The state of macreconomics: A practitioners view

The academic blogosphere is currently abuzz with posts about the state of macroeconomics in the wake of an article by former IMF chief economist Olivier Blanchard on dynamic stochastic general equilibrium (DSGE) models. Blanchard's post, which is well worth reading for anyone interested in a non-technical overview of the models used in cutting edge academic research, highlights that these models are "seriously flawed, but they are eminently improvable and central to the future of macroeconomics."

As Blanchard notes, DSGE models are based on microfoundations, and essentially model the behaviour of various representative optimising agents (firms, households, central banks) whilst making a number of unrealistic assumptions. These are not just simplifying assumptions – they are probably downright wrong. One such example is the assumption of pricing behaviour assumed in such models which is designed to handle nominal rigidities. This so-called Calvo pricing assumption  is elegant but is not observed in the real world, thus rendering it somewhat useless. Blanchard goes on to point out that such models are mathematically dense, and thus are impenetrable even to many economists. As he put it, they are bad communications devices. My major criticism of such models, and one echoed by Blanchard, is that they are designed to fit the theory rather than the data with the result that they are empirically unsound. This probably reflects the way I was taught to do econometrics, but there is a quaint old fashioned notion that models should be congruent with the data.

Paul Krugman argues very strongly that Blanchard is too kind on such models and that far from offering scope for improvement, they have led us up an intellectual cul-de-sac. In his view they have contributed no insight into the workings of the economy and that old-fashioned ISLM models offered more useful predictions in the wake of the financial crisis than did DSGE analysis.

Others, such as the always readable Simon Wren-Lewis are less trenchant in their view but still critical. As SWL put it "DSGE completely dominates academic macroeconomics, and there is no way that all these academics are going to suddenly decide this research programme is a waste of time ... What is at issue is not the existence of DSGE models, but their hegemony." He has long argued that journal editors have routinely turned away good papers on the grounds that they do not offer a microfounded or general equilibrium approach and he offers the hope that "criticism from one of the best macroeconomists in the world might" prompt them to change their view.

Now I am no academic but I have spent enough time building and running economic models to know when a modelling paradigm is going broadly in the right direction. And I am pretty sure that DSGE is not the way for someone like me to go. My job is to understand how the economy fits together, and we know that there are structural changes over time which means that things that once worked no longer do. Estimating structural models allows us to do that, in order to see whether econometric relationships which once held continue to do so. The models I use are structural forecasting models, which would not have looked out of place 20 years ago, and many academic economists dismiss them out of hand. For one thing, they often struggle to model expectations in a way which satisfies academic thinking (though I am quite happy to pretend that the rational expectations revolution never happened). In addition, they are not identified (i.e. it is impossible to derive a specification for each individual variable in the equation which gives a unique specification in terms of others in the system) and the economic theory underpinning such models is often ad hoc.

To a degree, these criticisms are all valid. But these models have not been usurped by a superior paradigm, and certainly not by DSGE. I thus have a lot of sympathy with Krugman's view that macroeconomics has taken a wrong turning. DSGE models do not help most economists to understand how the world really works, and they certainly do not help to inform the general public. They are highly sophisticated mathematical tools which explain the world as many economists think it should be, rather than as it really is. DSGE models were a brave attempt to try and move the economic debate forward but they have failed. If economics wants to be more relevant to the wider policy debate, we need to find better ways of understanding how the world works, but as Wren-Lewis notes, too much intellectual capital has been sunken into the field to hope that it will go away quickly.

However, perhaps macroeconomics is ready for a Popper-style paradigm shift in which empirical falsification will prompt another generation of economists to push the field in a new direction and get us out of the rut into which we appear to have sunk. We could certainly do with a bit more public credibility and in that sense DSGE models are clearly not the way to go.

