2022 in review: Setting us up for a difficult 2023

The economy in 2022

For the second year in three, 2022 was characterised by a one-off event that completely changed the economic landscape. Whilst 2020, and to a large extent 2021, was derailed by pestilence, this year was dominated by war. Those of a religious persuasion might recognise these as the first two Horsemen of the Apocalypse. Most of our predictions were derailed by the Russian invasion of Ukraine which resulted in a bigger surge in inflation than anticipated and forced central banks to raise interest rates to their highest since the GFC. However, this year was not just about monetary policy: governments were forced into using an active fiscal policy to offset the worst effects of the cost-of-living crisis on households. However, it will not be enough to prevent recession in large parts of the industrialised world in 2023 and the continued rise in government liabilities may yet turn out to be a big problem in future.

Covid slipped down the list of things to worry about in 2022. In my year-ahead piece almost a year ago, one of the options I laid out was that the Omicron variant would prove to be the last hurrah for Covid, which would regress to become an endemic problem. That is indeed how things panned out in 2022 although as China opens up following its zero-Covid measures there is every prospect that global cases will start to pick up once more. We cannot yet be sure that we are out of the woods. However, I did expect that as Covid related supply shortages began to ease, inflation would slow towards the end of 2022. It has not worked out like that.

Newspaper headlines have been full of suggestions that recent events herald a return to the conditions of the 1970s, with a commodity price shock triggering a surge in inflation accompanied by increasing industrial unrest as unions push for higher wage claims. Whilst the parallels are attractive on the surface, a closer look at the evidence suggests the comparison does not quite hold up. One of the key differences so far is that real wage growth has been crushed by the recent surge in inflation whereas in the 1970s it remained positive (although we have been compensated with lower real interest rates). Here in Britain, the strikes that have hit train, postal and health services are a response to the fact that many workers are being squeezed very hard, two years after they were lauded as key workers who kept the country going during the initial Covid lockdown. Labour relations are going to be a problem for governments in 2023, particularly in France and the UK.

One way to think about the inflation problem in the short-term is that it is the outcome of a distributional conflict between firms, workers and taxpayers which will only be resolved when the various actors accept the outcome. Indeed all players have to accept that they will be made worse off: At issue is the extent of the losses they are prepared to bear. The fact that central banks have raised interest rates to combat inflation has complicated matters by raising the burden on households. My issue has long been that higher interest rates will do nothing to offset a supply-side inflation shock, although central banks have to be wary of second round effects, particularly where labour markets remain tight as is currently the case in the US and UK. But as pointed out by the journalist Sarah O’Connor, author of this article on why worker power has not strengthened in 2022, while central banks fret about a wage-price spiral, the current situation looks more like a living standards bloodbath.

On the basis that inflation slows in 2023, as base-year effects drop out of the annual calculations, and as European economies – and maybe the US – fall into recession, the calls for interest rate cuts will build. Central banks are unlikely to heed these calls, and maintain policy tighter than might be justified by economic conditions, which would be a contrast to the post-GFC period when they held policy looser than justified by economic conditions. Central bankers are paranoid about repeating the mistakes of the 1970s when they eased policy too early only for inflation to take off again.

A bad year in the markets

On the basis of data back to 1928, 2022 was one of the worst years for total asset returns with the S&P500 losing around 17% whilst returns on Baa corporate bonds were the second worst in history (beaten only by the collapse of 1931). It was not supposed to be this way. Indeed I expected equities to perform relatively well, largely because of an absence of alternatives. But the surge in interest rates and fears of recession well and truly did for markets. It is not usual for a year of losses to be followed by a second consecutive decline but it has happened before – most notably for equities over the period 2000-2002. I would like to say that things can only get better but we cannot be sure that they will.

2022 was also the year in which crypto assets were reassessed. Long-term readers will be aware of my scepticism regarding cryptocurrencies but I was not prepared to write them off at the start of the year on the basis that there seemed to be genuine retail interest in their adoption. But as the energy costs associated with mining Bitcoin continued to rise, they became an increasingly unattractive prospect. Matters were not helped by the bankruptcy of the FTX exchange amid allegations of fraud. As a result Bitcoin lost two-thirds of its value against the USD, to currently trade at 16558 – still almost triple my back-of-the envelope estimate of fair value.

