Friday, 19 September 2014

Wishful thinking and economics

Economics is often called the dismal science, and the Scottish referendum showed why this description has stuck. The Yes side appeared full of hope and optimism about what could happen once the constraints of Westminster rule had been cast off, while the No campaign kept on going on about one problem or other, which usually involved economics.

The general meme is that this negativity was a tactical mistake by the No side, but it was a quite understandable mistake, because the economic problems were large and self evident. It is no surprise that the vast majority of economists thought Scotland would be worse off under independence (see here, or here, or here). They had looked at the numbers and issues, or looked at institutions they respected that had done so, and thought this does not look good. Even for some of those economists who are in favour of independence, like Joe Stiglitz for example, it is clear that the attraction is despite, rather than because, of the basic macro and fiscal numbers. (See also Adam Posen’s response.)

This is of course not new. Politicians on the right like to believe that tax cuts will pay for themselves, and it is boring economists who (mostly) point out this is not true. Politicians of all shades thought that austerity would not have much impact on output and growth, while the vast majority of economists knew better. One of the reasons for deficit bias is that politicians believe that their policies will galvanize the economy and raise the tax base, and most of the time the macroeconomy stubbornly refuses to be impressed.

Now it is tempting to say, given this evidence, that politicians will believe anything that suits them. But what the independence referendum showed us is that voters have similar problems. As the campaign progressed the stronger the Yes vote became, and there is some evidence that this reflected additional information they received. As I suggested here, the problem is that this information was superficially credible sounding stuff from either side, but often with no indication from those who might have known better of the quality of the analysis.

For me this has always been the major argument for establishing fiscal councils - independent institutions who are charged with, at a minimum, scrutinising fiscal projections. Although the OBR (the UK’s fiscal council) has a remit that is quite narrow, we also have the highly respected IFS. In Sweden the fiscal council itself has a much wider economic remit.

Whenever I make this point, someone puts forward the argument that this is anti-democratic, or that I want economists to dictate decisions. This is wrong on at least two levels. First, my general argument is not specific to economics, but involves any area that involves technical expertise. Indeed, the case I make here is partly to avoid politicians using the views of a small minority of economists as cover. Second, the problem with democratic accountability as normally defined is that it is very weak: voters make one decision every five years that involves a whole basket of issues. I would suggest that charging an institution with a small set of tasks, where there is effective democratic oversight over the performance of that institution, can make that institution more accountable to the electorate than any politician doing the same.

In the case of Scottish independence, although we did not have a direct assessment of fiscal prospects from the OBR, that organisation’s oil revenue forecasts were used by the equally respected and independent IFS to point out the problematic outlook that an independent Scotland would face. Although the Yes side attempted to suggest that the OBR was part of the very Westminster elite that it wanted a divorce from, I suspect many voters saw this as independent analysis and were concerned by it. In a world where politicians can always find some experts to back their view, I suspect it is only through singular institutions like the OBR and IFS that the views of the majority of economists get to have some influence, and the economics of wishful thinking gets exposed.

Wednesday, 17 September 2014

Keynes and the Macmillan committee

This book, by Peter Temin and David Vines, has just been published. As you can see from the endorsements, I liked the book. In this post I just want to focus on a particular chapter, which was Keynes’s role as part of the Macmillan committee, an episode I did not know about before. Just as the book does so well, I want to draw parallels between the past and current events.

It is the end of 1929: UK unemployment was already high as a result of going back on to the gold standard five years earlier, and Wall Street had just crashed. The new Labour government was overwhelmed, so in the British tradition it set up a committee to recommend what to do, and Keynes was a member. As Temin and Vines note, although Keynes was at the centre of economic discussion at the time, he was also outside the establishment, as a result of publishing his attack on the Versailles treaty in the Economic Consequences of the Peace.

Keynes diagnosis of why British unemployment was so high linked returning to the gold standard at an uncompetitive level and the problems of downward nominal wage adjustment. The book’s description of how the then governor of the Bank of England, Montagu Norman, failed to see the problem is amusing - from a distance of nearly a century - but of course as the book points out this is exactly the ‘conversation’ that Germany is currently having with the rest of the Eurozone.

