The UK and Europe: The Way Forward

I am British,  I am American, and I am continental European.  I was born and raised in Britain and I am a British citizen by birth.  I have lived in the United States for thirty years and I am an American citizen through naturalization.  I am a continental European through my two year stint of teaching economics in Italy where  centuries of European culture seeped into my pores by osmosis and took up residence in my bones.

The British people have voted to leave the European Union. You may, or may not,  have strong views about the outcome of that vote. All of us, wherever we are located  in this existential adventure that we call the planet earth, will be affected by it. Now is the time for those of us most directly affected, whether British or Continental European, to come together and help to forge a future in which all of us can prosper. That may not look much like the vision of Jean Monnet for a European Federation, but I am confident that it will not lead to a return to the Europe of fractured nationalisms that ended in two world wars.

I did not join the chorus of economic experts who threatened Armageddon if the vote were to turn out in favour of leave. There were persuasive arguments to be made for significant economic costs of leaving the EU. Some suggested that these costs would be long-term.  That is a hard case to make. Economists cannot accurately predict what will happen six months from now. If you want a long-term prediction I hear that reading entrails was effective for the Emperor Augustus.

That  is not to say we can avoid  short-run economic costs. But those costs will be a great deal worse for all involved if we allow an atmosphere of panic to take hold in the financial markets.  Mark Carney, Governor of the Bank of England, has promised to support UK financial institutions. That  was a good start and it will, I believe, prevent a further slide in the exchange value of the pound.

I am not overly concerned by the decline in the value of the pound that has occurred to date. I am more concerned by its cause. The pound fell because international investors pulled money from UK asset markets and fled to gold and to US treasuries. So far, with the possible exception of the French stock market, international asset markets have been volatile but they have not gone into free fall. A persistent free fall in the financial markets will, if allowed to occur, cause  a major recession.

The Bank of England should make clear that a catastrophic drop in the financial markets will not be permitted. I recommend a statement that the Bank will, if necessary, buy shares in an  exchange traded fund to support the value of the FTSE and that it will pay for those shares by selling short-term treasury securities. As I argued here, if necessary, the Treasury should support that action by providing the Bank with the authority to borrow on its behalf.

My recommendation is based on empirical research that shows a stable persistent connection between the value of financial assets and the unemployment rate. My own research was conducted on US data. Studies conducted at the Bank of England and at Hamburg University have replicated my findings  on UK data and on German data.

Some economists have called for lower interest rates, perhaps even moving into negative territory. I do not think that is the right answer. Interest rate control was effective for more than twenty years as a tool to control inflation. We need a new approach to deal with financial crises. That approach should, in my view, take the form of a direct intervention in the asset markets by the Bank of England,  to prevent the excess volatility that is caused by fear of the unknown. It is the job of policy makers to contain that fear. It is the responsibility of journalists and opinion makers to refrain from exacerbating it.

We should refrain from pouring petrol onto the fire of volatile financial markets by speculating that the sky is falling. It isn’t: Yet. Words are powerful and may become self-fulfilling prophecies. Let us choose them carefully.

I discuss these ideas, and many more, in my forthcoming book, Prosperity for All.

Confidence is not a fairy and it is not an illusion

Figure 1: The IS-LM-NAC Model

My coauthor, Konstantin Platonov, and I, have recently completed a working paper, “Animal Spirits in a Monetary Economy”. In this paper, we introduce a framework we call the IS-LM-NAC model that, we hope, will replace the Hicks-Hansen IS-LM model as a way of thinking about the impact of economic policy on output and employment.  Figure 1 depicts  the graphical apparatus we use in that paper.

The IS-LM model originated with a paper by Sir John Hicks, "Mr. Keynes and the Classics", that simplified the major ideas from Keynes' General Theory. Hicks’ simplification of the General Theory can be summarized by  two curves in interest-rate output space.  The downward sloping IS curve presents points where Investment equals Savings, hence I and S. The upwards sloping LM curve presents points where preference for Liquidity equals the supply of Money hence, L and M.

