Sunday, 28 October 2012

A Change of Tune

Predictably, Ken Clarke has retracted his statement on married-couple tax breaks, suggesting that the use of the tax system to force people to conform to Villa Tory ideals of family life will not in fact be postponed beyond the next election. But, as Isabel Hardman points out, the real story is what he said about the Conservatives' campaign strategy in 2015:
“It would be absolute folly to turn around and say it will all be fine by Christmas. Anybody who says we are absolutely certain we are bouncing back to strong growth is being very optimistic. What I am confident we will be able to say at the next election is we were a strong hand on the tiller.”
Basically, this is a recognition that the gamble the Tories decided to take in 2010 probably isn't going to pay off. The argument was that austerity measures would allow the government to say that they had been tough on debt, while the economy would be rebounding by 2015 anyway. Indeed, if austerity made the recession worse and the recovery slower, well, that just meant a bigger bounceback closer to election time.

This is starting to look increasingly unlikely. I'm still optimistic that the output gap is larger than most people think, and that we'll have a recovery eventually that gets us at least partway back to trend, but it might not happen until too late to win the Conservatives a majority. Remember that in order to do so the Tories would have to flip voters that they couldn't attract when they were running against Brown. And not winning a majority means not governing, because even if they win the most seats in a hung parliament, as last time, the Coalition is unlikely to persist beyond 2015. It would be the end of the Lib Dems.

It's not too late, of course, for the Conservatives to jump-start the recovery. Of course, George Osborne is extremely unlikely to direct the Bank of England to raise its inflation target, or in a best-case scenario target the level of nominal GDP. But there are other things the Treasury could do.

I'm more optimistic than most market monetarists about the potential usefulness of fiscal stimulus, particularly in terms of the 'balanced-budget multiplier' - shifting government spending from low-multiplier items to high-multiplier ones. It's not completely implausible that the Tories could decide to reduce low-multiplier cash transfers (i.e. benefits), and spend the money on building new roads and houses. And the standard critique of the balanced-budget multiplier, that the composition of government spending is inappropriate as an instrument of short run demand management, doesn't really apply, because we probably should be spending more on public goods and less on welfare in the long term.

Ultimately, though, the Tories are going to have to start thinking about what they're going to do in 2015 if growth over the next few years remains decidedly anaemic. It might be almost too easy for Labour to point out that a 'strong hand on the tiller' isn't a good thing if you're steering in the wrong direction.

Saturday, 27 October 2012

Why Do Too Many People Buy Houses?


Josh Barro and Noah Smith made the point today that housing is a pretty bad investment for most people to make, and it seems pretty clear that houses are overvalued. The problem is that for many people there’s something special about home ownership – people don’t see taking out a mortgage to buy a house as just any old investment. If they did, they would do a lot less of it.

Compare buying a house to investing the deposit, plus the money which you would have spent on mortgage payments above and beyond what it costs to rent, in a global stock market fund. In simple terms, housing probably offers a worse return than the stock fund would. Barro notes that it’s also much more strongly correlated with unemployment. Your savings are most important when there’s an economic downturn – you stand a higher chance of losing your job and needing to rely on those savings. But house prices are also likely to drop sharply in a recession. Because house purchases are so highly leveraged, the effects of a decline in value can be disastrous – losing your job means you can’t pay your mortgage, and suddenly the savings you had in the form of your house have been repossessed. Housing is a savings vehicle that becomes worthless as soon as you need to access it. You’d be much better off if you had your savings somewhere that isn’t likely to collapse at the same time as you lose your job, like China.

Another cost to housing as an investment is its inflexibility. If you need to tap those savings, because you’re between jobs or your car breaks down or your son really needs you to e-mail him a plane ticket back from Thailand, it’s really hard to get money out of your house. You might be able to refinance over a longer term, effectively reducing your payment, or with a higher principle, but remortgaging is time-consuming, expensive, and is subject to the whims of your bank. Equity-release schemes, meanwhile, are risky and charge exorbitant rates. It’d be much easier to sell some of a stock portfolio.

However, this inflexibility might also explain why housing is attractive. Comparing buying a house to investing in stocks assumes that you invest the same amount of money either way. If you rent, though, you’re going to have a lot more disposable income, and it’s going to require a much greater effort of will to save that money. ‘I would have to put less money into my portfolio this year’ is a much less likely to persuade Future You to forego the family summer holiday than ‘I wouldn’t be able to pay the mortgage.’ In this sense, you’re entering into an inflexible commitment to save.

You might have very good reasons for doing this. Perhaps you’re worried that Future You will be seduced by the allure of the Costa del Sol or a V8 penis substitute, and won’t save enough to finance the retirement you have in mind. By entering into a big inflexible mortgage, you force Future You to save that money. It’s the same logic as that of the dieter who puts a lock on the fridge door at night, or the blogger who pays someone to slap him when he checks Facebook. By increasing the costs of a lapse in self-control, you can make it more likely that you get the long-term outcome you want – in this case, adequate savings for later life.

