Saturday, 21 March 2015

Repeat after me: sectoral balances must sum to zero

I do like sectoral net lending charts. This one is from the OBR's latest Economic Forecast:


The thing to remember about sectoral balances is they must sum to zero. It is not possible to have a negative external balance, as the UK does, with concurrent surpluses in the public, household and corporate sectors. If the UK is a net borrower from the rest of the world because of its current account deficit, then somewhere in the domestic economy must be a balancing deficit.

It is pretty obvious where this deficit has been. In 2010, the external sector was in deficit (green line on chart) and corporates (yellow line) were net saving. The external balance had been in deficit for a long time, but corporate net saving commenced at the same time as the public sector (red line) switched from surplus to deficit. This may have been a traumatic response to the dot-com crash, but to me this looks more like a policy change around 2001 that encouraged corporate saving. I wonder what it was. Any suggestions?

The net saving of corporates and foreigners during the pre-crisis years was balanced both by a public sector deficit and by a growing deficit in the household sector (blue line). We now know that the household deficit was associated with unsustainable credit growth. When the crash came, households switched abruptly from deficit to surplus. Foreigners, corporates and households were all net saving at the same time. As I said, the sectoral balances have to sum to zero: so the increase in the government deficit balanced the desire of all three private sectors to save at the same time. When no-one wants to spend, someone must, and that someone is inevitably government. Government is the "spender of last resort".

The trouble is that when everyone is saving like crazy (including paying down debt, which economically is equivalent to saving) people get very worried indeed at the sight of apparently out-of-control government deficit spending, failing to see the relationship of that spending to their own saving behaviour. So governments then embark on austerity programmes to shrink the deficit. The result of this (assuming no fall in GDP) is that deficit spending moves around. The public sector deficit is shifted back to the private sector.

If you are Germany, deficit spending moves abroad, and you run an ever-larger trade surplus. But if you are the UK, with a deeply entrenched external deficit in part because of a still-dominant financial sector, deficit spending moves to domestic households and corporations. George Osborne's claim that he wants to build an economy "based upon savings and investment" is economic gibberish, since his plans aim only to eliminate the fiscal deficit, not the trade deficit. As the chart above shows, the OBR forecasts - based upon the Treasury's spending plans as outlined in the Budget last week - that for the foreseeable future the only people doing any significant saving will be foreigners.

Saving is not necessarily a good thing. Generally, we expect households to save (for their old age, for rainy days) but corporations to invest. The problem prior to the financial crisis was that corporations were saving and households were investing (in property). Now, despite everything we have heard about corporations hoarding cash, corporate saving is falling and the corporate sector has switched from surplus to deficit. This is a welcome development, since it suggests that corporations are investing. And indeed they are:


Business investment is now back to its 2000 level. This is no doubt what has generated the UK's recovery. Perhaps the malaise that has affected corporations ever since the dot-com crisis is over? The OBR seems to think so. It forecasts corporate investment continuing to rise to historically unprecedented levels. Is this credible? I confess that I am unconvinced. The path of business investment has never been smooth. Not only the level of investment projected for 2020 but also the rate of change looks unsustainable to me. I reckon it would level off or dip sooner than that. Indeed there was a dip at the end of 2014 which the forecasters chose to ignore. Hockey-stick projections always worry me.

Sadly, the picture for households is not so encouraging. The household saving ratio has already fallen considerably from its 2010 high:


Perhaps more worringly, there is an evident downwards trend in this chart. Household saving has been diminishing since the late 1990s. The OBR projects that the household sector will be in deficit by 2018, no doubt as a result of the planned sharp fiscal squeeze in 2016-18. As older and richer households would still be net savers, the growing deficit of the household sector would be due to sharply rising debt, particularly among younger and poorer people. Here is the OBR's projection for household debt to income:


The OBR expresses some concern about this:
Strong growth of residential investment and ongoing growth in house prices and property transactions leave households’ gross debt to income ratio rising back towards its pre-crisis peak by the forecast horizon. That seems consistent with supportive monetary policy and other interventions (such as Help to Buy and further support for first-time buyers announced in this Budget), but it could pose risks to the sustainability of the recovery over the medium term.
This concern is well-founded. Despite all his rhetoric about encouraging saving, the Chancellor's fiscal plans actually depend on blowing up a household debt bubble of larger proportions than that which burst disastrously in 2008, and using various forms of government support to delay its inevitable implosion. Why do we have to repeat the errors of the past?

