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!
Saturday, 26 November 2016
Wednesday, 23 November 2016
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.
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.
Sunday, 20 November 2016
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:
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.
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.
Wednesday, 16 November 2016
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.
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.
Saturday, 12 November 2016
The dawn of fiscal reality?
The week in markets ended on a volatile note as they began to digest the full economic implications of President Donald Trump. Emerging markets took the full brunt as it dawned upon them that the protectionist rhetoric which passed for economic debate during the election campaign was now a step closer to being realised. But bond markets also sold off sharply. The yield on 10-year Treasuries has risen by 30 basis points since Tuesday, dragging other industrialised markets in their wake. This in turn was triggered by fears of higher inflation stoked by a significant expansion of US fiscal policy.
According to analysis by the Tax Policy Center (here), Trump’s tax proposals would boost growth but cut Federal revenues. They include
reductions in marginal tax rates; increases in standard deduction amounts;
lower personal exemptions; caps on itemised deductions and allowing business to
expense investment rather than depreciating it over time, though businesses
doing so would not be allowed to deduct interest expenses.
A simple static calculation of the costs suggests this would cut revenues by $6.2 trillion over the first decade. But a looser fiscal stance would boost output, with simulations indicating an increase in output of between 0.4 and 3.6 percent in 2017, 0.2 and 2.3 percent in 2018, and smaller amounts in later years. The analysis indicates that over the first eight years, higher activity partially offsets the static revenue losses. But in the longer-term higher interest rates resulting from bigger budget deficits begin to crimp investment, thus leading to slower GDP growth and even higher revenue losses. All told, the plan would increase the debt-to-GDP ratio by 25.4% over a ten-year horizon and by 55.5% by 2036. Faced with these kinds of numbers, it is hardly surprising that bond markets are worried.
But just as a Trump presidency raises fears about the long-term prospects for free world trade, so it could also mark a pivotal moment in the mix between fiscal and monetary policy. Although the attacks by politicians on the independence of central banks in recent months have overstepped the mark, both the Brexit and US presidential votes suggest that electorates are fed up with what they are getting from governments. Indeed, households in all industrialised economies are not paying any less tax but they are receiving less back from the state as outlays are cut. With the UK government due to present its Autumn Statement on 23 November, the expectations are that it will adopt a much less aggressive approach to eliminating the public deficit than we have seen over the last six years.
Some of us would say that it is about time governments recognised that fiscal policy has a role to play in helping to get the economy back on its feet. It is certainly one of the key lessons of the 1930s, when the policy of monetary orthodoxy in the wake of the crash of 1929 contributed to the severity of the Great Depression. My own efforts to get this message across have fallen on deaf ears in recent years, with continental European economists particularly hostile to the view. But in a paper in early 2015, I pointed out that IMF research indicated that fiscal tightening could – under certain circumstances – prove to be counterproductive. Everything depends on how high we believe the fiscal multiplier to be. In simple terms, the multiplier measures the proportional change in economic output for a given change in the fiscal stance. Thus, if a fiscal tightening (expansion) of 1% of GDP produces a reduction (increase) of less than 1% in GDP the multiplier is less than unity. This can be used to justify a policy of fiscal austerity to tackle excessive fiscal imbalances.
But if a 1% fiscal tightening produces a decline of more than 1% in GDP, the multiplier is greater than unity and a policy of austerity becomes self-defeating. Prior to the Great Recession, the standard view was the multiplier was less than unity. However, much of the recent academic evidence indicates that pre-recession estimates may have been too low, which should give pause for thought in the fiscal policy debate. I will highlight the empirical analysis resulting from this paper on another occasion, but suffice to say that for countries such as Greece the multipliers appear to have been larger than initially assumed. This in turn has contributed to what can only be described as a Greek economic depression.
Governments and policy makers across Europe woke up this week to the fact that popular resentment is rising. The EU may have been able to dismiss the Brexit vote as a little local difficulty in a country which has never bought into its ideals. But it cannot ignore the message from the US electorate. It may be too late for Italy, which heads to the polls on 4 December. But the French election next spring now assumes even greater relevance for the future of the EU project.
