Wednesday, 31 August 2016

Fiscal rules should target the deficit, not spending

This jointly authored VoxEU piece on making the EU more resilient after Brexit that came out nearly two months ago has already had some unfavourable comment: Paul Krugman calls it timid, and Brad Delong does not like it much either. I want to pick out one particular idea, which I think is simply wrong and dangerous, and which I find it extraordinary that so many economists signed up to. Here is the relevant passage, in a section about the public finances.
“In most countries, the level of [government] expenditure – rather than the deficit – is the main problem. High expenditure makes it difficult to raise taxes and balance the budget, leading to dangerous debt dynamics. Thus, a focus on expenditure rules, linking expenditure reduction to debt levels, appears to be one of the most promising routes.”

Now this sounds to me like saying two things. The first is that the size of the state is too large in most countries. [1] The second is that we can use the need to bring government debt down as a way to correct that. It sounds to me exactly the policy that I accuse US and UK governments of following, although in their case the linkage is generally concealed. In this article it is suggested it should be explicit.

Whatever your views about the size of the state (including having no a priori view), it seems obvious that this is an intensely political issue. In contrast questions about the appropriate long run size of government debt are not so political, but more importantly they involve a completely different set of issues to those involved with the size of the state.

That is why policies or fiscal rules that aim to stabilise or bring down government debt focus on the budget deficit. It keeps the issue separate from the appropriate size of the state, and hopefully takes a good deal of the politics out of that issue. Linking the two issues makes it very easy to fall into what I call deficit deceit: saying we must cut government spending because government debt is too high, rather than because the state is too large. Even if that is avoided, associating the two sets back the cause of sensible debt management by needlessly politicising it.

That is why sensible fiscal rules target the deficit in some form, and allow how that deficit is achieved to be a political choice. I know this may seem obvious to me because I have written a lot about fiscal rules, but I would have thought the point might have also occurred to one of the economist authors of that article. When heterodox economists argue that the mainstream is hopelessly embroiled in the neoliberal project, they will be able to cite this article as evidence.


[1] You might say that, perhaps with certain European countries in mind, this is just a recognition that there is too much inefficiency and needless bureaucracy within government, rather than being a deeper statement of what governments should and should not do. If that is the case the authors should say so, but even then the coupling with debt control is problematic.

Tuesday, 30 August 2016

Project Fear = We have had it with experts

Normally reading the Financial Times you are safe from ‘I cannot believe he said that’ moments. But occasionally you come across something like this, in this case from the normally reliable Wolfgang Münchau:
“Those who campaigned for the UK to stay in the EU are shaping up to be two-time losers. They lost the referendum vote on June 23; now they are losing the battle to keep the UK inside the single market. Both defeats are based on repeated misjudgments.
Their original mistake was to exaggerate the economic effects of Brexit. The long-run consequences are hard to gauge. What we do know, so far, is that the result did not cause an immediate crisis — and this is what matters politically. This is why the consensus within the Conservative party has been shifting towards a harder version of Brexit.”

Forget all the conflicting and unreliable monthly data and surveys, and focus on the two clear impacts that the Brexit vote has already had. The first is a large depreciation in sterling, which makes almost everyone poorer. [1] The second is a cut in interest rates plus a reactivation of unconventional monetary expansion. To imply that these events strengthen the Leave case is just completely and utterly bizarre. It is just another version of the ‘they predicted Armageddon’ trick which I complained about here. Any objective referee would judge the score so far to be

Economists 2 Leavers 0

As for ‘the long-run consequences are hard to gauge’, this homily implies that making trade harder with our immediate neighbours might make us better or worse off. This is wrong. Common sense, along with all the economic models, suggest the uncertainty is all one-sided. Estimates are for a reduction in UK living standards of between 3% and 8%.

Michael Gove was widely derided for saying the UK has had enough of experts. But using the label ‘Project Fear’ is exactly the same. It has been used in the Scottish referendum and Brexit as a way of discounting expert advice. Yet in the political world calling warnings about the impact of either Scottish independence or Brexit ‘Project Fear’ is seen as a successful tactic. If you believe this report, it is why the Labour leadership chose not to endorse (and in fact rubbished) the government’s warnings about the economic dangers of Brexit (although as I note here the suggested involvement of the Economic Advisory Council in that is incorrect). It is true that Project Fear is applied to government warnings about the economic impact of independence/Brexit, but when those warnings are backed by nearly all experts it amounts to an attack on expert advice.