Perhaps more importantly, it is by no means clear that such an increase in debt is actually possible. Productivity is on the floor and nominal wage growth remains poor. The OBR identifies this as a key risk to the recovery:
Domestically, productivity and real wages remain weak and the pick-up we forecast from 2015 is a key judgement. If productivity fails to pick up as predicted, consumer spending and housing investment could falter as the resources to sustain them would be lacking
If productivity and wage growth do not pick up, then the fiscal squeeze planned for 2016-18 would have serious consequences for the recovery. The OBR points out that deep spending cuts to unprotected government departments and the welfare budget would have a direct impact on GDP, and expresses concern about the scale and pace of the cuts:
We expect some significant changes in the composition of expenditure associated with the fiscal consolidation and, in particular, with the fact that on current policy so much of that consolidation is delivered through cuts to day-to-day spending on public services that will directly reduce GDP. The scale and speed of the adjustments this switch in spending implies may also represent a risk to the economy evolving in line with our central forecast.
 The OBR's central forecast for the path of GDP shows real GDP growth over the next 5 years of around 2% per annum. But there is a considerable amount of uncertainty around this forecast:


Note that the worst-case scenario here is for the UK to fall into recession from 2016 onwards. This would be likely to be the case if productivity and wage growth disappointed and the fiscal squeeze hurt household incomes sufficiently to eliminate debt-fuelled consumption and investment spending.

And this brings me back to my sectoral net lending. Remember that sectoral balances must sum to zero. If household income falls so much that spending and borrowing cannot be sustained, as the OBR suggests, then there are two possibilities. The first is that there is a sharp correction to the trade balance. This would be due to collapse in imports as domestic demand falls, and rising exports as corporations seek markets elsewhere. We have seen this in many EU (not just Eurozone) countries in the last few years. It is always accompanied by recession, which may be severe.

But if the trade balance does not correct - and remember that the UK's trade deficit is deeply entrenched - then fiscal consolidation becomes all but impossible. Deficit reduction slows to a crawl, as this chart from the OBR shows:



The worst-case scenario here (deficit of 4% of GDP in 2020) would be associated with the worst case in the GDP fan chart, i.e. the UK in recession. When GDP is falling, public sector borrowing as a proportion of GDP naturally rises. This chart therefore assumes that fiscal consolidation efforts would continue despite recession, no doubt because of disappointing deficit reduction. But continued attempts to eliminate the deficit and reduce the deficit would drive the economy ever deeper into recession. Although the deficit itself may reduce further, debt/GDP actually rises in this scenario. As Irving Fisher put it, "the more the borrowers pay, the more they owe". For Greece, this nightmare was probably inevitable. But the UK has no reason whatsoever to go down that path. If it does, it will be because of political stupidity on a simply mammoth scale.

Unfortunately the simple fact that sectoral balances must sum to zero is currently being ignored by all of the main parties. I do wish politicians would pay more attention to national accounting. It would save a lot of grief.




Sunday, 15 March 2015

Happy days are here again

Here's a shocking chart from the LSE's John Van Reenen:


This chart deserves to be seen by every adult in the UK. It charts all too clearly the true cost to them of the financial crisis and its aftermath.

It is clear that the financial crisis was severe. The sharp drop in GDP per capita in 2008 is unprecedented since 1970. That was bad enough. But what is far worse is the evidence that the UK still has not recovered. Even with recent encouraging growth, GDP per capita remains far below its long-term trend. Those who argue that the financial crisis simply eradicated debt-fuelled "bubble" income are clearly wrong, unless they think the whole of the last 45 years was a bubble.

So what exactly has caused this awful fall in per capita income? Was it due to Coalition policy, as some think, or were there other causes?

In the report from which this chart comes (pdf), John offers a balanced explanation:
The failure to recover lost output shown in Figure 1 cannot be attributed to UK austerity only. The eurozone crisis, the lingering effects of the banking crisis, higher commodity prices, and the decline of high productivity sectors like oil and gas should also be apportioned some part of the blame (Corry et al, 2012, offer an assessment). 
But what is striking is how much worse the UK performed during the first half of this Parliament when austerity bit hardest. Between 2010 and 2013, GDP per capita growth was worse than in the United States and Japan, both of which had independent currencies like the UK. UK performance was similar to the countries in the eurozone hit by even more severe austerity and a currency crisis.
So although the UK was hit by severe secondary shocks, the fiscal policy pursued by the Coalition government in its first three years contributed to the UK's poor recovery. The OBR estimates that Coalition fiscal consolidation cut GDP growth by 2% in 2010-12. John suggests the real figure may be higher because the OBR uses conservative multipliers and ignores hysteresis effects.