Project Stupidity kicks in

As a general rule I am not given to reading newspaper editorials, preferring to form my own biases rather than imbibing those of others. But this one from the Daily Telegraph is so extraordinary that it simply cannot be allowed to pass without comment. It is entitled "Don't blame Brexit for this rate cut. Blame Project Fear" and argues that the Bank of England is responding to irrational fears by easing monetary policy. As it happens, I am not sure that bold monetary easing is necessarily the right response to a shock of this nature although it is easy to understand why the MPC acted as it did. But when the Telegraph goes on to say that the economic problems facing the UK in the wake of the Brexit referendum are "due to the pessimism of the previous government, the Labour Party, Barack Obama, global institutions, sections of the media and, of course, the Bank [of England] itself" the only sound I hear is the rattling of loose screws.

I'm not sure whether the Telegraph is in the habit of allowing inexperienced teenagers to dictate their editorial policy, but it seems that Project Stupidity is taking over from Project Fear as the dominant feature of the post Brexit debate. I would certainly suggest to anyone working for me, who tried to pass off such a work of fiction as a piece of analysis, that they might want to seek alternative employment. It is risible, and shame on the Telegraph for allowing this to be published in a newspaper which is read around the world. 

Such abrogation of responsibility will not be allowed to stand. Those responsible for promoting the case for Brexit without giving a clear vision of the economic consequences will continue to be held to account. And the Telegraph gave plenty of column inches to such parties, notably Boris Johnson. Not everyone writing for this newspaper takes such a blinkered view, however. Ben Wright took a much more pragmatic view, arguing in a very sensible article that whilst the deed is done, the "grumpy Remainers" perform a necessary service by acting as a check on the worst instincts of the gung-ho leavers.

But before we all get carried away with the impact that Brexit will have on the economy, let us remember that we have no real idea at this stage, thus rendering the efforts of those who wish to get their retaliation in first rather futile. The NIESR has suggested that GDP contracted in July, but its estimate is based on nowcasting techniques rather than hard data, so we should be wary of extrapolating too much from that. Data later this week on retail sales will give us a firmer view of how consumers acted last month. The survey evidence is mixed: British Retail Consortium data suggested a decent rate of expansion in July although the CBI's Distributive Trades Survey pointed to a weaker outturn. However, the forecast consensus is that spending held up.

Whatever happens in the next few months, it is likely that the real damage will occur only over the medium term. It is only then that we will see the full impact of the cancellation of an investment project here or a factory closure there. And by reducing immigration flows, the UK will also limit the contribution to potential GDP growth from labour. This may not be noticeable immediately but if the economy grows by, say, 0.25% more slowly per year this adds up to an income loss of 2.5% over 10 years, 5% over 20 years etc. Had this performance been repeated over the last 43 years – coinciding with the period of EU membership – the economy would be around 10% smaller than otherwise (and that does not account for any second round effects which would likely raise the potential losses).

I have made it clear all along that I believe the UK will be poorer by being outside the EU, although I never signed up to the worst predictions of George Osborne that it would lead to imminent collapse. But I have also pointed out that many of Britain's economic problems are home made and are not all the result of international issues, as the Telegraph editorial suggests. The Brexiteers have long made the claim that building better relations with the rest of the world will help the economy to make up for the shortfall in loss of trade with the EU. Undoubtedly some of them will be frothing at the mouth in the wake of the suspension of the Hinkley Point deal which threatens the flow of Chinese investment. But it just goes to show that the UK is not the attractive investment location it is cracked up to be if foreign capital can only be lured with deals which are inimical to the interests of British taxpayers. So the challenge to Brexiteers remains: Convince us you have an economic plan. I have been listening for months and all I hear is the sound of silence. And don't blame any economic downturn on Project Fear. This is down to you, and the lies which were spun during the referendum campaign. And I for one will continue to hold you to account.

The nuclear option

The recent decision by the new British prime minister to put the decision to build a nuclear power station at Hinkley Point on hold highlights a number of weaknesses in key areas of British policy. The fact that the Cameron administration wanted to go ahead with it at all, on the basis of the cost structure put forward, was bad enough. But this was compounded by Mrs May’s decision to freeze the project just after the EDF had agreed to go ahead with the deal. To compound this triumph of diplomacy, Mrs May’s government managed to annoy Chinese investors by citing security concerns arising from Chinese involvement in such a sensitive infrastructure project. And this in the wake of a Brexit referendum which will leave the UK ever more dependent on non-EU investment. You almost could not make it up. 

