How bad is it going to get? That was the question that the UK Guardian asked the head of the UK Office for Budget Responsibility in an interview last week. It was in relation to the likely fallout if Greece defaults and leaves the Eurozone. He replied that the UK would be irreparably damaged. The fact is that Greece has already defaulted. The other fact is that if they do leave the EMU (which would be the best strategy) the impact on currency-issuing nations such as Britain can be managed away by sensible fiscal policy. For those who are predicting deep gloom the culprit is not the possible actions of Greece or any Eurozone nation but rather the irresponsible pursuit of austerity among sovereign nations. The reason Britain has a double-dip recession is all down to the decisions its own government have made. Organisations like the OBR support the flawed decisions with poor forecasting. Taken together this malaise reflects a mainstream macroeconomic framework that is incapable of providing policy advice which will deliver sustained prosperity to the population. The same flawed theoretical framework spawns the ever-growing hysteria about what will happen if Greece exits. The mania is reaching proportions similar to those a few years ago when rising budget deficits were predicted to cause huge hikes in interest rates and/or hyperinflation. All these forecasts fail because they are made by those who do not understand how the system works.
As an example of the sort of claims being made – over the weekend there was an article (May 19, 2012) in the Sydney Morning Herald – Locals brace for final act of Greek tragedy – that suggested that the Australian dollar might collapse as a consequence of the Greeks leaving the Euro.
We read that “Analysts say the Aussie could fall further, noting its plunge to near US60¢ in 2008”. No analysts were actually cited which is typical when outlandish claims are being made.
Even more extreme was this article in the UK Guardian (May 18, 2012) – UK ‘may never recover’ if Greece exits euro – which was about as bad as it gets.
The article was reporting on an – interview – that the chair of the UK Office for Budget Responsibility (one Robert Chote) gave. He was held out in the article as the “expert responsible for the government’s economic forecasting”.
So the same organisation that predicted the UK would grow by imposing fiscal austerity. Already, one might conclude his views are behind the 8-ball of veracity.
Chote claimed that “a Greek exit from the single currency threatens to plunge Britain into a second recession equal in ferocity to the record postwar slump of 2008-09”.
The UK economy is already double-dipping and the Greeks haven’t moved! The British plunge back into recession is all the work of its Government aided by the forecasting of Chote’s organisation.
The actual interview is long and detailed but the news story cuts to the chase and talks about:
1. “a fresh downturn would do irreparable damage to the UK”.
2. “Britain … can … go down and you never quite get back up to where you started”.
3. “trying to produce firm predictions was not “particularly helpful””.
I will get to the interview presently. The fact is that fiscal austerity is doing irreparable damage to the UK. The machinations in Europe are secondary to what the attack on domestic expenditure is doing.
Britain can insulate itself from the Euro crisis because it issues its own currency. It can always stimulate domestic demand and create employment. The problem is that in adopting the fiscal austerity mantra the Government also promotes the export-led recovery lie.
Neither – interlinked strategies – will deliver growth in an environment where austerity is being imposed almost universally.
Firm predictions are clearly possible. I predicted that the UK would double-dip this year if they imposed fiscal austerity. They have. It was obvious that would happen. Those who denied the possibility were using the mainstream macroeconomic theories which mislead them.
These theories provide no meaningful insights into how the modern monetary economies operate; the impact of the government sector on private spending and saving; the psychology of private spending when unemployment is rising and private debt is high, and the rest of it.
The Chote Interview provides ideal material for a Billy Blog Saturday Quiz major final term assignment – please find all the flaws in the macroeconomic reasoning presented!
Chote was asked about the likely impact of a Greek exit. He said (summarising):
… there would be negative growth for two years, deflation in 2013-14, unemployment higher than 10% and that the chancellor would miss his targets.
There would only be negative growth and a rise in unemployment in Britain (assuming the predictions of export demand declines and private investment collapses occur) if the Chancellor continued, in the face of all evidence that it was irresponsible, to pursue his austerity program.
He was asked about the reliability of the OBR forecasts – which to date have been very poor indeed – the interviewer noted that “Two years ago you were predicting growth of 2%-plus in 2012, and now it’s 0.8% and coming down”. Chote replied:
Judging that is harder because the numbers continue to be revised long after you think you know who’s done a good forecast and who’s done a bad one. That was very clear in 2010. All the forecasts we produced in 2010 under-estimated economic growth in 2010 … If you look at why growth appears to have been weaker in 2011 than we thought – and indeed I think that every one of the independent forecasters polled at the beginning of 2011, no one had anything as weak as 0.7, which is where we’ve ended up – the main reason for that appears to be the fact that there were pressures on inflation that were higher than people expected. Things like higher oil prices and food prices were squeezing household incomes, squeezing consumer spending.
