Holding the centre

In his poem The Second Coming, WB Yeats wrote “Things fall apart; the centre cannot hold; Mere anarchy is loosed upon the world.” It was written in 1919 as an allegorical description of the state of European politics in the wake of World War I. It is an apt description of where we are today. Over recent years I have consistently made the point that the failure of western governments to be honest with their electorate about the scale of the economic challenges they face will ultimately be to their detriment. We have seen this writ large in the form of the Brexit referendum and the election of Donald Trump but it has also been seen in the strong performance of populist parties in Dutch, French and German elections this year. It is thus interesting to look at the vote shares of populist parties over recent years to assess the scale of the problem.

The Swedish think tank Timbro notes that the share of the European populist vote, whether to the left or right of the political spectrum, rose from around 8% in 2004 to 20% today (chart). As the authors of the study point out “in the 33 countries included in this index, there are a total of 7843 seats in national parliaments …  representatives of illiberal and/or anti-democratic parties today hold 17.5% of all seats within European national parliaments.” It is popularly believed that populist parties advocate right-wing solutions – low taxes, smaller government and opposition to immigration – but as Timbro points out, there has been a resurgence of so-called radical left parties, particularly in those southern European countries so badly affected by the euro zone crisis.

The flip side of the rise of radicalism, of course, is that centrist ideas are squeezed out. To the extent that this has proven to be the bedrock upon which the economic successes of the past 70 years have been based, this has to be a cause for concern. Moreover, political extremists do not have to hold office in order to wield influence. In Germany, for example, votes gained by the AfD ate into the SPD’s vote share and prompted it to stand aside from the coalition government, raising the likelihood that the FDP will form part of the government. To the extent that the FDP does not necessarily share Angela Merkel’s future vision of the EU this could have a major bearing on whether Emmanuel Macron’s ideas on European reform will find acceptance in Germany.

We see the same forces at work in the UK. UKIP has had very little success in securing parliamentary representation yet it was one of the prime grass roots motivators behind the Brexit referendum. The wider consequences of the Brexit vote have yet to be realised but as Simon Nixon pointed out in the Wall Street Journal last week, whilst the Brits may have voted to leave the EU, they did not vote for a revolution. But in effect, that is precisely what they have got. In his words “what makes Brexit so destabilizing is that it shares two features common to revolutions. First, it has created a parallel legitimacy, pitching the supposed ‘will of the people’ expressed in the referendum against the traditional sovereignty of Parliament … Second, it has created a power vacuum … [Brexiters] shook the economic order but without a coherent plan as to what to put in its place.”

This resultant power vacuum at the heart of the UK government is a major problem, for it is diverting energy away from the most pressing issue of the day – how to ensure that Brexit does not tip the economy over the cliff. Instead, we hear a constant stream of press stories suggesting that ministers are fighting amongst themselves. Such is the apparent disarray that the prime minister, who would like to see some form of transitional agreement with the EU, cannot get her colleagues to fall in line. David Davis, the UK’s chief negotiator, has thus been allowed to hold to his hard line in the negotiating chamber with the result that at next week’s summit, the EU27 will almost certainly decide that “insufficient progress” has been made during phase 1 of negotiations to allow discussions on a trade deal to begin.

Most people in business are increasingly worried about the implications of where the Brexit negotiations are headed as pessimism mounts. There is also some evidence to suggest that voter preferences have changed, with the share of those believing that voting to leave the EU was the wrong choice now sharply higher than in the spring (chart). This may have something to do with the fact that Brexit is not the easy option which voters were promised. It is also a warning to those who are seduced by the simple policy prescriptions of populists. If something were that easy, it would have been done already. Now, Mr Trump, about that wall …

A Nobel cause

Economics is a social science and although many economists do not like to admit it, it is bracketed alongside disciplines such as anthropology and psychology. Indeed, in the second half of the eighteenth century, when Adam Smith was setting out the principles of the invisible hand so beloved in market analysis, psychology did not exist as a separate discipline. The work of many of the early economists such as Smith and Jeremy Bentham, was closely intertwined with issues which are now the preserve of academic psychologists. Economics thus has deep roots in the field of psychology.

