Economic forecasters are in the dock. Last week, none other than the chief economist of the Bank of England, Andy Haldane, was confessing the crimes of the profession.
The failure to predict the financial crisis was, Haldane said, economic forecasting’s “Michael Fish” moment. Thirty years ago, the BBC weatherman predicted that the UK would avoid the hurricane which devastated the south of England.
Haldane went on to admit that the Bank had “not anticipated” the strength of the economy after the Brexit vote. This is something of an understatement. The Treasury predicted an immediate recession, with the economy shrinking dramatically in the July to September period at an annual rate of up to 4 per cent. The latest Office for National Statistics estimates show that it grew at an annual rate of 2.5 per cent, almost the complete opposite of the prediction made in June.
He attributed these forecasting failures to the fact that economic models assumed that people behaved rationally. However, they had been “irrational” in continuing to spend after the Brexit vote.
This tells us a lot about the mindset of the economics profession. Economists were overwhelmingly in favour of Remain. If you think that the European Union is a great economic success story, bursting with dynamism and innovation, then it would be irrational to continue to spend after a Leave vote. You should be saving for a rainy day. Consumers have taken a different view, but one which may very well be rational.
A serious problem for economic forecasters, and indeed the profession as a whole, is groupthink. Writing about the crisis of the 1930s, Keynes said: “a sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no-one can really blame him.” There is a real reluctance to go out on a limb and risk being proved wrong.
But there is a deeper reason why forecasts repeatedly fail. The problem is that the data on key variables such as GDP and inflation does not contain very much genuine information.
To make successful forecasts in any scientific setting, the data needs to have regularities which can be identified. No-one, for example, can successfully predict over time the outcome of the next shake of a fair dice. The outcome is completely random.
Economic data is not quite as bad as this from a prediction perspective. But the economy is bombarded continuously by so many different events that it is hard to pick out any underlying structure.
Imagine watching a hospital soap in which a screen shows the regular heart beat of a patient. Imagine now the screen plagued by constant interference. It would be difficult to distinguish the “signal” (the heart beat) from the “noise” (the interference). This is what economic data is like. And this is why forecasts are often wrong.
As Clint Eastwood said in Magnum Force: “a man’s gotta know his limitations”. Time for forecasters to wake up to this fact.
As published in CITY AM on Wednesday 12th January 2017
Last year was a year of celebrity deaths. But perhaps the most significant of all received very little coverage. Just before Christmas, Thomas Schelling, Nobel Laureate in economics, died aged 95.
In the early, tense years of the Cold War between America and the Soviet Union in the late 1940s and 1950s, Schelling’s ideas were enormously influential in preventing nuclear conflict from breaking out. As he pointed out in his Nobel Prize lecture, there was a real danger of this.
The US government invested heavily in the then new science of game theory. How do you handle a weapon which is so devastating you do not want to use it, while at the same time convincing the other side that you might? Schelling was instrumental in creating the strategy of credible threats.
But his mind ranged powerfully over a wide range of disparate issues. Our understanding of crime, obesity, smoking, binge drinking – a whole host of social problems – has been improved substantially by Schelling’s work. He saw that there are underlying similarities in how they develop.
His most important work in this area was published in 1973, in a paper with the fantastic title “Hockey helmets, concealed weapons and daylight saving”. Schelling’s inspiration was a piece in the sports section of a newspaper about ice hockey, a game even more brutal than Rugby League.
A star player had suffered serious head injuries from the flying puck while not wearing a helmet. The reporter interviewed other leading players, none of whom wore helmets. It was clear that they understood the very real dangers involved. A rational economic person, weighing up the costs and benefits, would always wear a helmet. But when asked why he didn’t, a top boy answered “I don’t because the other guys don’t”.
Schelling crystallised this into a mathematical concept he called “binary choice with externalities”. The choice facing an individual is binary. Either you wear a helmet or you don’t. Either you smoke or you don’t. But your choice may affect how other people in your peer group make their choices.