Using data from the OBR, John shows that in 2010-12, the UK's deficit reduction actually proceeded faster than planned:


But despite this front-loaded consolidation, the Coalition's intention of eliminating the current budget deficit by the end of this Parliament has not been achieved. John says that this is because the austerity programme has tailed off since 2013: in the current financial year there has been no fiscal austerity at all. Funny, that. As the election approaches, austerity diminishes.....

So having failed to deliver on their original mandate, the Conservatives now plan to repeat the whole exercise again. Severe austerity in the first three years of the next government (assuming they win the election), followed by relaxation in the last two years. The economic effect would be similar:
Explicit macroeconomic modelling of the impact of alternative paths of fiscal consolidation suggests that by 2019-20 output, employment and debt would be a bit higher under Labour and Liberal Democrat plans compared with the Conservatives (Kirby, 2015).  
I find it odd that the opposition parties are not shouting about the negative prospects for employment and per capita incomes in the short term that Conservative plans imply.

But the really scary part of all of this is the effect on investment. The Coalition government has achieved the majority of its deficit reduction by means of sharp cuts to investment: as the chart shows, public sector net investment has fallen from 3.3% of GDP before it came to power to 1.4% in the current financial year. The Autumn Statement committed the Conservatives to achieving an overall budget surplus by 2019-20, achieved through spending cuts alone. John points out that this leaves little room for investment:
By including public investment in plans for balance, this would prevent a future Conservative government from borrowing for additional public investment. The Autumn Statement pencils in public investment as just 1.2% of GDP from 2017-18 onwards.
 How is the "long- economic plan" going to create long-term economic prosperity if it includes little or no long-term investment in infrastructure, human capital and innovation?

Sadly, it seems increasingly unlikely that the public will hold the Conservatives to account for their part in the UK's poor economic performance in recent years. It seems unfair that the Conservatives can claim to have generated a recovery that they actually did their level best to prevent, but people have short memories. Recent fiscal relaxation coupled with giveaways for key voter groups has created a "feel-good factor": people whose real incomes are rising now after years of falls don't notice that they still are poorer than they were in 2007.

In the interests of balance, however, I should point out that Labour and the Liberal Democrats also plan further austerity after the election. The parties really only differ over the pace of consolidation and the means by which deficit reduction would be achieved. Whichever party wins, the next few years will be tough.

Happy days are here again....until the election.

Related reading:

Austerity: growth costs and post-election plans - Pieria
Be careful what you wish for, Mr. Cameron - Pieria
The Chancellor's incredible spending cuts - Pieria
What derailed the UK recovery?

Wednesday, 11 March 2015

Greece's real problem

Professor Hausmann has responded again to my reply to his reply to my criticisms of his Project Syndicate post. It is a very gracious response.

We are substantially in agreement on the three points that I raised in my previous post: the long-standing nature of Greece's fiscal fragility, the illusory GDP growth fuelled by the pre-crisis debt bubble that obscured the deterioration in Greece's financial position, and - above all - the long-term decline of Greece's competitiveness. And oddly enough, this means that we are also in agreement about the current situation in Greece, though we frame it differently. Professor Hausmann says that austerity is not the problem. I say that Greece's fiscal finances are not the problem. We are really saying the same thing. The real problem is competitiveness.

Greece's problem has been competitiveness for a very long time. It has run a large and persistent trade deficit for the last half-century (blue dotted line):


Exactly why Greece's competitiveness has been so poor for so long is unclear. Tomas Hirst attempts to explain it in terms of oil shocks and politics, which I think is partly true. But I also think there are other factors at play, notably the ageing of Greece's population, the unusually high number of small and micro businesses in the Greek economy, and the influx of cheaper labour into Western markets after the fall of the Iron Curtain. I shall have a look at this in another post.