So nothing about the negative outlook engendered by the fiscal austerity and the loss of public sector jobs already under-way.
He was asked – “Why has the OBR been so wildly optimistic, when Keynesians predicted double dip would be the result of extreme austerity?”: He replied (almost incoherently):
We sit down, we puzzle over the data and the information and we reach the best view that we can, whether the Treasury agrees with that or not … We all sit and discuss the uncertainties about what is going on. But at the end of the day the great discipline is transparency. We have to show our working. There will always be people who disagree with the view that you express. That’s the nature of economics.
Which didn’t answer the question at all – which should have zeroed in on the conceptual basis of their forecasts in an environment of austerity, which the OBR has supported and championed.
The journalist didn’t see fit to pursue the real issue – how can you forecast growth under conditions of austerity? It is all very well to sit down and puzzle over data – but what lens are they using to filter the data? That is the question. The interviewer failed to do their job correctly.
Some conceptual matters could have emerged later when the discussion turned to the “(s)ustainability of public sector pensions”. Chote was asked whether public sector pensions were sustainable and he replied that while public pensions as a per cent of GDP were likely to fall over time:
… there was an upward pressure on the public finances. So, if you want to deal with the upward pressure in aggregate, you can decide whether to cut the bits that are falling by even more, or whether to try to cut some of the bits that are rising by a bit. It depends on whether you are looking at it in isolation, or whether you are looking at it more widely.
So whether it is sustainable depends on whether you are looking at the public spending cake as a whole, or the public sector pensions bit of it?
The arithmetic is obvious. But the conceptual point is – what basis can a public outlay in sterling be unsustainable for the government which issues the sterling as a monopolist?
MMT clearly tells us that such outlays can never be financially unsustainable and redirects our queries into issues about the availability of real goods and services that will be required to sustain material standards of living as societies age.
The other economic issue is whether nominal spending growth will outstrip the real capacity of the economy to absorb it – and hence introduce inflation threats.
But the capacity to pay the pensions is never in doubt. Another opportunity for the interviewer to expose the ideological leanings of Chote were missed here.
The final topic was whether austerity should be made operational via “(t)ax increases or spending cuts in the long term”. The interviewer quoted from the OBR “fiscal sustainability report” – that public finance was “likely to come under pressure over the longer term” and that “in the absence of offsetting tax increases or spending cuts this would eventually put public sector net debt on an unsustainable upward trajectory”.
Chote was then asked “What does that actually mean in practice?”, which is a good question. He replied:
It’s the idea that on unchanged policy the share of national income that you get in tax revenues does not really change very much as you go into the future. The fact that the population is ageing, and there are more people above working age than below working age, doesn’t affect the total amount of tax revenue you get in very much, partly because older people are still buying things and they’re paying VAT on them. However, if you then look on the spending side, that does rise as a share of GDP on unchanged policy, partly because, as the population ages, you need to spend more on things like the state pension, long-term care, health expenditure. That is where that pressure comes in.
Which doesn’t explain anything? What pressure? All he is suggesting is that, other things being equal, the budget deficit will rise as a proportion of GDP over time as less people are working.
What pressure does that place on a sovereign government issuing its own currency? Answer: nothing especial.
There are huge questions about future productivity – providing the expanding access to high quality real goods and services including health care as the dependency rate rises.
But then why would OBR support a government strategy that further entrenches unemployment and concentrates disadvantage among the youth of Britain – all of whom will need to be educated and trained to develop skills far in excess of their parent’s generation if the society is to maintain material standards of living.
All of that suggests on-going budget deficits will be required. Exactly the opposite to what OBR is supporting.
Again – the interviewer lets him off the hook and after quoting some large numbers relating to “required” tax increases and spending cuts – asks Chote “Do think policymakers have grasped the size of this challenge?”.
Why would one frame the issue in this way? Why not ask Chote to justify the magnitudes and the underlying logic rather than simply accept the logic and ask whether the pollies get it.