To put this deal into context, the UK has agreed to phase out all coal-fired power stations by 2025. That is all well and good, except for the fact that we will need to make up the shortfall by generation from other sources. According to DECC, last year the UK produced 22.6% of its energy from coal so in simple terms the UK will phase out almost a quarter of its generation capacity within a decade. No wonder the government was desperate to bring Hinkley Point online. But in their haste to do a deal, the Cameron government realised that it would be virtually impossible to assemble a UK team to do the job in the decade or so that it would take, and turned to EDF – which is 85% owned by the French government – to do the job for them.

In order to sweeten the deal, the government offered a guaranteed fixed price of £92.50/MWh (2012 prices) which will be adjusted for inflation over the 35 years of the contract. The difference between this strike price and the market price will be made up by the UK taxpayer. Earlier this year, the National Audit Office calculated that with the price of electricity having fallen to £45/MWh since the deal was agreed in 2013, this would raise the cost to the taxpayer from an original estimate of £6.1bn to £29.7bn. As far as EDF is concerned, this would generate a double-digit return on equity (estimates vary from 13% to 20%), which in essence makes this a project largely funded by the UK taxpayer  to support a French state owned enterprise. So where, you may ask, do the Chinese fit in? Back in 2015, the Chinese state-owned CGN agreed to fund one-third of the expected £18bn construction costs, thus easing the burden on EDF, and in return would be considered for the provision of reactor technology at the planned Bradwell nuclear station.

A cursory glance at the headline economics suggests that the finances of Hinkley Point simply do not stand up. But the reason why they are so bad is that they reflect the desperation of the Cameron government, aided and abetted by George Osborne, to scramble together a deal to get a nuclear station online by 2023 (a deadline which everyone now knows will not be met) in order to meet carbon emissions targets whilst managing to keep the lights on. It is the product of policy on the hoof. To compound the problems, the reactors proposed for Hinkley have run into technical difficulties, which has raised doubts about their suitability. Add in the fact that the costs of building Hinkley recently exceeded the entire market cap of EDF and that numerous European states have filed objections on the grounds that the government is breaching EU rules on state aid, and it is understandable why the project remains beset by doubts.

Theresa May’s objections to the deal on national security grounds are surely to miss the point. If she were to object on financial grounds, surely that would be sufficient. But then that would be to admit that the government of which she was part has committed an act of fiscal stupidity (doubly ironic when you think of George Osborne’s austerity mantra) and would annoy the French even more than this delaying tactic has already. Whilst it is understandable that the government might have concerns about allowing the Chinese to have a big say in a crucial infrastructure project, citing these concerns in public is no way to win friends and influence people (let alone win foreign investment deals). In any case this eleventh hour delay, which smacks of capriciousness, makes life more difficult for foreign investors looking for certainty in the wake of the Brexit vote.

What the government needs to do – and fast – is to come up with a credible energy policy. The UK needs Hinkley if it is to close its coal-fired stations by 2025. My guess is that this won’t happen and their life will be prolonged. I also suspect that the government will agree to go ahead with Hinkley, albeit on altered financial terms. Though whether the French and Chinese will be willing to go through all the negotiations again is a lot more doubtful.

An un-save-ry business

The Bank of England’s action yesterday to ease monetary policy by driving interest rates deeper into all-time low territory has both positive and negative aspects. On the plus side, the fact that the central bank has acted pre-emptively illustrates that it is aware of the potential economic consequences of the Brexit vote. Another welcome innovation was the Term Funding Scheme, which is designed to ensure that banks can obtain funding at a cost “close to Bank Rate” which in turn means that they can pass on a significant chunk of the lower interest rates to their customers. As the BoE pointed out, the all-in cost of funding in the wholesale market is close to 100 bps and the TFS will ensure that banks can access funding at between 25 and 50 bps, depending on their lending volume. In this way, banks will be able to avoid the margin compression which is such a problem in a low rate environment, and hopefully will prevent many of the distortions which have been such a feature of the euro zone in recent months.