However, there is a widespread perception that Greece's problems are primarily due to fiscal profligacy and excessive public sector debt. The story goes that out-of-control government spending caused the deficit and debt to rise to the point where markets refused to fund it any more, causing a "sudden stop". The primary focus of the EU & IMF adjustment programme so far has been on eliminating Greece's fiscal deficit and reducing debt/gdp in the hopes of preventing a further fiscal crisis: growth was supposed to return once confidence had been restored through successful fiscal adjustment. The fiscal deficit has indeed been more-or-less eliminated. But there is no sign either of improved confidence or much in the way of growth. And the aim of reducing debt/gdp has been thwarted by Greece's deep and persistent recession. Greece is therefore still under pressure to make further improvements to its fiscal finances.

So is the Troika right to focus on restoring Greece's fiscal finances, including reducing debt? And is Syriza also right to focus on it, though from a different standpoint?

Professor Hausmann does not think that Greece's debt overhang is such a big deal:
But the truth is that the recession in Greece has little to do with an excessive debt burden. Until 2014, the country did not pay, in net terms, a single euro in interest: it borrowed enough from official sources at subsidized rates to pay 100% of its interest bill and then some. This situation supposedly changed a bit in 2014, the first year that the country made a small contribution to its interest bill, having run a primary surplus of barely 0.8% of GDP (or 0.5% of its debt of 170% of GDP).
Philippe Legrain, in a comment on Tyler Cowen's blog, disagrees:
It is fair enough to point out that Greece was living well beyond its means until 2009, and that its productive structure needs upgrading. That inevitably implies a painful adjustment. But the pain has been unnecessarily great - a cumulative loss of more than 100% of GDP over the past five years - because Greece has laboured under unpayable debts, with most of the 'generous' EU loans used to pay private-sector creditors (notably, German and French banks) who should have taken a big hit in 2010. Had Greece's debts been restructured in 2010, austerity would have been less brutal, the private-sector recovery swifter and the slump less deep than they have been. Even now, Greece's massive debt overhang - and the uncertainty about Grexit and the chill to investment that this creates - is a huge obstacle to recovery 'whatever reforms' Greece does.
How can we reconcile these two views?

Philippe is absolutely correct that Greece's debt overhang seriously impedes recovery, But it is not just public sector debt. The real problem is that both the public AND private sectors are over-indebted. This chart shows how the private sector balance shifted from surplus to deficit in the late 1990s:


Since during that time the government deficit did not grow, the private sector deficit was funded by external capital inflows. In other words, the private sector borrowed from foreigners to fund domestic investment spending, resulting in a worsening external balance:


As can be seen from this chart, the private sector's debt-financed investment boom came to an abrupt end in 2008-9 when the capital inflows reversed. The external deficit reduced, the private sector deficit disappeared completely, the government deficit ballooned and real GDP fell off a cliff.

So the story of the Greek crisis is not really one of fiscal profligacy resulting in a "sudden stop". It is one of PRIVATE sector profligacy fuelled by rising external debt, itself resulting from (or caused by) falling competitiveness. As happened to so many countries in 2008, the banking crisis forced private sector debts on to the public sector balance sheet.

The difference between Greece and other Eurozone countries is that when it was forced to socialise private sector losses, it already had legacy debt of 100% of GDP. The fact that debt/GDP had been that high since 1993 was not the point. Seeing Greece's debt/gdp soaring, frightened by papers such as this from Reinhart & Rogoff suggesting that high debt/gdp was economically disastrous and angered by the disclosure that Greece's fiscal position was far worse than they had been led to believe, investors ran for the hills, causing Greece's borrowing costs to spike and creating a real risk of default. Their behaviour brought about the very situation that they feared.

The often-repeated argument that capital inflows to Greece were used for consumption rather than investment (which supports the "profligacy" story)  is not wholly supported by evidence. Consumption was indeed high, but there was also significant capital investment. Here is gross fixed capital formation for Greece since 1995 (OECD data via the St. Louis Federal Reserve's FRED database):


Clearly, there was substantial investment in fixed assets, which abruptly reversed in 2008. The spike just prior to 2004 is probably construction for the Athens Olympics. But what was the spike after that? The fact that the capital flows reversed so dramatically in 2008-9 suggests that this was generated by "hot money" looking for return without commitment. Similar spikes in other countries at the same time are associated with residential and commercial property booms. Did Greece have a property boom in the mid-2000s? Whatever it was, it wasn't long-term productive investment.

