Correlation and Causality

We've now got through the course content for econ101b in lectures, so enjoy the vacation! I thought I'd link up an article by John B Taylor, who has recently become a staunch proponent of government austerity. He's supported/encouraged by Greg Mankiw, who is another Republican poster child.

For those more averse to all things US, the Republicans are much more right wing than any of the mainstream UK political parties, although their closest equivalent would be the Conservative Party.

John B. Taylor is the man who proposed the Taylor Rule, a rule that monetary policymakers should follow when setting monetary policy. He strongly believes the sole cause of the Financial Crisis was that monetary policy was too loose, according to his model (scroll through old posts on his blog and you'll get a sense of this, I can't find the original article).

In the main linked article though, Taylor takes us through some scatter plots. Now these are interesting scatter plots - they show that government purchases are positively correlated with unemployment, and that investment is negatively correlated. From this, Taylor draws the conclusion that austerity is fine and should be encouraged (since it means lower government purchases) while at the same time investment should be encouraged.

This is all well and good, but a scatter plot shows correlation and not causality. Why does this matter? Well, Taylor proposes austerity (cutting back government purchases drastically) because in his mind it will cause lower unemployment. But what if the causality is the other way? What if high unemployment causes higher government purchases? Now this is hardly controversial really, since if people become unemployed, the government will have more to do: Higher benefits, likely higher other costs too, and naturally we might see some attempt by government to stimulate the economy by increasing purchases (data is 1990 on). If this happens, the purchases happen at the same time as the unemployment exists, hence we get a correlation like in the plot.

So does Taylor's plot really tell us much? Even if the government purchases worked, this plot wouldn't tell us that since it's a dynamic picture - i.e. the reduction in unemployment wouldn't necessarily come instantaneously! So the plot has ignored causality and also the dynamic nature of cause and effect in the macroeconomy.

It's another example of why it's very hard to know who to trust when doing economics. Blogs are great - they contain the opinions of top economists who can comment on real world events as they are happening. But they are not what we call peer reviewed. For a paper to get into a journal, it must be read by a number of referees who decide on its quality. Shoddy data work like that shown in this blog post, would not get past the referees and editors at a top journal.

The conclusion to draw - be careful, and in particular if you do read blogs (and I'd recommend it!) try to read a balanced selection of them - something like the list given on the right-hand side of this blog.

The Budget

Yesterday George Osborne gave his first full budget, and in reality it did not change a lot. There is much commentary all around, but often the best place to go to for informative and balanced comment is the Institute for Fiscal Studies. A little look at their track record over time shows they are happy to criticise whichever party is in government. Here is their take on yesterday's budget. Well recommended. And enjoy that extra penny off each litre when you fill up next...

 

Related articles, courtesy of Zemanta:

• Budget 2011: George Osborne puts fuel in the tank, but potholes lie ahead
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• "George Osborne: We have done what we can to help families" and related posts
• Osborne cuts fuel duty by 1p

Superfreakonomics in Birmingham

I'm sure publicity for this will pick up in time, these guys are not shy by any stretch of the imagination, nor do they miss a money-making promotion opportunity. Stephen Dubner is in Birmingham on 20 June promoting his book with the economist Steven Levitt, Superfreakonomics, the "freakquel" to Freakonomics.

I'm quite sure it'll be a very entertaining show and if you're interested in pursuing economics further, and you're in Birmingham in June (or Brighton, Liverpool or Cambridge), then it will be worth your while getting along!

Monetary and Fiscal Policy

This week and next week we'll talk about monetary and fiscal policy.  I put up the link last week of the interview with Mervyn King, governor of the Bank of England, which contained his views on how monetary policy saved the economy from the abyss during the recession in 2008-09.  Equivalently, politicians and many economists argue that fiscal policy can have an impact on growth - but that impact is complex, as we'll find out.  Nonetheless, Labour have today started talking about their proposals for growth, ahead of next week's Budget.

Changes to fiscal policy (how the government spends and taxes) are bound to have an impact on the economy; you learnt in econ101a how taxing wages distorts incentives in markets, and this is the same in goods markets too.  Hence governments are able to influence economic activity in dramatic ways.  In econ101b we'll look a little more at this at the macro level, thinking about government spending as an aggregate and how that can influence economic activity.

Mervyn King Interview

Quite soon we'll start to look in quite a bit of detail at monetary policy.  Here's an interview in the Torygraph Telegraph with the Governor of the Bank of England, Mervyn King, which is very interesting reading.

Chancellor and Governor

Later in term we will spend some time thinking about monetary and fiscal policy; these are the two ways in which governments attempt to influence economic activity, wisely or otherwise.  Both are currently in the news regularly; fiscal policy because the Coalition is running a very tight fiscal policy in order to bring down the government deficit, and monetary policy because interest rates remain essentially at zero yet inflation is high.

The current monetary policy arrangements have the Bank of England commissioned by the government to set interest rates to achieve an inflation target of 1-3%.  However, for 20 of the last 30 months, that target range has been missed by the Bank.  Every time the target is missed, the Governor of the Bank of England, Mervyn King, must write a letter to the Chancellor explaining why the Bank has failed in its duty.  The Chancellor usually responds, and these letters, in the interests of openness, are published on the internet.  Here is George Osborne's recent response to King.

The interesting aspect of this letter is that Osborne suggests that by staying the course of the government's very tight fiscal policy, this will help monetary policy to be more effectively conducted because without it, inflation would surely happen.  Of course, there are plenty of counter arguments to this assertion, not least that given inflation is generally imported inflation currently (cost push), then it will not necessarily fall due to domestic actions by governments (unless they can increase the exchange rate).  Furthermore, such a contractionary fiscal policy could yet see the UK returning to a recession (we saw negative growth in the last quarter), in which case again if inflation is imported, there seems little reason why this would make the Bank's job any easier: Inflation will still be high, and the economy in a recession.

Furthermore, whatever the government does with fiscal policy, the Bank can always counteract with monetary policy: Assuming their efficacy, if fiscal policy was loose, then tight monetary policy would suffice to keep economic activity reasonably constant, and equivalently a tight fiscal policy could be counter-balanced with a loose monetary policy (so QE2 and more).

The Bank of England's Big Decision

In about half an hour, the Bank of England will announce its decision on interest rates. Each month, on the first or second Thursday, the Monetary Policy Committee (MPC) of the Bank of England meets to decide on monetary policy. The main tool of monetary policy used by economies around the world currently is the interest rate, and the MPC will decide whether it is going to keep the interest rate on hold for another month at its lowest practical value of 0.5%, or whether it will increase interest rates. It faces a tough decision.

Later in term we'll talk quite a bit about monetary and fiscal policy and we'll start to understand just why this decision is so tough. In any state of the world it is hard to forecast and know what is going to happen in the future and hence know the right thing to do with monetary policy.

Currently the Bank has a problem in that economic growth is negative yet inflation is above its target (of 2%). In an ideal world, the Bank would have one of these two problems to deal with, because they demand conflicting responses. Negative growth demands loose monetary policy, hence low interest rates, in order to stimulate economic activity. But high inflation demands tight monetary policy, hence higher interest rates, in order to keep economic activity in check and thus keep inflation down.

There's another part of this difficult question though which the Bank must factor in: Much of our inflation is imported from abroad, as the pound has lost so much value in recent years. As we've learnt recently, if interest rates did rise here in the UK, it is possible that the exchange rate would appreciate, hence reducing that imported inflation effect.

Either way, we lie in wait for the decision, expected in about 24 minutes...