economics

Corbyn and the Peoples’ Bank of England

Jeremy Corbyn’s proposal for ‘Peoples’ Quantitative Easing’ – public investment paid for using money printed by the Bank of England – has provoked criticism, including an intervention by Labour’s shadow Chancellor Chris Leslie. It seems the anti-Corbyn wing of the Labour party has finally decided to engage with Corbyn’s policy agenda after several weeks of simply dismissing him out of hand.

Critics of the plan make two main points: that the policy will be inflationary and that it dissolves the boundary between fiscal policy and monetary policy. It would therefore, they claim, fatally undermine the independence of the Bank of England.

The first point is inevitably followed by the observation that inflation and the policy response to inflation – interest rate hikes and recession – hurts the poor. As ever, the first line of attack on economic policies proposed by the left is to claim they will hurt the very people they aim to help. Leslie falls back on the old trope that the state must `live within its means’. It is well-known that this government-as-household analogy is nonsense. But what of the monetary argument?

Inflation is not caused by printing money per se. It is instead the result of a combination of factors: wage increases, supply not keeping pace with demand, and shortages of commodities, many of which are imported.

By these measures, inflationary pressure is currently low – official CPI is around zero. Since this measure tends to over-estimate true inflation, the UK is probably in deflation. There is finally evidence of rising wages – but this comes after both a sharp drop in wages due to the financial crisis and an extended period in which wages have grown at a slower rate than output. The pound is strong, reducing price pressure from imports.

More importantly, the purpose of investment is to increase productive capacity and raise labour productivity. Discussion of monetary policy usually revolves around the ‘output gap’ – the difference between the demand for goods and services and the potential supply. Putting to one side the problems with this immeasurable metric, the point is that investment spending increases potential output as well as stimulating demand, so the medium-run effect on the output gap cannot be determined a priori.

The issue of central bank independence is more subtle – certainly more subtle than the binary choice presented by Corbyn’s critics. That central banks should be free from the malign influence of democratically elected policy-makers has been an article of faith since 1997 when the Labour government granted the Bank of England operational independence. But, as Frances Coppola has argued, central bank independence is an illusion. The Bank’s mandate and inflation target are set by the government. In extremis, the government can choose to revoke ‘independence’.

More relevant to the current debate is the fact that the post-crisis period has already seen significant blurring of the distinction between monetary and fiscal policy. In using its balance sheet to purchase £375bn of securities – mostly government bonds – the Bank of England has, to all intents and purposes, funded the government deficit. The assertion that the barrier is maintained by allowing debt to be purchased only in the secondary market is sleight of hand: while the government was selling new bonds to private financial institutions the Bank was simultanously buying previously issued government bonds from much the same financial institutions.

At this point, critics will object that the Bank was operating within its mandate: QE was enacted in an attempt to hit the inflation target. This is most likely true, although during the inflation spike in 2011, there were suggestions the Bank was deliberately under-forecasting inflation in order to be able to run looser policy; as it turned out, the Banks’ forecasts over-estimated inflation.

None of this alters the fact that quantitative easing both increases the ability of the government to finance deficit spending and has distributional consequences; QE reduced the interest rate on government bonds while increasing the wealth of the already wealthy. Crucially, there won’t be a return to ‘conventional’ monetary policy any time soon. At a panel discussion at the FT’s Alphaville conference on ‘Central Banking After the Crisis’ featuring George Magnus and Claudio Borio among others, there was consensus that we have entered a new era in which the distinction between monetary and fiscal policy holds little relevance; there will be no return to the ‘haven of familiar monetary practice‘ in which steering of short-term interest rates is the primary mechanism of macroeconomic control.

The issue which has triggered this debate is the long-term decline in UK capital expenditure – both public and private. An increase in investment is desperately needed. Corbyn isn’t the first to suggest ‘QE for the people’ – a number of respectable economic commentators have recently called for such measures in letters to the Financial Times and Guardian. Martin Wolf, chief economics commentator at the FT, recently argued that ‘the case for using the state’s power to create credit and money in support of public spending is strong’. Former Chairman of the Financial Services Authority, Adair Turner, has made similar proposals.