Despite the best efforts of the profession to move away from the imprecision of psychological concepts, many of the paradigms explaining economic behaviour failed to stand up to rigorous testing. Whilst these were initially explained away as anomalies which did not negate the underlying assumptions, developments in cognitive psychology from the 1960s began to be seen in some quarters as better explanations of certain forms of economic behaviour. Over the last 20-30 years, a number of these insights, derived from experimental psychology, have been applied to economic and financial decision making as better explanations of behaviour than the standard model. The new field of behavioural economics, for which Richard Thaler this week won the 2017 Nobel Prize for economics, examines what happens when we relax the assumptions of rationality and perfect information which underpin much of modern macroeconomics.

Amongst the range of judgement and decision biases which clearly violate the principle of rationality, behavioural economists have focused on factors such as overconfidence, wishful thinking, conservatism, belief perseverance, availability biases and anchoring (estimates based on an initial, often random, value). Using a combination of empirical evidence and thought experiments, academic researchers have demonstrated that some of these characteristics are at work in driving the expectations formation process. For example, evidence for the overconfidence hypothesis suggests that the confidence intervals assigned to outcomes tend to be too narrow. In a famous 1974 paper, Kahneman and Tversky[1] find evidence that whilst individuals often start off with an initial value in making estimates of future values, they are often reluctant to make big adjustments to this estimate when revising their assessment (the anchoring problem). This might go some way towards explaining why economists are reluctant to radically change their forecasts on a regular basis.

We could go on, but the point is made that there is enough empirical evidence to challenge the rational expectations assumption and thereby the idea that markets are efficient. This is a problem for many economists to deal with, for they have often spent years learning to deal with the sophisticated mathematics underpinning their stochastic models, which use rational expectations as a convenient simplifying assumption. It is an even bigger problem for the finance industry which spent many decades convincing itself that prices adequately reflect all available information.

One of the great ironies of a trading environment is that if rationality is common knowledge, there ought to be relatively little trading since a rational investor should be reluctant to buy if another investor is willing to sell. But the converse is true since the trading volume on world exchanges continues to rise. Indeed, much of the empirical evidence suggests that traders would make higher returns if they trade less frequently. Moreover, the same body of research indicates that investors are unwilling to sell assets which trade at a loss relative to the price at which they were purchased – behaviour which may well reflect an irrational belief in mean-reversion.

There are also clear patterns in purchasing decisions where there is evidence to suggest that investors buy stocks which have previously been big winners (in the hope that this performance will be repeated) or big losers (in the expectation of mean reverting performance). Neither of these is consistent with rational behaviour, but one reason why investors may follow such strategies is that they do not have time to systematically analyse the whole range of stocks. The choice of which to sell is limited to the range of stocks currently owned, but the range of stocks from which investors can choose to buy is enormous, and they are attracted to the outliers in what is known as the attention effect.

Clearly, markets display characteristics at odds with efficiency and expectations are not always formed rationally. The world thus owes a debt to Thaler and his colleagues for pointing out some of the absurdities in conventional economic thinking. Behavioural economic does not have all the answers. In the minds of many people it is just a collection of theories which can only ever be tested on small samples and thus its wider applicability is limited. But to the extent that it makes us think about some of the reasons why economics has not always come up with the right answers, Thaler’s award is well deserved.

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[1] Kahneman, D. and Tversky, A. (1974) 'Judgement Under Uncertainty: Heuristics and Biases,' Science, 185, 1124-1131

Monetary policy complications

A couple of months ago I wrote a post (here) which posed the question whether we knew what was really driving inflation. Last month, Claudio Borio, head of the Economic and Monetary Department at the BIS, delivered a speech (here) asking a similar question. Borio raised three key issues:

1. Is inflation always and everywhere a monetary phenomenon, as claimed by Milton Friedman? Or do real factors play a much bigger role than often assumed? 
2.  Are we underestimating the influence that monetary policy has on real interest rates over longer horizons?
3. If these two claims are true, does it then follow that central banks should place less emphasis on inflation in designing monetary policy, and more on the longer term effects of monetary policy on the real economy through its impact on financial stability?

