Thursday, 18 December 2014

Why these updated fiscal rules are a backward step

The coalition government in the UK has just updated the fiscal rules that govern how it decides budgetary policy. I think it is helpful to distinguish between the form of those rules and the particular numbers attached to them. I and many others have already discussed the numbers on various occasions. My bottom line: it is stupid to commit to further significant fiscal contraction (‘austerity’) when interest rates are still at or close to their lower bound. It means we become more vulnerable to adverse shocks to demand. An academic quibble? No, it is what happened in 2010. Unlike 2010, however, no one with any sense thinks we must have austerity to avoid being punished by the markets.

I want to talk in this post about the form of the rules. Here the change compared to 2010 appears minor. The primary mandate now has a 3 rather than 5 year rolling horizon, and the date for the secondary target of a falling debt to GDP ratio has just been shifted ahead to 2016/7.

In my paper with Jonathan Portes (here or here), we argue that fiscal rules can have two goals. They can try to mimic optimal fiscal policy, or they can be effective at restraining a government that is subject to deficit bias (basically spending too much and taxing too little). The main point about optimal fiscal policy is that government debt and deficits should be shock absorbers, and spending and taxes should be adjusted slowly to meet any debt target.

In this context the coalition’s secondary target remains a bit of nonsense. Getting the debt to GDP ratio to fall at some stage is a good idea, but having a target for a specific year is silly. It is not optimal because if some shock hits the economy before 2016/7 which means debt tends to rise relative to GDP, it is crazy to try and counteract that to meet the target in such a short space of time. It is not effective because it can be gamed by the government fiddling the timing of expenditures.

In contrast, Jonathan and I argue that the form of the original primary mandate makes a lot more sense, as long as interest rates are not at their zero lower bound. Having a five year rolling target for the deficit allows fiscal policy plenty of time to adjust to shocks. We saw this in action over the last few years, as the Chancellor was able to reduce the pace of fiscal consolidation from 2012 when the economy failed to recover as quickly as he had hoped. Changing this mandate from five to three years gives any Chancellor less time to adjust, which is why it is a backward step.

In talking about the change, the Treasury says it “reflects the progress that has been achieved in tackling the deficit, which means that the mandate can be safely shortened to create a tighter constraint on future fiscal policy choices.“ This is one of those lovely phrases that sounds plausible until you think about it. The whole point of having a rolling target is that it gives you time to adjust to shocks, when too rapid an adjustment would be costly. Has the expected size of shocks got smaller, so we can safely create “a tighter constraint on future fiscal policy choices“? I don’t think so.

Of course I know, and indeed everyone knows, that the reason for this change has nothing to do with economics and everything to do with politics. Whether it is clever politics or not I will leave to others to debate. In addition on this occasion the numbers in the rule, and the risk he is taking because we are still at the zero lower bound for interest rates, matter more than this change from a 5 to 3 year rolling target. But it is still a shame we are going backwards. I have just finished an article, due to appear in February, on the coalition’s macroeconomic policy, and to set against the obvious mistake I was able to count two successful innovations: the creation of the OBR and the 5 year rolling fiscal mandate. Now we are left with just one.    

Tuesday, 16 December 2014

Robert Peston, Mr Market and me

Paul Krugman picked up on my post commenting on the views of Robert Peston’s pals in the bond market, and Robert Peston has now responded. To characterise this as a debate would I think be wrong. Being the excellent journalist that he is, Peston is reporting the views put to him, rather than taking a particular side. In his response, he does a reasonable job of presenting Paul and my views, and does not argue too hard against them. I have two significant clarifications, and one key point.

The first clarification is that Peston still downplays the importance of having your own central bank and borrowing in your own currency. He says that is ‘partly’ why the UK has avoided the fate of the Eurozone PIIGS. I would argue that is entirely why the UK (and the US, and Japan) have done so. Both Paul and I would argue that fiscal policy should have been expansionary and not contractionary in 2010 [1], and in my view this would have had no detectable influence on any risk premium. The recent IMF self-evaluation that I discussed here also argues at a global level that the switch to fiscal contraction ('austerity') in 2010 was a mistake caused by a misreading of the Eurozone crisis.