If no one else wears a helmet, you look soft by wearing one. If all your friends smoke, you may do so just to fit in. So the decision of an individual can have effects which are “external” to the decision itself. Understanding this is crucial to policy-makers trying to influence the outcome. Rational choice theory may not always apply.
His ideas on game theory live on. Indeed, they appear to have influenced President-Elect Trump. Trump has sent out many signs that he wants to work with Putin’s Russia. But just before Christmas, he tweeted, inexplicably to many, that America should expand its nuclear arsenal. He was in fact making a credible threat. Putin, an ex-KGB man, knew that it was Reagan ratcheting up defence spending which finally broke the old Soviet Union. So Trump signals in a single tweet: we want to cooperate, but if you don’t, your economy will collapse as you try to keep up with us.
Thomas Schelling, polymath of genius, I salute you!
As published in CITY AM on Wednesday 4th January
Image: Bomb by _Gavroche_ is licensed under CC BY 2.0
It’s certainly been an eventful year. But rather than dwell on the past, what sort of things can we expect in 2017? Here are a few eclectic predictions.
Sweden may become the world’s first cashless economy. Notes and coins are already fast disappearing as a means of payment, and retailers are legally entitled to refuse to accept them. Cash transactions make up less than 2 per cent of the total value of transactions in the Swedish economy. Over half of bank branches have no cash in hand and refuse to accept cash deposits. ATMs are increasingly hard to find.
The central bank, the Riksbank, is well advanced with its plans to launch its own digital currency, the e-krona. If this idea is adopted more widely by central banks, and it certainly feels like one whose time will come, where will this leave Bitcoin? Possibly as the international criminal’s e-currency of choice, possibly for use as baby sitting tokens, or equally possibly, it will become extinct.
Switching tack, there may be quite a lot of sympathy for the antics of the rail unions next year, certainly more than the Tory MPs demanding government curbs imagine. The long-suffering commuters of Southern will disagree with this point. Others, however, might look at South West trains, their near neighbour, and wonder how they manage to run a successful and profitable franchise without having driver-only operation of trains.
More widely, anti-globalisation sentiment is unequivocally on the rise. Any liberal still baffled by the US election might usefully read a paper in the July 2016 American Economic Review by Justin Pierce of the Federal Reserve and Peter Schott of Yale. They show that the sharp drop in US manufacturing employment after 2000 can be attributed to a change in US trade policy that eliminated potential tariff increases on Chinese imports. The electors in the rust belt states are the ones who suffered most.
The trade unions in recent decades have often been their own worst enemies, and have behaved stupidly. But sentiment is shifting, and the Prime Minister needs to be cautious.
Thinking of trade unions, readers of a certain age will recall the miners’ leader, Arthur Scargill, and his ludicrous attempts to conceal his essential baldness with a comb-over. President-Elect Trump, in contrast, has a truly marvellous barnet. His front-combing appears to defy the laws of gravity, just as his election appeared to defy the conventional laws of politics. Perhaps with Trump’s stylist, Scargill would have won the miners’ strike.
The crucial question is the hair style of Mark Carney. The crisp short-back-and-sides, with the immaculate side parting, is the epitome of the Daddy on the Daddies Sauce bottle of the 1950s and 1960s. Is this the real forward guidance which the governor of the Bank of England is trying to convey to us? That he expects a restoration of the economic conditions of those decades? GDP growth averaging 3 per cent a year, the government finances in balance, booming living standards, and unemployment of only 2 per cent. After Brexit, anything is possible.
As published in CITY AM on Wednesday 21st December
Image: bitcoin by fdecomite is licensed under CC by 2.0
The buzz-phrase of the moment in political discussion is “post-truth”. Shell-shocked metropolitan liberals are astonished by both Brexit and Donald Trump’s success. How could their own rational analysis not find favour with the electorate? People in the internet age must be no longer capable of recognising the truth.
Both the Brexiteers and Trump certainly created narratives about the future which appealed to people in a positive, exciting way. “Make America Great Again!”
