OK, but where does this leave us?

I have two conclusions. One is that the only good reason to have a war would be to defeat an enemy. If our leaders want to make our economy work better in everyone's interests, and if they have legitimate instruments to achieve this, and if such improvements would also be an accidental by-product of a war, then that is not an argument for a war. It is an argument for adopting peaceful ways to achieve these things that carry democratic consent and do not also involve the irreversible losses and persistent collateral damage that a war would bring.

My other conclusion is that the original question ("how big of a war we would need to have in order to drive the US out of this recession?") confuses the problem for the solution. It's true that the Great Depression ended in the most terrible war the world has seen. But it did not end because of the war; the depression would have come to an end anyway. In fact, the war curtailed the natural recovery process.

But why did the war come about? World War II happened for a number of reasons, but one of them was the great powers' failure to avert the Great Depression in the first place, and rapidly to mitigate it once it came along. Many of the ingredients for violent conflict were there, but until the Great Depression they lacked a spark. Before 1929, was Germany evolving gradually towards a normal parliamentary democracy? Yes. Would Hitler have come to power without 30% unemployment in Germany in 1932? Probably not.

Eurasia today, from the Baltic to the China Sea, has many of the ingredients for violent nationalism. Scattered around that vast landmass, there is more than enough petrol and a good supply of oil-soaked rags. Meeting in London today, the G20 has the power to coordinate an effective international response to the global economic calamity that threatens us. If they fail, it is not just an economic calamity that we should fear; the world's leaders are playing with matches.

Mark Harrison writes about economics, public policy, and international affairs. He is a Professor of Economics at the University of Warwick. He is also a research fellow of Warwick’s Centre on Competitive Advantage in the Global Economy, the Centre for Russian and East European Studies at the University of Birmingham, and the Hoover Institution on War, Revolution, and Peace at Stanford University.

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