I agree, however, with the view that it makes more sense to fund public investment the old-fashioned way – using bonds issued by the Treasury. Where I disagree with Corbyn’s critics is on the sanctity of `independent’ monetary policy; the Bank should stand ready to ensure that these bonds can be issued at an affordable rate of interest.

Why has Corbyn – supposedly a throwback to the 1980s – proposed this new-fangled monetary mechanism? Rather than some sort of populist gesture, I suspect this reflects a status quo which has elevated the status of monetary policy while downgrading fiscal policy. This, in turn, reflects the belief that the government can’t be trusted to make decisions about the direction of the economy; only the private sector has the correct incentive structures in place to guide us to an optimal equilibrium. Monetary policy is the macroeconomic tool of choice because it respects the primacy of the market.

Given that the boundary between fiscal and monetary policy has broken down at least semi-permanently, that status quo no longer holds. It is now time for a serious discussion about the correct approach to macroeconomic stabilisation, the state’s role in directing and financing investment and the distributional implications of monetary policy. It is to Corbyn’s credit that these issues are at last being debated.

What if Reinhart and Rogoff had adopted a more Keynesian perspective?

Illustration by Ingram Pinn (Financial Times)

Illustration by Ingram Pinn (Financial Times)

In two very influential papers, Reinhart and Rogoff (2010) and Reinhart et al. (2012) investigated the relationship between public debt and economic growth. By classifying the annual observations of their data set into public debt categories (low debt, medium debt, high debt, very high debt) and identifying public debt overhang episodes, they indicated that higher public debt-to-GDP ratios are related to lower economic growth. They also emphasised that this relationship is non-linear: although the debt-to-growth correlation is weak below the 90 per cent debt-to-GDP threshold, it becomes much stronger above it. As is well-known, these results were used by many policy makers in support of the austerity policies that have been implemented over the last years in various countries.

In their popular critique Herndon et al. (2013, 2014) called the results of Reinhart and Rogoff into question. They pointed out three problems: (i) coding errors; (ii) selective exclusion of available data; and (iii) inappropriate weighting of summary statistics. They showed that when these problems are tackled, economic growth does not dramatically reduce when the public debt-to-GDP ratio passes the 90 per cent threshold. Reinhart and Rogoff (2013) responded by acknowledging the coding errors in their estimations; however, they disagreed that their weighting method is inappropriate and that they made selective exclusion of data. They themselves presented some corrected estimations according to which the negative relationship between growth and debt remains, but ceases to become stronger above the 90 per cent threshold.

An interesting perspective to this debate is that the whole discussion about the relationship between public debt and economic growth would have been completely different if Reinhart and Rogoff had decided to focus on the adverse effects of low growth on public indebtedness rather than on the adverse effects of high public indebtedness on growth; in other words, if they had analysed their data set using a more Keynesian perspective that emphasises the role of automatic stabilisers and the direct favourable impact of a higher GDP on the debt-to-GDP ratio. In a note that I recently published (Dafermos, 2015) I show what their results would be in that case. Using the same descriptive statistics techniques that Reinhart and Rogoff utilised in their papers, I classify the annual observations of their data set into economic growth categories (low growth, medium growth, high growth, very high growth) and I indicate that the public debt-to-GDP ratio increases as economic growth declines. I also identify low growth episodes and I show that in most countries these episodes are characterised by higher public indebtedness. Therefore, if Reinhart and Rogoff had decided to present their data in this way, the main implication of their analysis would have been that growth policies need to be adopted by policy makers in order to avoid high public indebtedness; and not that policy makers need to focus on the reduction of public debt in order to avoid low growth.

Of course, Reinhart and Rogoff are careful about this issue: they clearly state that their analysis does not capture causality. However, by classifying their data set into public debt categories and identifying debt overhang episodes they unavoidably concentrated on the growth-reducing effects of high debt, relegating the debt-increasing effects of low growth to the sidelines. On the contrary, if they had adopted a more Keynesian perspective, they could have focused on the debt-increasing effects of low growth. In that case, their conclusions, which informed the policy debate, would have been completely different.