Two other elements of the package were an additional £60bn of gilt purchases and up to £10bn of corporate bond purchases, both of which were designed to further reduce yields, thereby giving additional monetary stimulus, and triggering portfolio balancing by forcing investors out of bonds and into other assets. Perhaps the most impressive part of the package was that it demonstrated a degree of joined-up thinking. The distortionary effect of low interest rates on banks’ business models is a well-known problem and the BoE clearly went some way towards addressing this crucial issue in a way which the ECB has not.

But it is not all good news. Driving interest rates ever lower is placing a serious burden on savers and is most certainly having an adverse effect on our retirement incomes. When pressed on this during the press conference, Governor Carney basically suggested that it is a choice between sacrificing savers and putting lots of people out of work. I think this is a false choice. For one thing, the Brexit fallout represents an uncertainty shock which is not readily amenable to monetary solutions. Lower borrowing costs will not determine whether Nissan decides to continue investing in its British operations. Indeed, if the Brexit negotiations go awry, Nissan could put lots of people out of work AND savers retirement incomes will still be under pressure.

What is more pernicious is that many policymakers, past and present, argue that more monetary easing does no harm so why not just do it. But that is also false. As noted above, low rates hurt savers. And there is another problem: By national accounting definition the current account deficit represents the difference between domestic saving and investment. If we reduce the incentive so save, so the economy can only invest by borrowing from the rest of the world – and the UK just happens to have one of the biggest current account deficits in the OECD (exceeded only by Colombia). So you still think that low rates are a good idea?

Another thing that concerns me is that central bankers have been loath to tighten monetary policy even once a recovery appears to be underway. There is thus a real risk that we get sucked into a world of low interest rates for far longer than is necessary, with all the attendant risks outlined above. And finally, there is general recognition that the Brexit problem is by no means as serious as the shock in the wake of the Lehman’s bust. So why then has the BoE implemented a monetary stance which is even more expansionary than we saw in 2009?

Maybe I am being a little too harsh. But the problem is that monetary policy remains the only game in town, given that the previous occupant of 11 Downing Street pursued an aggressive austerity policy which left no room for fiscal expansion. Many economists would welcome a change of policy on this front. And if over the course of the next year or two we do see a more activist fiscal approach, the BoE should be far less squeamish about raising interest rates. After all, savers could do with a break after seven years of squeeze.

The lowdown on interest rates

Over the course of the past seven years, monetary policy has been at its most expansionary setting in history, a point made by Andy Haldane in a speech last year. Indeed, we have become dangerously used to interest rates at near zero – and in some cases below.

It used to be thought that when interest rates get close to zero, there was very little else central banks could do. But in 2001, the Bank of Japan began the process of flooding financial markets with liquidity by buying huge quantities of financial assets in a bid to head off deflation (so-called quantitative easing). In 2002, Ben Bernanke argued, in what has gone down as one of the most influential speeches in modern central banking history, that a policy of central bank balance sheet expansion was guaranteed to reflate moribund economies and if it was failing in Japan, this was primarily a result of specific Japanese factors. Little did we know that western central banks would quickly exhaust all their conventional ammunition in the wake of the meltdown triggered by the Lehman’s bankruptcy, and that by 2009 the Fed and Bank of England would  be pumping huge amounts of liquidity into the financial system with the European Central Bank following suit in 2015.

We don’t have space to go into a detailed discussion of these unconventional monetary policies here, but suffice to say that although I was critical of the QE strategy in 2009, it did serve a purpose by preventing a market meltdown, and it probably did help to stabilise the real economy and set the stage for a recovery. The key point, however, is that it helped markets first and foremost. It did so by forcing investors to abandon the safe haven of government bonds, as central bank purchases drove down yields, and into riskier assets yielding higher returns. But with the ECB only starting to embrace QE last year, when global markets were a lot more stable than in 2009, this struck me as too little too late. It has had no discernible impact on generating a pickup in activity and although the ECB will doubtless argue that the situation would have been worse in its absence, that remains unproven.