The present position is that both the public and private sectors are significant net foreign debtors. Neither is in a position to lend, so the only source of funds is external. And since neither can pay back what it already owes, foreigners are understandably reluctant to lend more. Restoring fiscal finances without further falls in real GDP is therefore only possible if there is a large and sustained external surplus. Professor Hausmann is indeed correct about this. In the absence of international funding, Greece's only hope is to export its way to recovery.

But this is where the competitiveness problem comes in. Greece has struggled to maintain its current account in balance, let alone surplus, for the last half-century. Even with the enormous falls in unit labour costs in recent years, it is hard to see that it would be able to maintain the substantial trade surplus that is needed to restore its economy.

Professor Hausmann says that Greece's problem is that it doesn't make products that the world wants. But I don't buy this line of argument. Demand for Greek olive oil or feta cheese would be significantly higher if they were properly marketed and sensibly priced. No, the real problem is that businesses are far too short of capital investment and productivity is far too low. And Greece is also hampered by the abject failure of the EU to deal with the large and growing trade surpluses in certain core countries, and by general shortage of demand both within the Eurozone and globally. This is not a good time to be trying to generate an export-led recovery from an appallingly low base.

And for that reason, I stand by my original argument. Greece's fiscal problems are not the "core" issue. Rather, they are symptomatic of a long-term private sector malaise. Furthermore, trying to restore Greece's public finances without addressing Greece's dismal business investment and the shortage of aggregate demand in the Eurozone as a whole is doomed to failure. The EU & IMF adjustment programme is fatally flawed, not because it is "unfocused" as Professor Hausmann suggests, but because it focuses on the wrong things.

Greece needs debt write-down in both the public and private sectors, plus business and infrastructure investment. The core countries that are allowing their trade surpluses to grow well beyond agreed limits require EU adjustment programmes of their own. And measures are required to improve Eurozone aggregate demand: the ECB's QE programme may help, as may Juncker's investment scheme, but it is questionable whether these will be sufficient to offset what remains an unjustifiably tight fiscal stance across the entire bloc.

Greece's post-war recovery was made possible by the Marshall Plan. Who now will provide a credible plan for its post-crisis recovery?
_______________________________________________________________________________

All charts in this post except the FRED chart come from this 2012 Levy Institute paper:

Current Prospects for the Greek Economy - Papadimitriou, Zezza & Duwickquet

I recommend reading the whole paper. 

Friday, 6 March 2015

Send Back The (Eurogroup) Clowns

Latest from the Lucey/Coppola double act, with apologies to Stephen Sondheim.



The Germans give nicht;
Grexit looms quick.
Drachmas at last on the ground.
The Euro will tear!
Send back the clowns.....

The union's adrift -
an Ordoliberal split:
Podemos is gaining ground.
But the centre won't move.
Why are there clowns?
Send back the clowns!

Let them stuff T-bills
In banks,
Extend a loan, defer, then they're yours.
Another long meeting again, and wit is quite spare.
Few there are kind....
Sense is not there.

Don't you love farce?
Whose fault? It's clear:
We all colluded and winked,
Now Greeks they pay dear.
The Eurogroup clowns,
Oh, those scary clowns,
Oh bother - they're here.

The centre is rich,
Periphery blitzed,
It isn't a union, you know.
Common currency, it's clear
Designed by clowns
And run now by clowns
Well shielded, it's clear.

Thursday, 5 March 2015

Dear Professor Hausmann.....

Professor Hausman has replied to my criticisms of his Project Syndicate post about Greece.

Unfortunately, Professor Hausmann has misrepresented what I said. I did not say that Greece's fiscal position only worsened from 2009 onwards. On the contrary, I said that Greece's debt/gdp remained stable from 1993-2008 DESPITE a sizeable fiscal deficit. The fiscal deficit increased considerably from 2004 onwards. I also pointed out that this was due to the worsening current account deficit. For some reason Professor Hausmann decides to ignore this and give me an economics lesson on how current account deficits drive fiscal deficits. Professor Hausmann, you should retract.

Professor Hausmann points to infrastructure in Spain as evidence of constructive investment in the boom years. Airports where  no plane lands, roads where no cars drive, houses where no-one lives: this is "productive investment", is it? I'm sorry, this is not credible.

Professor Hausmann also criticises the data I use. I used charts from tradingeconomics.com for convenience, but I cross-checked the data with Eurostat before posting. Is Professor Hausmann arguing that Eurostat data is not reliable?