The obvious solution was therefore devaluation, and the book seems a little ambivalent about whether that was not much discussed because it was ‘off the table’ for political reasons, or whether Keynes and others thought that, having joined (which Keynes had opposed), Britain should stay the course. (Eurozone parallels again. Ironically Britain did devalue three months after the report was published, although as I note here, this was forced rather than a choice.) What Keynes argued for was instead increased government spending, but he failed to convince the committee that its impact on unemployment would not be crowded out. Here Temin and Vines attribute this failure not to the ability of the others to see the obvious, but to the fact that Keynes arguments did not fit with the model he was using, which was the model of the Treatise. They write: “the Macmillan Committee is of interest to us because Keynes’ presentations to it didn’t add up to a coherent view. Rather, they show Keynes thinking on his feet at a time when his ideas were in flux.” Those ideas ended up, of course, with the General Theory.

Finally, one thought of my own. When I was younger, I drew the wrong inference about the Great Depression. If only the General Theory had been written 10 years earlier, I reasoned, much of the agony of the Great Depression could have been avoided. Instead I should have focused on the gold standard. Not because this was more important as a cause of the world wide Great Depression - it well might have been - but because of what it tells you about the influences on macroeconomic policy.

Montagu Norman said to the committee “I have never been able to see myself why for the last few years it should have been impossible for industry, starting from within, to have readjusted its own position”. This was a few years after the General Strike of 1926! This was not someone lacking a coherent theory, but someone blind to the evidence and human nature, and enthralled to the ideology of the gold standard. No doubt being a central banker rather than a worker, or even an industrialist, helped this blindness. The lesson I should have drawn from the Great Depression is that a powerful ideology, in the hands of people remote from those adversely affected by it, can overcome common sense and evidence. 

Tuesday, 16 September 2014

UK attitudes on the size of the state

This is a follow up to my post on shrinking the state, but actually it is about something I found when thinking about the Scottish independence referendum, so let me start there. If Scotland votes for independence, it will be because enough Labour voters voted Yes despite Labour’s support for the Union. It seems quite clear from the Scottish Nationalists’ pitch in these closing weeks that the appeal to these voters is that by voting for independence you can ensure you never again have a Conservative government.

Yet there is a puzzle here. England and Scotland are not so different in terms of political attitudes. This is true across a wide range of issues: Scots are only a little more to the left than the English. Furthermore, as John Curtice and Rachel Ormston show here, this difference has not noticeably increased over the last ten years. Let’s focus on the specific issue of the size of the state. Here is the proportion of people who thought taxes should rise to increase spending on health, education and social benefits in each country.

The proportion is generally higher in Scotland, but not by much, and it has been falling in both countries over the last ten years.

When I saw this data, I wondered about what was missing from the chart. Respondents were given two alternative responses: the level of taxation should be less, or it should stay about the same. Here is the same question for the UK as a whole (source: British Social Attitudes survey).

The interesting result is how few people want lower taxes - always below 10%. The changes involve shifts between more spending and taxes to no change, rather than to lower spending and taxes.

In terms of movements over time, it is interesting to compare this with data on the levels of UK government spending and taxes, over a longer period than I gave in my previous post.

 If you think about the turn of the millennium as being the end of the Thatcher era, then the Thatcher years saw a reduction in the size of the state, whether measured in terms of taxes or spending. From the previous chart, it looks like this was against popular opinion at the time, because we saw a sustained rise in the proportion of people wanting a larger state in the 1980s. This proportion started falling over the same period that Labour were increasing the level of public spending, which again makes sense. So there is little evidence of a change in public attitudes here: the state was too small in the 1980s and 1990s, and it began to move towards a level the majority desired during the last Labour government. There is absolutely no public mandate for any renewed shrinking of the state.

Which prompted this thought. As public attitudes either side of the border are not so very different, and given these particular attitudes about the size of the state, perhaps the relevant question is not why the Conservatives and UKIP are so weak in Scotland, but why are they so strong in England? As John Ruddy notes here, in the mid 1950s the Conservatives won over 50% of the Scottish vote. What happened since then was not a collapse at the expense of Labour, but at the expense of the SNP and Liberals.

Perhaps a better way to start thinking about what has been happening is as follows. The big change over time has not involved public attitudes, but the political position on economic issues of the Conservative Party. Just like the Republicans in the US, it has moved substantially to the right, beginning with Thatcher, and continuing under Cameron. Just as with the Tea Party in the US, there is a sizeable minority that wants to go further. However this rightward shift does not reflect majority opinion, and so when enough alternatives exist - as in Scotland - votes have drifted away from the Conservatives to more moderate centre right parties. In a two party system like the US, or with a voting system that favours the two main incumbent parties like the UK, that cannot happen.

