Life at the bottom in the 21st century

It says in The Bible that the poor are always with us. As the fallout from the bursting of the Great Debt Bubble continues to spread, we begin to realise just how many people in western societies are indeed poor. Obviously, we cannot compare poverty levels to those of Victorian Britain: There have been significant improvements in public sanitation, health and education which have lifted millions across the world out of the desperate poverty which prevailed at the end of the nineteenth century. It is treated today as a relative problem: Those earning less than 60% of the national median income are defined as “poor”. It seems, however, that there are a lot of them about.

There has long been a puritan streak in western societies which blames the poor themselves for their lot. You see this in large sections of the British press, which has for many years called for an end to state distributed largesse – a view which has percolated into the mainstream of the Conservative party. You see it in Germany, where the terms imposed on the Greek debt bailout were designed to bring the Greeks to their senses so that they would not fall from the path of fiscal righteousness in future.

Yet it is not always easy to determine where to draw the line between offering self-help and financial support, primarily because people find themselves struggling for different reasons. An alcoholic and a divorcee may face very similar financial problems but very different personal circumstances. Moreover, lack of money is not the only cause of poverty: Social exclusion is a powerful factor reinforcing the downward spiral. How often do we hear tales of people who lose their job and end up living on the street? (Answer: More often than we should in a developed economy).

There are those who argue that UK government policy, which has hacked away at the welfare bill in order to get public finances under control, threatens to exacerbate the UK’s poverty problem. This is not wholly without foundation but also not the whole truth. The Labour government of 1997-2010 did try to reform the welfare system to simultaneously get more people into work whilst providing support for the poorest in society. But by 2013, the UK was spending more on family benefits as a percentage of GDP than any other OECD nation. Moreover, the system was extremely complicated, relying heavily as it did on a series of tax credits and a variety of taper rates with welfare support progressively withdrawn as individuals entered paid employment.

There is general agreement that the system needed reform and the Conservative-Lib Dem coalition government of 2010-15 began the process.  Its centrepiece was a system called Universal Credit which was designed to replace a number of other benefits whilst also being less generous than the previous system. But although it was announced in 2010, it still has not been fully rolled out and as the Institute for Fiscal Studies has pointed out, “changes to its future design have been … apparently at chancellorial whim.” Furthermore, one of the government’s first policy actions in 2010 was to restrict access to Legal Aid – a state supported means of financing access to the legal system to those who would otherwise be unable to afford representation. Combined with rising legal costs, this has contributed to restricting access to the justice system (see here for a summary of the Bach Commission analysis).

A less generous welfare system, coupled with implementation delays and restricted access to the legal system means that voluntary organisations such as Citizen’s Advice have been overwhelmed, with the majority of their cases dealing with debt-related issues. CA reckons that one in every five pounds on disputed debt which they deal with is owed to government (here). Indeed, Council Tax arrears (a local tax) are now the most common source of personal debt. This is partly the result of national reductions in benefit payments but also local council cuts in discounts offered to vulnerable groups and reliefs to low-income residents, which in turn is the result of funding cuts by central government.

Moreover, CA “found evidence of poor practice, including a lack of consideration given to whether people can afford repayments and people forced to pay a debt when it is under dispute.” Whilst government would doubtless argue that the debts they are trying to reclaim (such as Council Tax) are classed as priority debt that can result in serious legal action if not settled, the net result is to push people further into debt. It is hard to avoid the conclusion that the system is creaking at the seams.

It is no wonder that anger is rising amongst the so-called just-about-managing (JAM) households. A policy of getting benefit dependent households back into work, as the government desires, is laudable. But what sorts of jobs are available for them? Globalisation has wiped out the decently paid jobs for low-skilled workers, many of whom feel that work does not pay. At the same time, benefits are being squeezed.

