Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday, 15 January 2017

Blanchard joins calls for Structural Econometric Models to be brought in from the cold

Mainly for economists

Ever since I started blogging I have written posts on macroeconomic methodology. One objective was to try and convince fellow macroeconomists that Structural Econometric Models (SEMs), with their ad hoc blend of theory and data fitting, were not some old fashioned dinosaur, but a perfectly viable way to do macroeconomics and macroeconomic policy. I wrote this with the experience of having built and published papers with both SEMs and DSGE models.

Olivier Blanchard’s third post on DSGE models does exactly the same thing. The only slight confusion is that he calls them ‘policy models’, but when he writes

“Models in this class should fit the main characteristics of the data, including dynamics, and allow for policy analysis and counterfactuals.”

he can only mean SEMs. [1] I prefer SEMs to policy models because SEMs describe what is in the tin: structural because they utilise lots of theory, but econometric because they try and match the data.

In a tweet, Noah Smith says he is puzzled. “What else is the point of DSGEs??” besides advising policy he asks? This post tries to help him and others see how the two classes of model can work together.

The way I would estimate a SEM today (but not necessarily the only valid way) would be to start with an elaborate DSGE model. But rather than estimate this model using Bayesian methods, I would use it as a theoretical template with which to start econometric work, either on an equation by equation basis or as a set of sub-systems. Where lag structures or cross equation restrictions were clearly rejected by the data, I would change the model to more closely match the data. If some variables had strong power in explaining others but were not in the DSGE specification, but I could think of reasons for a causal relationship (i.e. why the DSGE specification was inadequate), I would include them in the model. That would become the SEM. [2]

If that sounds terribly ad hoc to you, that is right. SEMs are an eclectic mix of theory and data. But SEMs will still be useful to academics and policymakers who want to work with a model that is reasonably close to the data. What those I call DSGE purists have to admit is that because DSGE models do not match the data in many respects, they are misspecified and therefore any policy advice from them is invalid. The fact that you can be sure they satisfy the Lucas critique is not sufficient compensation for this misspecification.

By setting the relationship between a DSGE and a SEM in the way I have, it makes it clear why both types of model will continue to be used, and how SEMs can take their theoretical lead from DSGE models. SEMs are also useful for DSGE model development because their departures from DSGEs provide a whole list of potential puzzles for DSGE theorists to investigate. Maybe one day DSGE will get so good at matching the data that we no longer need SEMs, but we are a long way from that.

Will what Blanchard and I call for happen? It already does to a large extent at the Fed: as Blanchard says what is effectively their main model is a SEM. The Bank of England uses a DSGE model, and the MPC would get more useful advice from its staff if this was replaced by a SEM. The real problem is with academics, and in particular (as Blanchard again identified in an earlier post) journal editors. Of course most academics will go on using DSGE, and I have no problem with that. But the few who do instead decide to use a SEM should not be automatically shut out from the pages of the top journals. They would be at present, and I’m not confident - even with Blanchard’s intervention - that this is going to change anytime soon.

[1] What Ray Fair, longtime builder and user of his own SEM, calls Cowles Commission models.

[2] Something like this could have happened when the Bank of England built BEQM, a model I was consultant on. Instead the Bank chose a core/periphery structure which was interesting, but ultimately too complex even for the economists at the Bank.

Friday, 13 January 2017

Miles on Haldane on Economics in Crises

Anything that says economics is in crisis always gets a lot of attention, particularly after Brexit (because economists are so pessimistic about its outcome), and Andy Haldane’s public comments were no exception. But former Monetary Policy Committee colleague David Miles has hit back, saying Haldane is wrong and economics is not in crisis. David is right, but (perhaps inevitably) he slightly overstates his case.

First an obvious point that is beyond dispute. Economics is much more than macroeconomics and finance. Look at an economics department, and you will typically find less than 20% are macroeconomists, and in some departments there can be just a single macroeconomist. Those working on labour economics, experimental economics, behavioural economics, public economics, microeconomic theory and applied microeconomics, econometric theory, industrial economics and so on would not have felt their sub-discipline was remotely challenged by the financial crisis.