Second, I think what he writes at the end could be misleading. He says: “Now to be clear, there are economists who attack the idea that the deficit and debt can be cut by growing the economy with all the vehemence of Krugman's and Wren-Lewis's lampooning of me and Mr Market.” The minor point is that I did not lampoon either him or the market, but simply what his pals thought about how the market worked. But more seriously, the argument that debt could eventually be lower as a result of growing the economy through fiscal expansion - advanced for example by DeLong and Summers - is different from the point that Paul and I make about the irrelevance of default risk for the UK or US and the consequent foolishness of trying to cut the deficit when interest rates are at their zero lower bound.

Those clarifications apart, the main thing I wanted to say was this. Of course he was just quoting what was said to him by his pals in the bond market, and I would not want him to suppress those views, although I did get some feedback from others in the markets that their own view would have been rather different to his pals. My complaint was that he did not talk to some academic macroeconomists as well, and I explain here why their opinion on issues like this may be at least as useful as some players in the market. If he ever wants my opinion, he just needs to email!
[1] See for example Paul’s recent book, and Jonathan Portes and my recent paper.

Sunday, 14 December 2014

Deficits, Mediamacro and Popular Opinion

The level of the government’s budget deficit is not the most important macroeconomic problem facing countries today. In the UK, for example, the fact that labour productivity has been stagnant since the recession is potentially far more important. If we fail to regain this lost productivity growth in the next few years, the average UK citizen will be substantially poorer as a result, in terms of consumption of both private and public goods and services. If the budget deficit rises by a few tens of billions, leading government debt to eventually rise or fall by even ten or twenty percentage points of GDP, the consequences will be negligible by comparison. To misquote George Osborne, the world will not fall in.

Yet mediamacro presents a very different picture. When Labour leader Ed Miliband forgot to mention the deficit in his party conference speech, the media could talk of almost nothing else but this ‘huge gaffe’. When Prime Minister David Cameron said nothing about the productivity slowdown in his party conference speech, no one in the media bothered to even mention this.

One of the fall back positions of the media on issues like this is that they are only reflecting popular opinion. In the case of the deficit it would hardly be surprising if this were true. If people are not told otherwise, they are bound to think about the government’s budget as they think about their personal budget. The Eurozone crisis was in the news constantly for two years, and the number of people explaining that the Eurozone was special because of the ECB was dwarfed by those who suggested it could happen here. A popular fear of market reaction is also not surprising as we are still suffering from the impact of the financial crisis.

But is mediamacro reflecting public opinion? Here is a question that YouGov recently asked in a poll for the Sunday Times (full poll results here, HT Duncan Scott).

Thinking about how the next government handles the issue of Britain's deficit, which of the following best reflects your view?

A.    The next government should prioritise reducing the deficit, mainly through making cuts to spending on public services

B.    The next government should prioritise reducing the deficit, mainly through increasing the level of taxation

C.   The next government should not prioritise reducing the deficit, and should spend more on public services or cutting taxes to try and promote growth instead

(A) could be described as the Conservative view, (B) as maybe the Labour or Liberal Democrat view, and (C) is the position taken by some nutty academics. Of those that chose one of these three options, 27% went for option (A), 25% for option (B) and 48% for option (C).

So around half said not only that cutting the deficit should not be a priority, but also agreed that fiscal policy should be used to promote growth. For these people, none of the major political parties represent their position. Of course Labour’s positioning could still be shrewd politics. It may be correct in thinking that this 48% will still prefer to vote Labour because they intend to reduce the deficit by (a lot) less than the other parties, but by pledging to make cutting the deficit its first priority it may attract some of (B), and also get mediamacro off their back.

The other implication is that maybe forgetting to mention the deficit is not, for many people, quite the gaffe that mediamacro thinks it is. Of course a large part of the UK media decided it was a major gaffe for purely political reasons, as another stick to beat Ed Miliband with. If the non-partisan part of the media went along with this because they thought reducing the deficit should be the top macroeconomic priority, they are simply wrong, as most economists will tell them. If they went along with this because they thought they were just reflecting public opinion, then maybe they should think again. If mediamacro continue to obsess about the deficit, the only conclusion to draw will be that we have a media consensus driven by a partisan press.