Whilst from a macro perspective the policy is being conducted for the right reasons, it is also leading to a series of unintended consequences. As one case worker said to me, “it’s as if the government does not really understand the magnitude of the problems which the JAMs face.” That being the case, failure to get to grips with the social consequences of fiscal austerity measures could have far more profound political effects than the Brexit decision. And the fact that this problem is being repeated to a greater or lesser degree in many other industrialised countries is a matter of great concern.

More than just the leaves aflutter

In the course of the last week, the new Chancellor Philip Hammond presented his Autumn Statement to parliament. As a general rule, this interim report on the state of UK public finances is only of interest to those of us who have an interest in fiscal policy issues. But this year, there was a lot more interest as it provided us with the first view of how the Office for Budget Responsibility –the fiscal watchdog – assessed the cost of Brexit, and what sort of fiscal response the government was able to provide.

The main takeaways were that the economy will grow more slowly than projected in March, when the exercise was last conducted, and that both public deficits and debt will be higher in the medium-term. Moreover, the government has amended its fiscal rules such that it must no longer achieve a budget surplus in three years’ time, and it will be content with a falling debt-to-GDP ratio over this horizon. The Institute for Fiscal Studies always provides a sober analysis of UK fiscal issues (here) and for a short overview of their take, Director Paul Johnson’s introductory remarks nail most of the issues (here). The only area where I would disagree with the IFS is that the additional capital spending goes nowhere near far enough to tackle the infrastructure spending deficit which has been building for a number of years.

My own forecasts, which you can find in the Treasury’s compendium of economic forecasts (here) have long suggested that official medium-term projections for public finance consolidation have been overly optimistic. For one thing, I have generally come up with slightly slower revenue projections than the OBR but more importantly, I have never been convinced that the government would be able to hold to its eye-wateringly tight spending assumptions. Two years ago, George Osborne’s plans implied that the share of public spending in the economy would fall to its lowest since the 1930s – he quickly dropped that pledge as the 2015 election loomed.

Even though current plans do not appear anywhere near as aggressive, they still imply a considerable amount of fiscal austerity. Whilst spending on the National Health Service is ring-fenced (health is protected from the budgetary cuts which hit other departments) this shifts the burden of spending cuts onto other areas. Moreover, an ageing population is putting strains on the health budget which the current fiscal plans do not address.  So the quality of its service will deteriorate without additional resources.

One of the great ironies of fiscal policy over the past six years has been the extent to which it has hit hardest those at the lower end of the income scale, since policy has focused on cutting the welfare budget which has resulted in major curbs on welfare entitlement. Yet much of the evidence suggests that the poorest households were much more likely to have voted for Brexit than those higher up the income scale. Anger at the squeeze on incomes is derived more from government policy than from the impact of EU migrants pushing down earnings (in much the same way that high immigration was the result of policy failures to curb non-EU migrant numbers, which still account for more than 50% of the total). 

Predictably, of course, pro-Brexit MPs were quick to denigrate the fiscal outline presented this week, particularly since the OBR attributes roughly half the deterioration in public finance forecasts since March to the decision to leave the EU. Iain Duncan Smith, said it was "another utter doom and gloom scenario" by an organisation that “has been wrong in every single forecast they've made so far." The walking cliché that is Jacob Rees-Mogg argued it has made "lunatic" assumptions and added that "experts, soothsayers, astrologers are all in much the same category." Ironically, as the FT pointed out yesterday (here), one of the Chancellor’s measures to provide support to a particular stately home directly benefits the Rees-Mogg family as it is the ancestral home of Jacob’s mother-in-law. So perhaps we could restore a little order to the public finances by removing that “lunatic” gesture?

More generally, I am beginning to find the Brexit brigade rather more than tiresome. Their tactic is to denigrate those who dare question whether Brexit is such a good idea. There will be longer-term economic consequences – we should have little doubt about that. And since when in a democracy has debate about the merit of an idea stopped just because we held a vote on it? As former PM John Major noted recently, the referendum result was a close call and “the tyranny of the majority has never applied in a democracy and it should not apply in this particular democracy.” He should know: Major had to suffer continued sniping from those he called the “cabinet bastards” (his “only excuse is that it was true”)

In my view, a tight fiscal policy helped stir up resentment at the status quo which morphed into the Brexit vote. Boris Johnson’s policy may be to have cake and eat it too, but that is not how economics works in the real world. Get used to it!