In short, Borio's answer to these questions is broadly yes. In the case of (1) he argues persuasively that the forces driving inflation are increasingly global, rather than local, with technological change and the entry of billions of new workers into the global workforce as a result of globalisation being primary contributory factors. Ironically, the economics profession generally believes that immigration has little impact on local wages but that raising the global supply of labour impacts upon global wages. That is a circle which needs to be properly squared.

With regard to (2), Borio uses a range of historical examples to indicate that the impact of monetary policy, via its influence on expectations, can have far longer-lasting implications on the real economy than is conventionally supposed. In other words the neutrality of money, which forms a key assumption underpinning much of modern macroeconomics, can be called into question. The logical conclusion is thus that a monetary policy purely focused on inflation can have dangerous side effects which cannot be ignored. Indeed, Borio argues for the "desirability of great tolerance for deviations of inflation from point  targets while putting more weight on financial stability."

I find this set of arguments highly convincing. Indeed, it is difficult to dismiss the thought that QE, which reduces interest rates and prompts a bubble in the price of other assets, ultimately impacts upon decision making in the real economy. For example, it prompts indebted firms to issue additional debt to fund capital expansion – hence the boom in the high yield debt market – which may ultimately come to a sticky end if interest rates start to rise.

A further suspicion is that the current monetary policy model is merely the latest in a long line of fads which may well be junked when (or if) it proves not to work. This chimes with the view expressed by Charles Goodhart[1] who has pointed out that since the 1950s there have been broadly three fashions in policy. From the 1950s to the mid-1970s, monetary policy was focused on labour markets and the bargaining power of unions. As the economics profession increasingly realised that simple Phillips curve analysis was insufficient to explain the relationship between inflation and unemployment, policy between the late-1970s until the 1990s switched to looking at money and monetary aggregates. But as this approach also failed to deliver control of inflation, the thrust of central bank policy switched to the NAIRU and the influence of expectations. But if Borio is right, this may simply be another in the long line of transitory policy fashions if it proves to have adverse longer term consequences which require more rapid-than-desired policy adjustment.

Indeed, central bankers will readily agree in private that they do not know what are the long-term implications of the current monetary approach. In particular, the impact of low interest rates on depressing pension returns is a problem which will only become apparent over a multi-year horizon. In effect, society has been forced to choose between protecting employment and labour income today at the expense of lower pension returns tomorrow. The jury is out as to whether it is a worthwhile trade off.

The question of whether the BoE should raise interest rates in the near-term should be seen in this context. On the one hand, there is a strong case for suggesting that rates are too low given the overall macroeconomic picture which is helping to exacerbate asset price distortions. But it is less clear that inflation should be the trigger for higher rates. Admittedly, inflation is running well above the 2% target. But wages remain muted and given the backdrop of Brexit-related uncertainty, they are likely to remain so.

It is hard to avoid the suspicion that justifying a monetary tightening on the back of inflation is a convenience which the general public can readily understand. Whilst households may not like it, higher rates may in fact be in the best interests of the economy. Not because there is an inflation problem, but because it might be the first step on the road towards taking some of the air out of the asset bubble which has built up in recent years. It may also help to give us a little bit more retirement income too.

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[1] Goodhart, C. (2017) Comments on D Miles, U Panizza, R Reis and A Ubide , “And yet it moves – inflation and the Great Recession: good luck or good policies?”, 19th Geneva Conference on the World Economy

Public or private: The debate continues

The debate on whether a free market or state enterprise is the superior form of economic governance is an old one which comes to the surface every now and again. It is currently being rerun once more, with numerous plebiscites across the industrialised world making it clear over the past 18 months that voters are keen to explore alternatives to a system which is perceived to have failed following the global financial collapse of 2008. The popularity of Bernie Sanders, particularly amongst younger voters, during the US presidential primaries last year testifies to the fact that there is a market for politicians prepared to speak about collective solutions to many of society’s current economic ills.