Chote replied that the large numbers should be seen as a “painting a general picture of direction” but didn’t answer the question nor was pushed to explain himself.
Overall an incredibly poor performance by the UK Guardian.
The capacity of mainstream commentators (as mouths for the feeds they get from economists) to accurately forecast anything has been clearly demonstrated by the crisis.
The Federal Reserve Bank of New York has an interesting blog – Liberty Street Economics – and last year (November 25, 2011) there was a good analysis of the The Failure to Forecast the Great Recession
The following graphic is derived from the data provided by the FRBNY analysis of its own staff forecast errors. The data (and other forecasts) are available from this spreadsheet.
The FRBNY say that:
The staff forecasts of real activity (unemployment and real GDP growth) for 2008-09 had unusually large forecast errors relative to the forecasts’ historical performance, while the forecasts for inflation were in line with past performance. Moreover, although the risks to the staff outlook were to the downside throughout this period, it wasn’t until fall 2008 that a recession as deep as the Great Recession was given more than 15 percent weight in the staff assessment.
Please read my blog – 100 per cent forecast errors are acceptable to the IMF – for more analysis of the systematic errors biases that have pervaded mainstream forecasting. They typically overestimate growth when they are advocating austerity and/or monetary policy and underestimate growth when discussing discretionary fiscal interventions.
The reason for the large forecast errors in mainstream models lies in the theoretical ideas that underpin the models. GIGO – garbage in-garbage out. At least the FRBNY is starting to acknowledge that.
The FRBNY paper provides a rather candid exposition of why they believed the FRBNY failed to “forecast the Great Recession”. They believe that the economics profession had become waylaid by the seeming stability associated with the “Great Moderation” and they say that:
… in the period leading up to the financial crisis, analysts who were suspicious of the stability of the Great Moderation offered assessments that proved to be significantly more accurate than the point forecasts of New York Fed research staff or most professional forecasters in gauging the potential for unlikely bad outcomes.
The early Modern Monetary Theory (MMT) proponents (Warren Mosler, Randy Wray, Stephanie Bell/Kelton, Scott Fullwiler, Mat Forstater and myself) were among only a few macroeconomists who poured scorn on the propositions that the mainstream economists were presenting in the late 1990s and in the period leading up to the crisis.
Please read my blog – The Great Moderation myth – for more discussion on this point.
I also dealt with the myth of the self-regulating market my 2008 book with Joan Muysken – Full Employment abandoned.
The point is that the Great Moderation was part of a wider believe that the “business cycle was dead”. The current crisis has reasserted what the arrogant mainstream of my profession tried to deny – that left alone the private market will not be able to mainstain long periods of output and employment growth.
The mainstream macroeconomists increasingly tried to claim in the 1990s and up until the recent crisis that they had “won” – been vindicated and those stupid Keynesians would never see the light of day again.
I have provided this notable example before but it is always worth reinforcing how out of touch the mainstream was in the period leading up to the crisis. In his 2003 presidential address to the American Economic Association, Robert E. Lucas, Jnr of the University of Chicago said:
My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades. There remain important gains in welfare from better fiscal policies, but I argue that these are gains from providing people with better incentives to work and to save, not from better fine tuning of spending flows. Taking U.S. performance over the past 50 years as a benchmark, the potential for welfare gains from better long-run, supply side policies exceeds by far the potential from further improvements in short-run demand management.
The Great Moderation became the norm and economists started to concentrate on increasingly banal and crazy research programs and increased the pressure on governments to deregulate further to let the market work. The crash that came was inevitable given the logic of the situation.
Once the deregulation train was running and financial markets were pushing credit down the throats of those who would never feasibly be able to pay and real wages were failing to keep pace with productivity growth and governments were intent on constraining net spending it was only a matter of time before the crisis emerged.
The FRBNY paper say that there were “(t)hree main failures in our real-time forecasting”:
1. They misunderstood the housing boom – “Staff analysis of the increase in house prices did not find convincing evidence of overvaluation” and so “downplayed the risk of a substantial fall in house prices”. The MMT discussions during this period were focused very heavily on the dynamics emerging as a result of the rapidly escalating private sector indebtedness.
While the neo-liberals were obsessed with governments reducing their debt levels they failed to realise that, under current institutional arrangements (associated with public debt-issuance and deficits) that a government surplus is a non-government deficit. They should have been focusing on private debt which carries a solvency risk and ignoring public debt among currency issuers which carries no zolvency risk.