So in the Orwellian world that we are now living in, the tactic of calling something Project Fear is newspeak for saying we have had enough of experts.

[1] If you own a large amount of assets denominated in overseas currency then you could be better off, at least for a time. However even here a permanent terms of trade loss will eat away at any wealth gain when real interest rates are negative. On average the UK is a net debtor, not a net creditor.  

Monday, 29 August 2016

Heterodox economics, mainstream macro and the financial crisis

When heterodox economists want to argue against the mainstream, they typically start by talking about the failure to predict the financial crisis. This can be done in two different ways. One is to invoke Minsky, and talk about risk perception, leverage and the failure of the banking sector. I think this argument is accepted by mainstream macroeconomists, which is why there has been an explosion of DSGE and other microfounded analysis putting a financial sector into macromodels.

I just want to make two points on this. First, it is a sin of omission rather than signifying some fundamental flaw in existing macroeconomic theory. That is why financial sectors can be added to existing DSGE models: nothing has to be torn up and thrown away. Second, the fact that leverage was allowed to increase substantially before the crisis was not something that most macroeconomists were even aware of let alone approved of. As I have said before, if I had seen a chart showing bank leverage (like the one shown here) before the crisis I would have been extremely worried. It is true that Rajan’s warning in 2005 was famously knocked down by Summers, but it is a mistake to assume that most academic macroeconomists either agreed or disagreed with Summers: it just wasn’t their field. As Andy Haldane says, before the crisis
“prudential regulation was a niche academic issue. In my view, this absence of academic debate and challenge contributed, in no small measure, to international prudential standards being set at levels which were, with the benefit of 20/20 hindsight, not just too low but ridiculously too low.” (my italics)

There is a second strand to the heterodox attack on mainstream economists concerning the financial crisis, and that invokes not Minsky but Wynne Godley. Here I think heterodox economists also have a point, but they tend not to put it very well and, perhaps as a result, it has not yet impacted on the mainstream. Godley had, since the start of the millennium, raised alarm bells about rising US debt. The US savings ratio had been falling since the 1980s, but the personal sector had only gone into deficit at the end of the 1990s. (Michalis Nikiforos has a discussion.) Godley said this was not sustainable, and eventually he was proved right.

It is at this point that most heterodox accounts go wrong. They focus on the model he used to do his analysis, a model that tracks sector balances and their implications for sector wealth, but which otherwise has minimal behavioural content. This has become the “Stock-Flow Consistent methodology”, and it is inferred that mainstream models fail to impose stock flow consistency. But this is accounting, not economics, and was not unique to Godley. When I was a young economist at the Treasury in the 1970s, their UK model was ‘stock-flow consistent’, and forecasts routinely looked at sector balances. The model I built in the 1990s, which unlike the Treasury’s model included many of the theoretical features we now associate with New Keynesian models, also tracked sector balances. In terms of theory these were mainstream macromodels, but not microfounded macromodels.

It is trivial to add this accounting to any macromodel. The reason why it is typically ignored when it comes to the personal sector is because in most mainstream models these balances are of no consequence. Steve Keen points this out, but does not take the next step of asking why this is. The answer is because of the simplicity of the dominant mainstream model of intertemporal consumption, where there is no desired level of wealth or debt which consumers try to attain.

To understand the behaviour of both consumption and financial balances over the last few decades you need to understand the changing nature of credit availability from the financial sector. The best analysis I have seen of that comes from mainstream macroeconomists, and in particular Chris Carroll and John Muellbauer. (I first wrote about this here, but subsequently here.) Simply having a fixed proportion of credit constrained consumers does not get you there, because it cannot model what happens when credit constraints change.

Why did most mainstream macro ignore this work, and as far as I can see continues to ignore this work? It is not because their analysis sweeps aside the basic intertemporal consumption analysis of mainstream theory. Carroll’s analysis builds on that model and adds some basic real world elements like finite lives and income uncertainty. I think this work was/is ignored because incorporating this analysis into microfounded models raises serious problems associated with heterogeneity across age and income. As Carroll shows it is possible to do, but not easy to do. Playing around with habits or some ‘rule of thumb consumers’ is much easier. Blanchard has recently made a similar point in his critique of DSGE models.