Importantly, the position of the IS curve depends on the animal spirits of investors;  aka confidence,  and on the fiscal and monetary policy instruments of government. The position of the LM curve depends on the balance sheet of the central bank and on the price level which, in Hicks’ world, is historically given. This graph was widely seen as a tool for understanding how the short-run equilibrium positions of output and interest rates are influenced by fiscal and monetary policy.

I first introduced confidence as an independent driver of the steady-state unemployment rate here. My work with Konstantin adds money to that framework. Our model also has an IS and LM curve and they play very similar roles to the IS and LM curves of Hicks’ theory. But we do not see them as short-run curves. They represent possible long-run equilibria positions for the interest rate and output. In our IS-LM-NAC framework, there is a third curve, the NAC curve which represents a No Arbitrage Condition. At every point on the NAC curve, the people in our model are indifferent between holding the stock market and holding government bonds.

Shifts in animal spirits, aka confidence, cause shifts in the NAC and the IS curves. Following a shift in confidence, the price level is initially ‘sticky’, but this has nothing to do with artificial costs of changing prices, as in modern new Keynesian theories. In contrast, it simply reflects the way that people form their beliefs. Eventually, after price adjustment has occurred, the LM curve comes to rest at a point that intersects the NAC and IS curves. How quickly this happens depends on a new fundamental, the belief function, a concept that I introduced in 1993 in the first edition of my book, the Macroeconomics of Self-fulfilling Prophecies. 

In the paper with Konstantin, we conduct two experiments. We show that an increase in confidence, or an increase in the money supply, may each lead to a self-fulfilling increase in output and employment. Interestingly, the long run impact of monetary policy depends on how people form their beliefs.

Paul Krugman, quoting a piece from Brad Delong,  has doubled down on the confidence fairy. They assert that a big fiscal expansion is the right way to cure a depression. I have read the same empirical papers as Paul and Brad and, as I explained back in January of 2010,  I am not convinced.

In my view, confidence is not a fairy, nor is it an illusion: It is very real.  "Animal Spirits in a Monetary Economy" explains why belief formation matters, in the context of monetary policy.  In an earlier piece I wrote with Dmitry Plotnikov, we show that, if private sector confidence remains depressed, fiscal spending can crowd out private sector spending.  Our argument does not depend on whether the interest rate is, or is not, at the zero lower bound.

Confidence is not a fairy, nor is it an illusion.  If businesses refuse to invest because their confidence is low, the outcome will be just as bad  for output and employment as a supply-side shock like a hurricane. As I explain in my forthcoming book, Prosperity for All, the right way to prevent another Great Depression, is by active intervention in the asset markets. You can pre-order my book from OUP, here.

Forecasting that the Unemployment Rate will stay Constant is a Bad Idea

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Jim Bullard, President of the St Louis Fed, has released a new, St Louis Fed model, for thinking about the way the Fed forecasts. According to the St Louis model, we should think about 'regimes'. There are three components to regimes. 1) Is the economy in a recession: YES or NO? 2) Is the short-term real interest rate HIGH or LOW? 3) Is productivity growth HIGH or LOW? 

Putting these pieces together, there are eight possible states. Recession can be YES or NO,  productivity can be HIGH or LOW and the natural real interest rate (Jim calls this R Dagger) can be HIGH or LOW. 

In Bullard's view the current regime is

Recession: NO,      Productivity growth: LOW,    R Dagger:   LOW

Using regime dependent forecasting, Jim thinks the best forecast of the US economy, moving forwards, is that productivity growth will stay low and the unemployment rate will stay where it is. That implies, according to Bullard, that the Fed should hold the interest rate at 63 basis points through 2018. 