What has become apparent is that central banks have become addicted to the provision of cheap liquidity. Indeed, in the euro zone the interest rate on cash deposits at the central bank is negative, as the ECB tries to force banks to lend rather than hold excess cash balances. There is little evidence that this policy is working.

In fact, lowering interest rates in the current environment is merely helping to magnify economic distortions. For one thing, they have forced investors to raise asset prices out of line with fundamentals by producing market bubbles which may well pop in future (at the very least, they raise market volatility by increasing the degree to which markets are dependent on central bank policy). For another, they distort the operation of the financial system, the main purpose of which is to match those with excess funds and those with insufficient funds. But in an environment of excess liquidity, banks are simply holding excess cash which – in the euro zone at least – is a drain on profitability because they have little option but to hold it at the central bank, which incurs a penal rate of interest. Then there is the problem of how savers can build up their balances in order to generate sufficient for their retirement. Today’s consumers may enjoy the dubious privilege of low rates today, but they will not thank central banks tomorrow when they see what their retirement funds are worth.

So it is against this backdrop that the BoE is widely expected to cut interest rates this week. But the truth is it will do little good. Whatever else the Brexit shock is, it is not a monetary shock to the system as we saw post-Lehmans when the global financial system seized up. At that point, radical monetary easing made sense. Lower interest rates today cannot compensate for any uncertainty shock which may cause companies to cut back on investment and employment. Nor is there any real need to expand QE – the BoE has already taken action to reduce banks’ countercyclical capital buffer which does much the same job.

The BoE will argue that the harm caused by inactivity outweighs the harm of further easing and the markets certainly will not take kindly to inaction. But the lesson of the past seven years is that once policy is eased, it has proven very difficult for central banks to consider unwinding it. We may not know the longer-term costs of cheap money for many years to come but it increasingly looks to me as though monetary policy is almost out of road and it is time for some heavy lifting from fiscal policy.

Stressful times

This morning’s financial pages are full of coverage of the European bank stress tests, which were released yesterday evening. The good news is that with two exceptions, the regulators were broadly satisfied that the 51 European banks under scrutiny would be able to withstand severely adverse market conditions, in the sense that they would be able to hold their common equity tier one (CET1) ratios above the absolute minimum of 4.5%. In plain terms, this means that banks should be able to maintain a sufficiently large capital cushion in order to continue operating during times of market stress and thereby remain solvent.

In the wake of the problems resulting from the Lehman’s bankruptcy in 2008, it makes sense for the authorities to pay greater attention to the risks posed by the banking sector. Indeed, the lack of regulatory oversight magnified the extent of the post-Lehman’s distress so it is a positive step that problems are being addressed. But previous efforts to stress test the European banking sector were criticised for not being stringent enough, and the same familiar refrains are being heard again this morning. It is true that the risks appear to have intensified in the wake of the Brexit referendum and it is also true that different countries face different degrees of macro risk, which makes it difficult to compare the impacts of the adverse scenarios across countries. 

But these criticisms are to miss the point. We can never know exactly what kinds of shock will materialise and the best that we can do is give a hypothetical benchmark against which to judge a range of possible outcomes. Like any forecast, they will probably prove to be wrong but if we get the broad direction of travel right, we can be satisfied (though we can only hope that we never have to find out).

In any case, as the European Banking Authority pointed out, banks are far better capitalised today than they were five years ago. The CET1 ratio at the end of 2015 across the panel of 51 banks was 13.2 % versus 8.9% at the end of 2010 (albeit on a slightly different definition). The rules have been tightened up and banks have done their best to comply with regulators’ demands for a broader capital base. There is little doubt that banks were under-capitalised pre-Lehmans and it is only right that they should be forced to build a better stable door, even though this has forced them to pull out of capital intensive businesses which has had a notable impact on profitability. 