In fact I would go further than this. I argue here that it was this microfoundations methodology that allowed mainstream macro to ignore the fall in personal savings in the US that preceded the crisis, because it is a methodology that allows you to be very selective about what empirical features you do or do not explain. As the best explanation for this decline in the savings ratio is easier credit, then any general equilibrium analysis would require modelling the financial sector. For this reason I speculate that had the microfoundations revolution been more tolerant of other methodologies (as it was in the UK until the end of the 1990s), macroeconomics may well have done more to integrate the financial sector into their models before the crisis. That is a rather different critique than the one typically offered by heterodox economists, but it is no less fundamental.

Mainstream macroeconomics addiction to microfoundations methodology has given heterodox economists an opportunity. If mainstream macro continues to shun what it calls policy models (models that use aggregate relationships justified by an eclectic mix of theory and data), then this space can be occupied by others. But to do that heterodox economists have to stop being heterodox, by which I mean defining themselves by being against almost all mainstream theory. As Jo Michell writes “The problem with heterdox economics is that it is self-definition in terms of the other”. As the scope and diversity of mainstream theory gets larger and wider, the space that can be occupied by those who reject the mainstream shrinks.


Friday, 26 August 2016

Why we must have a second referendum

I think many people who argue against a second referendum have not taken on board the scale of the difference between the various Brexit options. We could retain access to the single market and free movement of labour (the Norway option). Or we could just cut a trade deal with the EU, do nothing on services, and end free movement (the Canada option). Or other things in between. In economic terms the Norway option is much closer to EU membership than it is to some of the alternative forms of Brexit.

Perhaps an analogy is that you decide one day that it is time to move house, as you are really bored with your current property and aggravated by its various imperfections [1]. That decision is akin to the Brexit vote. But you have no idea where you are going to move to. It could just be a local move to a similar style property, or it could be to somewhere in another part of the country where property is cheaper but where you would have to find new friends and a new job.

The Brexit vote in practice is the green light to explore what possible alternatives are available. Having looked at the various alternatives, you may decide that you do indeed want to move. Or alternatively you may realise that your current house is not so bad after all, and is superior in many ways to the best available alternative, and so you decide to stay. To deny a second referendum is a bit like saying that once you have decided to move you cannot go back on that decision, no matter what the alternatives turn out to be. A slightly closer analogy is that you decide to move house, but then you get someone else to choose the best new house for you, and you have to accept the choice they come up with even if you think it is inferior to your current house..

So the key arguments for a second referendum are that the alternative to EU membership was not specified in the first referendum (they were also unknown at the time, and depend on what can be negotiated from the EU), and that these alternatives are very different from each other. I cannot see the logic in saying people should have a direct say on whether to leave the EU, but no direct say on what to leave it for. [2]


[1] I choose an analogy involving an individual rather than a group or society as a whole to avoid the (well known to economists) problems associated with non-transitive preferences for groups of individuals: see Jonathan Portes here.

[2] Note that I make no reference to voters being lied to in the first referendum. My argument still holds even if Leave had been completely honest.  

Wednesday, 24 August 2016

Why Corbyn’s Brexit campaign matters

I sometimes think discussions with Corbyn supporters is a bit like talking to one half of a couple going through a bad patch in their relationship. Let’s call them PLP and LPM. There is no doubt that for many years PLP had taken LPM for granted. And as a friend to both you can wholeheartedly agree that PLP’s flirtation with austerity in recent years was a serious breach of trust, and more generally a very foolish thing to do. You agree that in those circumstances LPM getting into bed with Corbyn was quite understandable.

But you can see that Corbyn is no good for LPM. Their relationship is going nowhere. What is more PLP is, perhaps as a result, full of remorse. Austerity has long gone, and PLP is promising almost everything LPM wants. You know that when LPM and PLP work together they are a great couple, perhaps even a winning couple. Yet when you try to say this to LPM you either get the hurt of an aggrieved party (how can I ever trust them again), or worse still the poisoned words of despair (that even at their best as a couple they were no better than anyone else).