David Miles is also right that economists have not found it difficult to explain the basic story of the financial crisis from the tools that they already had at their disposal. Here I will tell again a story about an ESRC seminar held at the Bank of England about whether other subjects like the physical sciences could tell economists anything useful post-crisis. It was by invitation only, Andy Haldane was there throughout, and for some reason I was there and asked to give my impressions at the end. In the background document there was a picture a bit like this.

I made what I hope is a correct observation. Show most economists a version of this chart just before the crisis, and they would have become very concerned. Some might have had their concern reduced by assurances and stories about how new risk management techniques made the huge increase in leverage seen in the years just before the crisis perfectly safe, but I think most would not. In particular, many macroeconomists would have said what about systemic risk?

The problem before the financial crisis was that hardly anyone looked at this data. There is one institution that surely would have looked at this like this data, and that was the Bank of England. As Peter Doyle writes:

“ .. it was not “economics” that missed the GFC, but, dare I say it (and amongst some others), the Bank of England.”

If there is a discussion of the increase in bank leverage and the consequent risks to the economy in any Inflation Reports in 2006 and 2007 I missed it. I do not think we have been given a real account of why the Bank missed what was going on: who looked at the data, who discussed it etc. I think we should know, if only for history’s sake.

What I think David Miles could have said but didn’t is that macroeconomists were at fault in taking the financial sector for granted, and therefore typically not including key finance to real interactions in their models. [1] As a result, the crisis has inspired a wave of new research that tries to make up for that, but this involves using existing ideas and applying them to macroeconomic models. There has also been new work using new techniques that has tried to look at network effects, which Andy Haldane mentions here. Whether this work could be usefully applied much more widely, as he suggests, is not yet clear, and to say that until that happens there is a crisis in economics is just silly.

The failure to forecast that consumers after the Brexit vote would reduce their savings ratio is a typical kind of forecasting error. Would they have done this anyway, and if not what about the Brexit vote and its aftermath inspired it, we will probably never know for sure. This kind of mistake happens all the time in macro forecasting, which is why comparisons to weather forecasting and Michael Fish are not really apt. [2] That is what David Miles means by saying it is a non-event.

What is hardly ever said, so I make no apologies for doing so once more, is that macroeconomic theory has in some ways ‘had a good crisis’. Basic Keynesian macroeconomic theory says you don’t worry about borrowing in a recession because interest rates will not rise, and they have not. New Keynesian theory says creating loads of new money will not lead to runaway inflation and it has not. Above all else, macroeconomic theory and most evidence said that the turn to austerity in 2010 would delay or weaken the recovery and that is exactly what happened. As Paul Krugman often says, it is quite rare for macroeconomics to be so fundamentally tested, and it passed that test. We should be talking not about a phoney crisis in economics, but why policy makers today have ignored economics, and thereby lost their citizens' the equivalent of a lot of money.

[1] In the COMPACT model I built in the early 1990s, credit conditions played an important role in consumption decisions, reflecting the work of John Muellbauer. But as I set out here, proposals to continue the model and develop further financial/real linkages were rejected by economists and the ESRC because it was not a DSGE model.

[2] Weather forecasts for the next few days are more accurate than macro forecasts, although perhaps longer term forecasts are more comparable. But more fundamentally, while the weather is a highly complex system like the economy. It is made up of physical processes that are predictable in a way human behaviour will never be. As a result, I doubt that simply having more data will have much impact on the ability to forecast the economy.