Monday, 15 September 2014

David Cameron (from Wikipedia 2100)

Prime Minister of UK (including Scotland until 2014) from 2010 to 2017. Widely seen as the catalyst behind the renewed decline of the UK, after a brief respite in the 30 years previously (see entries for Margaret Thatcher and Gordon Brown). On becoming Prime Minister in 2010, embarked on a fiscal austerity programme which delayed a recovery from the Great Recession until 2013, accelerated the privatisation of public services and encouraged social hostility to immigration and the poor.

This proved to be a decisive factor in Scotland narrowly voting Yes to independence in 2014. (The other was his decision not to allow a third option for greater devolution.) His administration was then bogged down in negotiations with Scotland for the next two years, which caused increasing bitterness between the two countries. In the UK election of 2015 the SNP captured many Scottish Labour seats, but refused to form a coalition government with Labour, allowing Cameron to continue to lead a minority government with tacit support from the LibDems and (initially) UKIP.

Most analysts naturally point to his promise of a referendum on EU membership as his biggest mistake. In the short term this meant that UKIP’s success in the 2015 election was as much at the expense of Labour as his own party. But his decision to recommend voting Yes to continued membership in the EU referendum in 2017 led to an attempt to unseat him as leader which narrowly failed (see entry on Boris Johnson), and then large scale defections of MPs from his party to UKIP. Campaigning under the slogan ‘If Scotland can do it, so can we’, and with the support of large sections of the press, UKIP leader Nigel Farage achieved a very narrow majority to leave the EU, forcing Cameron to resign. Some argue that the Scottish independence decision was critical here, as he would have won the referendum vote if Scotland had stayed part of the UK. A few argue that the decision to break up the BBC and allow partisan broadcasting, and in particular the rebranding of ITV into FOX-UK, was a more important factor in losing the EU vote.

There is some dispute as to how much Cameron himself is to blame for these events, or how much was the work of his Chancellor (and his successor as Prime Minister) George Osborne. There also remains some controversy over whether the inability of the economy to make up the ground it lost during the recession was due to the initial austerity plan, renewed austerity after 2015, controls on immigration or the uncertainty created by the referendum itself and subsequent EU exit.

It is a great irony that the only leader of this period whose current reputation is lower than Cameron’s is his opponent in the Scottish independence debate Alex Salmond, now widely known in Scotland as the Great Deceiver. Scotland’s own economic decline following independence was far greater, following a collapse in oil prices and the loss in UK markets when Scotland joined the EU.


Sunday, 14 September 2014

Shrinking the State

More on George Osborne’s plans, courtesy of the OBR’s latest publication. (Campaigning for a UK Fiscal Council was one of my better calls - just imagine if you had to rely on today’s government for this kind of information.)

Consider three points in time: 2001/2 (when the UK budget was last in balance, and still largely reflecting the actions of the previous Conservative government), 2007/8 (pre-recession, under Labour), and 2018/9, when George Osborne also intends us to be back in balance. The first chart actually comes from the OBR’s historical database, which only covers the broad aggregates. (It would be fantastic if this database could include more disaggregated information.)

This shows total government receipts (taxes) and expenditure (spending) as a percent of GDP. The two lines meet at the start and end. In 2007/8 we had a budget deficit of 2.6% of GDP. At the time that seemed a bit on the high side: something between 1.5% and 2% would have kept the debt to GDP ratio constant. (Budget balance implies a falling debt to GDP ratio.) For this post the point to note was that the Labour government chose to use this fiscal loosening to increase spending rather than cut taxes.

The Conservative government plans to do the reverse. So does that mean that it is just trying to undo the increase that occurred under Labour? The answer is no, and this is where the OBR’s latest report comes into its own.

Their chart shows how we get from the deficit of 2007/8 to the small surplus of 2018/9. (There is, as I note here, no good macroeconomic reason to aim for a surplus.) The cuts in spending are not just the size of the 2007/8 deficit - they are much larger for two main reasons: higher debt interest and higher ‘welfare’ spending. The reason for the higher debt interest is straightforward: debt is much higher because of the recession (and to a small extent the fiscal stimulus in 2009). Although academics often assume that higher debt interest is paid for by raising taxes, a more ‘neutral’ approach would be to raise taxes and cut government spending. Osborne plans to just cut spending.