So when I ask how can you expect Corbyn with only the confidence of 20% of his MPs to get many votes, I’m told that the PLP should not be able to dictate who the leader is, as if that somehow negates my point. [1] Life with Corbyn may be going nowhere, but it is all PLP’s fault. When I point out Corbyn’s major mistake during the Brexit campaign, I’m told it probably had no effect so why should it matter.

But it does matter. What Corbyn and his team decided to do as part of their Brexit campaign was to rubbish Osborne’s claims about the economic harm Brexit could do. They were rubbishing the key part of the Remain campaign. That decision was certainly an embarrassment for that campaign, and for his own PLP colleagues. It was a slap in the face for academic economists, 90% of whom did think that Brexit would be harmful.

Not only was it the wrong thing to do for those reasons, but it also puts Corbyn in a far weaker position after the Brexit vote. Let me quote a comment from that earlier post from Mike Berry, who knows a thing or two about the media. He says it was
“a gargantuan, colossal and highly stupid strategic error. If Corbyn, McDonnell and the rest of the shadow cabinet had repeated endlessly the warnings of economists about what would happen and continued this after the results, day after day after day on all the main media outlets they would now be in a very strong position because they would be able to conclusively pin the responsibility for the negative economic consequences of Brexit on the Tories. They could have forced the Tories to own the slump and shredded their deserved reputation for economic competence for a generation. Deeply disappointing.”

So why did they make such a big error? According to this report, “the Shadow Treasury team vetoed a story developed by Labour’s policy team for Shadow Chief Secretary Seema Malhotra, which warned of the effect of Brexit on the value of sterling.” It goes on: “Those close to the Shadow Chancellor felt that the independence referendum in Scotland had shown how Project Fear went down badly with Labour voters. McDonnell’s Economic Advisory Council (EAC) would have felt the sterling crisis idea was counter-productive too, one source said.”

It was blindingly obvious, from either macro theory or from market reaction to polls, that sterling would depreciate sharply if the UK voted Brexit. Mike Berry’s point continues to apply. But the reason given for not going with this is bizarre. Leaving the EU, as with Scottish independence, will have serious economic consequences for the UK and Scotland respectively. To not mention this, or worse still trash others that do, because it might not be believed is extraordinary logic. (It is like saying a lot of people do not believe in man made climate change, so let’s start supporting climate change denial.)

It is fine to talk about some of the issues the Remain campaign was ignoring, like workers rights, but you can do that without rubbishing what other people on the same side are saying.

What added insult to injury when I read this account was the reference to the EAC. The EAC certainly did not say that Corbyn should discount economists claims about economic costs, or that the likely exchange rate depreciation should not be mentioned. Some of us may have said that talk of some kind of financial crisis similar to 2008 was going over the top, but that is completely different. (A substantial depreciation is not a financial crisis.) It’s not good to misrepresent the EAC as a cover for bad decisions. You do not need to take my word for this. To quote from the statement five of us made after Brexit and Danny Blanchflower’s resignation: “we have felt unhappy that the Labour leadership has not campaigned more strongly to avoid this outcome”.

The reaction of Corbyn’s supporters to all this is to respond to a very different accusation, which is that Corbyn helped lose the Brexit vote. But that is something that is virtually impossible to decide. The issue for me is not whether Corbyn in undermining the Remain campaign influenced the final vote, but that he did it in the first place.

One possibility of course was that he was quite happy to undermine that campaign because of his own ambivalence towards the EU. After all, he did take a holiday during the campaign (imagine if Cameron had done that), and he didn’t actually campaign that hard. But let us instead take him at his word. What we have then is a major strategic failure by him and his team, a failure that will have consequences for the future.

A large part of politics over the next few years will be about Brexit. The Prime Minister is extremely vulnerable on this issue given the splits in her party. There is a huge difference between the various forms of Brexit, and a united Labour party with a passionate advocate of European engagement leading it could help influence events. If there is an economic downturn as a result of the uncertainty over Brexit the government must be made to own that downturn in voters eyes. You cannot do that if the leader of the opposition said the downturn wouldn’t happen.