It is also important that the econometric research that followed the publication of their papers was substantially affected by the decision of Reinhart and Rogoff to focus on the growth-reducing effects of high public debt: most researchers have paid attention to the adverse effects of high debt on growth and not the other way round. Interestingly, the literature has not so far provided strong support to the causality from public debt to economic growth (see footnote 1 in my note). This implies that the empirical research needs to investigate the debt-increasing effects of low growth in greater depth; as would have probably been the case if Reinhart and Rogoff had decided to analyse their dataset using a more Keynesian perspective, or if they had explicitly presented both ‘halves’ of the public debt-economic growth relationship.

Yannis Dafermos

Models, maths and macro: A defence of Godley

To put it bluntly, the discipline of economics has yet to get over its childish passion for mathematics and for purely theoretical and often highly ideological speculation, at the expense of historical research and collaboration with the other social sciences.

The quote is, of course, from Piketty’s Capital in the 21st Century. Judging by Noah Smith’s recent blog entry, there is still progress to be made.

Smith observes that the performance of DSGE models is dependably poor in predicting future macroeconomic outcomes—precisely the task for which they are widely deployed. Critics of DSGE are however dismissed because—in a nutshell—there’s nothing better out there.

This argument is deficient in two respects. First, there is a self-evident flaw in a belief that, despite overwhelming and damning evidence that a particular tool is faulty—and dangerously so—that tool should not be abandoned because there is no obvious replacement.

The second deficiency relates to the claim that there is no alternative way to approach macroeconomics:

When I ask angry “heterodox” people “what better alternative models are there?”, they usually either mention some models but fail to provide links and then quickly change the subject, or they link me to reports that are basically just chartblogging.

Although Smith is too polite to accuse me directly, this refers to a Twitter exchange
from a few days earlier. This was triggered when I took offence at a previous post
of his in which he argues that the triumph of New Keynesian sticky-price models over their Real Business Cycle predecessors was proof that “if you just keep pounding away with theory and evidence, even the toughest orthodoxy in a mean, confrontational field like macroeconomics will eventually have to give you some respect”.

When I put it to him that, rather then supporting his point, the failure of the New Keynesian model to be displaced—despite sustained and substantiated criticism—rather undermined it, he responded—predictably—by asking what should replace it.

The short answer is that there is no single model that will adequately tell you all you need to know about a macroeconomic system. A longer answer requires a discussion of methodology and the way that we, as economists, think about the economy. To diehard supporters of the ailing DSGE tradition, “a model” means a collection of dynamic simultaneous equations constructed on the basis of a narrow set of assumptions around what individual “agents” do—essentially some kind of optimisation problem. Heterodox economists argue for a much broader approach to understanding the economic system in which mathematical models are just one tool to aid us in thinking about economic processes.

What all this means is that it is very difficult to have a discussion with people for whom the only way to view the economy is through the lens of mathematical models—and a particularly narrowly defined class of mathematical models—because those individuals can only engage with an argument by demanding to be shown a sheet of equations.

In repsonse to such a demand, I conceded ground by noting that the sectoral balances approach, most closely associated with the work of Wynne Godley, was one example of mathematical formalism in heterodox economics. I highlighted Godley’s famous 1999 paper
in which, on the basis of simulations from a formal macro model, he produces a remarkably prescient prediction of the 2008 financial crisis:

…Moreover, if, per impossibile, the growth in net lending and the growth in money supply growth were to continue for another eight years, the implied indebtedness of the private sector would then be so extremely large that a sensational day of reckoning could then be at hand.

This prediction was based on simulations of the private sector debt-to-income ratio in a system of equations constructed around the well-known identity that the financial balances of the private, public and foreign sector must sum to zero. Godley’s assertion was that, at some point, the growth of private sector debt relative to income must come to an end, triggering a deflationary deleveraging cycle—and so it turned out.

Despite these predictions being generated on the basis of a fully-specified mathematical model, they are dismissed by Smith as “chartblogging” (see the quote above). If “chartblogging” refers to constructing an argument by highlighting trends in graphical representations of macroeconomic data, this seems an entirely admissible approach to macroeconomic analysis. Academics and policy-makers in the 2000s could certainly have done worse than to examine a chart of the household debt-to-income ratio. This would undoubtedly have proved more instructive than adding another mathematical trill to one of the polynomials of their beloved DSGE models—models, it must be emphasised, once again, in which money, banks and debt are, at best, an afterthought.