Nowhere is this debate more pronounced than in the UK where Labour leader Jeremy Corbyn has called for “21^st century” socialism in an echo of the slogan used by Hugo Chavez in Venezuela. Following on from the relative success of the Labour Party in the June election, Corbyn’s speech to his party faithful last week called for higher taxes and more government spending in a bid to differentiate Labour from the free market policies of the Conservatives. Ahead of her own party conference, Prime Minister Theresa May hit back in a speech by declaring the free market economy “the greatest agent of collective human progress ever created.” Neither is wholly right or wrong: there is some merit in both systems. But in reality, in a modern economy neither the total primacy of markets nor the heavy hand of government can hope to deliver the outcomes which their proponents believe. Mixed economies are the ideal – the hard part is to get the balance right.

Many free market idealists point to the success of the industrial revolution which was characterised by a market economy comprised of large numbers of small companies. But whilst this did deliver a significant increase in material living standards, it also had adverse side effects in the form of wealth and income disparities as some people became exceedingly rich at the expense of those who did back-breaking manual labour. Another side effect was that many small companies grew large enough to attain monopoly positions, which in the US triggered action by the government to rein in the “robber barons” via antitrust laws. There is no small irony in the fact that the US government’s action represented interference by the state in the operation of private sector companies. It pulled the same trick in the 1980s by forcing the breakup of AT&T at a time when the pro-market Ronald Reagan occupied the White House.

What this highlights is that governments do have a role to play in market economies by ensuring an institutional framework in which the interests of the consumer are best served. Ironically, the EU has been one of the great guarantors of consumer interests across Europe. Those of you who travel throughout Europe can thank the European Commission for the abolition of mobile roaming charges and for the widespread adoption of the European Health Insurance Card. The Commission also forced Microsoft to unbundle Internet Explorer from the Windows operating system because it “harms competition between web browsers, undermines product innovation and ultimately reduces consumer choice.” Those who criticise the EU for its stifling bureaucracy perhaps ought to look again at its record in championing competition which promotes consumer welfare.

This is not to say that a system of central planning will necessarily work either, as the examples of the Soviet Union and pre-Deng Xiaoping China have shown. In a less extreme example, Britain in the 1970s was characterised by institutional rigidities which overrode the operation of market forces, notably in the labour market, which held back growth and resulted in high inflation. It was thus not hard to make the case at the end of the 1970s for applying a new economic broom and applying the ideas advocated by Milton Friedman and his Chicago colleagues. It was argued that the prevailing problems could be cured by allowing the market to eliminate rigidities (restrictive practices, credit rationing etc.) and that a bright new dawn of prosperity lay ahead. And for a long time it worked. Voters got used to relative stability and rising incomes, until one day Lehman’s went bust.

Arguably, this was the point at which voter tolerance for the free market snapped. The popular narrative is that bankers played in a system without any rules and in which market forces ruled. Worse still, the private sector losses were loaded onto the public balance sheet and the system was reset to continue on its way, whilst the austerity required to get public finances in order hit the poorest disproportionately hard. Whilst this is a stylised version of what happened, enough people believe it such that they want change.

What this does highlight is that all economic policies have a limited shelf life as the downsides begin to show through. Corbyn’s call for a renationalisation programme taps into this wave. Thirty years ago, it was argued that opening up former state-owned utilities to competition would boost efficiency and improve choice for the consumer. I never fully bought that argument: Selling utilities off to the private sector was never going to automatically increase real choice. We still buy many of the same products delivered via the same distribution network – it’s not like competitors entered the railway market offering us new routes. The one stand out example where the policy worked was in telecoms but that was only because the mobile revolution changed the face of the business.

As Tim Harford concludes in an FT article on privatisation, “the picture is mixed, the details matter, and you can get results if you get the execution right.” The flipside of Harford’s conclusion is that the promise by Jeremy Corbyn to renationalise a significant proportion of the utilities will not necessarily produce better results. Equally, Theresa May’s push for the free market is not guaranteed to produce better outcomes either. There is a role for both systems: It is not clear whether the two competing political versions in the UK have the balance right.