Friday, 12 December 2014

Bond market fairy tales part 2

In part 1 I contrasted the way I think about how different speeds of deficit reduction in the UK or US today will influence interest rates on government debt with how at least some people in those markets say they think about the same issue. That was a particular example of a more general phenomenon. The macroeconomics coming from economists attached to financial institutions often seems to be rather different to the macroeconomics of academic economists. When it comes to an issue involving financial markets, then it seems obvious who mediamacro should believe. Those close to the markets surely must know more about how those markets work than some unworldly academic. This post will suggest a more nuanced view.

As is often the case in macroeconomics, it all depends on the time horizon. Are we talking about what may happen over the next few days or weeks, or are we talking about what will happen over the next few years?

In terms of very short term prediction, financial market economists beat academic economists hands down. The only thing most academic economists can usefully tell you is that it is unlikely you will outsmart market opinion. If you really want to try then you need lots of short term information and a good nose for how that short term information is interconnected. Most academics (there are exceptions) just do not have time to do that work. I always remember the reply an academic member of the Bank of England’s Monetary Policy Committee gave to some MP who asked him about the implications of some latest data. I must have been doing some marking (grading) at the time that came out, was the reply.

Perhaps more surprisingly, those working in the markets are not as concerned about the longer term (what might happen in three or five years time) as you might expect. That is because money is made in predicting short term movements, and knowledge of where things are going over the next few years is a relatively weak guide to what might happen over the next few days. When I first started doing work on ‘equilibrium exchange rates’, I got a lot of queries from those in the markets, but the interest largely disappeared when I told them that ‘equilibrium’ meant where rates might be in about five years time.

This may surprise you because economists attached to financial market institutions often tell longer term stories, and sometimes they even produce detailed numerical forecasts of the type produced by central banks or governments. (See the list that the UK Treasury compiles for example.) But as I have often said, macroeconomic forecasts are only slightly better than guesswork. So it is only really worth putting any significant resources into producing a macro forecast if you are taking or seriously influencing decisions - like setting interest rates - where the costs of getting things wrong are extremely large. My suspicion is that financial sector macro forecasts are mainly there to give the impression of expertise to the institution’s clients.

I also suspect that economists working for financial institutions spend rather more time talking to their institution’s clients than to market traders. They earn their money by telling stories that interest and impress their clients. To do that it helps if they have the same worldview as their clients. Getting things right over the longer term seems less important, as Paul Krugman keeps complaining about in the context of those who have been predicting rapid inflation as a result of Quantitative Easing. 

It is also useful if they leave their clients with the impression that they have some unique insight into how the markets work. So instead of suggesting - as an academic would - that markets are governed by basic principles, it is better to suggest that the market is like some capricious god, and they are one of a few high priests who can detect its mood. Now in the short term the market really can behave in volatile, unexpected and sometimes mysterious ways, but over the longer term there are some basic rules that markets obey.

The incentive system for academics is very different. They are judged by their peers. If they present stories to the media that differ greatly from conventional wisdom about theory or the empirical evidence, they will be given a hard time by their colleagues. They need to have an idea about how markets work to do good macroeconomics. They want to be more like scientists than high priests. (This has an unfortunate by-product. Most academics would rather not lose precious research time talking to journalists, particularly if the quotes they give may fail to contain the caveats normally demanded in academic work. In contrast talking to the media is part of a city economist’s job description.)   

So who should journalists trust on the economy? If you want to know about the latest retail sales numbers or where the economy might be heading over the next few months, with a few exceptions financial economists are better bets than academic economists. If you have a more long term question, like how alternative speeds of deficit reduction will influence interest rates, then perhaps surprisingly you may tend to get a more reliable answer from academics. Like most things in economics, this is a tendency: there are some seasoned city economists who I would trust over many academics.

There is an important implication about political bias as well. Academic economists are no saints on this, but I do not think there is a clear average bias among academic macroeconomists towards the left or right. However partly because financial economists need to be good at telling stories that their clients find sympathetic, their worldview tends to be one where a smaller state is good for the economy, higher taxes on top incomes are a bad idea, markets are generally efficient and regulation is harmful.