However, this does not excuse the fact that regulators were far too complacent about the risks which banks were running prior to 2008. Public calls to send bank chiefs to jail were never matched by calls to jail regulators for neglect! Indeed, whilst disgraced RBS chairman Fred Goodwin was stripped of his knighthood, former BoE Governor Mervyn King was ennobled and, it was noted this morning in the FT, “has quietly taken up a role as a senior adviser to Citigroup.” Lest the irony of that should escape anyone, Lord King argued in his recent book that the structure of the financial system in flawed and that “without reform of the financial system, another crisis is certain.” 

Back in 2011, former Barclays chairman Bob Diamond argued that it was time to end the criticism of banks over their role in creating the recession of 2008-09. He was ahead of his time: There were many problems with the banking system in 2011 which needed to be resolved, and there is still a lot to do today. But banking recovery is not being helped by the fact that interest rates are at all-time lows, making it harder for banks to generate profits and rebuild their capital base. With the Bank of England widely tipped to cut interest rates deeper into all-time low territory in the course of next week, that is an issue to which I will return,

London calling

As I write this, it is exactly four years since I was sitting in a restaurant watching the opening ceremony of the 2012 Olympics in London. It seems like an awful long time ago. Although there is a sense looking back that things were improving, following the savage recession of 2008-09, the economic data released at the time suggested that the UK economy was struggling to gain traction, although a more solid recovery was just around the corner. That said, there was a feelgood factor in the air, at least in London, and surveys conducted at the time pointed to a more general feeling of national wellbeing. 

Fast forward four years and things feel rather different. The national mood remains sullen in the wake of the EU referendum, although perhaps not quite as fractious as a month ago, whilst regional disparities have widened if anything. Economically, at least, London’s relative importance continues to rise, with a recent report suggesting that it contributes almost one-third of the UK’s tax receipts. It is to the UK what Germany is to the euro zone – it accounts for roughly the same share of output and is the UK’s paymaster in the same way that Germany is for the single currency region. 

Back when I was a lad, as they say, it all felt rather different. I was reminded of this by a number of films, which can be found on the British Film Institute website and on the North East Film Archive site which extolled the virtues of living in the thriving north east of England. The films were shot in the 1960s and were designed to convey the impression that the old days of flat caps and whippets were no more, and that the region was looking ahead to focus on the high tech and light engineering industries of tomorrow. It all seemed so optimistic and modern. As someone who grew up in the region around that time, I can relate to the sentiments portrayed. 

But I was also struck by the fact that within a decade, much of that optimism had crumbled as the heavy industries on which the region relied were wiped out, taking away the bedrock of support for the newer industries. Indeed it is from around the early-1980s that we became ever more aware of the inexorable drift southwards in the UK’s centre of economic gravity. 

Some 35 years on, even senior civil servants now admit that the UK is one of the most centralised economies in the developed world. And this is a problem since, as the Institute for Economic Affairs has pointed out, “decentralisation promotes … better matching of services to local preferences.” To the extent that many people outside the London bubble feel that they have increasingly been marginalised by their own government, which focuses ever more on the needs of the capital, this degree of centralisation may have been one of the contributory factors encouraging the electorate to stick two fingers up to the government last month. In fairness, there have been efforts to devolve powers back to the regions, with the creation of the Greater Manchester Combined Authority in 2011 the first attempt to give more control over planning and spending decisions. But the scheme is not without its critics and it is unclear to what extent it will be rolled out elsewhere, partly because not all cities want to follow the same model. 

It is thus ironic that during an EU referendum campaign in which one of the key slogans was “taking back control,” the government recognised the UK regional control problem, tried to do something about it (albeit perhaps too little too late) yet many were hesitant to grasp the opportunity when it was offered to them. It does make me wonder how we will be able to resolve many of the contradictions which dot the policy landscape. For an escapist reminder of how we see ourselves, you could do worse than go to Youtube and relive that Olympic opening ceremony. Indeed, maybe the Remain campaign would have done better to entrust their strategy to Danny Boyle. He certainly convinced me that things are better than they are.