Wednesday, 20 August 2014

The symmetry test

Two members of the Bank of England’s Monetary Policy Committee (MPC), Ian McCafferty and Martin Weale, voted to raise interest rates this month. This was the first time any member has voted for a rate rise since July 2011, when Martin Weale also voted for a rate increase. A key factor for those arguing to raise rates now is lags: “Since monetary policy …. operate[s] only with a lag, it was desirable to anticipate labour market pressures by raising bank rate in advance of them.”

The Bank of England’s latest forecast assumes interest rates rising gradually from 2015. It also shows inflation below target throughout. The implication would seem to be that the MPC members who voted for the rate increase do not believe the forecast. But it could also be that they are more worried about risks that inflation will go above target than risks that it will stay below, much as the ECB always appears to be.

I like to apply a symmetry test in these situations. Imagine the economy is just coming out of a sustained boom. Interest rates, as a result, are high. Growth has slowed down, but the output gap is still positive. Unemployment is rising, but is still low (say 4%) and below estimates of the natural rate. Wage inflation is high as a result, and real wages had been increasing quite rapidly for a number of years. Consumer price inflation is above target, and the forecast for inflation in two years time is that it will still be above target.

In these circumstances, would you expect some MPC members to argue that now is the time to start reducing interest rates? Would you expect them to ignore the fact that price inflation is above target, wage inflation is high, the output gap is positive and unemployment is below the natural rate, and discount the forecast that inflation will still be above target in two years time? There is always a chance that they might be right to do so, but can you imagine it happening?

You could? Now can you also imagine large numbers of financial sector economists and financial journalists cheering them on? 

Monday, 18 August 2014

Balanced-budget fundamentalism

Europeans, and particularly the European elite, find popular attitudes to science among many across the Atlantic both amusing and distressing. In Europe we do not have regular attempts to replace evolution with ‘intelligent design’ on school curriculums. Climate change denial is not mainstream politics in Europe as it is in the US (with the possible exception of the UK). Yet Europe, and particularly its governing elite, seems gripped by a belief that is as unscientific and more immediately dangerous. It is a belief that fiscal policy should be tightened in a liquidity trap.

In the UK economic growth is currently strong, but that cannot disguise the fact that this has been the slowest recovery from a recession for centuries. Austerity may not be the main cause of that, but it certainly played its part. Yet the government that undertook this austerity, instead of trying to distract attention from its mistake, is planning to do it all over again. Either this is a serious intention, or a ruse to help win an election, but either way it suggests events have not dulled its faith in this doctrine.

Europe suffered a second recession thanks to a combination of austerity and poor monetary policy. Yet its monetary policymakers, rather than take serious steps to address the fact that Eurozone GDP is stagnant and inflation is barely positive, choose to largely sit on their hands and instead to continue to extol the virtues of austerity. (Dear ECB. You seem very keen on structural reform. Given your performance, maybe you should try some yourself.) In major economies like France and the Netherlands, the absence of growth leads to deficit targets being missed, and the medieval fiscal rules of the Eurozone imply further austerity is required. As Wolfgang Munchau points out (August 15), German newspapers seem more concerned with the French budget deficit than with the prospect of deflation.

There is now almost universal agreement among economists that tightening fiscal policy tends to significantly reduce output and increase unemployment when interest rates are at their lower bound: the debate is by how much. A few argue that monetary policy could still rescue the situation even though interest rates are at their lower bound, but the chance of the ECB following their advice is zero. 

Paul De Grauwe puts it eloquently. 

“European policymakers are doing everything they can to stop recovery taking off, so they should not be surprised if there is in fact no take-off. It is balanced-budget fundamentalism, and it has become religious.”

They still teach Keynesian economics in Europe, so it is not as if the science is not taught. Nor do I find much difference between the views of junior and middle-ranking macroeconomists working for the ECB or Commission compared to, for example, those working for the IMF, apart from a natural recognition of political realities. Instead I think the problem is much the same as that encountered in the US, but just different in degree.