But most importantly, Professor Hausmann says he does not understand what point I am trying to make. So, here is a summary of my argument.

  • The fragility of Greece's fiscal position was of very long standing. Debt/gdp built up during the 1980s and was over 100% by 1993. Despite an attempted fiscal consolidation in the late 1990s, debt/gdp did not fall significantly. Therefore Greece was in a difficult financial position long before it joined the Euro.
     
  • From 2002 to 2008, Greece's debt/gdp was actually stable, though high. This was of course an illusion, since it was due to rising GDP which we now know was caused by a credit bubble. But since no government in the world understood that rising GDP at that time was illusory, it is unreasonable to expect the Greek government to have exhibited sense that seemingly was absent everywhere else. The big myth of the boom was that it would never end - until it did.
  • Greece's current account was already significantly in deficit when it joined the Euro, because of declining competitiveness in the 1990s. It would have been useful for Professor Hausmann to have offered some explanation for this decline in competitiveness PRIOR to Greece joining the Euro. Unfortunately the only explanation he gives is "Greece produces products no-one wants to buy". Really, that won't do. Is it changing market preferences, relatively high prices, poor quality?
In short, I wish Professor Hausmann had taken a longer view of the historical performance of Greece, rather than focusing only on the post-Euro years and repeating the same old mantras about "fiscal profligacy". Long-term competitiveness decline in Greece is a large part of its problem: joining the Euro intensified, but did not cause, this. That is why I say the fiscal problems that emerged after the financial crisis are a red herring.




Tuesday, 3 March 2015

Greek myths and legends

Ricardo Hausmann argues that Greek spending was "out of control" during the years prior to the Eurozone crisis - which as far as Greece is concerned actually started in 2009 with its first debt crisis, not in 2012 when the whole bloc nearly collapsed. He says:
"Greece piled up an enormous fiscal and external debt in boom times, until markets said “enough" in 2009."
Since the world was in recession in 2000-1 because of the dot.com crash, we have to assume that by "boom times" he means 2002-6 (since the financial crisis in Europe started with the failure of IKB in July 2007). So is he correct?

Here is Greece's debt/gdp from 1981 to the present day:

Nowhere in this chart is anything indicating a vast increase in debt/gdp from 2002-6. The vast increases in debt/gdp occurred prior to 1993 and from 2009 onwards. Greece's debt/gdp was high but stable from 1993 to 2009. Sixteen years of stable debt/gdp does not suggest a profligate government piling up an enormous debt due to out-of-control spending. It does suggest a government that was unable or unwilling to cut its debt/gdp in the boom times, but Greece is hardly alone in that.

Ok, so Hausmann is wrong about the external debt/gdp. Greece's high debt/gdp did not come about during the 2002-7 boom. It dates from the recessionary 1980s.

What about its external debt? Now there was indeed a huge increase during the boom times:


Which was of course because of this:


Yes, that is a large and growing trade deficit. The last time Greece's current account was in balance was in 1995. Hausmann does have a point about Greece's competitiveness. But the damage was done in the years from 1995 to 2001. During the boom years 2002-6 it appears that Greece's current account deficit was actually shrinking. So again, Hausmann is incorrect. Greece's trade deficit pre-dates the boom years.

What about its fiscal deficit? After all, it does appear to have been servicing its debt without increasing it. Here's Greece's government budget to GDP:



Well, this is odd. Greece's debt/gdp was stable until 2009 even though it was running a sizeable budget deficit throughout that period. These figures are of course all ratios, so we need to look at what was happening to GDP during that time. Here's Greece's annual growth rate:


That's really a rather healthy growth rate. No wonder Greece's debt/gdp was stable despite its budget deficit. And no wonder no-one saw the crisis coming. Why would anyone think an average annual growth rate of about 4% for over a decade was unsustainable?

Hausmann's claim that Greece built up unsustainable fiscal and external debts "during the boom times" is clearly wrong. The fiscal debt built up during the 1980s, and the external debt built up during the 1990s. Both were fed by recession. Profligacy there may well have been - but it was a long time ago. And there was no doubt a missed opportunity to reduce the debt burden. But should Greece really be blamed for failing to take advantage of an opportunity that just about every other government in the Western world missed?