The increase in welfare payments is probably not what you might think it is. The report’s Table 5.7 shows it is not higher unemployment benefits or income support: by 2018/9 unemployment benefit is the same as in 2007/8, and income support is 0.5% lower as a share of GDP (which is the main reason why poverty will increase over the next five years). Housing benefit is 0.3% higher as a share of GDP (partly reflecting depressed real earnings), but the main reason is the state pension, which is almost 1% higher as a share of GDP. This represents both an increased ‘caseload’ (more pensioners) and a more generous value of pensions themselves. Although the numbers suggest that here too Osborne plans to pay for this additional spending by cutting the size of government, he has indicated that he hopes to reduce this increase in welfare payments by some, as yet undeclared, means.

So this is why the reduction in the size of the state planned for 2018/9 is much more than reversing Labour’s increase: in fact, if welfare cannot be cut further, to decrease its size to “probably to the lowest share of GDP since 1938” (p128). In this particular respect, therefore, this government plans to go well beyond anything Margaret Thatcher ever attempted. I suspect when some people write that this Conservative party is more right wing than any since the war, many reading think this is hyperbole. On this metric at least, it is simply fact.  

Saturday, 13 September 2014

Can a country be too competitive?

In my earlier post on the failure of the Eurozone to understand the lessons of the Great Depression, I talked about Germany becoming ‘too competitive’. From some comments it seemed this was a contradiction in terms: how can a country ever be too competitive? I think it was obvious then that I was talking only about relative prices: being competitive in quality is something else. The problem is that Germany did become too competitive in price terms from 2000 to 2007 relative to pretty well all its Eurozone partners.

Graphs that compare some measure like unit labour costs over this period in Germany and some periphery country are ubiquitous. The discussion normally moves on to talk about how this was a problem of the periphery country’s own making alone: for whatever reason demand was too strong, which put upward pressure on inflation. However, as Francesco Saraceno points out, the really notable outlier here is Germany. Germany did not just increase its competitiveness relative to particular periphery countries; it also became more competitive with its immediate neighbours. From 1999 to 2008, whole economy unit labour costs were flat in Germany, compared to average annual increases in France of 2%, in Italy 3%, in Belgium 2.1%, in the Netherlands 2.3%. (Source OECD Economic Outlook Annex Table 22.)

The reason for this was a remarkable degree of real wage restraint in Germany. The chart below plots annual increases in real wages in Germany (either relative to the CPI or the GDP deflator) compared to labour productivity. Although these two series do not always move together, divergence between real wages measured relative to the GDP deflator and labour productivity are unusual because they imply a changing share of labour income.

German real wages and productivity: source OECD Economic Outlook

Whatever the reason behind this unusual wage restraint, it is bound to cause problems within a monetary union if other countries do not do the same. Unless Germany entered the Euro at an exchange rate that was unsustainably uncompetitive (and there are good reasons for doubting this possibility), and unless there is a structural deterioration in Germany’s non-price competitiveness that needs to be offset (which seems unlikely given its huge current account surplus), then these competitiveness gains have to be reversed. German inflation, which was below the rest of the Eurozone, will have to be above inflation in the rest of the Eurozone for some time. These are the rules of the game for a monetary union. 
As Germany is the outlier, this is a problem of Germany’s making. I’m normally reluctant to mix macroeconomics with morality, but those that suggest that it should be other countries that have to adjust towards Germany have things completely wrong here. Even if you believe that German real wages had to fall to reduce structural unemployment, Germany has no right to impose the same policy on other countries. A price it should pay for undercutting its neighbours is to experience a period of above ECB target inflation (e.g. 3% CPI inflation, which probably means nominal wage increases of something between 4% and 5%). If that is not going to happen, Germany should stimulate its economy to ensure it does. Anything else is the monetary union equivalent of anti-social behaviour.

Thursday, 11 September 2014

Scotland and the SNP: Fooling yourselves and deceiving others

There are many laudable reasons to campaign for Scottish independence. But how far should those who passionately want independence be prepared to go to achieve that goal? Should they, for example, deceive the Scottish people about the basic economics involved? That seems to be what is happening right now. The more I look at the numbers, the clearer it becomes that over the next five or ten years there would more, not less, fiscal austerity under independence.