Politics: Some right calls, some wrong

If I got anything right about 2022 it was that geopolitics would be at the forefront of the agenda after two years in which governments were preoccupied with Covid. I did point out there was a risk that Russia would invade Ukraine and that western relations with China would continue to fray. I also tipped Emmanuel Macron to get a second term as French President. However, the one call that went badly wrong was that Boris Johnson would end the year as UK prime minister. As I wrote at the time: “Ditching a third Tory leader in six years, before their term is up, will not play well with an electorate that appears increasingly restive, particularly when there is no obvious candidate to replace Johnson.” I stand by the logic – Johnson’s departure will do the Tories no favours at the ballot box. But I could not have foreseen that Johnson’s replacement would themselves be replaced after a spectacularly incompetent fiscal plan was rushed through.

Last word

Tough times are now the order of the day. We survived the GFC, coped during the pandemic and are having to tighten our belts to deal with the most significant war on European territory since 1945. I look back fondly to the days of the Great Moderation when we had to invent things to worry about (who now remembers the Millennium Bug?). We can be thankful we got through 2022 relatively unscathed but as we look ahead to 2023, there will be bigger challenges ahead. Happy New Year to you all.

On Christmas Night ...

Twas the night before Christmas, when all through the house, not a creature was stirring, not even a mouse. There certainly weren’t many train drivers around either, Rishi mused, given that they were on strike. Ambulance drivers, nurses and postmen were, like Christmas cheer, also a little thin on the ground this year. Rishi shivered. Ever since he had moved into his London townhouse almost three months earlier, his life appeared to be running out of control.

He had the sense that the place was haunted. The portraits of all the previous occupants gazed out on him as he went up and down the stairs to the cramped but expensively decorated apartment that one of the recent occupants had lavished so much money on. He could almost hear their disapproving whispers urging him to get tough with the unions and bring the country back to its senses.

Rishi sighed as he trudged up to bed. At least tomorrow he could shut himself off from everybody and lounge around in his underwear drinking Crème de Menthe by the pint. It may not be much but it was at least a plan. It’s not like there was a Queen’s Speech to look forward to this year. Dejectedly Rishi slumped into bed. It had been a tough year and he was glad it was almost over. A good night’s sleep was just what he needed.

A quick slug of whisky provided the tranquilliser that would send him to sleep: A deep slumber when the pressures of the job would fall away. Then suddenly he heard it. Tap-tap-tap on the window pane. One of the most secure houses in London and someone was trying to break in. Incensed, Rishi stormed over and flung open the window. And there, sitting on the windowsill, was Tony Blair.

 “What the hell are you doing there?” asked Rishi.

“I am the ghost of Christmas past,” replied Blair.

“But you’re not even dead, at least not physically,” said Rishi. “How can you be a ghost?”

“You don’t have to be dead to be a ghost,” Blair answered. “Just look at Keith Richards. Anyway, I’ve come to show you what life was like in Merrie England in the days of BC.”

Seeing Rishi’s puzzled look, Blair helpfully added, “Before the Conservatives. Here, grab hold of my arm. And do call me Tony”.

Before he could even reply, Blair reached out and for a moment all went blank. But then Rishi recovered his composure and realised that the two of them were standing in a hospital waiting room. “Where are we?” he asked.

“This is the waiting room at St Thomas’ Hospital,” replied Blair.

“But it’s empty,” said Rishi. “Is everyone on strike?”

Blair visibly bristled. “No. It’s 2010 and the place is empty because a Labour government has ensured there are sufficient staff to tend to patients quickly with the result that waiting times are minimal.”

This time it was Rishi’s turn to bristle: “Your spending plans crashed the economy,” he snapped.

“Remind me again,” retorted Blair, “how high is the public debt to GDP ratio now compared to 2010? How weak is the pound? And what about…”

Before Blair could finish the sentence, Rishi cut him off.  “What about Iraq?” he yelled.

“Brexit,” responded Blair.