If you think this is just self-serving conjecture, look at this evidence. The question of whether, in the UK, the 2013 recovery vindicated 2010 austerity was a no-brainer. Anyone who thinks about the logic for a moment will realise the answer is no, even if they think austerity was a good idea. To suggest otherwise would be to argue that it was a good idea to close half the economy down for a year, because growth in the following year would be fantastic. To answer yes to this question probably indicates political bias rather than lack of thought. When the Financial Times asked this question, only two out of twelve academics gave the answer yes. About half the city economists who were asked said yes. 

Thursday, 11 December 2014

Bond market fairy tales part 1

In a recent post I argued that the days when budget deficits mattered because of concerns about default are over. In 2010 it briefly looked as if deficits could be so large that default was a real possibility, but we now know that was never true for the US and UK, and within the Eurozone it was only true for Greece, and since then austerity has (unfortunately) brought deficits down substantially. In most countries deficits are now around sustainable levels, by which I mean that they can be financed and sustained at close to current tax rates and spending regimes. 

Which raises the question, why isn’t this common knowledge? Why in mediamacro do people act as if we were still in 2010? In this respect BBC journalist Robert Peston has an interesting post. Robert Peston is no fool, and his coverage of banking issues in particular is rightly famous in the UK. In his post, he notes correctly that there is a huge gap between the amount of austerity planned by Conservative and Labour after 2015. Let me quote what he says next.

“And here, of course, is where we need to ask Mr Market what he thinks of all this….The Tory view is that those [low] interest rates can only be locked in if the government continues in remorseless fashion to shrink the state and net debt. What Labour would point out is that countries in a bit of a fiscal and economic mess and currently refusing to wear the hairshirt that the European Commission thinks necessary, such as Italy and France, are also borrowing remarkably cheaply."

So what Mr. Market should tell Robert Peston at this point is that France can borrow more cheaply than the UK not because the French government is more credible and less likely to default - these are no longer important issues. The reason is that expected future short rates in France are lower as a result of the Eurozone recession. This means that because the Conservatives will cut back on spending more (than Labour), this will tend to reduce demand and output more, which in turn will mean expected future short rates will be a little lower under the Conservatives than Labour (as monetary policy tries to undo the impact of greater austerity). What Mr. Market actually told Robert Peston is as follows:

"And here is where Mr Market may be capricious, according to my pals in the bond market. They say the UK's creditors would probably be forgiving and tolerant of George Osborne borrowing more than he currently says he wishes to do, in that his record of reducing Whitehall spending by £35bn since taking office in 2010 has earned him his austerity proficiency badge. But Ed Balls has never been chancellor, although he was the power behind Gordon Brown when he ran the Treasury and much of the country, both in the lean years from 1997 to 2000 and the big spending Labour years thereafter.
So Mr Balls has yet to prove, investors say, that he can shrink as well as grow the apparatus of the state.”

What Robert Peston's pals in the bond market seem to be telling him (assuming that nothing was lost in translation) is that it is all about Labour's lack of credibility at being able to shrink the state. My immediate reaction: ?!?!? I have two problems.

1) Why the talk about credibility? Talking about credibility makes sense if we are worrying about default, but there is no chance Ed Balls is going to choose to default. You might worry that Labour will not cut the deficit by as much as they plan, which will intensify the mechanism working through monetary policy that I outlined earlier. If that is what his pals meant, why didn't they say this, and why does that involve the markets being capricious?

2) What is this about shrinking the apparatus of the state? Shrinking the deficit yes. But in what world does the return on bonds depend on the size of the state?

So it seems that my understanding of how the bond markets work is worlds apart from the understanding of Robert Peston's pals. I suspect that for mediamacro there really is no choice here: why would you believe an academic economist in their little old ivory tower rather than the guys who are directly in touch with the markets you are trying to understand. The fact the explanation they give you could have been drafted by someone in No.11 Downing Street (the UK Chancellor's residence) just suggests that George Osborne is in tune with financial realities.

Part 2 of this post will be why this logic is wrong.