But narratives about the future have always been important, not just in politics but in central banking too. During one of the recurring crises in the Eurozone, in 2012, European Central Bank president Mario Draghi proclaimed he would do “whatever it takes to save the euro”. Quite what he would have done if financial markets had continued to attack the currency is not at all clear. It was, in today’s terminology, a post-truth statement. But it worked. His narrative convinced traders and speculators to back off, and the euro lived to fight another day.
Of course, most elections aren’t fought on sweeping narratives about the future but on rather more mundane issues. Who can now remember, for example, what were the themes in the British general election of 2005, just over a decade ago? Even last year’s election was decided on pretty humdrum everyday stuff. Everyone knew things had been rather grim since the financial crisis, but could Labour be trusted to make them any better? In the marginal seats, the answer to this bread-and-butter question was a resounding “no”.
Memorable elections have been ones in which narratives about the future were important, when voters were asked to believe in a vision rather than dwell on the facts. At the end of the Second World War, Attlee’s Labour Party won a huge victory with its picture of a universal welfare state. In 1964, Harold Wilson overturned a massive Conservative majority with his portrayal of science and technology as the future, which Labour technocrats owned. The example of Mrs Thatcher needs no further description. And in 1997, Tony Blair projected a vision of peace and happiness in “Cool Britannia” – a post-truth concept if ever there was one!
The internet and social media certainly enable narratives so that they spread more rapidly and their noise levels are amplified. But the technology does not of itself create “post-truth”. There are far more dramatic and older historical examples of post-truth politics than the British examples above. Under Lenin and Stalin, the entire population of the Soviet Union lived “post-truth”. The reality of everyday existence diverged spectacularly from the narratives which the Communist Party worked so hard to create, and which so many people really believed.
The Brexiteers and the Trump camp knew how to use the networked society of social media. It is not just the message, but the maths which matters now. They understood which sites and tweeters to target, they grasped how to manipulate Google’s page rank algorithms. Despite their veneer of stupidity and supposed distrust of experts, they were actually much smarter than their liberal opponents.
As published in CITY AM on Wednesday 14th December 2016
Image: Donald Trump in Reno, Nevada by Darron Birgenheier is licensed under CC BY 2.0
So farewell then, Matteo Renzi! The resignation of the Italian Prime Minister after his heavy defeat in Sunday’s referendum on constitutional reform has created turmoil. Fears have been resurrected about the stability of the Italian banking system, and even the possibility of Italy leaving the euro has been raised.
But the problems of the Italian economy, along with the rest of the PIGS (Portugal, Greece and Spain), go much deeper. The long boom of the 1990s and 2000s in the Western economies ended in 2007. GDP began to fall in almost all Western economies during 2008. In the US, output is now some 10 per cent higher than it was at its previous peak in 2007. In the UK it is around 9 per cent up, and in Germany the increase is 8 per cent.
In Italy, GDP is still 8 per cent below its level of 2007. In Spain, the fall is 3 per cent, in Portugal 5 per cent, and the Greek economy is a staggering 26 per cent smaller than it was in 2007.
This is an exceptionally long period for output to remain below its previous peak level. By the early 1950s, for example, West Germany, which had been heavily bombed and overrun by foreign armies, had surpassed its previous peak level of output of the mid-1940s. So, too, had Japan, which had been attacked with nuclear weapons.
Why have the PIGS performed so spectacularly badly? A conventional reason, and one which has considerable force, is membership of the euro. The average growth rate since 2007 in the Eurozone member countries is negative: -1 per cent. In contrast, the average in Western economies which are not members of the Eurozone, such as Australia, the US and the UK, is a positive 10 per cent.
But there is an even more fundamental reason for the failure of the PIGS to recover, which goes to the heart of why Renzi wanted a radical reform of the constitution. Their societies are corrupt. The problems this creates can be plastered over in good times. But a major shock like the financial crisis opens the cracks.
Transparency International rates all countries on a scale of one to 10, with 10 being the most transparent and least corrupt. In 2007, most Western countries scored eight or more, the UK being 8.4. Spain was 6.7 and Portugal 6.5, which puts them at the level of Costa Rica. Italy registered 5.2 and Greece 4.6, down with the likes of Ghana.