But the “chartblogging” slur is not even half-way accurate. The macroeconomic model used by Godley grew out of research at the Cambridge Economic Policy Group in the 1970s when Godley and his colleagues Francis Cripps and Nicholas Kaldor were advisors to the Treasury. It is essentially an old-style macroeconometric model combined with financial and monetary stock-flow accounting. The stock-flow modelling methodology has subsequently developed in a number of directions and detailed expositions are to be found in a wide range of publications including the well-known textbook by Lavoie and Godley—a book which surely contains enough equations to satisfy even Smith. Other well-known macroeconometric models include the model used by the UK Office of Budget Responsibility, the Fair model in the US, and MOSES in Scandinavia, alongside similar models in Norway and Denmark. Closer in spirit to DSGE are the NIESR model and the IMF quarterly forecasting model. On the other hand, there is the CVAR method of Johansen and Juselius and similar approaches of Pesaran et al. These are only a selection of examples—and there is an equally wide range of more theoretically oriented work.

This demonstrates the total ignorance of the mainstream of the range and vibrancy of theoretical and empirical research and debate taking place outside the realm of microfounded general equilibrium modelling. The increasing defensiveness exhibited by neoclassical economists when faced with criticism suggests, moreover, an uncomfortable awareness that all is not well with the orthodoxy. Instead of acknowleding the existence of a formal literature outside the myopia of mainstream academia, the reaction is to try and shut down discussion with inaccurate blanket dismissals.

I conclude by noting that Smith isn’t Godley’s highest-profile detractor. A few years after he died—Godley, that is—Krugman wrote an unsympathetic review of his approach to economics, deriding him—oddly for someone as wedded to the IS-LM system as Krugman—for his “hydraulic Keynesianism”. In Krugman’s view, Godley’s method has been superseded by superior microfounded optimising-agent models:

So why did hydraulic macro get driven out? Partly because economists like to think of agents as maximizers—it’s at the core of what we’re supposed to know—so that other things equal, an analysis in terms of rational behavior always trumps rules of thumb. But there were also some notable predictive failures of hydraulic macro, failures that it seemed could have been avoided by thinking more in maximizing terms.

Predictive failures? Of all the accusations that could be levelled against Godley, that one takes some chutzpah.

Jo Michell

Response to Tony Yates’ critique of Teaching Economics After the Crash

Tony Yates has written a critical rejoinder to Aditya Chakrabortty’s Radio 4 documentary on student demands for changes to university teaching of economics. Yates’ contribution is welcome as a rare example of a mainstream economist publicly engaging with the issues raised by dissatisfied students. For too long, the response of the mainstream has been to ignore criticism. Yates’ willingness to enter into dialogue – even if motivated by unhappiness with the content of the programme – is encouraging. Further, it clarifies the view of (some) mainstream economists on the teaching debate.

Yates’ first complaint is that the programme is an opinion piece rather than a report in which equal space is given to each side. It is true that the bulk of the programme focused on the grievances raised by the student movement – this was after all the subject of the piece – and provided only brief slots for dissenting voices. Criticising the programme on this basis ignores the bigger picture of total dominance by mainstream economics – not only in academia but also in the media and public debate. The number of critical economists who appear regularly on television and radio can be counted on one hand. Chakrabortty’s programme and the student movement that pushed it onto the agenda are welcome, yet remain a drop in the ocean.

Yates might reflect on the following question: Were a programme broadcast that defined economics in the terms he believes – a rigorous scientific discipline systematically discovering objective truths and discarding past mistakes – would he object to such an equally one-sided narrative?  For decades, this narrative has dominated to the extent that, until recently, there was no publicly audible debate. It is to the enormous credit of student groups that they have raised the volume of critical voices such that Chakrabortty’s programme could be made.

The more substantive criticisms made by Yates relate to what he regards as manifold factual inaccuracies peddled by interviewees and allowed to go unchallenged – in particular, inaccuracies about the assumptions of mainstream economics.

There are two important problems with Yates’ argument.  First, Chakrabortty’s programme was explicitly concerned with teaching economics – teaching economics at undergraduate level specifically.  Yates’ response is mainly concerned with academic and professional economics in general and, in particular, the higher reaches of contemporary research programmes. Second, and more importantly, Yates condenses students’ calls for increased methodological pluralism into a debate between rational choice theory and its (neoclassical) alternatives. One of the first students interviewed by Chakrabortty complains about a “lack of alternative perspectives, lack of history or context, that could include politics . . . lack of critical thinking, and lack of real world application” in undergraduate degrees. Yates’ response entirely fails to address this key issue.