Publicly forcing yourself to commit has implications for relationships, too. Home ownership is inevitably tied to the institution of marriage – and its importance is increasing as the traditional social attitudes to divorce weaken. Getting a mortgage with your partner is an explicit commitment to your long-term relationship. It makes leaving the relationship costly, forcing you to expend a lot of effort trying to make that relationship work when you might otherwise be impetuous. It’s also an important signal that you are the kind of person who places value on the importance of commitment, in the same way that the dieter’s girlfriend might be impressed by the lock on the fridge door. If, on the other hand, you extoll the virtues of your highly portable global stock index, your partner might start to worry about your motivation for trying to minimise the impact of divorce on your savings. And so you have an incentive to commit.

People don’t treat buying a house like they would other investments, but it’s not enough to say that this is simply irrational. There are a lot of good reasons why people might not be indifferent between owning and renting, and why they might want their chosen savings vehicle to be highly inflexible.

Wednesday, 10 October 2012

Exogenous Reality Shocks: Conservatives, Cuts and Conference


David Cameron's conference speech mostly retreads the same old ground, but one passage about developing country competitiveness stuck out:

"What do the countries on the rise have in common?
They are lean, fit, obsessed with enterprise, spending money on the future – on education, incredible infrastructure and technology.
And what do the countries on the slide have in common?
They’re fat, sclerotic, over-regulated, spending money on unaffordable welfare systems, huge pension bills, unreformed public services."

This is a common argument from moderate voices on the right - that we should be spending money on education, on infrastructure, on things that boost the economy and competitiveness, rather than squandering public money on welfare. It combines a defence of the importance of opportunity-enhancing public goods with a crusade against the wasteful bureaucracy and poor incentives that stem from overly generous welfare systems. In general, I'm very sympathetic to this argument, and Cameron (incongruous 'fat' comments aside) makes it pretty well. It's the argument I'd be making, if I was a conservative.

Of course, I'm not a Tory, and won't be so long as the NIMBY populists continue to outshout the free-marketeers on immigration and on Europe. But Cameron's speechwriters are definitely onto something here. Sadly, policymakers aren't helping out - as it turns out, the government is spectacularly failing to 'spend money on the future.' As this graph (courtesy of Jonathan Portes) shows, investment is the last thing on the Coalition's agenda:


The basic problem here is exactly the same problem that austerity governments always have. It's very difficult to cut spending. If you try and cut spending, what you end up cutting are the least visible elements of government spending, which also often happen to be the most important. That means cutting infrastructure, maintenance and R&D, where the costs of doing so are much less visible than those of taking Gran's winter fuel allowance away. It means cutting funding for administrative staff, so that you can boast about protecting frontline services while highly-paid police and doctors are forced to waste more time filling out paperwork. And ultimately it means that you end up making things worse and discrediting deficit reduction when really you started out with mostly good ideas.

Of course, the extent to which this is excessive electioneering by the Tories, rather than the unfortunate consequence of misaligned political incentives, is debatable. But the right could be doing this so much better.

Soak the Rich (In Liquidity): Monetary Policy, Left-wingers and Debt Deleveraging


Lately I've been seeing an increasingly large number of attacks on monetary stimulus, like this one, coming from the left of all places, even though there’s evidence that tight money massively increases inequality. Partly this is because denying that monetary policy is effective makes the argument for fiscal expansion much stronger, which is a good thing if you want to see a larger state and more redistribution. But even so it is baffling when QE is condemned as ‘giving money to fatcat bankers.’ There’s a perception that it inflates asset values, benefiting the rich, while not helping the working class or impoverished pensioners.

Krugman and others have modelled the Great Recession as a debt deleveraging story, with heterogenous agents – people with different preferences and constraints. What they show is that when, say, a big credit crunch leaves the poor unable to borrow, the rich (who are not liquidity-constrained) have no reason to raise their spending. This leads to an overall decline in nominal spending, plummeting output, rising unemployment and so on. The poor are busy paying off their debts, so if the government appears sublimely uninterested in fixing the housing market, there’s not much short of helicopter drops that you can do to increase their spending, especially once interest rates hit zero.

Under these circumstances, the state could step in to boost spending, confiscating the idle savings of the rich (perhaps through debt, which is essentially a promise to tax people in future periods) and putting that money to work in the economy. There are, however, good reasons why you wouldn't want to do this. It could have damaging incentive effects, and – in Europe, if not in America – we’re probably close enough to the optimum government share of the economy that we don’t want to permanently increase the size and reach of the state in response to one teensy little demand shortfall (which is arguably how the Great Depression got fixed). And there’s always the Sumner Critique to contend with. So ideally, unless you’re Ben Bernanke, you want monetary policy to shoulder the burden of boosting aggregate demand.