Before he had a chance to think of a clever retort, Rishi found himself sitting up in bed. Had he merely dreamed his weird encounter? Whatever was in that whisky, it wasn’t good. Rishi lay awake in his bed, too pumped to sleep, when his thoughts were interrupted by a tap-tap-tap on the window. “If that’s Blair, I will push him off the windowsill,” said Rishi to himself. Flinging back the curtain, expecting to see Blair’s grinning visage, Rishi was astonished to be greeted by the sight of Liz Truss.

“Don’t tell me you’re the ghost of Christmas present,” said Rishi shakily.

“I am indeed,” replied Truss. “I’m here to show you the power of free market economics and the Britain that I created during my term in office.”

Rishi was bemused: “But you were only in the job for 44 days. How much could you actually do in that time?”

“Clearly you are not a believer in Trussonomics. Come with me to a Citizens Advice Bureau to see how the people gratefully acknowledge the power of markets to set them free,” she replied.

“Maybe not a great move, Liz,” said Rishi. “Got any other venues in mind?”

“How about any Conservative Party branch in the country?” said Truss, hopefully.

“Maybe not a great choice either given what you did to the brand,” he muttered sarcastically.

“A group of hedge fund managers, then?” She was beginning to sound desperate.

“Why would I want to mix with those peasants?” said Rishi, loftily.

“Oh, come on Rishi. You’re not exactly entering into the spirit of this exercise, if you’ll pardon the pun,” wailed Truss.

“Well, the truth is, Liz, that my life is so much more miserable thanks to your misguided tax-cutting plan.” Rishi was shouting now.

“But that was all Kwasi’s idea.” She seemed on the verge of tears.

“I don’t care. Go away and leave me alone.” He was definitely shouting.

“There are many worse ghosts than me you know,” pouted Truss.

“I really don’t see how. Anyway, I don’t believe in ghosts and I certainly don’t believe in you. I’m going back to bed.” With that Rishi slammed the window shut and realising that he was in some sort of bizarre Dickensian plot sat down to await the ghost of Christmas future, musing that it was better than waiting for the Four Horsemen of the Apocalypse. At this point in the story, you are probably expecting Keir Starmer to tap on the window and show Rishi how bleak and miserable the future will be unless he changes course. But Starmer never showed up, which frankly is a blessing. After all, we will soon enough see what it will bring. 

Merry Christmas to you and yours.

The DSGE paradigm: Do Stop Generating Errors

From RBC to DSGE

The recent passing of Ed Prescott, the 2004 Nobel Laureate in economics, was a cause for sadness across the economics profession. Prescott was universally recognised as a revolutionary thinker in the field of macroeconomics and one of his great innovations (along with fellow Laureate Finn Kydland) was the introduction of so-called Real Business Cycle (RBC) models. In simple terms, these models postulate that business cycle fluctuations arise as a result of labour supply decisions in response to stochastic shocks. One of the consequences of this paradigm is that business cycles are optimal responses to productivity shocks and that interventions to offset such shocks are harmful because they cause the economy to deviate from its long-run optimal path.

The first attempt to produce an economic model based on these principles was Prescott’s 1986 paper ‘Theory Ahead of Business Cycle Measurement’ which was very much based on calibrated responses rather than one which used statistical techniques to fit the data. It was also a model which assumed a world in which there were no distortions. Unsurprisingly, Keynesian economists did not take the RBC conclusions lying down. They argued that the economy was characterised by frictions such as nominal rigidities, the existence of monopoly power and information asymmetries which can result in involuntary unemployment, thus opening up a role for governments to smooth the cycle. In response, the so-called New Keynesians devised a model paradigm which required the imposition of a number of restrictive assumptions in order to approximate the world as they saw it.

Thus did the literature on New Keynesian Dynamic Stochastic General Equilibrium (DSGE) models come into being: Dynamic because they operate over very long (infinite) horizons; Stochastic because they deal with random shocks and General Equilibrium because they are built up from microfoundations. Such models now dominate much of the academic thinking in the modelling and policy literature. But they are mathematically complex, opaque and founded on a series of assumptions that calls into question whether they have anything useful to contribute to the future of macroeconomics[1].

What’s not to like? Quite a lot as it happens!