The mistake academics can often make is to believe that what they regard as received wisdom among themselves will be reflected in the policy debate, when these issues have a strong ideological element or where significant sectional financial interests are involved. In reality there is a policy advice community that lies between the expert and the politician, and while some in this community are genuinely interested in evidence, others are more attuned to a particular ideology, or the interests of money, or what ‘plays well’ with sections of the public. Some in this community might even be economists, but economists who - if they ever had macroeconomic expertise - seem happy to leave it behind.

So why does ‘balanced-budget fundamentalism’ appear to be more dominant in Europe than the US. I do not think you will find the answer in any difference between the macro taught in the two continents. Some might point to the dominance of ordoliberalism in Germany, but this is not so very different to the dominance of neoliberalism within the policy advice community in the US. Perhaps there is something in the greater ability of academics in the US (and one in particular) to bypass the policy advice community through both conventional and more modern forms of media. However I suspect a big factor is just recent experience.

The US never had a debt funding crisis. The ‘bond vigilantes’ never turned up. In the Eurozone they did, and that had a scarring effect on European policymakers that large sections of the policy advice community can play to, and which leaves those who might oppose austerity powerless. That is not meant to excuse the motives of those that foster a belief in balanced budget fundamentalism, but simply to note that it makes it more difficult for science and evidence to get a look in. The difference between fundamentalism that denies the concept of evolution and fundamentalism that denies the principles of macroeconomics is that the latter is doing people immediate harm.  

Sunday, 17 August 2014

Why central banks use models to forecast

One of the things I really like about writing blogs is that it puts my views to the test. After I have written them of course, through comments and other bloggers. But also as I write them.

Take my earlier post on forecasting. When I began writing it I thought the conventional wisdom was that model based forecasts plus judgement did slightly better than intelligent guesswork. That view was based in part on a 1989 survey by Ken Wallis, which was about the time I stopped helping to produce forecasts. If that was true, then the justification for using model based forecasting in policy making institutions was simple: even quite small improvements in accuracy had benefits which easily exceeded the extra costs of using a model to forecast.

However, when ‘putting pen to paper’ I obviously needed to check that this was still the received wisdom. Reading a number of more recent papers suggested to me that it was not. I’m not quite sure if that is because the empirical evidence has changed, or just because studies have had a different focus, but it made me think about whether this was really the reason that policy makers tended to use model based forecasts anyway. And I decided it was probably not.

In a subsequent post I explained why policymakers will always tend to use macroeconomic models, because they need to do policy analysis, and models are much better at this than unconditional forecasting. Policy analysis is just one example of conditional forecasting: if X changes, how will Y change. To see why this helps to explain why they also tend to use these models to do unconditional forecasting (what will Y be), let’s imagine that they did not. Suppose instead they just used intelligent guesswork.

Take output for example. Output tends to go up each year, but this trend like behaviour is spasmodic: sometimes growth is above trend, sometimes below. However output tends to gradually revert to this trend growth line, which is why we get booms and recessions: if the level of output is above the trend line this year, it is more likely to be above than below next year. Using this information can give you a pretty good forecast for output. Suppose someone at the central bank shows that this forecast is as good as those produced by the bank’s model, and so the bank reassigns its forecasters and uses this intelligent guess instead.

This intelligent guesswork gives the bank a very limited story about why its forecast is what it is. Suppose now oil prices rise. Someone asks the central bank what impact will higher oil prices have on their forecast? The central bank says none. The questioner is puzzled. Surely, they respond, higher oil prices increase firms’ costs leading to lower output. Indeed, replies the central bank. In fact we have a model that tells us how big that effect might be. But we do not use that model to forecast, so our forecast has not changed. The questioner persists. So what oil price were you assuming when you made your forecast, they ask? We made no assumption about oil prices, comes the reply. We just looked at past output.

You can see the problem. By using an intelligent guess to forecast, the bank appears to be ignoring information, and it seems to be telling inconsistent stories. Central banks that are accountable do not want to get put in this position. From their point of view, it would be much easier if they used their main policy analysis model, plus judgement, to also make unconditional forecasts. They can always let the intelligent guesswork inform their judgement. If these forecasts are not worse than intelligent guesswork, then the cost to them of using the model to produce forecasts - a few extra economists - are trivial.


Saturday, 16 August 2014

Search in the goods market?