Wednesday, 9 November 2016
The day of fate
In German, 9 November is known as Schicksalstag – the day
of fate – for it was on this day in 1848 that the politician Robert Blum was assassinated;
in 1923 Hitler launched his first failed attempt at a coup;
in 1938 Kristallnacht took place and in 1989 the Berlin Wall was opened. For the record, it was the day in 1921
that the Italian fascist party was formed. It will also be remembered as the
day that Donald Trump was elected as the 45th President of the
United States.
At 5.30 am this morning, as the rain was beating down against the window, markets also looked to be taking a beating as the news came through that Donald Trump was on his way to the White House. In the event the markets took the election in their stride. Compared to the chaos which ensued after the Brexit referendum, it was small beer. I can only assume that whatever reservations markets have about Trump’s plans, they know that today is not the day to express them. For one thing, he has to wait another two months before being given the keys to 1600 Pennsylvania Avenue. For another, markets learned a lesson after the Brexit vote that it may pay to digest the wider implications of the vote before making a move.
But as one of my colleagues noted today “if 1989 was the year that the walls came down, 2016 was (metaphorically) the year they went back up again.” Voters in the UK and US have now sent a strong message that their tolerance for globalisation has reached its limit. And with Italian Prime Minister Renzi next month staking his future on a constitutional referendum which he may lose, and general elections next year in Germany and France, the stage is set for a period of extreme uncertainty in western politics – and by extension economics.
Economic fears centre primarily on the new president’s attitude towards foreign trade. Unfortunately, globalisation has been seen as a zero-sum game in which there is one winner and one loser. This is far from the case, though try telling that to the former steel workers in the rust belt. Undoubtedly, manufacturing jobs have been shifted offshore although in the process US consumers are now able to gain access to high quality goods at lower prices than if they were produced locally. Clearly, their utility function is such that they would trade some of their better material prosperity for some of the jobs which have been lost. This does not make their economic argument right, or indeed wrong, though I suspect it tells us something that I have long suspected – namely, that attempts to measure consumer well-being in monetary terms defines too narrowly the problem of economic dislocation in the wake of globalisation. It was a failure of successive UK governments to comprehend this that led to the vote in favour of Brexit.
But where Trump is wrong is to suppose that starting a trade war will alleviate the problems. In a first act, he is likely to kill the Trans-Pacific Partnership, a trade pact involving 12 Pacific Rim nations, which Obama had hoped would be approved by Congress after the election. Indeed a press conference involving representatives from Australia, Japan, New Zealand and Singapore which was scheduled for tomorrow, has now been cancelled. This may be a recognition that progress is unlikely. Admittedly, ending the TPP would not involve any additional costs since it has not been ratified anyway.
But threats to pull out of NAFTA would be more problematic. Trump wants to impose steep tariffs on goods imported from Mexico in order to deter additional jobs from moving south. Economists continue to debate whether NAFTA is beneficial to the US. But it is likely that many of the jobs lost would have gone anyway, and with the US trade deficit with China roughly five times bigger than that with Mexico, around five times as many jobs have been lost to China as Mexico. Moreover, outsourcing some of the lower value added processes to Mexico and reimporting them into the final product has helped to keep US labour costs down. You can argue about it, but it does not seem as though NAFTA has been the killer that Trump has argued.
Threats to impose import tariffs on the likes of China would quite simply be very bad economics. For one thing, we know where that got us in the 1930s, as beggar-thy-neighbour policies depressed world trade. For another, China holds large swathes of the US bond market. Attempts to pick a trade war could have adverse consequences if the Chinese decided to dump their Treasury holdings.
Trump’s fiscal policies don’t add up either for they imply a lot of unfunded promises. We can come back to this at a future date but suffice to say that if you want to expand fiscal policy, it may not be a great idea to antagonise the Chinese too much: They might turn out to be the best customers for your bonds! Finally, and in an echo of the UK debate, relationships between Trump and Fed Chair Yellen are not exactly cordial which has given rise to speculation that Yellen could walk the plank when her term expires in January 2018. It would not be the first time that the White House and the Fed have clashed in this way but it does not send a particularly positive signal to the markets on the conduct of monetary policy.