In the words of Olivier Blanchard, “there are many reasons to dislike current DSGE models” particularly because of the apparently arbitrary nature of the assumptions on which they are based. For example, aggregate demand is based on infinitely lived households which are assumed to have perfect foresight. Show me one of those and I will give you some hen’s teeth. Furthermore, the inflation equation is based on a forward looking equation that does not take any account of inflation persistence. But perhaps the most contestable features of DGSE models is their slavish adherence to microfoundations. These attempt to embed economic behaviour patterns that are invariant to a particular state of the world. This allows macroeconomics to escape from the charge posed by the Lucas critique that the parameters of any model change as circumstances change – a criticism of the models in operation in the 1970s, and which was perceived to be one of the reasons why they performed so badly in predicting the recessions of the time.

There is a lot wrong with this way of thinking. For one thing, the microfoundations are based on the behaviour of representative agents. In other words, they impose a theory of how individual firms and households act and assume that we can scale this up to the wider economy. As one who grew up using models based on aggregate data, it has always struck me as odd that we should discard much of the richness inherent in the observational evidence of macro data. An interesting theoretical paper published in 2020 makes the more subtle point that for the representative agent to mimic the preference structure of the population requires the imposition of extreme restrictions on the utility function used to describe household behaviour. The supreme irony of this is that the DSGE revolution was able to capture the intellectual high ground because the structural modelling paradigm that it replaced was unable to counter the criticism levelled in Chris Sims’s classic 1980 paper that such models relied on “incredible” identifying assumptions.

A further thought is that we have little evidence that the utility functions of representative agents are invariant over time, as modern macro theory assumes. But whilst there is no doubt that the research underpinning the macro revolution in the late-1970s and early-1980s – including the influential work of Lucas – is intellectually persuasive, the evidence of this year alone, in which inflation spiked to 40-year highs unforeseen by most models in 2021, does not persuade me that the DSGE revolution has significantly enhanced the thinking in modern macro.

By this point you have probably gathered that I am highly sceptical of much of the work conducted in modern macro modelling in the last 40 or so years. This is not to deny that it is intellectually fascinating and I am more than happy to play around with DSGE models. But as Anton Korinek points out in this fascinating essay, “DSGE models aim to quantitatively describe the macroeconomy in an engineering-like fashion.” They fall victim to the “mathiness” in economics, of which Paul Romer was so scathing.

And their forecasting performance is poor

We might be more accepting of the DSGE paradigm if it produced significantly better forecasting results than what went before. The events of the past 15 years suggest that this is far from the case and it is now generally acknowledged that the out-of-sample forecasting performance of DSGE models is very poor. If this does not render them useless as a forecasting tool, it suggests that they are no better than the structural models which the academic community has spent forty years trying to knock down. Proponents will argue that this is not what they are designed to do. Rather they are designed to understand how the economy is constructed around the deep-seated parameters underpinning household and corporate decision-making which allows for policy evaluation.

This debate was brought into sharp focus recently following the publication of a fascinating paper on the properties of DSGE models which is less concerned about whether they represent good economics but whether they represent good models in a statistical sense. The answer, according to the authors, is that they do not. The paper can get quite dense in places but one of the things it does is to examine how well it can fit nonsense data. By randomly swapping the series around and feeding them into the DSGE model, “much of the time we get a model which predicts the [nonsense] data better than the model predicts the [actual] data.” They draw the damning conclusion that “even if one disdains forecasting as an end in itself, it is hard to see how this is at all compatible with a model capturing something – anything – essential about the structure of the economy.”

Last word

As one who for many years has used models for forecasting purposes that have been sniffily dismissed by the academic community, it is hard to avoid a sense of schadenfreude. Blanchard offers us a way out of this impasse, arguing that theoretical models of the economy have a role to play in “clarifying theoretical issues within a general equilibrium setting ... In short, [they] should facilitate the debate among macro theorists.” By contrast, policy models of the type with which I am most comfortable, “should fit the main characteristics of the data” and be used for forecasting and policy analysis. 

There is some merit in this argument. By all means continue to tinker with DSGE models to see what kinds of insight they can generate but do not let them anywhere near the real world until their forecast performance substantially improves. In the words of statistician George Box, “all models are wrong but some are useful”. And some are DSGE models.

---

[1] For an excellent introduction to many of the issues in modern macro, check out this free online textbook ‘Advanced Macroeconomics: An Easy Guide’ By Filipe Campante, Federico Sturzenegger and Andrés Velasco