2. They failed to analyse “the rapid growth of new forms of mortgage finance” because in their own words:
… the reliance on the assumption of efficient markets appears to have dulled our awareness of many of the risks building in financial markets in 2005-07″.
Efficient Markets Theory is only part of the overall mainstream approach to macroeconomics that was in error. But the efficient markets hypothesis was at the centre of the claim that markets would self-regulate and deliver optimal outcomes for all.
In this extraordinary – Interview with Eugene Fama – with the New Yorker’s John Cassidy (January 13, 2010), Fama, an economist at the University of Chicago, and most known for his work promoting the EMH, denies that the current crisis represents market failure.
The EMH asserts that financial markets are driven by individuals who on average are correct and so the market allocates resources in the most efficient pattern possible. There are various versions of the EMH (weak to strong) but all suggest that excess returns are impossible because information is efficiently imparted to all “investors”. Investors are assumed to be fully informed so that they can make the best possible decisions.
I recall one economist told me that “you cannot profit by riding the yield curve”. I pointed out that hedge funds profit in this way every day, to which he said that was “impossible”. That is the level of denial that abounds in my profession, which has been ideologically captured by the mad-cap ideas such as the EMH.
Fama told John Cassidy that the financial crisis was not caused by a break down in financial markets and denied that asset price bubbles exist. He also claimed that the proliferation of sub-prime housing loans in the US “was government policy” – referring to Fannie Mae and Freddie Mac who he claims “were instructed to buy lower grade mortgages”.
When it was pointed out that these agencies were a small part of the market as a whole and that the “the subprime mortgage bond business overwhelmingly a private sector phenomenon”, Fama claimed that the collapse in housing prices was nothing to do with the escalation in sub-prime mortgages but rather:
What happened is we went through a big recession, people couldn’t make their mortgage payments, and, of course, the ones with the riskiest mortgages were the most likely not to be able to do it. As a consequence, we had a so-called credit crisis. It wasn’t really a credit crisis. It was an economic crisis.
John Cassidy checked if he had heard it right asking “surely the start of the credit crisis predated the recession?” to which Fama replied:
I don’t think so. How could it? People don’t walk away from their homes unless they can’t make the payments. That’s an indication that we are in a recession.
Once again he was prompted to think about that – “So you are saying the recession predated August 2007?, to which Fama replied:
Yeah. It had to, to be showing up among people who had mortgages.
He was then asked “what caused the recession if it wasn’t the financial crisis”?
(Laughs) That’s where economics has always broken down. We don’t know what causes recessions. Now, I’m not a macroeconomist so I don’t feel bad about that. (Laughs again.) …
Fama asserted that “the financial markets were a casualty of the recession, not a cause of it”.
Please read my blog – Evidence – the antidote to dogma – for more discussion on this point.
At least, agencies such as the FRBNY are seeing that this sort of blindness helps to explain why none of the mainstream models were able to see the crisis coming.
3. “Insufficient weight given to the powerful adverse feedback loops between the financial system and the real economy. Despite a good understanding of the risk of a financial crisis from mid-2007 onward, we were unable to fully connect the dots to real activity until 2008.”
Most of the mainstream consensus models – the so-called New Keynesian models – didn’t even have financial sectors within the structure of the theoretical model. This is as ridiculous as some Post Keynesian models that eschew the explicit analysis of the government sector in private debt models.
Please read this blog – Mainstream macroeconomic fads – just a waste of time – for more discussion of the deficiencies in the mainstream macroeconomic framework.
In conclusion, the FRBNY say that:
However, the biggest failure was the complacency resulting from the apparent ease of maintaining financial and economic stability during the Great Moderation. Perhaps most important, as noted by some analysts as early as the 1990s, these adverse consequences of the Great Moderation were most likely to arise from the actions, judgments, and decisions of financial market participants …
That was the line that MMT was taking in the 1990s. It is good that the FRBNY is catching up some 20 years after the trends began but I suppose it is better late than never.
The problem is that the reasons that explain why the mainstream were unable to predict the crisis are the same reasons why it cannot offer anything by way of coherent recovery streatites.
They are the same reasons why the mainstream are making otulandish comments about the impact of a possible Greek default and Eurozone exit.
They are the same reasons that have been used to justify the imposition of austerity in the face of everything that says such a policy approach is the highest form of folly.
That is enough for today!