Bombard(ier)ed by bad news

The news that the Department of Commerce has proposed a 219% tariff on sales of Bombardier aircraft into the United States bodes ill for the future. This stems from a complaint by Boeing that the Canadian government is subsidising sales of Bombardier’s C Series aircraft and thus undercutting Boeing’s sales of its 737 models. On the surface it thus looks as though the US government has sided with the US manufacturer in what may be the thin end of the protectionist wedge threatened by President Trump as his America First policy begins to take shape. Ironically, this comes just weeks after Boeing won an appeal against the WTO ruling in the case brought by Airbus that the US company had benefited from tax breaks in order to site a production facility in Washington state. However, the companies have been at daggers drawn for many years, with each accusing the other of receiving subsidies and there are still cases pending at the WTO between the two parties.

Ironically, one of the biggest subsidisers in the commercial aircraft business is the state-owned Commercial Aircraft Corporation of China (Comac). According to the BBC’s business editor Simon Jack, “Boeing sources tell me that the only reason they haven't taken a case against Comac to the WTO is that they cannot point to any commercial harm – yet.” But as Jack also points out, with China estimated to require another 3,200 new aircraft over the next decade, neither of the big two western manufacturers will be too keen to take China to the WTO for fear of the damage it will do to their future business prospects in China.

Indeed, this highlights the dichotomy at the heart of global trade negotiations. The US can inflict much greater economic pain on a smaller player such as Canada without fear of major repercussions than if it were to try the same tactic on China. This should serve as a wakeup call to any deluded Brexiteers who believe that the UK will simply be able to roll out of the EU in 2019 (or 2021) and blithely sign a wide variety of trade deals which will suit the UK. Ironically the news of Bombardier’s problems broke on the same day that the pro-Brexit MEP Daniel Hannan (described on his Wikipedia page as an Anglo-Peruvian journalist) announced the launch of the Institute for Free Trade which “makes the intellectual and moral case for free trade, and sees Britain’s withdrawal from the European Union as a unique opportunity to revitalise the world trading system.”

What Hannan fails to recognise is that by leaving the EU, the UK is leaving the largest and most successful free trade bloc in the world. He continues to cite the platitude that there are 165 non-EU countries with which the UK can strike better deals once outside the EU. But of these other countries, the only ones which matter are the US, which accounts for 16% of UK exports, China (5%), Switzerland (3%), the UAE (2%) and Japan (2%). If we are generous, we can include India (1%) more for its future than current importance. Adding the export share of the EU27 (47%) to these figures means that just 8 blocs account for 75% of UK exports. To put it another way, 159 countries account for 25% of UK exports. Only a crazed ideologue would believe that the risk-reward of jeopardising relations with its largest trading partner is a worthwhile endeavour. Moreover, with the US, China and India having considerably larger domestic markets than the UK, they will be in a stronger position to engage in trade deals with the UK designed to suit their own interests, as the Bombardier spat illustrates.

It is not exactly news to anyone that EU membership acts as a form of protection for the UK against the trade actions of larger economies. With politicians across Europe expressing reservations about the international repercussions of the mercurial Trump’s America First policy, it is ironic to say the least that the pro-America free traders on the Brexit wing of the Conservative Party continue to express few doubts that the UK will be able to cut a deal with the US. Yet there is potential fallout for the UK from the Bombardier dispute. The company employs around 4,500 people in Northern Ireland and at the behest of the DUP, the prime minister is believed to have raised the issue with Trump – apparently to no avail – which does not bode well for post-Brexit Transatlantic relations or indeed the future of Theresa May who relies on DUP support to remain in government. If anything, this should act as a wakeup call to those who still believe that no deal is better than a bad deal following Brexit. It cannot be stressed often enough how wrong this view is.

Vox populi

If Brexit was an earthquake which echoed throughout Europe then the performance of the AfD in yesterday’s German election is clearly one of the aftershocks. Like the performance of Geert Wilders’ Freedom Party in the Dutch election or the performance of Marine Le Pen in getting through to the second round of the French presidential election, the AfD has upset the fragile balance of domestic politics. More than six months after the Dutch election, the determination of prime minister Mark Rutte to keep the Freedom Party out of government means that as yet it has proven impossible to finalise the composition of the coalition. Angela Merkel faces a similarly difficult task to put together a coalition given that the SPD has indicated it will not continue the current arrangement. Moreover, with the leader of the Bavarian CSU faction apparently questioning whether it should continue in coalition with Merkel’s CDU, the picture has been further complicated.