Hausmann is also guilty of a cardinal statistical error. He says that "By 2007, Greece was spending more than 14% of GDP in excess of what it was producing, the largest such gap in Europe". Indeed it was. But as the current account to gdp chart above shows, that 14% trade deficit did not gradually build up during the boom years, as Hausmann implies. Greece's current account deficit actually started to decline in 2005, having improved from 2001-4:

>
The mirror image of this is of course the increasing inflows of capital from 2005 onwards:

Any analysis of Greece's external position that looks only at the current account deficit and ignores the growing capital account surplus is telling only half the story. Hausmann chooses his data to suit his argument that Greece's problems are all due to its profligate government spending and lack of investment, He ignores the (substantial) role of capital OUTFLOWS from other countries in the Eurozone, notably but not exclusively Germany. And he ignores the fact that the period 2005-7 was characterised by dangerous buildup of credit bubbles throughout the Western world. I've written elsewhere about the Eurodollar ("US-in-Europe") leveraging flow system that burst catastrophically in 2007-8. There was an equivalent Euro leveraging flow system circulating between the core and periphery Eurozone countries. This is what we are looking at in the chart above.

Capital has to go somewhere, and it has to be used for something: and that something is not necessarily productive. In Spain and Ireland, capital outflows from core countries blew up real estate bubbles. In Greece, they fuelled a consumption boom and enabled the government to maintain a high budget deficit. Is Greece's use of those capital flows any more dysfunctional than Spain or Ireland's?
And why was capital flowing to that extent at all? Why was it not funding commercial businesses in its countries of origin? Germany hardly has a stellar investment record either. The truth is that NO-ONE used that capital for investment. No-one at all.

Why are we not blaming this on the banks whose highly-leveraged, unproductive lending caused this collapse? We have been quick to blame banks for the "US-in-Europe" crisis. But we have blamed sovereigns, not banks, for the equivalent "core-in-periphery" crisis. Yet the cause is the same, and as this chart shows, even the timing is the same.

And yet....Greece does have a competitiveness problem. In this Hausman is correct. But the question we should be asking is why Greece's competitiveness declined so much in the 1990s, why it started to improve in the 2000s prior to the development of the "core-in-periphery" leveraging flow system, and what can be done now to restore it. Greece's public finances are a red herring.

FOOTNOTE. Hausmann is also wrong about Greece's goods exports. Its principal exports are oil and pharmaceuticals. But we should also question his underlying assumption that plant and machinery exports are "good" and exports of basic consumption products "bad" (or unwanted, which is the same thing). Food products are exported all over the world: the fact that Germany does not import much says more about Germany than it does about Greece.  If Greece can't compete in food exports then either its prices are too high or its quality too low. Both of those would respond to investment designed to improve efficiency of production.

Thursday, 26 February 2015

The failure of macroeconomics


This is the text of a talk given at Manchester University on 26th February 2015 proposing the motion "This house believes that mainstream economics has failed". It was followed by contributions from Trina Watson of the Post-Crash Economics Society (supporting), Dr. Andrew Lilico and Dr. John Ashworth (opposing), and a lively debate. 

Since the financial crisis there has been growing criticism of “economics”. From the Queen’s famous question “why did no-one see this coming?” to the Occupy movement and now to the Post-Crash Economics society founded by students at this university, people have questioned the purpose of an economics profession that failed to see the disaster approaching and seemed to have little coherent idea what to do about it.

Nonetheless, a blanket condemnation of "economics" as having failed is I think too wide. I therefore wish to narrow the framing. There are many economists out there doing important work, both in industry and in academia, on labour markets, on the behaviour of firms and households, on trade dynamics, on market functioning. I do not by any means wish to suggest that these have failed. Microeconomics, as a discipline, is going from strength to strength. My beef is with macroeconomics.

Olivier Blanchard, the IMF’s chief economist, recently wrote:
We in the field did think of the economy as roughly linear, constantly subject to different shocks, constantly fluctuating, but naturally returning to its steady state over time. Instead of talking about fluctuations, we increasingly used the term “business cycle.” Even when we later developed techniques to deal with nonlinearities, this generally benign view of fluctuations remained dominant.
The models that macroeconomic practitioners developed reflected this essentially linear view. Blanchard went on to observe that although macroeconomists did not ignore the possibility of extreme tail risk events, they regarded them as a thing of the past in developed countries. Western governments had inflation licked because of inflation-targeting central banks. Bank runs had been solved by deposit insurance and central bank lender of last resort functions. Sudden disastrous reversal of capital flows and balance of payments crises were problems for emerging market economies, not for developed European economies. And anyway, central banks could prevent or stop market “panics” by flooding the place with liquidity. If you get the policy settings right, linear models will work.

