The case for normative economics

The epithet dismal science is often used to dismiss economics and its practitioners. This is unfair in many respects. Those who think economics is dismal are advised to have a look at Kilkenomics, the world’s first economics and comedy festival which celebrated its tenth anniversary in 2019. As for whether it’s a science, the jury is still out.

If we define science as what Ernest Nagel called the search for “repeatable patterns of dependence”, (here, p4) then economics could indeed be classed as a science. But if we define it as a reliance on experimental method, Robert Heilbroner suggests that this “throws into limbo certain central ideas of economics, such as value or utility, for which no experiments seem to be possible”.  Since Heilbroner wrote these words almost 50 years ago, there has been a considerable amount of progress in experimentally testing some of these central economic hypotheses, thanks to the work of people like Daniel Kahneman, who has applied psychological techniques to key economic concepts. But still the debate rages.

The moral dimension

I raise this question because it throws up an important issue: that of value judgement in economics. A discipline which pursues the cold hard logic of the physical sciences has no room to make moral judgements. But one of the pioneers in the field of economics was Adam Smith, who in 1759 wrote a book titled The Theory of Moral Sentiments. As titles go, that is as far away from value free economics as you can imagine. More importantly, it provided the ethical, philosophical, psychological, and methodological underpinnings for Smith's later work such as The Wealth of Nations which is now regarded as the first great work in western economics.

Over time, economics moved away from its philosophical roots and by the 1930s, neoclassical economists argued that since the notions of utility and culture which underpin economics are difficult to measure, we should simply avoid them. Rational choice theory, pioneered by Lionel Robbins, postulated that individuals perform a cost-benefit analysis to determine whether to pursue a particular course of action – a way of thinking that quickly came to dominate mainstream thinking. However, rational choice theory could never explain why individuals undertake actions that appeared not to yield any direct benefit to them, such as charitable giving. But by the time economists began to understand that a whole range of cultural factors determined why individuals took a particular course of action, so entrenched was the culture of positivism that it became increasingly difficult to challenge the status quo.

Whilst economics has gone to great lengths to sidestep the moral issues which its analysis throws up, as Timothy Taylor put it “moral judgments aren’t willing to sidestep economics.” As he points out, economics starts to get into difficulties when it becomes subject to “mission creep”. At the heart of the problem is the reliance on the price mechanism to assign value to a particular activity. But this quickly falls down when valuing an activity which is deemed ethically dubious or where the price mechanism is simply not the appropriate tool.

I have often thought that this reliance represents a form of economic singularity – the point at which conventional laws break down. Indeed, my own reservations stem back to my undergraduate days when I was taught that the cost benefit analysis of health programmes was based upon the value of human capital defined on the basis of lifetime earnings. This never struck me as sensible. I later came to realise that the relevant metric is willingness to pay to avoid particular outcomes – a cost that could potentially become infinite in order to avoid the worst-case outcomes. It is precisely because of such calculations that I have been rather scathing over the years about the field of health economics which takes a very narrow cost-benefit approach to one of the most fundamental issues we face – the matter of life and death itself (in fairness, it has moved in the direction of willingness to pay analysis in recent years, thus mitigating part of my criticism).

Why this matters

The issue of ethics in economics is an important one. Policy cannot be framed without some reference to what society deems morally acceptable. It is simply not enough to adopt a positivist approach. In macro terms we can debate the righteousness of the guiding principles followed by the Reagan and Thatcher governments of the 1980s but they were at least coherent: They were designed to reduce the role of state interference in the lives of ordinary citizens and empower the individual. In other words, there was a normative element to the policy. As it happens, they focused on a very narrow set of criteria which boosted short-term material prosperity but failed to take account of the wider long-term costs (rising inequality and the hollowing out of the industrial base to name but two). Nonetheless, the ideas were so electorally popular that subsequent generations of politicians on the other side of the political divide (Clinton/Obama and Blair/Brown) did not try to reverse the tide and instead tried to marry it with the idea of promoting social justice.

In recent years neither the US nor UK policy agenda appear to have been guided by any form of coherent economic thinking. Starting in 2010, the British government adopted a positivist approach based around deficit reduction but this had significant adverse consequences for the less well-off members of society and played a big role in whipping up the discontent which ultimately led to the Brexit vote. The populist governments which emerged post-2016, notably those led by Trump and Johnson, do not appear to offer any coherent economic vision at all.