The election clearly was not a Brexit moment for Germany. In that sense, we should not over-dramatise the rise of AfD. The general consensus is that it represents a protest which has gained momentum on the back of Merkel’s opening of German borders to huge numbers of refugees. Perhaps the tide of outrage prompted by the actions in 2015 may subside over time, but there should be no doubt that the German elite misjudged the domestic mood in much the same way as politicians did in the US, UK and France. Whilst The Economist does not speak for Germany, its views are very much in tune with well-educated liberal voters across the western world. But even two years ago, its editorial comment that “Willkommenskultur shows that the people of Europe are more welcoming than their nervous politicians assume. The politics of fear can be trumped by the politics of dignity” did appear a little complacent. No-one doubts that it was the morally right thing to do but Merkel’s unilateral decision enraged the likes of Hungary and prompted unprecedented border closures throughout the EU. With the passage of time, many domestic voters are beginning to wonder if it was such a good idea.

But we should not forget that AfD was originally formed as a party to protest against the Greek bailout. It was a protest movement in the truest sense. However, it morphed into something else as it attracted voters with rather more nationalist views. One of its founders was the economist Bernd Lucke who has since drifted away from the party. In an excellent overview of AfD’s rise to prominence, the Financial Times quotes Lucke as saying “[Its] views are opposite to the ones I had when I founded it …When I led it, I had the support of 7 per cent [of voters]. That doubled when they became anti-Islam and anti-immigrant.” 

Nonetheless, the surge in support for AfD was “part of a bigger shrinkage of the political centre” to quote Gideon Rachman in today’s FT. Perhaps it is more accurate to say that this represents more a reorientation of the political landscape. Voters have every reason to be unhappy with the response of their governments in the wake of the financial crisis, though some countries have more cause for complaint than others. Excessive austerity in many European economies, coupled with intensified pressures from globalisation and the use of market solutions to price people back into work (zero hours contracts in the UK, for example) have proven a toxic cocktail which eroded many workers’ faith in the present system. There is also a lingering grievance that the “elite” were bailed out during the financial crisis and that the ordinary working person has paid the price. Against this backdrop, it is not surprising that many voters feel the system is loaded against them.

US voters went for the full nationalist option in the form of Donald Trump. The Brexit vote was also partially driven by nationalism whilst the 2017 election result indicated that many British voters sought an alternative to solutions which rely on more market and additional austerity. Italian voters last December rejected constitutional amendments, in part because it was a chance to stick two fingers up to the establishment which supported the changes. Even in France, where Emmanuel Macron swept the board in presidential and parliamentary elections earlier this year, the new president’s polling ratings have dipped sharply and Macron’s party performed poorly in yesterday’s elections to the upper house, gaining only 8% of the vote.

Research by the political scientist Gabriel Lenz suggests that in the case of economic data, voters focus on the most recent evidence “in large part because of the way the news media and the government report economic statistics.” He goes on to point out that “voter behavior appears to reflect a pervasive human tendency to inadvertently substitute an easily available attribute for an unavailable one, a tendency that Daniel Kahneman calls ‘attribute substitution.’”

This explains why populists can get away with making outrageous claims: They are simply not challenged on the evidence, which allows them to propose solutions designed to placate anxious voters but which will make many of them worse off in the long-term. But as Trump, Brexit and to a lesser extent the AfD have shown, appealing to reason will not work if that is not the message which people want to hear. As Charles Dickens wrote in 1859 in A Tale of Two Cities, “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity.” Some things never change.

Non-linearity in economics

Gertjan Vlieghe is characterised as one of the more dovish members of the Bank of England MPC, so his recent speech in which he suggested that “the evolution of the data is increasingly suggesting that we are approaching the moment when Bank Rate may need to rise” was indeed noteworthy. It is thus a pity that the rest of the speech was overlooked for it was a fine exposition of the factors driving real interest rates. But it was his dismissal of the “fairly deeply rooted, but wrong, notion in modern macroeconomics, namely that real interest rates are primarily driven by the growth rate of the economy” that really got me thinking.