Unfortunately, there isn’t a whole lot you can do to get the poor spending, and so the shortfall in nominal spending has to be made up by the rich. But how do you get the rich to spend more, when really they’d rather hold cash? You make it possible for them to hold cash and spend at the same time, by buying their assets with newly-minted electronic money. The problem, of course, is that if you give the rich extra cash, most of it isn’t going to get spent, because their marginal propensity to save is a lot higher than that of the poor. But the beauty of monetary policy is that, unlike with fiscal intervention, you don’t have to worry about getting ‘bang for your buck', because the only major cost to printing money is the risk of overheating the economy. Provided you stand ready to take the punch bowl away, the actual dollar value of your stimulus package is pretty irrelevant. That means it’s fairly easy to overcome the propensity of the rich to save by giving them lots of money, so that what they do spend is enough to kickstart the economy again. Yes, this is a crude way to look at it, and it somewhat simplifies out the (vital) role of expectations, but it’s essentially what’s going on.

So is this a big transfer to the greedy plutocrats? Implicit in the monetary stimulus is that the injection of money is mostly temporary. If the central bankers are targeting inflation, they make it clear that the excess liquidity will be sucked out of the system before things get too out of hand. Under NGDP targeting, the central bank’s promise is essentially that enough of the expanded monetary base will be made permanent to get nominal GDP back to trend, but the rest is going to be removed. If we give every banker in the country a million pounds, but promise to take it all away again in five years, it might be enough to get the economy moving again, and get people back to work. It might also look like we were giving a bunch of cash to the wealthiest in our already-unequal society, even though that wasn’t what was really happening, and the poor ended up better off.

So that’s the story of QE you might tell if you were a New Keynesian. Those of a more monetarist bent, of course, don’t need to stoop to ‘telling stories’ about how a boost in the money supply affects nominal spending. Good for them.

Thursday, 20 September 2012

Gove-Levels, like all education policies, are a terrible idea


Politicians love to talk about making difficult decisions. The Conservatives ran in 2010 as the party of ‘tough decisions.’ However, despite having spectacularly bungled the easy decisions – notably on fiscal policy (more infrastructure spending needed) and controlling immigration (don’t), they addressed few of the problems to which there really isn’t a clear right answer. That is, until last weekend, when Education Secretary Michael Gove announced that GCSEs were going to be scrapped.

Education is always a political grey area, where there are no magic bullets, and nowhere is that more clear than in exams policy. As someone who has been through the system pretty recently, I can attest that the GCSE is an awful way to test 16-year-olds. There are two main issues. The first is that the exams too often reward learning how to phrase your answer in order to best fit the mark scheme and, rather than testing real knowledge and understanding. Things are improving, though, and some courses are better than others.

The more severe and intractable problem is that GCSEs are aimed at giving a basic grounding to the median student. The brightest pupils get very little out of two years of make-work exam practice, and syllabuses fail to adequately stretch them. Take the Biology, Chemistry and Physics GCSEs I did eighteen months ago. Sciences are not my forte, I did virtually no work for three years, I didn’t do much meaningful revision either, and I went into my physics paper barely understanding electricity or magnetism. Many of my friends are much more scientifically gifted than I am, and they also worked a lot harder. They all ended up with the same three A* grades I did. This is what the government is trying to fix – the newly announced EBacc, promptly dubbed ‘Gove-levels’ in the Education Secretary's honour, will aim to award the top grade to only 10% of pupils, raising standards, differentiating the exceptional from the merely good and helping to engage the most able kids in a reformed curriculum.

So far so good. But the other effect of raising standards is to exacerbate the most serious flaw GCSEs have – they are a complete waste of time for a huge number of the less academically inclined. Already, far too many people are leaving school with very little to show for their years of study. The cost of making Gove-levels better suited to the most able pupils is to spectacularly screw over the same people who struggle most under the current broken system.

Of course, there is a way to make the smartest 16-year-olds fulfil their potential, while still making sure you actually teach something to those at the other end of the distribution. A two-tier system, like the old O-Levels and CSEs, would mean fewer people being forced to sit an unsuitable exam. Ostensibly, it seems like a fairly good idea. Much of the current GCSE maths syllabus is only useful from an academic perspective, whereas a second tier of exams might teach to a high standard the practical skills which are being neglected under the current regime.  Everyone would come away from public education with at least some acknowledgement that what they did was worthwhile. And yet the very idea of a two-tier system is abhorrent to many people, and with good reason. There’s something very wrong about writing off a kid’s academic potential at the age of fourteen. There are going to be some people who end up suffering because they’re in the wrong half of a two-speed system. It divides kids into distinct groupings, which can’t be good for social cohesion. And if soft-hearted policymakers refuse to fail anyone, many argue, what’s the point in taking exams at all?