All in all, markets may have dodged a bullet today but there is enough for them to worry about in future to suggest that today could only be the calm before a very big storm.
At 5.30 am this morning, as the rain was beating down against the window, markets also looked to be taking a beating as the news came through that Donald Trump was on his way to the White House. In the event the markets took the election in their stride. Compared to the chaos which ensued after the Brexit referendum, it was small beer. I can only assume that whatever reservations markets have about Trump’s plans, they know that today is not the day to express them. For one thing, he has to wait another two months before being given the keys to 1600 Pennsylvania Avenue. For another, markets learned a lesson after the Brexit vote that it may pay to digest the wider implications of the vote before making a move.
But as one of my colleagues noted today “if 1989 was the year that the walls came down, 2016 was (metaphorically) the year they went back up again.” Voters in the UK and US have now sent a strong message that their tolerance for globalisation has reached its limit. And with Italian Prime Minister Renzi next month staking his future on a constitutional referendum which he may lose, and general elections next year in Germany and France, the stage is set for a period of extreme uncertainty in western politics – and by extension economics.
Economic fears centre primarily on the new president’s attitude towards foreign trade. Unfortunately, globalisation has been seen as a zero-sum game in which there is one winner and one loser. This is far from the case, though try telling that to the former steel workers in the rust belt. Undoubtedly, manufacturing jobs have been shifted offshore although in the process US consumers are now able to gain access to high quality goods at lower prices than if they were produced locally. Clearly, their utility function is such that they would trade some of their better material prosperity for some of the jobs which have been lost. This does not make their economic argument right, or indeed wrong, though I suspect it tells us something that I have long suspected – namely, that attempts to measure consumer well-being in monetary terms defines too narrowly the problem of economic dislocation in the wake of globalisation. It was a failure of successive UK governments to comprehend this that led to the vote in favour of Brexit.
But where Trump is wrong is to suppose that starting a trade war will alleviate the problems. In a first act, he is likely to kill the Trans-Pacific Partnership, a trade pact involving 12 Pacific Rim nations, which Obama had hoped would be approved by Congress after the election. Indeed a press conference involving representatives from Australia, Japan, New Zealand and Singapore which was scheduled for tomorrow, has now been cancelled. This may be a recognition that progress is unlikely. Admittedly, ending the TPP would not involve any additional costs since it has not been ratified anyway.
But threats to pull out of NAFTA would be more problematic. Trump wants to impose steep tariffs on goods imported from Mexico in order to deter additional jobs from moving south. Economists continue to debate whether NAFTA is beneficial to the US. But it is likely that many of the jobs lost would have gone anyway, and with the US trade deficit with China roughly five times bigger than that with Mexico, around five times as many jobs have been lost to China as Mexico. Moreover, outsourcing some of the lower value added processes to Mexico and reimporting them into the final product has helped to keep US labour costs down. You can argue about it, but it does not seem as though NAFTA has been the killer that Trump has argued.
Threats to impose import tariffs on the likes of China would quite simply be very bad economics. For one thing, we know where that got us in the 1930s, as beggar-thy-neighbour policies depressed world trade. For another, China holds large swathes of the US bond market. Attempts to pick a trade war could have adverse consequences if the Chinese decided to dump their Treasury holdings.
Trump’s fiscal policies don’t add up either for they imply a lot of unfunded promises. We can come back to this at a future date but suffice to say that if you want to expand fiscal policy, it may not be a great idea to antagonise the Chinese too much: They might turn out to be the best customers for your bonds! Finally, and in an echo of the UK debate, relationships between Trump and Fed Chair Yellen are not exactly cordial which has given rise to speculation that Yellen could walk the plank when her term expires in January 2018. It would not be the first time that the White House and the Fed have clashed in this way but it does not send a particularly positive signal to the markets on the conduct of monetary policy.