Trump’s economic policy was based around an America first philosophy which served only to trash the global rules-based order and lit the touchpaper for the disaster which has unfolded in Afghanistan in recent days. Even leaving this catastrophe aside, pursuing what amounts to an isolationist stance in an increasingly interconnected world makes little sense as an economic strategy. The Johnson government has followed a similar stance in that it has trashed the UK’s relationships with its erstwhile European partners. But the criticism most frequently levelled at the Johnson government is that its policies are opportunistic rather than aimed at a coherent set of normative goals. There are some elements of a moral economic policy – notably the promise to “level up” regional inequalities – but over the last year its actions have created an impression that it is out to secure the interests of its members rather than the electorate it is meant to serve. Moreover, in areas such as NHS reform and defence spending – both of which are driven by economic considerations – there is no sense of a coherent, principled approach.

All this gives economics a bad rap, partly because politicians tend to blur the lines between complex economic issues and simple budgetary concerns. Economic policy should concern itself with the wider implications of its actions rather than focusing merely on the monetary aspects. Whether or not people think of economics as a science matters less than the fact that it has roots which emerge from its philosophical traditions, and we would do well to remember that sometimes we have to think in terms of more than assigning monetary values to policy objectives. Adam Smith would undoubtedly have approved.

Faster, higher, costlier

Even as a big fan of athletics I must confess to ambivalence ahead of the Olympic Games, being unsure of the wisdom of them taking place when the vast majority of Japanese did not believe they should go ahead this year. In the event they provided a welcome distraction with a number of great track performances to whet the appetite (world record performances in the men’s and women’s 400m hurdles being particular highlights). Technologically, broadcasters met the challenge of delivering the games superbly. The BBC, for example, which usually sends large teams of reporters out to the host city, managed to cover the games from its studio in Salford (5865 miles or 9466km from Tokyo) and if they had not told us, we may not have been any the wiser.

The Olympic legacy: A big bill

Now that the Games are behind us, many of us will miss waking up to our daily fix of Olympics news. But as the Olympic juggernaut moves on to Paris in three years’ time, spare a thought for the good people of Tokyo who will be left with the costs of dealing with an event which comes with a considerable bill attached. According to Bent Flyvbjerg and his co-authors who have looked at all Olympic Games (winter and summer) since 1960, “at 156 percent in real terms, the Olympics have the highest average cost overrun of any type of mega-project. Moreover, cost overrun is found in all Games, without exception; for no other type of mega-project is this the case” (see chart below). The 1976 Olympics, held in Montreal, resulted in a cost overrun of 720% relative to budget and saddled the city with huge debts for the next 30 years. Not for nothing was the Olympic Stadium nicknamed "the Big Owe".

Tokyo is living down to these expectations. According to Victor Matheson and Andrew Zimbalist, “Tokyo was awarded the hosting rights in 2013 with a bid of $7.3 billion. Yet a government audit has shown the total cost to approach $30 billion.” Even allowing for a $1.3 billion defrayment contribution from the International Olympic Committee (IOC), that is a serious cost overrun. Matheson and Zimbalist reckon that around $3 billion of the cost overrun can be attributed to Covid-related expenditure.

In order to estimate the net financial position we need to take account of revenue where the pandemic has had a significant impact. Not that the host city ever gets a fair slice of any revenue, even in the good times, since the IOC creams off most of the TV revenue and gives only a small proportion back to the host (chart below). Consequently, the host bears most of the financial risk associated with staging the Games whilst the IOC generally gets most of the benefits (the same is true of World Cups, where FIFA takes the largest slice of the revenue). This time around matters were complicated by the enforced absence of spectators which resulted in around $800 million of lost ticket sales whilst it is estimated that Tokyo lost out on $2 billion of associated tourist revenue.

Adding together the Covid-related costs and revenues implies a hit to the bottom line of around $6 billion (almost as much as the event was scheduled to cost when the bid was first submitted in 2013). But even stripping out these special factors, the underlying cost of the Games is almost $23 billion – a 215% increase over the original budget. Incidentally, it is reported that had the Games been cancelled, the IOC would have had to refund $4 billion to its broadcast partners. Unless there are other penalty clauses in the agreement between the organising committee and the IOC, it would have been cheaper for Tokyo to refuse to hold the games than incur the Covid-related hit.