Even after allowing for the effect of the euro, there is a strong negative correlation between the Transparency International scores of the Western economies and their GDP growth over the 2007-2016 period. Full technical details are in a paper I published in Economic Affairs in October. The more corrupt a society, the less able it has been to recover from the crisis.
The reforms proposed by Renzi were just the first step in what is needed to modernise the structure of Italy’s society and economy. Their failure means that Italy is doomed to stagnation.
As published in CITY AM on Wednesday 7th December 2016
Image: https://www.flickr.com/photos/sozialdemokratie/ is licenced under CC BY 2.0
Economic forecasts have become a political hot potato. The Office for Budget Responsibility’s (OBR) predictions, presented as part of the chancellor’s Autumn Statement, have put the government under pressure. The OBR has revised down its forecast for GDP growth over the next four years by 1.4 percentage points.
The real controversy is that their gloomy projections for GDP and government finances have been put down to Brexit. In the simple phrase of the OBR: “Any likely Brexit outcome would lead to lower potential output”. Lower output leads to lower tax receipts, and worse government finances.
To be fair, the OBR does say that “in current circumstances the uncertainty around the forecasts is even greater than it would be in normal times”. But just how great is this uncertainty?
Studies are published from time to time about the accuracy of economic forecasts. The best set of records is kept in America, though less systematic evidence for the UK shows that the track records are very similar in the two countries.
The Survey of Professional Forecasters (SPF) collects the forecasts on variables such as GDP growth and inflation from a wide range of forecasters. Its database goes back almost 50 years to 1968. Just one quarter ahead, the predictions are on average completely accurate. “One quarter ahead” means the next three months, so it would currently refer to the period January to March 2017.
This average accuracy conceals errors in most forecasts for any particular quarter, the errors cancel out over time. For example, the quarter from July to September 2008 marked the onset of the major recession of the financial crisis. At an annual rate, GDP fell by 1.9 per cent compared to the previous quarter. But the SPF predictions made in the April to June period for July to September were for growth of 0.7 per cent.
The SPF predictions account for only 25 per cent of the variability around the average. When we go four quarters ahead – just one year – the predictions are even worse. Negative growth, for example, has never been predicted, even though there have been 26 quarters of negative growth since 1968.
The track record, which has not got any better over time, shows that in relatively calm times, forecasts just one year ahead have a reasonable degree of accuracy. But when major changes are taking place, just when they are really needed, they have none.
The OBR cannot be blamed for producing predictions four years ahead when the track record of the forecasting community shows them to be of no value. That is what George Osborne mandated it to do when he set the independent body up in 2010. But four years ahead, almost any set of predictions is just as good – or bad – as another.
It would be much better to abolish the OBR and restore responsibility to the Treasury and, ultimately, to the politicians. If they get it wrong and are too optimistic, we can at least kick them out.
As published in City AM on Wednesday 30th November
Asked what “forward guidance” meant, he answered smoothly: “The thing about forward guidance is that it is guidance that is forward. Which is not to say it is meant to be in any way accurate. Indeed, it would be surprising if it were. The most important thing about forward guidance is that the underlying economic determinants should be correct, not that it should be helpful.” Cue collective bafflement of the assembled MPs!
But the statement actually tells us a great deal about how mainstream macroeconomists believe the economy operates.
“Forward guidance” has been the key element in policy-making by the Bank since Carney himself introduced it in the summer of 2013. It is meant to give guidance about the economic circumstances in which the Monetary Policy Committee (MPC) will start to raise interest rates.
The first attempt was certainly not in any way accurate. The governor stated that the MPC would not consider raising interest rates until unemployment fell to 7 per cent, which he predicted would take about three years. It took less than six months. By January 2014, the rate of unemployment had fallen to 6.9 per cent.
This just seems to have been a piece of poor analysis by the Bank. But it does not detract from the more fundamental reason economists think that forward guidance will not usually turn out to be accurate.
The forward guidance is deliberately based on the assumption that behaviour will not change. Yet the mere fact that the central bank makes a pronouncement about the future might induce people to alter their behaviour. And if behaviour changes, the forward guidance might very well prove to be inaccurate.