The “caricatures” of mainstream economics to which Yates takes offence include rational choice, rational expectations, perfect markets, quantifiable risk, and an ignorance of money, banking and finance. Yates argues that this characterisation fails to take account of recent innovations such as bounded rationality, asymmetric information, monopolistic competition, learning effects, uncertainty, sticky prices, credit frictions, and so on. Moreover, Yates has previously argued that a course based on these types of models could adequately replace the course on Bubbles, Panics and Crashes which Manchester University cancelled.

Putting aside, for the moment, issues of methodological pluralism and historical context, does Yates really believe that Farmer’s multiple equilibrium models, internal rationality in intertemporal optimisation, or search models of money and credit should be taught in undergraduate degrees? One of us (Jump) took an MSc on which John Hardman Moore taught. Even there, the “collected works of the Kiyotaki-Moore collaboration” didn’t make it onto the syllabus. One can hardly criticise a programme about teaching economics – and, by extension, those involved with the various student movements – for ignoring papers that most PhD students find difficult to follow.  Regardless of the validity of the approach, “crunching exotic nonlinear ordinary differential equations” is unlikely to become part of the undergraduate economics syllabus any time soon.

A squabble over the exact models taught is not, however, the real issue.  While true that, since the heyday of real business cycle models, the mainstream has pulled back from the most egregious extremes of asserting a world of continuous full employment and total policy ineffectiveness, subsequent modifications to general equilibrium models – sticky prices for instant price adjustment, internal rationality for rational expectations, asymmetric information for full information – are always assumed to be “frictions” and “imperfections”; deviations from some socially optimal baseline.  Arguing about which specific unrealistic assumption has been dropped in this or that model misses the wood for the trees. The students want to be allowed to engage with different methodological approaches to economics – not to be told that if they study for another two years they can learn the Bernanke-Gertler financial accelerator model instead of the Woodford version with “perfect capital markets”.

The methodological approach of neoclassical economics – equilibria derived from optimisation problems couched in ever-more complicated mathematical settings – is highly restrictive, ideologically loaded, and universally imposed on undergraduates. The result of the complete elimination of any other approach from the curriculum is that students spend all their time learning how to manipulate abstract mathematical models which appear to hold little relevance for the real-world problems they are interested in addressing – as is made clear from the interviews conducted by Chakrabortty.

An important consequence of this methodological narrowing has been the (almost complete) eradication of economic history and the history of economic thought from the undergraduate curriculum.  This is a point conceded by Karl Whelan who argues, in his response to Chakrabortty’s programme, that mixing the formal neoclassical syllabus with “broader knowledge” would produce more rounded students – a conclusion also reached by the RES steering group on teaching economics.

Yates admits that he doesn’t believe that “any of the monetary policymakers I worked for or read believed much of [the workhorse NK model].  They worked off hunches, gut instinct, practical experiences.” (This is ironic given that Gali and Gertler – key architects and advocates of the models Yates claims policy-makers weren’t using – believe the models were introduced because previous versions were so inaccurate that “monetary policymakers turned to a combination of instinct, judgment, and raw hunches to assess the implications of different policy paths for the economy”.) What are such hunches and instincts based upon?  Aside from personal experience, one imagines that historical knowledge of previous crises played a part here (e.g., Ben Bernanke). Re-introducing this type of material into economics teaching would, as Whelan argues, produce more capable graduates.  Moreover, knowledge of the way that theory has evolved alongside economic events would provide valuable context for the “exotic non-linear equations” – but it would also cultivate an awareness of the dramatic methodological narrowing within the subject.

One of us (Michell) put this point to Yates on Twitter – admittedly not the ideal medium for careful debate. His response was approximately the following: economic history and history of economic thought are irrelevant – at best, a fun diversion for bath-time reading. This is because economics continually progresses so that the history of the discipline only reveals things “either discarded or whose husks were bettered and extracted”. As an example: “I don’t need to read Keynes to understand the liquidity trap … Wallace and Woodford suffices”.