All in all, markets may have dodged a bullet today but there is enough for them to worry about in future to suggest that today could only be the calm before a very big storm.
Monday, 7 November 2016
A brief history of currency unions
Monetary unions have a long history in international
economics and we can trace them as far back as that between Phocaea and
Mytilene in the late fourth or early fifth centuries BC. But it was from the
late eighteenth century that formal monetary unions began to proliferate,
partly as a way to consolidate political union but also to promote the
conditions for cross-border trade to flourish. Two of the more successful to
emerge from this period were the US monetary union which came into being with
the signing of the Constitution in 1789 (which later evolved into the dollar system)
and the Zollverein of 1834 which laid the foundations for German political and
monetary union in the 1870s.
History suggests that the most successful monetary unions are those which encompass what we would now define as the nation state. Without getting too philosophical about it, a shared language raises the likelihood that smaller regions will find sufficient common ground to form a political union. It is therefore no surprise that the US and German monetary unions have tended to be more durable than those which have looser ties. But as the experience of Belgium and Switzerland indicates, a successful currency union can still emerge from regions which are neither nation states nor share a common language.
However, strong monetary unions tend to be based on regions with common interests, often based around language – and almost always where currency issuance is controlled centrally. Thus the nineteenth century gold standard – which met neither of these criteria – eventually collapsed. There are some similarities between the gold standard and European Monetary Union. Admittedly EMU members share common political aims, if not a language, and the system is underpinned by a central issuer of currency in the form of the European Central Bank. But in both cases member countries are linked together in a system of fixed exchange rates and have given up monetary sovereignty to one degree or another. Whilst in EMU the operation of monetary policy has been fully contracted out to the ECB, under the gold standard individual countries at least retained their own central monetary authority, although in neither case do members have monetary autonomy and both systems require economic deflation as a cure for imbalances.
The post-1945 Bretton Woods system suffered from many of the same flaws, and although it made provision for devaluations (a feature which the UK twice utilised in 1949 and 1967) it was designed to be a painful experience. One of the problems evident with the classical gold standard was (to quote John Maynard Keynes) that adjustment was “compulsory for the debtor and voluntary for the creditor.” Despite Keynes’ best efforts to eliminate asymmetric adjustments, the Bretton Woods system operated under the same principle.
Whilst EMU is different to previous cross-border monetary systems because it has a central bank which controls currency issuance and provides a centralised payments system which helps to smooth out capital needs, the fiscal rules which underpin the system highlight other deep flaws. The Maastricht Treaty of 1992 contained a “no bailout” clause in which one country would not be held responsible for the debt of another, and these were enshrined in targets for deficits and debt relative to GDP. Not only were debt targets ignored – after all, Italy and Belgium joined when debt ratios were around 100% versus a stipulation that it should be below 60% – but the “no bailout“ clause was deeply flawed in the first place. In an integrated economy such as the EU, one country’s debts largely represent the assets of another. Consequently, the no bailout clause was never going to hold in the long-term unless the creditor countries were prepared to take a degree of pain in the event that others experienced debt problems.
Moreover, no attention was paid to external imbalances during the EMU entry process. And we should have known better, since it was external imbalances which eventually did for Bretton Woods. An economy such as Greece, which was reliant on international inflows to cover its external deficit was always vulnerable to a sentiment shift such as occurred in 2008. EMU is thus subject to the Achilles Heel of previous systems – how to manage current account imbalances in a system of fixed exchange rates. The painful truth is that we cannot unless surplus countries are prepared to recycle liquidity to finance the debt of others.
It is for this reason that the huge surpluses being built up by the likes of Germany pose such a threat to the existence of the single currency. Whilst the EU and IMF call for Germany to expand its fiscal policy in a bid to stimulate demand, and thus help to alleviate the imbalances, we may not even have to go that far. A simple recycling of the surplus by other means will suffice – perhaps via the banking sector, which after all funded the deficit countries prior to 2008. However, the European banking system is not in sufficiently good shape to perform the same role today. So if surplus countries are not prepared to loosen their fiscal stance, the EU’s warning issued earlier this year may yet come back to haunt the single currency region: “[Germany’s] persistently high current account surplus … accounts for three quarters of the euro area surplus [and] has adverse implications for the economic performance of the euro area.” As the economist Herbert Stein once warned “if something cannot go on forever, it will stop.”