This is why I make the point that education reform presents a genuinely tough decision. The current system is untenable. It’s not clear whether Gove’s reforms will address the biggest problems with the education system, which are at the bottom rather than at the top end. But all of the choices are really bad, and a two-tier system might be the worst of the lot. At the end of the day, there’s only so much the exam system can do if the government isn’t prepared to invest more money in schemes like paying teachers more, extending the school day or implementing a US-style voucher system.

Note: I’ve focused mostly on course content and difficulty here, because that’s what I think the most influential part of the reforms will be. The replacement of piecemeal retake-friendly modules, with single final three-hour exams, is a big and significant change, though. While the module system is flawed, a gruelling final exam has its own problems. What about the people who happen to screw up on the day? What about the people who don’t test well under deliberately adverse conditions? It seems to run counter to the idea that the focus will be less on exam technique and more on genuine knowledge and aptitude. Just because many Conservatives look back on the arbitrary cruelty of the school system they themselves went through with a kind of nostalgic pride, doesn’t mean that we should be putting kids today through it.

Sunday, 5 August 2012

Boarding Up the Overton Window




On Incentives in Political Systems

There is a vocal consensus that the American political system is more polarised than ever before. I think, though, that this is partly endemic to the way it is designed. For all that the founding fathers naïvely assumed that partisanship would not invade their political institutions, the structure of the establishment rewards political extremism far more than it does in the parliamentary systems of Europe.

Imagine, for example, that all policy sits on a single left-right continuum. You are a moderately right-wing voter, and current policy is in the ‘centre.’ You want to shift policy towards your chosen position. In the UK, where the ruling party gets to do basically whatever it wants, your strategy is simple – vote for the party which most closely represents your political position. That makes them more likely to win and, in so doing, implement your preferred policies. Voting for a party whose policies are to the right of yours doesn’t help, because you get a different set of policies you disagree with (although you do get to ‘kick the bums out’).

By contrast, in the USA, most meaningful policy changes rely on some degree of bipartisan compromise. If you vote for the politicians who best represent your views, then the moderate right-wingers you elect will end up compromising with the moderate left-wingers other people elect, and you’ll end up with policy… in the centre, where you don’t want it to be. Your best chance, then, is to vote for a far-right candidate, in the hope that they will drag the consensus view closer to your own preferred position. The Democrats want to raise taxes, your candidate wants to abolish the government, and you end up with the tax cut you were hoping for all along.

Political polarisation is exacerbated by the decentralised structure of American political parties. The primary system, and the relative independence of state and local parties, mean that voters have a much more direct influence on the political orientation of their chosen party. By selecting ever more conservative candidates, Republican primary voters have managed to shift the party ever more to the right. Moreover, they have been able to hold their representatives to account on issues like Grover Norquist’s pledge not to raise taxes. By contrast, candidates in Europe are largely selected by their party, and a voter’s only way to punish their party’s ideological purity is to vote for someone else. Extremist parties, however, are strongly penalised by most European systems. Germany, for instance, only allocates federal parliamentary seats to parties that get at least 5% of the vote. Britain is an even starker example. The UK Independence Party, which runs on an aggressively Eurosceptic and anti-immigration platform, won no House of Commons seats in 2010, despite doubling its share of the vote to 3% relative to three years earlier. The Tea Party, on the other hand, has had much more mainstream success, because it has been able to work within the Republican party and exploit its existing campaign apparatus and political legitimacy.

The upshot of all this is that America’s voters are much more able to control the positions of their chosen political party, and they have much stronger incentives to use that control to make their party more extreme. One interesting question is why this has had much stronger effects on the right than on the left. There is no real equivalent to the Tea Party on the Democratic side, with Dennis Kucinich basically alone on the lunatic fringe. Partly this is because progressives rarely have grassroots support. Perhaps the extreme left’s base is inherently disorganised; more likely, they are just much less inclined to engage with conventional politics, in stark contrast to the Tea Party’s constitution-worship and success in working through the traditional establishment. Maybe it is that rural areas provide the best breeding grounds for extremism, and the Democrats are strongest amongst urban populations who quite like their rampant consumerist lifestyles, thank you very much. Most high-profile progressives, notably, hail from the Midwest rather than the North-east.

And maybe it’s just that the American Overton Window of acceptable policy has already shifted so far that carbon taxes are just as much a fringe policy as abolishing the EPA, and fiscal stimulus is seen as no less extreme an economic policy than abolishing the Federal Reserve.

Wednesday, 27 June 2012

Pigou-Clubbing


Reading various (excellent) posts by Miles Kimball has got me considering the way that we think about taxation and spending. There’s been a lot of discussion over the last few years of fiscal policy as a macro policy tool for stimulating aggregate demand, but we have to remember that this isn’t the reason why governments tax, spend or even borrow money.