Let me end with a quote from a recent article by Martin Jacques. While I disagreed with his unqualified description of New Labour as neoliberal, I think he gets Corbyn exactly right in this quote.
“He is uncontaminated by the New Labour legacy because he has never accepted it. But nor, it would seem, does he understand the nature of the new era. The danger is that he is possessed of feet of clay in what is a highly fluid and unpredictable political environment”

I know it has only been a year. I know recent betrayals still hurt. But the road Labour is currently on leads nowhere, and the longer it takes for the membership to realise that the more damage is done. Once you stop seeing the alternative through jaundiced eyes it is so much better.

[1] Logical consistency often goes out of the window in such discussions. I’m asked how can I know that this no confidence vote will damage Labour in a General Election by the same people who tell me Corbyn’s current unpopularity in the polls is because Labour is split.

Tuesday, 23 August 2016

Minority rule: Migration, Brexit and Mandates

It is generally (not universally) agreed that the issue of migration played a large role in leading 52% of UK voters to want to leave the EU. However that does not mean there is a mandate to end Freedom of Movement (FoM) at the cost of losing access to the single market. I’m rather surprised by the number of people who think it does. There are lots of reasons why it does not, like voters being told they could end FoM and still stay in the single market, like that many people voted to end FoM because they wanted a better NHS, whereas the opposite will be true in practice. (Tony Yates discusses this general point here).

However the clearest reason why Brexit does not mean there is a mandate for ending FoM was made by Ian Dunt yesterday. Put simply, it is that a majority of a majority can be a minority. The fact that many people voted Brexit because they wanted more control over immigration does not imply that a majority of all voters did.

Suppose that everyone understood that there was an unbreakable link between freedom of movement (FoM) and membership of the single market. Suppose all the 48% who voted to Remain prefered to keep membership at the ‘cost’ of retaining FoM. Suppose 48% of those voting Leave felt the opposite. But 4% of those voting Leave wanted a Norway style arrangement, and wanted to leave for some other reason than FoM . In this case a majority want to keep FoM, and do not want further migration controls if that means being out of the single market.

Of course these numbers are made up, although polling evidence does suggest a majority of people prefer being in the single market to ending free movement. But the key point is that we do not know what the true numbers are. Yet the presumption seems to be being made in lots of quarters, from researchers to politicians, that the referendum result means that we cannot go for any arrangement involving FoM. This just does not follow.

Nor does the fact that the Leave campaign focused on immigration make any difference. Again imagine that the 4% who wanted to leave for reasons other than immigration were rock solid about voting Leave. For the undecideds, however, immigration was critical. In which case any decent campaign would focus on the undecideds. We could change the figures to make it even clearer: 30% of Leavers were rock solid because of sovereignty or financial issues, but 22% were undecided and also worried about immigration. Again a good campaign would focus on immigration, even though it was a minority concern. Election results, like prices, are determined at the margin.

There is therefore no mandate from the referendum result to sacrifice membership of the single market in order to end free movements. Which is one excellent reason why we need a second referendum on the final terms for Brexit before we leave.  

Monday, 22 August 2016

New Labour and neoliberalism

Anyone who talks about New Labour as being a “disciple of neoliberalism” really should define what they mean by neoliberal. One of the defining characteristics of neoliberalism as far as I am concerned is a dislike of ‘big government’. Neoliberals are not libertarians: they are happy to use the state and make it powerful in particular ways (e.g. defence). However neoliberals are in favour of the privatisation of many government activities, and cutting its welfare and redistributive roles. That is the only reason why austerity was a neoliberal policy.

There are lots of ways of measuring the size of the UK government, but here is one: government consumption as a share of GDP, using world bank data.


The share of UK government spending on this measure, as with others, rose steadily and significantly under the 1997-2010 Labour government. The contrast with the previous Conservative government could not be clearer. The positive benefit that brought to public services like the NHS was real and substantial.

There are other ways in which New Labour attempted to undo the impact of the market. One concerned child poverty. While they did not manage to reverse the increase in child poverty that occurred under Thatcher, it was not for want of trying. Relaxed about the inequality that came with neoliberalism for sure, but not relaxed about poverty. New Labour introduced the minimum wage.

New Labour could be described as neoliberal in some of the other things it did, or did not do. But true disciples do not usually pick and choose which of their leader’s teachings they follow. When it comes to the rather important issue of the size of the state, New Labour was not neoliberal.