History suggests that the most successful monetary unions are those which encompass what we would now define as the nation state. Without getting too philosophical about it, a shared language raises the likelihood that smaller regions will find sufficient common ground to form a political union. It is therefore no surprise that the US and German monetary unions have tended to be more durable than those which have looser ties. But as the experience of Belgium and Switzerland indicates, a successful currency union can still emerge from regions which are neither nation states nor share a common language.
However, strong monetary unions tend to be based on regions with common interests, often based around language – and almost always where currency issuance is controlled centrally. Thus the nineteenth century gold standard – which met neither of these criteria – eventually collapsed. There are some similarities between the gold standard and European Monetary Union. Admittedly EMU members share common political aims, if not a language, and the system is underpinned by a central issuer of currency in the form of the European Central Bank. But in both cases member countries are linked together in a system of fixed exchange rates and have given up monetary sovereignty to one degree or another. Whilst in EMU the operation of monetary policy has been fully contracted out to the ECB, under the gold standard individual countries at least retained their own central monetary authority, although in neither case do members have monetary autonomy and both systems require economic deflation as a cure for imbalances.
The post-1945 Bretton Woods system suffered from many of the same flaws, and although it made provision for devaluations (a feature which the UK twice utilised in 1949 and 1967) it was designed to be a painful experience. One of the problems evident with the classical gold standard was (to quote John Maynard Keynes) that adjustment was “compulsory for the debtor and voluntary for the creditor.” Despite Keynes’ best efforts to eliminate asymmetric adjustments, the Bretton Woods system operated under the same principle.
Whilst EMU is different to previous cross-border monetary systems because it has a central bank which controls currency issuance and provides a centralised payments system which helps to smooth out capital needs, the fiscal rules which underpin the system highlight other deep flaws. The Maastricht Treaty of 1992 contained a “no bailout” clause in which one country would not be held responsible for the debt of another, and these were enshrined in targets for deficits and debt relative to GDP. Not only were debt targets ignored – after all, Italy and Belgium joined when debt ratios were around 100% versus a stipulation that it should be below 60% – but the “no bailout“ clause was deeply flawed in the first place. In an integrated economy such as the EU, one country’s debts largely represent the assets of another. Consequently, the no bailout clause was never going to hold in the long-term unless the creditor countries were prepared to take a degree of pain in the event that others experienced debt problems.
Moreover, no attention was paid to external imbalances during the EMU entry process. And we should have known better, since it was external imbalances which eventually did for Bretton Woods. An economy such as Greece, which was reliant on international inflows to cover its external deficit was always vulnerable to a sentiment shift such as occurred in 2008. EMU is thus subject to the Achilles Heel of previous systems – how to manage current account imbalances in a system of fixed exchange rates. The painful truth is that we cannot unless surplus countries are prepared to recycle liquidity to finance the debt of others.
It is for this reason that the huge surpluses being built up by the likes of Germany pose such a threat to the existence of the single currency. Whilst the EU and IMF call for Germany to expand its fiscal policy in a bid to stimulate demand, and thus help to alleviate the imbalances, we may not even have to go that far. A simple recycling of the surplus by other means will suffice – perhaps via the banking sector, which after all funded the deficit countries prior to 2008. However, the European banking system is not in sufficiently good shape to perform the same role today. So if surplus countries are not prepared to loosen their fiscal stance, the EU’s warning issued earlier this year may yet come back to haunt the single currency region: “[Germany’s] persistently high current account surplus … accounts for three quarters of the euro area surplus [and] has adverse implications for the economic performance of the euro area.” As the economist Herbert Stein once warned “if something cannot go on forever, it will stop.”
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