For economists

Imagine an economy made up of independent producers, who individually produce some good. Producers each have a fixed ‘capacity’ k of the output they produce. Producers are also consumers, but cannot consume their own good. Instead they search for other goods by visiting other producers. Agents as consumers have a certain demand for goods, which will depend on how much of their own good they sell, as well as some initial endowment of money and the price of goods in terms of money.

Traditionally we ignore the costs for consumers of visiting producers, and we assume that any visit will result in a purchase. As a result, for a given price level, we can have three situations. In the first, aggregate consumption demand is below aggregate capacity (the sum of all k), and producers end up with either unsold goods or idle capacity. In the second, aggregate demand is equal to supply. In the third, aggregate demand is above capacity. In this case we must have rationing of goods.

In this framework output is not always determined by aggregate demand, but only up to some limit. This is not how macroeconomic models typically work - they generally assume output is always equal to aggregate demand. The way New Keynesian models justify this is by assuming that producers can produce above ‘capacity’ (or that they prefer to always have some spare capacity), and that they will be happy to produce above capacity at a given price because they are monopolistic.

A recent paper by Pascal Michaillat and Emmanuel Saez applies the framework of search to the goods market. First, each visit by the consumer is costly (visiting costs) - some of the produced good is ‘lost’ (does not increase utility) as a result. So output (y, the sum of all trades) is greater than consumption (c) because of these visiting costs. Second, a visit may not lead to a trade. Whether it does depends on a matching function, which depends on the ‘tightness’ of the goods market = x, defined as the ratio of visits to capacity. Here is a diagram from their paper.



The consumption demand line is downward sloping, because a larger number of visits raises the effective price of the produced good. The output line is upward sloping, because more visits result in more trade, but the matching function is such that it gets steeper with more visits. However if visiting costs are linear in visits, that implies what the paper calls ‘consumption supply’ has this rather odd shape. (Think about the constant capital line in the Ramsey model.) For a given price, the intersection of the consumption demand and supply lines defines equilibrium tightness. Perhaps a simpler way of putting it is that consumers plan the number of visits they need to make given their consumption demand schedule.

Now shift the consumption demand line outwards, by reducing the price. (In a New Keynesian framework, think about the price as the real interest rate.) The line pivots about the xm point, but output always stays below k. As tightness (number of visits) increases, more resources are used up in failed endeavours to make a trade, and consumption starts falling. Output is always ‘demand determined’, and there is no rationing.

It is still possible to think about different ‘regimes’, because the efficient level of tightness is where consumption is at a maximum. If tightness is below that point, we can say that demand is too low (the price level is too high), and vice versa.

Those familiar with matching models in the labour market will see the connections. Visits are equivalent to vacancies, for example. The key question is whether this transposition to the goods market makes sense, and what it achieves. To quote the authors: “casual observation suggests that a significant share of visits do not generate a trade. At a restaurant, a consumer sometimes need[s] to walk away because no tables are available or the queue is too long.” (What is it with economists and restaurants?!) We could add that this rarely means that consumption is rationed - instead the consumer attempts to make a similar trade at another restaurant. However this does have an opportunity cost, which this model captures.

In a subsequent post, I will look at their full model which has separate goods and labour markets, and the various types of unemployment that this can generate. Those that cannot wait can read their own account on Vox.

  

Friday, 15 August 2014

Conditional and Unconditional Forecasting

Sometimes I wonder how others manage to write short posts. In my earlier post about forecasting, I used an analogy with medicine to make the point that an inability to predict the future does not invalidate a science. This was not the focus of the post, so it was a single sentence, but some comments suggest I should have said more. So here is an extended version.

The level of output depends on a huge number of things: demand in the rest of the world, fiscal policy, oil prices etc. It also depends on interest rates. We can distinguish between a conditional and an unconditional forecast. An unconditional forecast says what output will be at some date. A conditional forecast says what will happen to output if interest rates, and only interest rates, change. An unconditional forecast is clearly much more difficult, because you need to get a whole host of things right. A conditional forecast is easier to get right.

Paul Krugman is rightly fond of saying that Keynesian economists got a number of things right following the recession: additional debt did not lead to higher interest rates, Quantitative Easing did not lead to hyperinflation, and austerity did reduce output. These are all conditional forecasts. If X changes, how will Y change? An unconditional forecast says what Y will be, which depends on forecasts of all the X variables that can influence Y.