At this point, one arrives at the inevitable argument that, whilst increasing methodological pluralism in undergraduate degrees may be a good thing, “heterodox economics” is best consigned to optional modules, or discarded altogether.  This misses a point of considerable importance: academic heterodoxy in economics is, more often than not, associated with methodological disagreement.  This is most clear in the further reaches of Post Keynesian and Austrian economics – e.g. Shackle, Lachmann – and in Marxian political economy where historical analysis is central.

If, for example, one wanted to teach the economics of financial crisis, surely the history of financial crises and inductive theory are the correct places to start?  Kindleberger and Minsky are the obvious candidates – after which more formal models could be considered.  This is not to say that the various heterodox approaches do not have their problems, but they are useful springboards to a deeper understanding of economic phenomena. Such empirically-based study would surely be a better starting point than learning Euler equations – despite the fact that the standard consumption Euler equation is known to fail miserably when taken to the data – or the standard model of a representative firm’s investment decision – despite the on-going failure of econometricians to find a robust relation between short run capital investment and the real interest rate.

Let us finish by returning to Yates’ Whig-historical view of the liquidity trap – a view which encapsulates much of the problem with mainstream economics. In modern neoclassical parlance, the liquidity trap refers to a situation in which nominal interest rates are equal to zero and quantitative easing is ineffective because changes in the quantity of (base) money have no effect on the (rational expectations) equilibrium future inflation path. As a result, the central bank is unable to reduce the real rate of interest and stimulate spending. All this matters because the economy fails to bring itself back to equilibrium in a timely fashion due to slow price adjustment.

This is unrecognisable to any serious scholar of Keynes. The liquidity trap refers to a situation in which fundamental uncertainty about the future leads people to hoard cash in preference to other financial assets, no matter how cheap those assets become. At the same time, uncertainty means firms may not commit to investment even if interest rates fall to a point that would previously have stimulated spending. The stickiness or otherwise of prices and wages is irrelevant because changes in output and employment provide the mechanism by which saving and investment are brought into equilibrium.

This brings other contentious topics to the fore, such as uncertainty, animal spirits and the neoclassical treatment of money. Each of these is highlighted by Yates as used in the programme to unfairly attack mainstream economics – he does concede that money as a veil over barter is a fair description for the most part.

Recall the definition of uncertainty emphasised by Knight and Keynes: a situation in which the future simply cannot be predicted, in contrast to a ‘risky’ situation in which all possible events are known, along with the probability of each.  This differentiation is fairly basic, and has been textbook material in game theory since (at least) Luce and Raiffa.  Now consider one example using Yates’ favoured approach to modelling uncertainty in macroeconomics: The central bank, unable to determine which of its three Phillips Curve models is correct, uses Bayesian inference to decide which model to use. This is almost beyond parody – simply a branding exercise which conceals the fact that the model has nothing whatsoever to do with the true meaning of the concept. Other “Keynesian” features of modern neoclassical economics highlighted by Yates are similarly grotesque caricatures of the original concepts.

By not studying Keynes in the original – or any other important economist from more than forty years ago – students are prevented from discovering such inconsistencies and are forced to take at face value the distortions and misrepresentations of mainstream economics. They are prevented from understanding how historical circumstance plays a role in the development and acceptance of economic theory: the Great Depression for Keynes and the stagflation of the 1970s for Friedman, for example. They also – crucially – fail to appreciate that economic and political power matters: mainstream economic theory is “history as written by those perceived to have been the intellectual victors of key debates”.

Yates describes Aditya Chakrabortty’s Radio 4 documentary as “a distorting dramatisation, on account of allowing multiple silly, uninformed critiques to go unchallenged in the program. Yet presented as a reasonable, impartial take on what is going on in economics.” This is unfair to the students involved in the reform movement and misses the main point of the programme. While we would not defend every claim made in the programme, we strongly support the call for a widening of the economics curriculum.

Given the role of the profession in contributing to the 2008 crisis, and in justifying the inexcusable policy packages imposed in response to the post-crisis expansion of sovereign debt, we might – at the very least – display some humility when addressing the inevitable public backlash. Beyond this, we must act on student demands and address past failings by implementing a fundamental overhaul of the economics curriculum.

 

Rob Jump
Jo Michell