Thursday, 12 January 2017

Kocherlakota’s argument for fiscal expansion in the US

Is there a macroeconomic case for tax cuts in the United States right now? Paul Krugman and I say no, using the following logic. The Fed thinks we are close to full employment, if we use the term to denote the level of employment that keeps inflation constant. Generalised tax cuts (rather than just tax cuts to the very rich) will tend to raise aggregate demand, which will lead inflation to increase. The Fed will therefore raise interest raise rates further to offset this increase in demand before it happens. As a result, the tax cuts will have no impact on demand, but simply make funding investment more expense.

There are clear grounds for saying that the Fed is wrong about the economy being close to full employment, and therefore any increase in aggregate demand from any source would not raise inflation. But a central bank that acts in the textbook manner will not wait for the higher inflation to materialise, but will anticipate it because it takes time for interest rates to influence demand and inflation. As a result, tax cuts will lead to higher interest rates and there will be no net impact on demand.

Narayana Kocherlakota, who used to be on the committee that sets US interest rates, presents another possible reason why an increase in demand will not raise inflation. He argues that aggregate supply has been suppressed by low demand, and that rising demand might itself stimulate supply. For example, a lot of technical innovations might have been shelved while demand was depressed, but would be brought into production if demand looked like expanding rapidly. As these technical innovations would expand the capacity of firms to produce more, they would not raise prices as a result of any increase in demand. As these innovations would produce more from the existing labour force, there would be no inflation pressure coming from wages either.

If this sounds like wishful thinking, remember than the US economy, like most, is still way below the level of output that pre-recession trends would have suggested were likely. Did research into new and better production techniques really slow down substantially during the recession years, or did the research still take place to be implemented at some later date?

Even if this argument is plausible, and I think it is, it would still be irrelevant if the Fed didn’t make any allowance for it. They would still believe that tax cuts would raise demand and inflation, and so they would raise interest rates and crowd out any increase in demand. Indeed, if the Fed believed this ‘endogenous supply’ argument, they surely wouldn’t have raised rates in 2016.

What Kocherlakota wants the Fed to do is follow an approach put forward by Federal Reserve Bank of Chicago President Charles Evans. He puts the case in this speech. Essentially the Fed should depart from the usual policy approach of targeting expected inflation, and wait for inflation to actually rise above target before it raises rates. This would mean that it ignored any fiscal stimulus (whether it be tax cuts or additional public investment), and focused simply on the actual inflation rate. If we were in fact below full employment, or if demand created its own supply, the fiscal expansion would raise output and welfare.

An important point that Kocherlakota makes, and I have made in the past, is that you do not need to believe with certainty that we are below full employment or that demand will create its own supply. All you have to do is give it some significant probability of being true. You then look at the costs and benefits of pursuing an Evans type monetary policy weighted by this probability. A key point here is that the costs of a short term overshoot of the 2% target are likely to be a lot smaller than the cost of missing out on a percent or two of national output for potentially some time.

Does this change my views on a prospective Trump stimulus package? Not really. There is a very strong case for more public sector investment on numerous grounds. But that investment should go to where it is most needed and where it will be of most social benefit, and I think it is very unlikely (along with I suspect most economists) that a Trump Presidency and a Republican House can deliver that. That extra public investment will give the economy the stimulus that could work with an Evans type monetary policy. From a macroeconomic viewpoint there seems no point in doubling up on stimulus through tax cuts, and in terms of how the Fed reacts it may even be counterproductive.

Tuesday, 10 January 2017

The French election and two-dimensional politics

Unless something very surprising happens, the French presidential election will be between Marine Le Pen of the Front National and Fran├žois Fillon, who recently won the primaries for a collection of parties (essentially the right wing republican party). Fillon’s platform was extremely neoliberal. As Renee Buhr describes here:
“His policy proposals largely indicate a small government, low taxation and free market approach to economic policy, while his campaign rhetoric takes aim at the usual ‘boogeymen’ cited by liberal politicians – government regulations, public expenditures, high taxes and public sector institutions and employees.“

This makes we worried that Le Pen will win.