On a basic level, government spending – has two linked but distinct purposes. The primary objective is to correct market failure by providing services that the free market does not – things like defence at the national scale or rubbish collection at the local one. Government spending also serves a redistributional purpose. We live in a society which doesn’t think that the poor and unemployed should starve, so we pay them benefits to make sure that this doesn’t happen. There is, of course, overlap between these two aims. The NHS is a service which is also redistributive, because the poor get the same standard of care as the rich would, and they don’t have to pay for it. Similarly, if you’re being brutally logical, you can define benefits as correcting a market failure; the mass starvation of workers that might one day be part of the labour force would be, if nothing else, bad in macroeconomic terms.

You can justify government intervention from a utilitarian perspective, or you can condemn it from a libertarian one – the lack of a threat of starvation does, after all, create warped economic incentives relative to the free market baseline – but, for the purposes of this post, we’ll assume that the government has to spend money on services and benefits. Of course, that’s not the whole story. Fiscal policy has two sides, and the government also needs to raise taxes to cover the cost of these services and benefits – either now, or in the future to pay off the cost of debt.

Taxes are bad.

That’s a fairly basic principle of economics. Taxes impose a real cost on the economy. They distort economic incentives so that effort is wasted on bad things, like complicated avoidance schemes, rather than on good things, like productive work. More, they encourage people to do less work than would otherwise be the case, because they retain less of the income from doing so.* Sadly, though, taxes are a necessary cost associated with public spending, and public spending is usually a good thing (because bins need to be collected, publicly-provided health is more efficient and mass starvation is bad).

Arguably, if tax collection is necessary, then it should be done as efficiently as possible. That’s why many economists are in favour of broad-based, flat-rate taxes like VAT. If a tax applies just to one good, then less people are going to consume that good than would at the market equilibrium, which can be presumed to be socially optimum in the absence of significant externalities. This means an overall loss of welfare. However, if a tax applies to all goods, then people will make broadly similar consumption decisions that they would have made in the absence of the tax (although the relative effects of income elasticity of demand mean their consumption pattern isn’t exactly the same). The distortionary effects of the tax are therefore minimised.

Of course, externalities do exist. In fact, contrary to the beliefs of libertarians, there are quite a lot of them. This opens up an intriguing possibility. If taxes distort the economy, why not use them to distort the economy in positive ways, reducing the consumption of goods which impose a cost on society whilst raising necessary revenue at the same time? That’s exactly what Greg Mankiw’s Pigou Club, which Kimball recently declared himself a member of, advocates. If we tax socially-harmful things like tobacco, alcohol and CO2 emissions, we get to raise revenue without damaging the economy – in fact, we help the economy, helping to combat issues like smoking and global warming without having to resort to blunter, riskier tools like regulation.

There are some problems with this argument, though. The problem is that economic efficiency isn’t the only goal of taxation. Taxes also serve a redistributive purpose. One of the reasons that we pay benefits is that – up to a point – we want to reduce inequality. You can argue, as the likes of Stiglitz and Krugman do, that inequality imposes absolute costs. Looking at marginal utility of income, it probably reduces welfare, if not GDP.  But whatever the economic arguments are, the fact is that we have a progressive income tax because, like with spending, one of the purposes of taxation is redistribution. Taking from the poor to give to the poor might be more economically efficient than robbing the rich, but it misses the point of why we tax and spend. Ultimately, part of the goal of taxation is that the tax burden should be distributed not just efficiently but fairly.

That might be why the UK government’s scrappage of a planned rise in fuel duty – a Pigouvian tax – has met with so much approval. It’s really quite shocking to see the Cabinet, Tory backbenchers and Labour all in agreement on an issue. You could see this as part of a broader narrative concerning the disconnection between what economists advice and what politicians do. Quite obviously, the move does in part simply reflect political reality, because people don’t like tax increases in general, and especially not tax increases that directly and explicitly affect the prices of basic goods which they regularly buy. But that doesn’t explain why opposition to a rise in fuel duty is so vehement compared to, say, the jump in VAT that the government imposed in January 2011.Basically, it represents the government responding (or pandering, depending on how you feel about the move) to voters who have broadly accepted the need for deficit reduction but don’t think that a rise in fuel duty is fair.

Part of the reason for that is that duty on tobacco, alcohol and fuel duty is seen – with good reason – to disproportionately affect the poor, because the poor spend a much larger proportion of their income on those items than the rich do, so they are hurt more when taxes go up. However, there’s another reason that I think is also important.