Reform of the process is clearly needed

Questions have been raised over the years as to whether the current model, in which a new host city is chosen every four years, is sustainable. The Tokyo experience has raised these questions to a new level, particularly with regard to the fiscal costs of supporting the economy in the wake of the pandemic, not to mention environmental concerns. This is not to deny that hosting an Olympics is a fun event – the 2012 Games in London will live long in the memory of those who experienced them. But cities are increasingly unwilling to bear the financial costs of acting as host. Boston, Budapest, Hamburg and Rome all withdrew their bids for the 2024 Games, leaving the field clear for Paris, whilst in an unprecedented action the 2028 event was awarded to Los Angeles without even making a call for other bidders.

History records that the LA Games in 1984 were the only one in modern times to make a profit. This was achieved because the organisers were able to leverage off existing infrastructure rather than create all the facilities anew which is where the problems lie. The cost problem is exacerbated by the fact that, to quote Matheson and Zimbalist, “a winning bid not only needs to show how the host will successfully manage the competition … but also how it will generate more amenities, more prestige, and more revenue to the IOC than any other competing bid, leading to an arms race where proposals are increasingly lavish and increasingly expensive.” But despite the claims made by all organising committees that the Olympics will act as a useful economic regeneration exercise, the reality is rather different. As Stephen Billings and Scott Holladay argued in a 2011 paper, “proponents argue that this investment will pay off through increased economic growth, but research confirming these claims is lacking.”

One of the selling points of the 2012 Games in London were the legacy aspects. Whether or not these have been delivered remains a point of contention even to this day. Similarly, investment for the 2016 event in Rio was justified on the basis of its impact on regenerating the local community. This has clearly not been delivered. Organising committees also like to highlight the tourism benefits and here, too, the evidence is mixed. Following the 1992 Olympics, Barcelona did rise from eleventh to the sixth most popular destination in Europe but London in 2012 received fewer tourists than expected as security concerns and expectations of overcrowding dissuaded a lot of potential visitors.

The evidence thus suggests that the direct benefits of hosting the Olympics are dubious at best and possibly non-existent. So why do countries want to put themselves through the ordeal? The one-word answer is simply “prestige.” However, democratic countries facing budgetary constraints may be less willing in future to step up to the plate but those with a less robust democratic tradition may be more willing to do so since fewer questions will be asked about the finances. In recognition of the fact that the field of potential bidders may narrow in future, the IOC has proposed to evaluate bids based on economic and environmental sustainability, which is a good start. Given the difficulties in judging costs and benefits ex ante, a more sensible idea may be for the IOC to choose a permanent site, thus lowering the long-term costs of holding the Games. In the event that this proves too controversial, it may consider a small number of sites based in cities (or regions) which already have a substantial amount of infrastructure in place, opening up the prospect of a rerun of London 2012 or Tokyo 2021 in the not-too-distant future.

As a sports fan who appreciates the significance of the Olympics and its impact in bringing people together, I am much in favour of continuing in the present vein. But they cannot be allowed to continue at any price. At a time when the world is acutely aware of environmental considerations there is a strong case for reining in the costs. It may be too late for the residents of Tokyo, but Parisians take note. It’s your turn next.

Finding a reverse gear

The Bank of England’s Monetary Policy Report is required reading for those interested in UK macro trends and today’s report was no exception. Listening to some of the media commentary ahead of the report’s release, people might have been forgiven for believing that monetary tightening was imminent. In reality, that was never the case although the BoE did provide some guidance on the sequencing as to how the easing of the policy throttle will occur.

The economic outlook supports lifting the foot off the gas

Turning first to the details, the BoE’s macro forecast suggested that UK GDP will grow by 7¼% in 2021 and 6% in 2022, and only slow to trend (1.5%) in 2023. One implication of this is that the level of output will get back to pre-recession levels by end-2021, which is a far sharper rebound than expected a year ago. As a result the output gap is expected to be almost eliminated this year and an excess demand position is anticipated in 2022 (i.e. a positive output gap). With inflation projected to hit 4% in Q4 2021/Q1 2022, questions have been raised as to whether the current exceptionally lax monetary stance is warranted.

One member of the MPC (Michael Saunders) voted to limit gilt purchases to £850bn (it currently stands at £825bn) rather than press on to the currently mandated upper limit of £875bn. Although the idea of calling a halt before reaching the current target is unlikely to make a great difference in the grand scheme of things, it would send a signal of intent that the BoE is prepared to scale back its asset purchases as circumstances dictate. Indeed, when the MPC announced an expansion of the upper limit for gilt purchases to £875bn in November 2020, inflation was expected to peak at 2.1% in late-2021/early-2022 whilst output was not expected to get back to pre-recession levels until early-2022 (i.e. one quarter later than in August).