It is actually a sensible addition to the Bank’s armoury of policy levers. Properly managed, it might enable the Bank to nudge behaviour in directions which it believes will give a better outcome than would otherwise be the case.
The final part of Carney’s statement appears the most gnomic: “The most important thing about forward guidance is that the underlying economic determinants should be correct, not that it should be helpful”.
The governor meant that forward guidance should be given on the basis of a model of the economy which is correct.
In each of the various different macroeconomic models which exist, the assumption is made that consumers and firms form expectations about the future as if their particular model, and no-one else’s, were correct. Yet despite many years of intensive research, macroeconomists still do not agree on what constitutes the model of how the economy works.
There is a challenging academic literature on the theory of how people go about learning the correct model of the economy. But in practice economists are unable to apply it to themselves. We might reasonably conclude that it is the theory which is wrong. Forward guidance is just the latest technocratic delusion foisted on us by mainstream macroeconomics.
As Published in City AM on Wednesday 23rd November
So the pollsters got it wrong again. After the general election last year and then Brexit, it is perhaps not surprising. What is surprising is just how wrong they were. The real problem is the enormous confidence with which they pronounced that Clinton would win.
The Princeton Election Consortium was probably top of the class, stating that Clinton had a 98 to 99 per cent chance of winning. Even the top Bayesian statistician, Nate Silver, who shot to fame by calling all 50 states correctly in 2012, gave Hillary a 71.4 per cent probability of victory.
Economists have been suspicious of opinions elicited by surveys for a long time. A fundamental concept in economic theory is that of “revealed preference”. The idea goes back much further than Adam Smith, the 18th century founder of modern economics. In the Bible, we find the phrase “by their deeds, ye shall know them”. In other words, it is not what people say what matters, it is what they do. If someone says repeatedly that he prefers Pepsi to Coke, but never buys Pepsi and always buys Coke, we can reasonably infer that, despite his words, he does in fact prefer Coke. His actions reveal his preference.
Readers above a certain age will recall the 1980s. Then, pollster after pollster reported that public opinion was firmly in favour of both more public spending, and higher taxes to pay for it. Yet in election after election, voters just as firmly returned Mrs Thatcher and the Conservatives to power. They revealed a preference for lower spending and lower taxes.
A great deal of environmental policy is guided by hypothetical questions in surveys of what people would be willing to pay to, say, preserve a species of newt or prevent an oil spillage. This approach even has its own name, that of “contingent valuation”. Peter Diamond is an MIT economist who has won the Nobel Prize. Jerry Hausman, also of MIT, might very well get one. Referring to a paper they co-authored in the early 1990s, in 2012 Hausman wrote “at the time Peter’s view was that contingent valuation was hopeless. I was merely dubious. But 20 years later, after millions of dollars of government funded research, I have concluded that Peter was correct”.
A fundamental problem is that people overstate how much they would be willing to pay in such surveys, compared to how much they will pay when they really have to – just like the British electorate in the 1980s.
A great deal of expertise has been built up over the years in how to put together carefully constructed surveys to find out what voters and consumers think. But their useful life is at an end. Instead, social media conversations have the potential to discover what people really do prefer. For all their chaotic and often incoherent nature, these unstructured conversations can reveal what people really are thinking and doing. Economists, with their concept of revealed preference, need to make common cause with computer scientists.
As published in City AM on Wednesday 15th November
Image: Trump with supporters by Gage Skidmore licensed under CC BY 2.0
A current headache for the government is the performance of the NHS, and whether it is running out of money. This was making the front pages until the judges’ decision on Brexit pushed it off.
Successive governments have discovered that the finances of the health service are a potentially bottomless pit. A key policy issue has been how to make the NHS more productive, to get it to deliver a better service for a given amount of money.
A paper in the latest American Economic Review provides strong evidence that extending patient choice is an effective way of getting better outcomes. In 2006, the Blair government mandated that patients in the English NHS had to be offered a choice of five hospitals when referred by their physician to a hospital for treatment. Prior to this reform, there was no requirement that patients be offered choice.