Except that they won’t. And that is because these models are not realistic views of how the economy actually works. Representative agents aren’t actually representative of anyone. Rational expectations are driven as much by emotion as logic. Behavioural economics is still in its infancy, but we are now beginning to understand just how much humans are driven by instincts such as herding. And nowhere is this more apparent than in the finance industry.

The financial crisis drew to our attention – once again – the crucial role of the finance industry. No industry that can cause such havoc when it goes wrong should ever be regarded as irrelevant or superficial. On the contrary: financial institutions perform the functions of capital allocation and money transmission which are so vital to our economy. Disruption or interruption of these functions, even if only for a brief time, has terrible consequences.

Yet macroeconomists regarded the behaviour of financial institutions and the motivations of those who work in the finance industry as so unimportant that they could safely be ignored. Representative agent models, flawed though they are, at least attempt to explain the behaviour of households and firms: but the behaviour of banks, and things that don’t call themselves banks but do bank-like things, stayed under the radar until far too late. Macroeconomists described the finance industry as a “veil”, rather than as the beating heart and circulatory system of the modern monetary economy: linear models, if they included banks at all, portrayed them as passive intermediaries, rather than active agents whose rational expectations are not necessarily aligned with those of their customers or, indeed, with the best interests of the economy as a whole.

The failure of most macroeconomists to foresee the financial crisis grew out of their incorrect understanding of how money is created, and perhaps more importantly, how leverage builds up. “Loanable funds” models, which portray the role of the financial sector as intermediating existing funds, are not only wrong, they are dangerous. They do not show how exuberance in credit creation arising from the irrational belief that asset values can keep rising forever carries the seeds of its own destruction. And they encourage belief in exogenous factors as the cause of financial crises – the “Asian savings glut” springs to mind. The huge increase in broad money prior to the financial crisis did not come from Asia, or from Mars. It was created by American and European banks.

Leaving banks out of economic models, or – worse – modelling their money-creating function incorrectly, made it impossible for mainstream economists to understand the significance of the build-up of credit that led to the financial crisis. The warnings came principally from people outside mainstream economics, particularly the followers of Hyman Minsky. After the crisis, Minsky’s “financial instability hypothesis”, long consigned to a dusty shelf in a dark cupboard, suddenly became hot news. Unsurprisingly, since we had just lived through something that looked very like a "Minsky moment".

Clearly, the exclusion of the financial industry from models of the macroeconomy was a major omission. Equally clearly, the fact that most macroeconomists did not, and to a large extent still do not, understand the mechanisms by which money is created and circulated in the modern monetary economy, is a big, big problem. Central banks are now “adding” the financial sector to existing DSGE models: but this does not begin to address the essential non-linearity of a monetary economy whose heart is a financial system that is not occasionally but NORMALLY far from equilibrium. Until macroeconomists understand this, their models will remain inadequate.

But macroeconomists are not oracles. It is their job to identify trends, not to predict specific events; it is both unreasonable and dangerous of the public to expect them to play the prophet. Macroeconomists have been cast in the role formerly held by priests and shamans, a role they appear to have welcomed though they are ill-equipped to perform it. They have garbed themselves with the cloak of infallibility and the breastplate of omnipotence. The financial crisis stripped them of these trappings, revealing them to be, underneath, somewhat skimpily clad.

It is fair to say that the academic macroeconomists have done a lot of soul-searching since the financial crisis, and there are important signs that things are beginning to change. But some of the most influential people in macroeconomics have spent their lives developing theories and models that have been shown to be at best inadequate and at worst dangerously wrong. Olivier Blanchard’s call for policymakers to set policy in such a way that linear models will still work should be seen for what it is – the desperate cry of an aging economist who discovers that the foundations upon which he has built his career are made of sand. He is far from alone.

At the Bank of England's One Bank Research Agenda seminar yesterday, Deputy Governor Ben Broadbent commented:
Economists cling to old ideas in the face of overwhelming evidence that they are wrong, or they choose the evidence that suits their particular framing.
Macroeconomics has indeed failed: not because of an intrinsic inadequacy in the discipline itself, but because of confirmation bias and selection bias among macroeconomists. Who would have thought it?

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