Tuesday, 9 December 2014

Small states, economics and food banks

I often know I have hit a raw nerve with one of my posts when I get responses of the ‘surely an economics professor at Oxford should know’ type. As an example, here is Tim Worstall responding to this post, where I suggested that statements from small state people that the cuts that have already been made have been achieved at little cost seemed to fly in the face of evidence. I used welfare cuts and the increasing use of food banks as an example.

In fact I was quite careful about the point I wanted to make. I did not claim that the fact that half of those using food banks said they did so because of problems with benefit payments proved that welfare reform had not worked. All I needed to show was that assertions by small state people that the cuts had been achieved at little cost seemed to ignore this obvious evidence which appeared to suggest otherwise.

Tim Worstall says that evidence should be ignored, as anyone with any knowledge of economics would know. Food banks offer free food. The demand for a free good is potentially limitless. So lots of people taking advantage of free food proves nothing. He says “it’s odd for an economist (even a macroeconomist) to miss this”. Worstall is not alone in discovering the reason for the popularity of food banks in elementary economics. Here is Lord Freud, Work and Pensions minister, making the same point.

Now this idea raises a little puzzle. Why exactly are the people running these food banks spending time and effort obtaining food from supermarkets and members of the public only to give it away free to people who do not really need it? That is not a question Mr Worstall asks, but not to worry, economist Paul Ormerod is on hand to provide the answer. “Some of those who set up food banks are undoubtedly sincere, and think their efforts are needed. But an opportunity exists for others to show conspicuously their concern for the poor, and at the same time demonstrate opposition to austerity.”

Well perhaps it is because I’m an economist (even a macroeconomist) that I would never make such silly economic arguments. How many times has Mr Worstall been down to the food bank to get his free food? It costs nothing after all, so it would be pointless for him not to at least see what they had on offer. Actually for most food banks you cannot just turn up - you have to be referred by another charity or by a local job centre. But still, if it’s free, why doesn’t he get himself referred by some obliging charity? I’m sure he wouldn’t mind pretending to be hungry - after all he is suggesting lots of other people do just that.

The less important reason why most people do not go to such efforts to get free food is that it is not free - you have to spend time and effort to get it, and that is a cost. For most people this cost far outweighs any benefit. In fact it is quite possible that the only group where the cost does not outweigh the benefit is those who would go hungry otherwise. The more important reason is that most people are quite ashamed to get food from a food bank, or to pretend they are hungry when they are not just to get a few bags of free food. Economists are allowed to take account of such feelings, even if sometimes they fail to do so. That is why the Financial Times says:

“Multiple case studies show people only turn to a charity for food if they have no alternative. Such visits are often described as a humiliating experience undertaken as a last resort. It is neither a lifestyle choice nor a wheeze to save a few pounds on tins of soup.”

Once you understand this, there is no need for Paul Ormerod’s rather contrived explanation of why people run food banks. They run them because it helps people who would go hungry otherwise. [1]

You might think that these arguments are so poor that they are hardly worth addressing. But I think they are indicative, and there is a danger that they end up giving economics a bad name. Anyone can misuse economic ideas, and small state people like Tim Worstall are no exception. Yet ironically by pretending that the rapid growth in UK food banks over the last decade is not a problem, they only reinforce the conclusions of my earlier post. Small state people are in danger of living in an imaginary world, while in reality the policies they support do serious harm.        

[1] While his idea might be applicable to millionaires at American style charity events, as an explanation for those working in food banks it seems both unlikely and insulting. 

Sunday, 7 December 2014

The imaginary world of small state people

“In the end, you are either a big-state person, or a small-state person, and what big-state people hate about austerity is that its primary purpose is to shrink the size of government spending.”

So said Jeremy Warner (assistant editor of the UK’s Daily Telegraph) last year. Jeremy is a small state person, and I think many other small state people think like this. But the statement is wrong. There are a large number of people - I suspect the vast majority - who do not have any prior view about the size of the state.

In many ways the bipolar view harks back to a bygone age, where - at least in Europe - there actually was a large constituency on the left that wanted a large state as a matter of principle. In the UK that constituency lost all its influence with Margaret Thatcher and New Labour, and it has also lost its influence in the rest of Europe. However this decline in the influence of big state people on the left was matched by a rise to power on the right of those who want a small state as a matter of principle. George Osborne’s plan for the UK over the next few years is the apotheosis of this neoliberal view.