The issue is one of fairness within income groups. A fuel duty rise affects those who drive a lot considerably more than those who don’t drive very often. My father drives a pickup, because he is a landscape gardener. He regularly makes 100-mile round trips on the notoriously congested M25. Because of this, he spends a lot of money on fuel, and would be severely affected by a rise in duty. Remember that our concern is equity as well as efficiency. Is it fair that he should be affected more than someone else earning the same income as a secretary? Is landscape gardening somehow detrimental to social welfare – and, if not, then why are we discouraging it? Voters – and, by extension, politicians – are concerned about this, and so they are likely to oppose a rise in fuel duty more than, say, an increase in VAT that would affect everyone equally.

The reason why rises in fuel duty are so much more contentious than similar measures targeted at tobacco and alcohol are complicated. Partly it’s one of blame. If you’re an alcoholic or a smoker, then you’re engaging in a socially stigmatised activity, and (rightly or wrongly) it’s perceived as being your fault. If tax rises disproportionately affect you, then it serves you right. Also, businesses don’t smoke or drink, but they do drive, and fuel duty offers politicians an issue on which they can appease both business and consumer lobby groups at the same time.

Ultimately, while Pigouvian taxes might seem perfect on paper, they do have some very real consequences, and the cynical explanation for why they don’t get implemented isn’t the whole story. It's important to remember why we're doing what we're doing. This is, in fact, one of the reasons why I’m somewhat apprehensive about fiscal policy as a tool of demand management – it makes it difficult to pursue a desirably efficient or egalitarian fiscal policy at the same time as providing stimulus. We tax and spend a lot of money and, given that that is the case, government should always keep its priorities in mind.


*Yes, I am aware that this may be counteracted by people working more to offset their effectively lower income. Nevertheless, whether people work harder for the same income, or less hard for a suboptimal income, it’s a negative effect.

Tuesday, 12 June 2012

Rate Expectations: NGDPLT and Uncertainty


Market Monetarism has been one of the most interesting developments in macroeconomic thought coming out of this crisis, led by Scott Sumner. What he essentially advocates is the Federal Reserve targeting the trend level of nominal GDP. I’m no expert on monetary economics, which is a fiendishly complicated subject, but stabilising the path of nominal incomes seems like a good idea. It would allow for what would amount to a temporary raising of the inflation target during times of depressed output, and a lower inflation target during times of high output. Doubtless Sumner would denounce me for thinking of monetary policy in terms of inflation at all, but it is a way to frame the concept in conventional terms.

So far, so good. But the central question is whether central banks could credibly hit an NDGP level target. This is particularly pertinent at a time when, with interest rates hard up against the zero lower bound, many doubt how much traction further attempts at monetary easing would actually have. Sumner responds to this line of argument by contending that the very act of announcing the new targeting system would change the stance of monetary policy, and would go a long way towards hitting the target with limited actual intervention. Given that monetary policy, especially at the zero lower bound, revolves around expectations, that’s a reasonable point. After all, who would bet against the Fed achieving its target, when it has promised to use all of its prodigious powers to hit that target?

It’s a similar situation to a central bank fixing the exchange rate of its currency. If there is the expectation that the central bank is willing and able to hold the currency at that level, it doesn’t have to utilise its foreign reserves to push up or hold down the value of the currency. Markets are expecting the exchange rate to hit the central bank’s target – and because foreign exchange markets are so reliant on expectations, that’s exactly what happens, even though the central bank hasn’t actually intervened. The target becomes self-fulfilling.

The problem comes when markets start wondering if the central bank is really willing and able to hold its stated exchange rate value. Speculative attacks start, and the same self-reinforcing effect happens, but in reverse – because people don’t think the central bank can hit its target, it becomes unable to do so. The British ERM fiasco in 1992 was an example of this.

The same thing applies to central bank targets. If enough people think that the central bank is limited in its ability to affect the economy, then the NGDP target would become meaningless. Whether or not a sufficient number of relevant individuals believe in the Keynesian-style liquidity trap is another matter.

Thursday, 31 May 2012

Small Logical Steps

Somewhat short of time, but a thought occurred to me and I wanted to lay out this curious little argument, even if it's a bit facetious and doesn't mean very much.

If you:
a) believe in rational expectations - that consumers will always act in their own self-interest,
b) believe in a classical free market economy - that the aggregation of individuals' self-interested decisions creates the optimum allocation of resources, and
c) believe that government is imposing a large burden on the economy, and believe that a substantial reduction in taxation and spending would provide major economic benefits, then
d) there is something seriously and fundamentally wrong with our democracy, and it is failing to represent the views of the people.

Think about it. If everyone acts in their rational self-interest, this produces the optimal economic outcome, and the optimal economic outcome involves a smaller state, then democracy must be failing to provide the people's desperate wish of a drastically smaller government.