If you see politics as all about a left/right axis, my concern makes no sense. Choosing someone whose economic policy is very much to the right of the centre/right parties should eat into Le Pen’s support, while those on the left will vote (reluctantly) for the lesser of the two right wing parties. However this one dimensional view is far too simplistic, and perhaps fatally so in this case.

To illustrate why, I want to briefly look at a piece by Jonathan Wheatley, which uses UK politics before the 2015 election. A sample were asked their views on 30 different policy issues. A technique was then used to find a pattern in the responses. The first interesting result was that the strongest pattern was two dimensional: there seem to be two common factors underlying these responses. To quote:
“The first is an economic dimension, drawing on issues such as the mansion tax, the bedroom tax, and privatisation of the NHS. The second is a cultural dimension, drawing on issues such as EU membership, immigration, same-sex marriage and English Votes for English Laws.”

We could say the cultural dimension was about identity, varying from communitarian to cosmopolitan views. He then looks at the political party people supported. Here is the result:

On the cultural dimension, party supporters are where you would expect. But on economic issues UKIP supporters are less rather than more right wing than Conservative party supporters.

I know of no similar analysis that looks at French voters, but this does not matter for the point I want to make. Suppose we use the same diagram to represent a political party's policy position. In that case the area occupied by UKIP in the diagram above does seem to correspond to Front National policies. Their position on the identity axis is certainly well to the south of other parties, but their position on economic issues is far from neoliberal. In choosing who to vote for, the voter will position themselves on the diagram, and look for the party that is closer to them in this two dimensional space. (Of course we cannot use the diagram to actually measure distance, as the implicit weighting between the two aspects is arbitrary, and may not correspond to that of the voter. But the conceptual argument still works.)    

From this two dimensional perspective, choosing a candidate to oppose Le Pen who is pretty right win in economic terms does nothing to capture Front National voters. But more seriously, it risks losing the support of left wing voters. While they may dislike Le Pen because of her stance on immigration and other identity issues, Le Pen is more acceptable in terms of economic policies than a very neoliberal candidate.

Sunday, 8 January 2017

Tough on the causes of immigration

In Tony Blair’s recent intervention on Brexit, I kept expecting to read “we need to be tough on immigration, and tough on the causes of immigration”. For those who do not know, when he was Shadow Home Secretary in 1993, Tony Blair came up with the slogan: tough on crime, tough on the causes of crime. It was a brilliant piece of political spin. The public had the perception that the Conservatives were tougher than Labour in dealing with crime. What Blair did with this slogan was to counterattack by suggesting that the Conservatives might be tough in the sense of locking people up, but maybe a smarter strategy would be to go for the causes rather than just the symptoms of the problem.

He didn’t say that about immigration. But I wish some of those who argue that we need to restrict immigration by more would say something like: “Rather than control immigration, we should do something about the causes of immigration”. There currently seems to be a presumption that if you decide immigration is too high, you automatically argue for some form of direct immigration controls and numerical targets to guide these controls. That does not follow. Indeed you could argue that it should not follow. Having some bureaucrat decide whether a firm should or should not be able to employ someone from overseas is likely to be arbitrary and inefficient. Having a points system to do the same risks being a blunt instrument that leads to many bad individual outcomes

You would think, in particular, that those politicians that extol the virtues of a free and flexible labour markets, and argue that we need to reduce red tape for UK business, would push this line, and argue for indirect rather than direct control of immigration..But there may be a good political reason why they do not. One of the political advantages of direct controls is that they hide the costs to firms of those controls.

Suppose, for the sake of argument (and against the evidence), that we agreed that immigration imposed some form of cost on society. The obvious solution, for an economist, would be to impose a tax on firms that employed immigrants. Indeed Theresa May floated such an idea in early 2016. But that immediately makes it clear to the public that controlling immigration has costs, and allows the business sector to lobby hard against this tax. A much milder idea of ‘naming and shaming’ firms that employed immigrants was floated at the last Conservative party conference, but was quickly dropped for similar reasons. As Brexit polls showed, many people only favour immigration controls when they think there will be no cost to them personally. Even government ministers behave in a similar way. The moment you make it clear that reducing immigration will harm business, support falls.