Modern macroeconomics: Is it really so bad?

I have to confess that I have long been torn between the intellectual pursuit of academic economics and the uselessness of much of the output. Part of the appeal of economic theory is that it attempts to address problems in a rigorous manner. Of course, that is also its Achilles Heel: the intellectual underpinnings of much that passes for current state of the art thinking are simply bogus. For that reason papers such as the one by Paul Romer, chief economist at the World Bank, entitled ‘The Trouble with Macroeconomics’ (here), always strike a chord. In many ways, this is a subversive read for macro economists and makes a number of serious, but in my view substantiated, allegations regarding the state of economics today.

Romer’s key thesis is that the “identification problem” in economics has essentially taken us round in a circle back to where we started in the 1970s. I hope readers will forgive a little digression at this point so that we can more easily understand the nature of the problem which Romer sets out. The identification problem requires, as Chris Sims noted in a famous 1980 paper, that we must be able to identify “observationally distinct patterns of behaviour” for a given model. This is both a philosophical and empirical argument. Philosophically, it requires us to specify very carefully how our economic system works. In an empirical sense, it means we must construct models in which unique values for each of the model parameters can be derived from other variables in the system. This in turn allows us to clearly identify how economic linkages operate.

As it happens most empirical macro models in use in 1980 were over-identified: It was possible to explain each variable in the model by various different combinations of other variables. Consequently, we were unable to determine precisely how the macroeconomy worked. In his 1980 paper entitled ‘Macroeconomics and Reality’ (a title which, when I first read the paper, seemed to be most inappropriate) Sims noted that such models could only be made to work by applying “incredible” identifying restrictions.

This identification problem is the key to understanding Romer’s critique of much modern macroeconomic theory. In his view, by trying to get away from imposing such “incredible” restrictions, macroeconomists have ended up devising models which themselves are increasingly divorced from reality. Romer starts by taking direct aim at Real Business Cycle (RBC) models which were a direct response to many of the criticisms of the over-identified macro models of the 1970s. He argues that they make a hugely simplifying assumption that cyclical fluctuations in output are solely the result of shocks. The question Romer poses is "what are these imaginary shocks?" Is there really no role for monetary policy, as much of thinking in this field suggests? If that is true, we should all pack up and go home – and the Fed, ECB, BoE et al should abandon attempts to stabilise the economic cycle.

He then aims his blunderbuss at the DSGE models which followed from this, arguing in effect that they are a post-truth way of looking at the world because they rely less on data and more on a series of assumptions about how the world works. (I posted on this topic here). Indeed, such is Romer’s apparent contempt for some of this analysis that he states “the noncommittal relationship with the truth revealed by these methodological evasions [and] dismissal of fact goes so far beyond post-modern irony that it deserves its own label. I suggest ‘post-real’.”

Even worse, in his view, is that many of the proponents of modern macroeconomics have tended to band together and reinforced each other’s views rather than challenging them. This unwillingness to challenge belief systems has, in Romer’s opinion, promoted a stagnant culture which has slowed the advancement of new ideas in economics.

Faced with such a nihilistic view of economics, you may wonder what is the point of it all? I share Romer’s criticisms of many of the ideas which have found their way into the economic mainstream. But I also adhere to the George Box school of thought that whilst all models are wrong, some are useful. There is thus nothing inherently wrong with the idea of going in the direction of RBC or DSGE models – it is just that they have captured the high intellectual ground and have proven difficult to shift. And like it or not, many of the competing theories have not proven up to scratch either.