Of course, the people who hold these views aren't really upset at our democracy for failing to represent the interests of the people. They aren't calling for direct democracy; it's interesting, in fact, that the calls for greater democracy are coming from the leftist Occupy movement, which rejects free markets, let alone rational expectations. What irritates neoliberals is the failure of democratic institution to propagate their own - patently correct - views.

I'm not blaming them for this. I get quite angry when government policy deviates from my views of how things should be. But it does bear thinking about, because the majority of people aren't voting for the Super Neoliberal Party. The closest thing we have is the Tories, many of whom are far too preoccupied with being tough on immigration, crime and the moral decline of society for most economists' tastes (though it is arguably this message that strikes the best chord with the wider electorate).

So, either consumers are irrational, free markets aren't best anyway, or the state isn't too big. Otherwise we need more direct democracy.

Just a thought.

Wednesday, 30 May 2012

Where's the Deflation?


I think it’s time to throw my fedora into the ring regarding the inflation debate. One of the most interesting things about the economic crisis has been the conspicuous absence of deflation. With large output gaps pretty much everywhere, even today, it’s strange that inflation remains around or above target in most advanced economies (ignoring for a moment the internal devaluation taking place in countries like Ireland and Spain). One would expect that, with large excess capacity, prices would fall. Britain is the starkest example of this not being the case; consumer price inflation is still running at 3% year-on-year, having peaked at over 5% in 2011. There are a few different explanations for this phenomenon.

One is that output gaps simply aren’t as large as we think they are. Perhaps the financial crisis seriously damaged potential GDP. There has been quite a lot of focus on hysteresis effects recently – the effect of a reduction in GDP on potential GDP. Estimates of maximum capacity have been revised significantly down pretty much across the board, including in the US and UK. Certainly, if the economy was running at above capacity before the crisis, and potential GDP has been almost flat since then, the output gap might be a lot smaller than estimated, and so might not be exerting nearly as much downward pressure on prices as previously assumed.

This has disturbing implications, because it implies that the high unemployment and low growth that we see today have become permanent structural problems within the economy rather than being symptoms of a reversible shortfall in demand. Rising rates of long-term unemployment and falling labour-force participation support this conclusion. The structural hypothesis basically surmises that unemployment is high not because employers are unwilling to hire, but because they can’t find workers with the right skills and experience.

Fortunately, it is unlikely that our structural problems are quite this bad. For one thing, the economy might not have been running too far above capacity prior to the crisis. After all, inflation was fairly close to target in 2006 and 2007. So, even if there has been low growth in potential GDP over the past few years, there’s still likely to be a sizeable output gap, at least in the UK, where actual GDP is still 4% below its pre-crash peak. Further, there is some evidence suggesting that the woes of the economy are more to do with demand than structural problems. Employment hasn’t fallen only in specific declining industries – every sector has seen significantly reduced payrolls. Moreover, this chart suggests that most UK employers would be able to find workers with the right skills, if only they were actually looking to hire at all. Ultimately the buck stops with the demand side; any structural issues are actually being created and reinforced by a persistent lack of demand. This means that, while structural problems are an issue, fiscal and monetary stimulus would help remedy the problem, by increasing actual GDP and preventing the structural problems from getting worse.

Meanwhile, if there is a large output gap, then something else must be to blame for high inflation. Some economists, notably Paul Krugman, have attributed the lack of deflation to sticky prices, specifically the downward nominal rigidity of wages. It’s not especially counterintuitive a concept; most people understand, if they think about it, that it is very difficult to cut people’s wages in nominal terms. If people aren’t getting wage rises (and so losing out in real terms), that’s one thing. But an actual wage cut has different implications and employers are very reluctant to reduce wages. The upshot of this is that wages haven’t fallen despite high unemployment; in fact, most people’s wages have remained completely flat, with small rises for some earners, leading to an overall rise in wages. This chart from Krugman illustrates this trend nicely. Rising nominal wages exert upward pressure on prices, and so deflation is prevented and inflation remains stubbornly high.

This story is convincing and sticky wages have, in my view, contributed to high inflation. But there’s something deeper at work here, too. The current crisis has been compared to the Great Depression ad infinitum over the last five years. Interestingly, one initial response to the Depression in America was to prevent wage cuts in what was arguably a much more flexible labour market than today’s. This, it was hoped, would prevent prices from falling and so stop the debt deflation spiral which was ravaging America’s economy. But it didn’t work. Wholesale prices, especially, continued to tank and the result was the worst depression in modern history.

What had happened, of course, was deflationary pressure not from wages but from elsewhere. Reduced demand and the consequent fall in production in every industrial economy meant a collapse in commodity prices and this was a deflationary shock which policy was unable to offset. The million-dollar question, of course, is this – what’s changed since then?