I have one big problem with this forecasting framework. Take a look at the figure above which depicts US unemployment since 1950. Jim Bullard wants to talk about a 'regime dependent equilibrium'. I have no problem with that idea. But there is no period in the post-war period when the unemployment rate was even approximately constant. It was either increasing or it was decreasing.  If we stick with the regime dependent paradigm, I would replace, [Recession = Yes or NO], with, [Unemployment = INCREASING or DECREASING].

That may seem like a semantic change. But it makes a big difference to a regime dependent forecasting model because the unemployment rate cannot keep falling forever. That suggests that, the longer we are in the [Unemployment = DECREASING] state, the higher is the probability of a regime switch into [Unemployment = INCREASING]. That suggests to me, that the risk of another recession while productivity and the natural real interest rate are low is higher than Jim Bullard thinks. 

I'm glad that the St Louis Fed has moved to this new framework as I've argued for a long time that the existing paradigm is broken.

You can preorder my book, Prosperity for All, which says a lot more about these issues, HERE.

Is the US economy healthy?

I wrote this piece for  John Kiernan at Wallethub ... you can find how some other economists answered the same question here. 

The US economy is not dead, but it's not about to run a triathlon any time soon. We're in intensive care in a third rate hospital in the hands of a medical team struggling to come up with a convincing diagnosis. The good news is that the patient is resilient and the knowledge we gain from experimental cures  will  help us save future patients.

There are two problems. The first is the hangover from a binge lending episode that ended badly in 2008. That episode was caused by a bout of optimistic expansion in which half the world lent to the other half. Everyone knew the asset price boom would end. But the gains made during the upswing were too big to ignore. And when it came: the landing was hard. The borrowers are still paying down their accumulated debts.

The problem with the capital markets is not, as some would claim, that people are irrational. During the debt crisis, we were all acting in our own best interest. And we knew it. People are rational.  Markets are not. The world economy is recovering from a nasty bout of idiopathic rational exuberance. 

The 2008 debt crisis taught us that financial markets sometimes screw up in a major way. In my forthcoming book, “Prosperity for All: How to Prevent Financial Crises”, I explain what went wrong and how to fix it. We must  create an institutional mechanism to stabilize swings in the financial markets that always, eventually, end badly.

The second problem is chronic.  Doctors swear to “do no harm”. Economists swear to “block no trade”. That's been a healthy doctrine for most people in the world: if you don’t believe me, just ask the 1.5 billion Chinese workers who saw  growth rates of more than 10 percent a year for decades. And it's been a healthy doctrine for the wealthy and educated elites in the US whose income is derived from owning physical or human capital. But 1.5 billion Chinese workers do not vote in US elections. And American workers have not fared so well. 

The second problem for western democracies is to find a way to redistribute the gains from global trade to working class and middle class voters who have seen their living standards eroded at the expense of Chinese workers and the educated western elites who control the debate. 

Its the wiggles not the trend

Chart 1: Number of unemployed people and number of people in the labor force. Both series normalized to December 2007=100.

A commentator on my blog asks if the reason that unemployment appears to be more important than labor force participation as a cause of recessions is that the scales are different on Chart 2 from my previous blog post. I don't think that's it.

Chart 1 (left) shows the data in a different way. The red series is the civilian labor force. The blue line is the number of unemployed people. Both series were originally measured in thousands of people. The data on the graph have been normalized by constructing index numbers.  In each case I normalized the series in December 2007 (the start of the Great Recession) to 100.

Both series have un upward trend. That's because of population growth: there are more people in the labor force each year and there are more unemployed people each year. My point has nothing to do with the trends. Its about the wiggles. 

Look at it another way. If I gave you the red series and asked you to predict the number of people in the US labor force in 2015, using data through 1990, you'd probably do a pretty good job using lagged values of the labor force, lagged values the US population, and a quadratic time trend. If I also told you there was going to be a major recession lasting from December of 2007 through June of 2009, it wouldn't have helped you much, if at all, in your prediction. Recessions are all about the wiggles. Participation is all about the trend.