We can immediately see why the failure of unconditional forecasts tells us very little about how good a model is at conditional forecasting. A macroeconomic model may be reasonably good at saying how a change in interest rates will influence output, but it can still be pretty poor at predicting what output growth will be next year because it is bad at predicting oil prices, technological progress or whatever.

This is why I use the analogy with medicine. Medicine can tell us that if we eat our 5 (or 7) a day our health will tend to be better, just as macroeconomists now believe explicit inflation targets (or something similar) help stabilise the economy. Medicine can in many cases tell us what we can do to recover more quickly from illness, just as macroeconomics can tell us we need to cut interest rates in a recession. Medicine is not a precise enough science to tell each of us how our health will change year to year, yet no one says that because it cannot make these unconditional predictions it is not a science.

This tells us why central banks will use macroeconomic models even if they did not forecast, because they want to know what impact their policy changes will have, and models give them a reasonable idea about this. This is just one reason why Lars Syll, in a post inevitably disagreeing with me, is talking nonsense when he says: “These forecasting models and the organization and persons around them do cost society billions of pounds, euros and dollars every year.” If central banks would have models anyway, then the cost of using them to forecast is probably no more than half a dozen economists at most, maybe less. Even if you double that to allow for the part time involvement of others, and also allow for the fact that economists in central banks are much better paid than most academics, you cannot get to billions!   

This also helps tell us why policymakers like to use macroeconomic models to do unconditional forecasting, even if they are no better than intelligent guesswork, but I’ll elaborate on that in a later post.


Thursday, 14 August 2014

The risks to the UK recovery are fiscal not monetary

So this is how it is going to go. As the UK recovery proceeds, and rapid employment growth continues, at some point firms will begin to find it difficult to fill jobs. There are few signs (pdf, section 3) of that yet, but it is likely to happen sometime in 2015 or 2016. At that point, real wages will start to rise. Labour scarcity, and the recovery in investment that has already begun, will mean that at some point in the next year or two UK productivity growth will also recover to more normal levels.

What happens to interest rates will depend crucially on the relative timing of these two changes. If productivity increases when real wage growth resumes, wise heads on the MPC will note that cost pressures remain weak. If there are no other inflationary pressures, the case for raising interest rates also remains weak. However if real wages start rising before productivity growth picks up, such that unit labour costs rise, then the MPC will raise rates.

Which will happen is I think anyone’s guess, given the uncertainties associated with the UK productivity puzzle. It may come down to measurement errors in the data. However I also suspect it will not matter a great deal either way. This is because I take the MPC seriously when they say rate increases, when they come, will be small and gradual.

We can speculate about the impact of one or two quarter point increases in interest rates, but I think this would be ignoring the elephant in the room. That is fiscal policy, where its 2010 all over again. We have two austerity programmes: for simplicity call them Labour and Conservative. One is tough, the other is - well let’s just say very tough. Here is a picture.

Alternative Austerity Paths for cyclically adjusted net borrowing (excluding Royal Mail and APF transfers): source OBR and my estimates for Labour

We see the sharp fiscal contraction in 2010 and 2011. Thereafter it eases off. (If we look at the primary balance, which excludes interest payments, the easing off is even more noticeable - see here). Under the current government’s plans, fiscal tightening resumes again in earnest after the election. My guesses for what would happen under Labour are based on their (somewhat vague) statements so far.

In the past I have been a bit dismissive of these government plans, saying they represent a political gambit by Osborne to make Labour look relatively profligate. However that may have been politically naive. After all if the Conservatives win the 2015 election (or are part of a new governing coalition) this will have been achieved having followed a strategy of frontloading austerity. So why change a winning strategy? They might therefore keep to these plans, cut spending and welfare sharply in the first two or three years (more hits on the poor and disabled), and then again ease off, perhaps with tax cuts in the second half of the five year term.