What is also interesting is that whilst many economists passionately advocate a particular school of thought, few people of my acquaintance argue in public in such terms. So either this debate is a particularly American academic thing or it is confined to those pushing hard to get their material into the journals (and failing). And finally, I have long argued that the financial crisis will act as an efficient way of winnowing out many of the worst ideas in macroeconomics. Just as the Great Depression of the 1930s produced the ideas of Keynes and his acolytes, so the current crisis in the western word may yet lead to a more fruitful approach to many economic issues. So chin up, Mr Romer. The darkest hour comes just before dawn.

Brexit: A Bayesian view

The Reverend Thomas Bayes was an English clergyman who lived in the first half of the eighteen century, and who also happened to be a mathematician. He gave his name to a branch of statistics which has emerged from relative obscurity in recent years, and which helps better understand the world around us. The insight of Bayesian statistics is that it characterises probability as uncertainty, which represents a belief about a particular outcome. The only real thing is the data and as a result some outcomes are more believable than others based on the data and their prior beliefs. 

So-called classical statistics, which is most people’s introduction to the subject, relies on the insight that probability represents a fixed long-run relative frequency in which the likelihood of an event emerges as a ratio from an infinitely large sample size. In other words, the more observations we have, the more likely it is that the most frequently observed outcome represents the true mean of a given distribution.

To illustrate how these two schools of thought differ, consider the case of horse racing. Two horses – let’s call them True Blue and Knackers Yard – have raced against each other 15 times. True Blue has beaten Knackers Yard on 9 occasions. A classical statistician would thus assign a probability of 60% to the likelihood that True Blue wins (9/15), implying a 40% chance that Knackers Yard will win. But we have additional information that on 5 of the 7 occasions when Knackers Yard has won, the weather has been wet whilst True Blue won two wet races. The question of interest here is what are the odds that Knackers Yard will win knowing that the weather ahead of the sixteenth race is wet? To do this, we can combine two pieces of information: the head-to-head performance of the two horses, and their performance dependent on weather conditions.

In order to do this, we make use of Bayes Theorem which is written thus:

P(A | B) = P(B | A). P(A)  

                P(B)

P(A|B) is the likelihood that event A occurs conditional on event B. In this case, we want to know the probability that Knackers Yard wins conditional on the fact it is raining. P(B|A) is the probability of the evidence turning up, given the outcome. In this case, we want to know the likelihood that it is raining given that Knackers Yard wins. Since there were 7 rainy days in total and Knackers Yard won on five occasions, the answer is 5/7 or 83.3%. P(A) is the prior probability that the event occurs given no additional evidence. In this case, the probability that Knackers Yard wins is 40% (it has won 6 out of 15 races). P(B) is the probability of the evidence arising, without regard for the outcome – in this case, the probability of rain irrespective of which horse won. Since we know there were 7 rainy days out of 15 races, P(B)=7/15 = 46.7%. Plugging all this information into the formula, we can calculate that P(A|B)=71.4%.

Now all this might appear to be a bit geeky but it is an interesting way to look at the problem of how the UK economy is likely to perform given that Brexit happens. Our variable of interest is thus P(A|B): the UK’s economic growth performance conditional on Brexit; P(B) is the likelihood of Brexit and assuming (as the government seems to suggest) that it is set in stone, we set it to a value of 1. Moreover, assuming that Brexit will happen regardless of the economic cost (i.e. ministers are not overly concerned about accepting a hard Brexit) then P(B|A) is also close to unity.

In effect, the Bayesian statistician might suggest that P(Growth│Brexit)=P(Growth). Since the only concrete information we have on economic performance is past performance, it is easy to make the case from a Bayesian perspective that the UK's future growth prospects can be extrapolated from past evidence. Those pro-Brexiteers who say that UK’s post-Brexit performance will not be damaged by leaving the UK may unwittingly have statistical theory on their side. But one of the key insights of Bayesian statistics is that we change our prior beliefs as new information becomes available. If growth slows over the next year or so, then other things being equal, it would be rational to reduce our assessment of post-Brexit growth prospects.