While this might be a concern for those who want to use immigration as a political weapon (to deflect attention from the consequence of austerity, for example), it should not be for others (in the Labour party, for example) who simply want to appease public opinion. Above all else, focusing on the causes of immigration rather than direct controls should produce a much more honest public debate.

Wednesday, 4 January 2017

Reactionary Keynesianism revisited

I wrote my original post on this to counter the idea that the size of any increase in the deficit was at least as important as its composition, with particular reference to any fiscal expansion likely to come from Donald Trump. To put it very simply, I argued that any fiscal expansion that focused on tax cuts for the very rich and extremely dubious mechanisms designed to increase infrastructure investment should not be welcomed by those who think (as I do) there is still spare capacity in the US economy. Some subsequent helpful feedback suggests that in making this argument I should have said some things a little better.

I started my discussion with an example of how a tax cut for the rich could, in theory at least, be deflationary. The idea was that the rich would immediately consume very little of any tax cut, but if the non-rich thought that in the future their taxes might rise because of the higher deficit they might decrease current consumption. [1]

Talking about the rich and non-rich was very imprecise of me. I actually had in mind people who were income rich. The distinction between income and asset rich could matter, following an Econometrica paper by Kaplan and Violante that Narayana Kocherlakota pointed me to. This paper argues that there is an important group that they call the ‘hand-to-mouth wealthy’. These are asset rich individuals that hold their wealth in non-liquid form (e.g a pension), and because of the non-liquid nature of the wealth they might have a high marginal propensity to consume out of current income. It is an interesting idea with some empirical backing, but which I think only emphasises the importance of thinking about the composition of any tax cut when calculating the degree of stimulus.

In retrospect it might have been simpler to give a better known example of the potential disconnect between the aggregate deficit and a stimulus, which is the balanced budget multiplier. To the extent that fiscal policy under Trump may involve cuts in government consumption, that example could be very relevant, as Paul Krugman notes.

In the case of public investment, I again argued that the nature of this investment mattered. If the mechanism used to increase public investment (see this piece by Stiglitz for example) meant that a good proportion of this investment involved projects with a low social return (white elephants), then once again people on average would not be better off. This point depends on something which I took for granted but which I should have been spelt out: monetary offset.

Because the US economy is no longer at the zero lower bound, then an increase in GDP caused by building lots of white elephants would almost certainly lead to an increase in interest rates. [2] As a result, GDP might not actually increase, and useful private investment would be crowded out by useless public investment.

Once interest rates start rising from their zero lower bound, then those who argue that demand should be increased in the US (see here or here) are really complaining about monetary policy, not fiscal policy. An expansionary fiscal policy that is crowded out by the Fed might have some indirect advantages, in raising the natural interest rate for example, but the famous ‘digging holes’ argument used by Keynes no longer applies.

Once we leave the zero lower bound, tax cuts for the rich amount to a regressive redistribution of income. People should not be fooled into thinking that the tax cuts will somehow pay for themselves, through Keynesian or any other means. There is an extremely strong case for a large expansion in public investment financed by additional public borrowing, but this investment needs to go where it is needed, rather than to schemes that will generate a quick return to private sector financiers. There is a strong case for using additional demand to expand the US economy, but it will not happen as long as the Fed believes otherwise.

[1] I confusingly talked about the wealthy as acting as if Ricardian Equivalence held, when I should have simply said that because they were wealthy they would focus on lifetime rather than current income, and so would have a low MPC from a temporary tax cut. Assuming a tax cut for the rich is permanent is equivalent to assuming the Republicans never lose power.

[2] Assuming, of course, that the Fed remains independent, but Krugman argues that even if it did not we might still see higher interest rates.