Maybe the UK economy will be luckier than it was after 2010. Perhaps the recovery will be strong enough to shrug off this fiscal contraction, as the US economy has been able to. (Although many will correctly claim that the US recovery has been slower than it might have been as a result.) But the key similarity with 2010 is that UK interest rates will be at or close to their lower bound, so there is no insurance policy if things do go wrong. Just as in 2010, the government will be taking a huge gamble by embarking on a sharp fiscal contraction. The one difference from 2010 is that this time there is no pretext to take such a risk.  

Wednesday, 13 August 2014

Inequality and the common pool problem

One observation from looking at the comments on my post on maximum wages was how many people just considered the impact of this idea on those with high wages, rather than seeing this as involving a redistribution of income.

The classic common pool problem in economics is about how the impact of just one fisherman extracting more fish on the amount of fish in the lake is small, but if there are lots of fishermen doing the same we have a problem. Those thinking about fiscal policy use it to describe the temptation a politician has to give tax breaks to specific groups. Those groups are very grateful, but these tax breaks are paid for (either immediately or eventually) by everyone else paying more tax. However the impact of any specific tax break on the tax of other people is generally so small that it is ignored by these people. As a result, a politician can win votes by giving lots of individual tax breaks, as long as each one is considered in isolation.

Discussion of the minimum wage often focuses on whether the measure is good for the low paid worker (e.g. will they lose their job as a result?). If distributional issues are considered, it generally involves the employer and employee (see for example the case of the Agricultural Wages Board discussed here). Sometimes discussion might stretch to firms doing something that could impact on other workers, like raising prices. However, if changes in the minimum wage have no impact on the overall level of GDP, higher real wages for low paid workers must imply lower real incomes for someone else.

The same logic can be applied to high executive pay, but it is often ignored. Here is part of one comment on my original post that was left at the FT: “the rise in incomes at the very top ... may be a worry in the dining halls of Oxford but in many decades not one person has mentioned such a worry to me. What worries people here, especially those at the bottom of the income distribution, is the decline in real wages …” But if higher executive pay has not led to higher aggregate GDP that pay has to come from somewhere.

Perhaps there is a tendency to think about this in a common pool type way. The impact of high wages for any particular CEO on my own wage is negligible. But that is not true for the pay of the top 1% as a whole. Pessoa and Van Reenen look at the gap between median real wages and productivity growth over the last 40 years in the US and UK. They have a simple chart (page 5) for the UK which is reproduced below. (The legend goes in the opposite direction to the blocks.) I’ll explain this first and then how the US differs.



In the UK over this period median real wages grew by 42% less than productivity. None of that was due to a fall in labour’s share compared to profits - called net decoupling in Figure 1. Most of it was due to higher non-wage benefits - mainly pension contributions in the UK - and rising inequality. There are two obvious differences in explaining the larger (63%) gap between median real wages and productivity in the US: the non-wage benefits were mainly health insurance, and in the US there is some decline in the labour share. However in both counties rising inequality explains a large part of the failure of median real wages to track productivity gains.

Unfortunately the paper does not tell us how much of this increase in inequality is down to the increasing share of the 1%, but a good proportion is likely to be. For example, Bell and Van Reenen find that, in the 2000s in the UK, increases in inequality were primarily driven by pay increases (including bonus payments) for the top few percent. “By the end of the decade to 2008, the top tenth of earners received £20bn more purely due to the increase in their share ... and £12bn of this went to workers in the financial sector (almost all of which was bonus payments).” If that £20bn had been equally redistributed to every UK household, they would have each received a cheque for around £750.

More generally, we can do some simple maths. In the US the share of the 1% has increased from about 8% at the end of the 70s to nearly 20% today. If that has had no impact on aggregate GDP but is just a pure redistribution, this means that the average incomes of the 99% are 15% lower as a result. The equivalent 1% numbers for the UK are 6% and 13% (although as the graph shows, that 13% looks like a temporary downward blip from something above 15%), implying a 7.5% decline in the average income of the remaining 99%.

So there is a clear connection between the rise in incomes at the very top and lower real wages for everyone else. Arguments that try and suggest that any particular CEO’s pay increase does no one any harm may be appealing to a common pool type of logic, and are just as fallacious as arguments that some tax break does not leave anyone else worse off. It is an indication of the scale of the rise in incomes of the 1% over the last few decades that this has had a significant effect on the incomes of the remaining 99%.