Incidentally, a joke doing the rounds of the statistics community at present suggests that although Bayes first published the theorem which bears his name, it was the French mathematician Laplace who developed the mathematics underpinning this branch of statistics. As a result, Brexit may present a good opportunity to give due credit to the Frenchman by naming it Laplacian statistics. It’s enough to make arch-Bayesian Nigel Farage choke on his croissant.

Boiled frogs and QE

For a long time central bankers told us that quantitative easing was the best thing since sliced bread. It would, so the conventional wisdom went, allow for a potentially limitless expansion of the central bank balance sheet which would flood the economy with liquidity and, at some point, eventually result in a recovery in demand.

Those who have been reading my material over the years will know that I have never been fully convinced of the merits of QE. Back in 2009, I pointed out that using QE to stimulate domestic recovery would be hampered by the weakness of the banking sector. I also suggested that “it is unclear whether a policy which acts to improve credit supply will help to stimulate activity when demand for credit remains limited.” In response to such criticisms, the BoE later held an impromptu session to explain to financial sector economists that the main channel through which QE worked was via the wealth effect. In this way, BoE purchases would drive down yields and force bond holders to switch into other assets. This in turn would boost household wealth and help support an economic upturn. In fairness, the BoE was correct in its assessment that investors would be forced to switch into higher yielding assets – the problem was (and is) that it is financial investors who have benefited rather than households.

It is this kind of thinking which has prompted much of the recent criticism of central bank policy, particularly by politicians. But as BoE Governor Carney noted yesterday in parliamentary testimony “an excessive focus on monetary policy in many respects is a massive blame deflection exercise.” He is certainly right on that, as those of us who believe there is an expanded role for fiscal policy in the current conjuncture would attest. However, the BoE should not be allowed to get off scot-free. Some five years ago I recall having a conversation with one BoE official who, in response to my question of why QE should be expanded given that its marginal impact had cleared waned, replied in effect that “more QE does no harm, so it cannot hurt to do too much rather than too little.”

Being charitable, I guess that no policymakers thought that monetary policy would have to remain in post-crisis expansionary mode as long as it subsequently has done. And it probably seemed reasonable to central bankers in 2011 that a further dose of bond purchases would probably not do much harm. After all, there were not that many suggestions at the time that QE was overly harmful. However, I did point out as long ago as 2009 that “the impact of quantitative easing in lowering bond yields will pose real problems for pension funds.” We might have been able to wear that for a year or two, but few if any would have expected that both the BoE and ECB would still be buying assets in 2016 which in part suggests that it is the duration of the monetary easing phase, rather than the easing per se, which is the problem. Indeed, as Carney’s quote suggests, it is the government’s failure to step in to provide additional policy support which has thrown the onus onto central banks.

One of the great ironies of QE is that rather than making life easier for the banking system by providing it with a huge liquidity injection, things have got a lot tougher. Action to cut short rates to zero, or into negative territory, has increased the cost to banks of holding excess reserves whilst the QE policy has flattened the yield curve, which in turn has reduced the spread which banks need in order to make money. In many ways, the side effects of QE are akin to the frog-boiling syndrome. If you put a frog in a pan of boiling water it will immediately jump out, but if you put it in a pan of cold water and gradually turn up the heat, it will not realise that it is being boiled alive. Banks in particular are now waking up to the prospect of being boiled alive, and the ECB may even turn up the heat still further if it announces an extension of its QE programme in December.

Some respite may be afforded by the recent Trump-induced rise in bond yields, which if sustained could alleviate some of the margin pressure. But we are all now increasingly alert to the dangers of relying on more QE. This is not to say that it should necessarily be reversed but without more thought to the mix between monetary and fiscal policy, electorates in other countries might be tempted to follow the example set by the US and UK, and jump right out of the pan.