As the MPC minutes pointed out, the MPC “had policy guidance in place specifying that it did not intend to tighten monetary policy at least until there was clear evidence that significant progress was being made in eliminating spare capacity and achieving the 2% inflation target sustainably.” Although “some members of the Committee judged that … the conditions were not yet met fully”, it is hard to know what more evidence they need to justify scaling back monetary easing with inflation running at twice the target rate and with the output gap set to close. It is important to stress at this point that I agree with those who believe it is perhaps too early to significantly tighten policy. But this is not to say there is a case for easing off the throttle. On the basis that the stock of assets purchased is more important for policy purposes than the flow of purchases, setting a lower limit for gilt purchases implies a very moderate reduction in the degree of planned monetary easing.

Dealing with tightening

The BoE did indicate that when the time for tightening comes, its preference is to use Bank Rate as the instrument of choice and suggested that “some modest tightening of monetary policy over the forecast period is likely to be necessary.” As the Resolution Foundation has pointed out, this has the advantage of being swift to implement and can swiftly be reversed if necessary. But the BoE also indicated that it “intends to begin to reduce the stock of purchased assets, by ceasing to reinvest maturing assets, when Bank Rate has risen to 0.5%.” This could lead to a swifter unwinding of the balance sheet than might be expected and would go a long way towards assuaging the concerns of those who believe the balance sheet is too big.

To illustrate the impact of this, we start by looking at the details of the debt stock currently held by the BoE (here). We can use this information set to determine the precise maturity date of gilts on the balance sheet and my calculations suggest that the median maturity of gilt holdings is just over eight years. Assuming that Bank Rate reaches 0.5% by end-2023 and does not fall back below this level, allowing all maturing debt to roll off will halve the balance sheet in money terms by 2034. Further assuming nominal GDP growth of around 4% per year in the longer term, gilt holdings would decline from around 40% of GDP in 2021 to 12% by 2034. The BoE may, of course, choose to reinvest a certain proportion of maturing debt, rather than letting it all run off, and the resultant stylised scenarios are shown in the chart below. It is notable that even if gilt holdings remained at £875bn over the longer-term, the GDP assumption used here would be sufficient to reduce the balance sheet relative to GDP back towards 2013 levels even in the absence of any direct action.

In addition, the Bank suggested that it would be prepared to consider selling off assets once Bank Rate reaches 1%, thus adopting an even faster rate of balance sheet reduction. In my view, for what it is worth, this may prove unnecessary given the sharp pace of reduction generated by ceasing reinvestment. It may also significantly complicate the government’s efforts to finance the deficit. After all, if the BoE is selling gilts into a market which is saturated by primary issuance, the upshot is likely to be a sharp rise in bond yields.

Whilst there clearly are some risks associated with a policy of running down the balance sheet, the BoE believes that “the impact on monetary conditions of a reduction in the stock of purchased assets, when conducted in a gradual and predictable manner and when markets are functioning normally, is likely to be smaller than that of asset purchases on average over the past.” In other words, running down the balance sheet gradually is likely to have only a modest impact on the economy. However, it is generally accepted that central bank balance sheets will not fall back to pre-2008 levels any time soon. For one thing, there has been an increase in demand for central bank reserves by the banking sector due to changes in regulation and banks’ risk management techniques which has resulted in increased demand for high quality liquid assets. For this reason, it is unlikely that the BoE will follow a policy of full disinvestment over the medium-term.

The likes of the now-departed Andy Haldane expressed concern that the BoE’s balance sheet was too big. Therefore reducing it over the medium-term is likely to diminish the criticism that the BoE is somehow engaged in deficit financing – a point Governor Andrew Bailey was keen to refute during today’s press conference. Nonetheless, balance sheet management is a policy tool which is here to stay. With downward pressure on equilibrium interest rates, as a result of population and productivity trends, the scope for using conventional interest rate policy is diminished and balance sheets will therefore remain a useful addition to the policy armoury. But just as increasing balance sheets proved to be controversial, so the process of running them down will likely prove to be a lot more difficult than currently imagined, as the 2013 US taper tantrum illustrated.