I think I’m like the majority of people in not having any fixed ideological position about whether the state should be large or small. The state is clearly good at doing some things, and bad at doing others. In between there is a large and diverse set of activities which may or may not be better achieved through state direction or control, and they really need to be looked at item by item on their merits.

My first major problem with small state people is that they are not prepared to look at these items on their merits. Instead they have a blanket ideological distaste for all things to do with government. The evidence that government is ‘always the problem’ is just not there. The idea that private sector activity is always welfare enhancing and is best left alone was blown out of the water by the financial crisis. My second major difficulty with many small state people, like George Osborne, is that they are using fear of a debt crisis (a possibility which for the UK and US is non-existent) to achieve their ends. This is political deceit on a grand scale. My third major problem follows from the second: reducing government spending during a liquidity trap recession does real harm. It wastes resources on a huge scale.

For the UK, the OBR estimates - conservatively - that austerity reduced GDP by 1% in 2010/11, and by a further 1% in 2011/12, so GDP was 2% below what it could have been in 2011/12. As there has been no offsetting fiscal stimulus in later years, and because monetary policy has been constrained by the zero lower bound, this waste of resources will not necessarily be eliminated in subsequent years. So the cumulative cost of 2010 austerity could easily exceed 5% of GDP. That is a colossal sum to waste. The estimated numbers in the Eurozone, where the austerity squeeze continues, are even worse - nearer 10% territory and counting. As I argue in this new short piece for the Economist, the fact that Osborne risks doing the same thing again from 2015 onwards is a sufficient reason not to give him the chance.

Which brings me to a final problem I have with small state people, which is their disregard for the evidence. It is true that most people are bad at acknowledging counter evidence, but those with an ideological conviction are worse than most. A common theme among small state people following Osborne’s Autumn Statement is to ask what all the fuss is about. In his rant at the BBC, Osborne says “I would have thought the BBC would have learned from the last four years that its totally hyperbolic coverage of spending cuts has not been matched by what has actually happened. I had all that when I was interviewed four years ago and has the world fallen in? No it has not.” He remembers it well, because he tried to intimidate the BBC back then as well. The claim of hyperbole is nonsense of course, as Tony Yates sets out, but I want to focus on the ‘world fallen in’ point.

Here is Janan Ganesh in the FT making the same claim in spades:

“[Osborne] has also made the spending cuts he promised without the country turning into a medieval wasteland. This is a deeper intellectual wound to the left than we currently understand; it will change the terms of debate about the proper size of the state long after Mr Osborne has gone.”

With both Osborne and Ganesh the intended meaning is that cuts have been achieved at relatively little cost. They clearly hope this idea will become received wisdom in the media. But is it true? Take the one area that Osborne has earmarked for further cuts: welfare. [1] The argument that the cuts made so far to welfare have been achieved without significant costs flies in the face of the evidence. The number of food banks in the UK has grown massively over the last five years. The Trussell Trust estimate that more than half of their clients were receiving food because of benefit delays, sanctions, and financial difficulties relating to the bedroom tax and abolition of council tax relief. As James Harrison relates in this excellent long article, the government simply denies the evidence. The Economist notes: “Welfare reform was intended to be one of the big achievements of the coalition government. But almost all of the radical ideas promised are turning out to be duds.” These are duds that create real misery. Now maybe this is all just teething problems, but the prima facie evidence is hardly that cuts have been achieved at little cost.

So how can small state people have the audacity to claim otherwise? Perhaps it reflects the power of an ideology that its protagonists want to see no evil. Perhaps it is because those hurt by austerity somehow do not count. But the claim that Osborne’s cuts have been such a success that they will cause a “deeper intellectual wound to the left than we currently understand” is simply delusional. These are fantasy ideas from those living in an imaginary world, while in reality the policies they support do serious harm.

[1] I choose welfare only as an example. It does not appear to be an isolated one. Here is an account of Chris Grayling, prisons and the Howard League, or see Alex Marsh on the UK justice system more generally. Or think of those who suffered from flooding as the government cut back money for flood prevention, while the government still pretends there were no cuts.