Thursday, 29 December 2016

Left and Right in 2016

Before the Christmas break David Blanchflower asked me a question on twitter: “why do you think we have seen the move to right-wing rather than left-wing populism?” This is my reply. I’ll just talk about the US and UK because I do not know enough about other countries. (Here is an interesting analysis of populists in Eastern Europe.) I’ll take it as read that there are currently well understood reasons for people to want to reject established politicians, and the Blanchflower question is really about why that rejection went right rather than left.

In my answer I want to distinguish between two types of people. The first are those that are not that interested in politics, and are therefore not well informed. They depend on just a few parts of the MSM for their information. The second are those that are interested in politics and are well informed, using multiple sources which are not just confined to the mainstream media (MSM). I want to argue that this distinction is crucial in helping us understand what happened in 2016.

I also want to use the term populist for policies in its most simple form, as policies that are likely to be immediately popular with the public, without the negative connotations that I discussed here. Populist policies on the left would focus on measures to curb financialisation and the power of finance (‘bashing bankers’), and measures to reduce inequality (which are popular if expressed in terms of the 1%, or CEO pay). Right wing populist policies include of course controls on immigration, combined with constant references to national identity. The need to control international trade can be invoked by left and right.

Among those who are well informed, there is no evidence that dissatisfaction with existing elites broke right rather than left. Indeed membership of political parties in the UK suggests the opposite is true. Party members in the UK are almost by definition likely to be much more interested in politics than the average citizen, and will not be dependent on one or two elements of the MSM for information. As the Labour party leadership has shifted left and adopted some of the left wing populism I’ve described, its membership has exploded. The figures are remarkable. The Labour party currently has a membership of over half a million. This is probably [1] at least three times the membership of the Conservative party. UKIP, the populist party of the right, has a membership of only 39,000, which is below the membership of the Greens.

The Sanders campaign indicates both the popularity of left wing populism among political activists in the US, but also that left wing populist policies can be as popular with voters as those from the right when they get a national platform. Sanders put greater taxes on the rich and additional Wall Street regulation at the centre of his platform, as well as opposition to trade agreements. The campaign was largely funded by individual donations, in contrast to the other campaigns. With the exposure that an extended election process gave him, Sanders’ brand of left wing rhetoric got national coverage and proved pretty popular. Sanders claimed, with some justification, that he actually polled better against Trump than Clinton, and it remains an open question whether a populist from the left might have done better against Trump than Clinton, who epitomised the establishment.

During the Sanders campaign left wing populist ideas did get wide coverage in the MSM, but this is the exception rather than the rule. After the financial crisis there was a brief period of about a year when these more left wing themes were a major media focus, but since then they appear only occasionally in the MSM. In contrast parts of the MSM in both countries has for many years produced propaganda that supports right wing populism, and the non-partisan elements of the MSM have done very little to contest this propaganda, and on many occasions simply follow it.

Let me put these points in a slightly different way. For the few of us that do attach great importance to the media in understanding recent events, it would be a major problem if on occasions where alternative ideas were given considerable coverage in the media they were ignored by voters. It would also be a major problem if those who were much less dependent on one or two MSM sources for information behaved in the same way as the average voter. But fortunately for us both the Sanders campaign and UK party membership suggest neither problem arises, but instead these pieces of evidence provide support for our ideas.

So in both the US and UK, among those who are exposed to left wing populism or who access a much broader range of information than that provided by the MSM, there is no puzzle of asymmetry. Left wing populism continues to appeal. The asymmetry at the level of the popular vote, that gave us Brexit and Trump, can be explained by asymmetry in the media. Right wing populist ideas not only get much more coverage than left wing populist ideas, but sections of the MSM actively promote these ideas. Given that this focus on the importance of the providers of information is intuitive, it is really up to those who think otherwise to provide both theory and evidence to support their view that the MSM is unimportant.

[1] I say probably because the latest data we have for Conservative party membership is 2013. However I think it is reasonable to speculate that lack of publication means numbers have been going down, not up.