Economic theory regards choice as a Good Thing, but also recognises that, in complex areas like health, things might not be completely straightforward. For example, information on quality might be imperfect. Very difficult cases might be sent disproportionately to one of the very best surgeons, who, because of this, has a relatively low success rate. Understanding technical information might itself be difficult.
Even so, the authors show that the introduction of choice had unequivocally positive results. Patients became more responsive to clinical quality in deciding where to go. In turn, hospitals responded to this demand by improving the overall quality of the service. There was a small but very definite reduction in mortality. And, in the dry language of economics, there was a “substantial increase in patient welfare”.
Gaynor and colleagues make appropriate qualifications about the accuracy of their calculations, but they work out that the monetary value of the improvements in service to each patient in their sample was $6,226. The average value of each of the small number of lives saved was $300,900.
There were fears prior to the reforms that only the better off would benefit. On the contrary, those who were either more severely ill or from low-income areas benefited the most.
The importance of this evidence goes considerably beyond its immediate sphere of a single area of elective surgery in the health system. It has become an article of faith among the liberal, educated elite that ordinary people lack the ability to process information properly when making decisions about complex issues.
Whether on Brexit, on making choices about hospitals, or choices about schools for their children, the broad masses are deemed too stupid to understand. It follows that choice is bad for them and, instead, they should simply do what their so-called betters decide for them. But even in a complex area like elective surgery, given the opportunity, people can make good decisions and improve their lives.
As published in City AM on Wednesday 9th November
The scenes as the migrant camp was cleared in Calais once again provoked bitter divisions in British society. Metropolitan luvvies and liberals tweeted their virtue and called for no restrictions on immigration. In more traditional areas, there is active resentment at the possibility of even further inflows of foreigners.
When New Labour decided in the early 2000s to allow large-scale immigration from new EU member states, we were seriously invited to believe that an influx of immigrants on a scale unprecedented in our history would only have positive economic effects and would boost economic growth.
Economics certainly suggests that an increase in labour supply can increase growth in output. But in the so-called neoclassical growth theory of economics, even in the post-endogenous variety made notorious by Ed Balls in his previous incarnation, by far the most important source of sustained growth is innovation.
A truly modern economy does not rely on more and more capital and labour being fuelled into the machinery of production. That was the old Soviet model.
A modern economy relies instead on innovation. So there are at best limited benefits from importing more and more labour. True, immigrants can bring new skills, found innovative new businesses and, as they tend to be younger, they can slow down the ageing of society. But they, too, get older eventually, so this is not a long-term solution.
The anxieties about immigration are not couched in the arcane language of economic theory. But a fuller appreciation of the theory does enable us to understand why people worry so much. Underlying the theory are the assumptions that supply and demand balance in labour markets, and that the prices of the various kinds of labour – in other words, wages – are set at appropriate levels.
A recent paper in the Journal of Economic Perspectives by Christian Dustmann and Uta Schönberg of University College London shows that large-scale migration in fact creates serious imbalances and mismatches in labour markets.
They provide extensive evidence of what economists call “downgrading”. “Downgrading” occurs when the position of immigrants in the labour market is systematically lower than the position of natives with similar education and experience levels. The authors calculate that, in Germany, recent immigrants have wages which are on average 17.9 per cent below those received by natives with similar age and skill profiles. In the US, the figure is 15.5 per cent and in the UK 12.9 per cent.
Dustmann and Schönberg illustrate the disruption which mass migration can cause even more starkly. They calculate that while 69.7 per cent of immigrants in their samples can be classed as high skilled in terms of their education, only 24.6 per cent are in high skilled jobs. In their dry terminology, this means that “immigrant arrivals to the United Kingdom were a supply shock in the market for low-skilled workers”.
Mass migration has not simply meant more people competing for jobs. It has meant that people with higher skill levels are competing for your job. In other words, the people of Burnley and Bradford have been right all along, and the metropolitan liberal elite completely wrong.
As published in CITY AM on Tuesday 1st November
Image: Calais Jungle by malachybrowne is licensed under CC by 2.0