One of the major differences is in monetary policy. In the early years of the Great Depression, America was on the Gold Standard and so didn’t have control over the money supply. This meant that they could do very little to discourage hoarding, because money was effectively guaranteed to maintain its value. Thus deflation became self-reinforcing, as people hoarded cash because it would be worth more following expected further deflation in the future. By contrast, the modern response to the depression and to the threat of deflation was massive monetary stimulus. Reduced interest rates and quantitative easing have meant that there has been an increase in the money supply that has offset reduced monetary velocity. You can debate endlessly the influence – or lack of it – that central banks have when interest rates are at the zero lower bound, but it seems likely that monetary policy at least contributed significantly to staving off deflation.

The other difference between today and the 1930s is globalisation. The world economy is increasingly integrated and there are a lot more industrial economies. In the Great Depression, steel prices collapsed because almost all of the demand for steel came from industry in America and Europe. Prices didn’t recover until industry did. In the modern crisis, commodity prices did drop, as the financial crash reverberated around world markets. But then something strange happened. Even though output was still severely depressed in the developed world, especially in Europe, commodity prices began to increase again. It wasn’t because of any isolated incident. Floods in Asia, the Libyan Civil War and so on may have disrupted the production of particular commodities, raising their prices. But the trend was present across the board, from corn to oil to copper, and the main reason for this is that demand is now global. Demand for these commodities might have fallen in the developed world, but it has increased massively in fast-growing China, India and Brazil. Countries like the USA and especially the UK, which buy large amounts of commodities from abroad, are particularly vulnerable to imported inflation from global market price increases. This is an important factor in considering why deflation has failed to materialise. Demand is rising in other places, and that’s having an effect on prices here in a way that it wasn’t during the Great Depression.

In the 1970s, ‘stagflation’ was a structural issue. Growth was low because potential GDP growth was low and the economy was running above full employment. Today this phenomenon occurs for different reasons. Large output gaps and low growth should and are be causing deflationary pressure, but this is being offset by commodity price rises as a result of increased emerging-market demand. And that’s an important part of the story, which sticky-wage-emphasising Keynesians too often fail to account for.

Monday, 28 May 2012

When Is Overinvestment Not Malinvestment?


This week’s edition of The Economist has a special report on the Chinese economy. It makes some interesting points, many of which I agree with. Its particular focus is de-emphasising the role of exports and China’s trade surplus, which is now below 3% of GDP and falling. Instead, the report identifies the main engine of Chinese growth as investment, which runs at over 45% of GDP – far larger than other East Asian economies like South Korea and Japan during their boom years. Unsurprisingly, this enormous rate of investment has led many to conclude that Chinese growth is unsustainable, fuelled by an inflating investment bubble which is inevitably doomed to burst.

The Economist’s report seeks to characterise the nature of this bubble by marking a distinction between overinvestment – investment which exceeds savings to an unstable extent – and malinvestment – inefficient and unproductive investments, of which the ‘ghost city’ of Kangbashi is one example. It is easy to argue that Chinese investment, largely provided by state-owned enterprises and financed by banks at artificially low rates, is inefficient. However, whether the Chinese are investing too much is another issue altogether.

The Economist concludes that, with the savings rate even higher than investment at 51% of GDP, charges of overinvestment cannot be levelled at China. But the distinction between overinvestment and malinvestment seems to imply there can be overinvestment without malinvestment - efficient, productive investment being a bad thing.

This is a little bit strange. Surely ‘too much’ investment would be too much purely because it was inefficient? An excess of investment over saving is not always a bad thing. Obviously, excess of investment over savings would ordinarily cause a rise in the interest rate, so that the excess disappears. However, the interest rate may be sticky, either for generic reasons or because the Chinese government caps the return payable on bank deposits. It would then not adjust to correct the imbalance. What then happens is that the increased investment causes GDP and incomes to rise; as people see their incomes rise, their propensity to save increases, and balance is achieved through an increase in saving.

An interesting counterpoint to this theory is that, as the Chinese get richer, it is expected that consumption will become a greater proportion of GDP. In this case, what is occurring is that, though savings rates fall, the balance is achieved by a greater fall in investment as the economy adjusts to a model more dependent on domestic consumption.

The effect of an increase in GDP restoring the investment-saving equilibruium would obviously not occur if the investment did not serve to increase GDP – i.e. the investment was wasteful and inefficient. The Economist article refers to the East Asian financial crisis of the 1990s as an example of overinvestment. However, here, foreign finance clearly served solely to inflate asset price bubbles rather than for any real economic gain. This implies that some of the investment was unproductive, and that the real problem was malinvestment. A similar story is visible in the Spanish economy of the 2000s.

It is clear that market liberalisation would lead to reduced malinvestment in China. It is also evident that, as the economy inevitably shifts towards a model more dependent on domestic consumption, rates of both savings and investment will fall. However, this will probably represent a fall in the productive rate of investment combined with less malinvestment; it won’t be because there are productive investments to be made, but making them would be unsustainable.