The Institute for Fiscal Studies is widely respected as an independent and impartial source of expertise on everything to do with government spending, borrowing and taxation in the UK. It has produced a detailed analysis (recently updated) of the fiscal (tax and spending) outlook for an independent Scotland, compared to what would happen if Scotland stayed in the UK. It has no axe to grind on this issue, and a considerable reputation to maintain.

Their analysis is unequivocal. Scotland’s fiscal position would be worse as a result of leaving the UK for two main reasons. First, demographic trends are less favourable. Second, revenues from the North Sea are expected to decline. This tells us that under current policies Scotland would be getting an increasingly good deal out of being part of the UK. To put it another way, the rest of the UK would be transferring resources to Scotland at an increasing rate, giving Scotland time to adjust to these trends and cushioning their impact. Paying back, if you like, for all the earlier years when North Sea oil production was at its peak.

The SNP do not agree with this analysis. The main reason in the near term is that they have more optimistic projections for North Sea Oil. The IFS analysis uses OBR projections which have in the recent past not been biased in any one direction. So how do the Scottish government get more optimistic numbers? John McDermott examines the detail here, but perhaps I can paraphrase his findings: whenever there is room for doubt, assume whatever gives you a higher number. In my youth I did a lot of forecasting, and I learnt how to be very suspicious of a series of individual judgements all of which tended to move something important in the same direction. It is basically fiddling the analysis to get the answer you want. Either wishful thinking or deception.

I personally would criticise the IFS analysis in one respect. It assumes that Scotland would have to pay the same rate of interest on its debt as the rUK. This has to be wrong. Even under the most favourable assumption of a new Scottish currency, Scotland could easily have to pay around 1% more to borrow than rUK. In their original analysis the IFS look at the implications of that (p35), and the numbers are large.

So what would this mean? Could Scotland just borrow more? I am all for borrowing to cover temporary reductions in income, due to recessions for example, which is why I have been so critical of current austerity. However, as the IFS show, North Sea oil income is falling long term, so this is not a temporary problem. Now it could be that the gap will be covered in the longer term by the kind of increases in productivity and labour supply that the Scottish government assume. Governments that try to borrow today in the hope of a more optimistic future are not behaving very responsibly. However it seems unlikely that Scotland would be able to behave irresponsibly, whatever the currency regime. They would either be stopped by fiscal rules imposed by the remaining UK, or markets that did not share the SNP’s optimism about longer term growth. So this means, over the next five or ten years, either additional spending cuts (to those already planned by the UK government), or (I hope more realistically) tax increases.

Is this a knock down argument in favour of voting No. Of course not: there is nothing wrong in making a short term economic sacrifice for the hope of longer term benefits or for political goals. But that is not the SNP’s case, and it is not what they are telling the Scottish people. Is this deception deliberate? I suspect it is more the delusions of people who want something so much they cast aside all doubts and problems.

This is certainly the impression I get from reading a lot of literature as I researched this post. The arguments in the Wee Blue Book are exactly that: no sustained economic argument, but just a collection of random quotes and debating points to make a problem go away. When the future fiscal position is raised, we are so often told about the past. I too think past North Sea oil was squandered, but grievance does not put money into a future Scottish government’s coffers. I read that forecasting the future is too uncertain, from people who I am sure think about their future income when planning their personal spending. I read about how economists are always disagreeing, when in this case they are pretty united. (Of course you can always find a few who think otherwise, just as you can find one or two who think austerity is expansionary.)

When I was reading this literature, I kept thinking I had seen this kind of thing before: being in denial about macroeconomic fundamentals because they interfered with a major institutional change that was driven by politics. Then I realised what it was: the formation of the Euro in 2000. Once again economists were clear and pretty united about what the key macroeconomic problem was (‘asymmetric shocks’), and just like now this was met with wishful thinking that somehow it just wouldn’t happen. It did, and the Eurozone is still living with the consequences.

So maybe that also explains why I feel so strongly this time around. I have no political skin in this game: a certain affection for the concept of the union, but nothing strong enough to make me even tempted to distort my macroeconomics in its favour. If Scotland wants to make a short term economic sacrifice in the hope of longer term gains and political freedom that is their choice. But they should make that choice knowing what it is, and not be deceived into believing that these costs do not exist.