Vlieghe pointed out that “the idea persists, because of commonly adopted – but misleading – practices in solving macro models.” Modern macroeconomics is based on highly non-linear models but in order to make them more tractable for solution purposes, we use logarithmic transformations to linearise them. Vlieghe uses the example of how the linear transformation of the standard method of discounting future consumer utility results in “a tight relationship between the real interest rates and growth, and nothing else ... it kills off, mechanically, anything that might have been interesting about risk … In the linearised world, there is no risk-free real interest rate.” For those interested in the detail, the relevant part of Vlieghe’s speech is reproduced in a footnote[1].

As it happens, this is perhaps an overly-rigorous theoretical interpretation of the relationship between growth and interest rates. Admittedly, the fact that there is a strong correlation between (real) short-term interest rates and (real) GDP growth does not necessarily imply a causal relationship. But the work of the late-nineteenth century economist Knut Wicksell postulated that there is a ‘natural’ interest rate which is determined by the real disturbances affecting the economy. To the extent that these disturbances are manifest in output growth and inflation, it is clear that nominal GDP growth and interest rates ought to be closely related. It is not a 1:1 relationship, but over the long-run the rate of return on real assets ought to be similar to that on financial assets in order to satisfy equilibrium conditions. Not for nothing have many economists argued that there is a strong case for using nominal GDP growth as an anchor for monetary policy.

That said, Vlieghe’s point on how linear approximations can result in specious outcomes was well made. All students of econometrics spend a lot of time learning about the properties of linear regression models which partly explains why grubby practitioners like me are comfortable applying linear transformations in order to easily apply linear estimation techniques. Another reason for preferring linearity in econometrics is that non-linear solutions can be indeterminate because we do not know whether they are the universally right answer, or whether they apply only under certain conditions. The reason for this is that many of the common solution techniques rely on grid searches conducted over a range of values. In the jargon, we do not know whether we have found local maxima only within the range in which the search is conducted or whether the “true” answer lies outside it. Our models may thus be biased – in other words, deliver the wrong answers under certain conditions – and as a result many economists stick to what they know in the form of linearity.

But this bias towards linearity, tempting though it is, can be applied to situations in which it is not appropriate. The authors of a paper in experimental psychology[2] assessed the accuracy of long-term growth estimates by panels of “experts” and laypeople. Whilst both groups tended to underestimate growth at rates above 1%, the degree of underestimation was greater for “experts” because they ignored exponential effects more often than the group of laypeople. Another paper by DeBock et al (2013) is interesting because it provides a literature review of the reliance on linearity and reports the findings of an experiment amongst business economics students who were confronted with correct and incorrect statements on linearity in economic situations. The authors concluded that many of the students showed over-reliance on linearity in their analysis.

An interesting paper on nonlinearity by Doyne Farmer (here) looks at various aspects of nonlinearity and complexity in economics. He makes the point that DSGE models are too highly stylised to say anything useful about the behaviour of economies in the real world. Instead, economics might start to take lessons from areas such as meteorology which builds very complex data-based nonlinear models. This has been enabled by the significant increase in computing power which allows simulation analysis to be conducted much more cheaply and effectively than in the past.

For policymakers, the fear is that linear approximations in a nonlinear world lead to distorted policy conclusions. One problem is that economics tends to focus on equilibrium solutions. But as noted above, there may not be a single equilibrium. Indeed, the impact of the financial crash of 2008 was an object lesson in how nonlinear feedbacks can produce outcomes far beyond our expectations.

The mathematician Stan Ulam used to give lectures on nonlinear mathematics and apologise that the title was a misnomer, for all interesting maths involves nonlinearity. As Farmer put it, “just as almost all mathematics is nonlinear, almost all economic phenomena are complex … A more tractable topic would be whether there are any problems it does not illuminate, or should not illuminate.”

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[1] 

[2] Christandl, F., and D. Fetchenhauer (2009) ‘How laypeople and experts misperceive the effect of economic growth’, Journal of Economic Psychology (30) pp 381–92