What you will learn this year...

So you chose economics, and you've arrived at university.  If your A-level economics was anything like mine, you may have been given a stylised history of the UK with some brief treatment of the 1970s before moving on to the 1980s and Margaret Thatcher.  You probably got the impression from how the material was presented to you that Labour had a reputation for being unable to manage the economy - something that bedeviled them in 1992, but something New Labour managed to overcome in 1997.

One thing though has become remarkably clear since the May General Election this year - the Conservatives are remarkably good at rewriting economic history, and unfathomly good at getting people (who don't necessarily even vote Tory) to believe what they say about the economy.

You will learn this year and in your three years studying economics that politicians generally are not folk to be trusted when they open their mouths about the economy.  You'll learn about incentives, and how incentive structures influence perverse outcomes (e.g. see page 19 of this newsletter about this).  You probably already knew this, but the incentives in play for politicians influence the things they utter on the economy - they are party political first, and truthful a distant second.

An example of this was William Hague on Radio 4 yesterday morning.  Cuts will harm defence, yet as with any Tory comment on anything related to cuts, they try and paint a picture of how shambolic Labour was, the mess they left, etc., in order to (1) score some political points (who would ever vote that lot in again after this?!) and (2) excuse themselves from the blame for the adverse effects of the cuts they intend to make.

The fundamental underlying matter here though is that people do actually seem to believe cuts are unavoidable.  You would almost think, given this, that the economics profession was in consensus about this: Cuts are necessary and unavoidable.  It may, then, come as some surprise to find that a lot of prominent economists actually don't believe this.  Paul Krugman, Joseph Stiglitz (both Nobel prizewinners), Brad DeLong, Martin Wolf (writer at the FT), Robert Skidelsky to name but a few, dissent.

Stay tuned then: Don't skip lectures, listen in them, attempt the assignments you get for each class and attend each class, and you'll learn a lot more about why these economists think the way they do, and why you should treat with scepticism every economic utterance from a politician...

A Classic Economics Debate

The more I explore of the blogs various leading economists write, the more I wonder whether they have private lives - I don't understand how they can blog, and comment on other peoples' blogs, as much as they do and remain productive, without their non-work lives being squeezed into basically sleeping 5-6 hours a night tops.

But that's by the by.  I've been intrigued by the debate the last few days about a speech by Narayana Kocherlakota, who is the President of the Minneapolis Fed (part of the US central banking system).  The point that has generated the debate is this:

To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation.

So someone very high up in the US Central Banking system is making the point that low interest rates must (not might, or could) lead to deflation (that's negative inflation).  This is, of course, counter to most folks' intuition - at least folk who have studied monetary economics at a basic level.  There, we teach that lower interest rates encourage investment and discourage savings, hence raising aggregate demand.  With higher aggregate demand, one expects inflation to be the result of low interest rates.

Hence, perhaps unsurprisingly, a number of people are frothing at the mouth: Paul Krugman, Scott Sumner, Nick Rowe, Mark Thoma and Andy Harless, to name but a few prominent US economists and bloggers.  I'd say it's interesting to have a read of most of these links - particularly the one for Nick Rowe as the comments there are particularly extensive.  Andy Harless has perhaps the most humorous take: Kocherlakota it seems has mistaken "must lead to" with "are a result of", and hence Harless suggests that perhaps umbrellas cause rain.

Now of course the blogosphere is full of such strongly put opinions, and I suspect the most widely read blogs are those that are particularly forthright and strong in how they put forward ideas - rather than the mild-mannered blogs that don't say anything particularly strongly.

The other side of this can be found in the comments on Nick Rowe's blog from two people: Steven Williamson and David Andolfatto.  Williamson is a particularly forthright economist, and spends most of his time bashing Paul Krugman.  I used to teach a module for which the textbook I inherited was his textbook.  If I was still teaching that module, I would have dropped the textbook by now, simply because of the outright hostility he holds to all schools of thought other than his own, and the associated intellectual arrogance he exudes in all posts.

The essence of Williamson's response is that of course you can put together a model which explains the statement Kocherlakota wrote.  That's the standard economist's response.  And because he can think of a model, then he decides he has to mock and deride all those who don't subscribe to the simple model he wrote down.

Of course, what isn't answered by Williamson is the empirical relevance of the model.  Does his mini-theory have any relevance whatsoever in the real world?  (in economist-speak is it empirically relevant?).  The model he puts forward makes one particular assumption that stands out: Prices move freely.  So prices aren't sticky at all.  This is a standard debate amongst macroeconomists, would you believe - whether prices are sticky or not.  Forget shoe-leather costs, wage contracts, etc., all the obvious empirical evidence for sticky prices.  Some people, like Williamson reject that prices are sticky - on intellectual grounds, not empirical ones.  Williamson finds the theoretical underpinning arguments for sticky prices unpersuasive, and so therefore these sticky prices can't possibly exist.

So basically we're left with a debate between people who look at the world, see the frictions and issues with the economic mechanism and design models that represent these problems and hence draw conclusions likely relevant for policymakers, who draw the conclusion that low interest rates in general should not be synonymous with deflation, and others who take a theoretical view of the world starting from the premise it functions just perfectly (I don't see a good reason why sticky prices exist therefore they don't).  In the latter world, which bears no relation to the real world, it is possible to defend the initial umbrellas-cause-rain position of Kocherlakota.  In the former world, it really isn't possible.  I'm firmly in the former world.

100 Days of the Coalition

Today marks 100 days since the Tories and the Lib-Dems agreed to join forces in a coalition government in the aftermath of the inconclusive election back in May.

Naturally, the Coalition is trying to put a positive spin on what it has achieved in 100 days.  Most of this is journalists trying to fill space - August is a nororiously dry time for news stories.

Econ101b teaches about monetary and fiscal policy having time lags for implementation, and we learn that the UK government actually has little power over monetary policy these days, having granted the Bank of England independence in 1997.  Given these long time lags, it is probably quite unrealistic to expect that the Coalition can have had any impact thus far on economic outcomes - at least at the macroeconomic level.

It's trying hard though - and another argument we come across in econ101b can give them some credence for trying to argue they've had an impact thus far: Expectations.

Expectations are powerful things.  Investors decide whether to invest or not based on their expectations.  Expect a downturn, and they won't invest - at least not in physical projects.  Why build a new office block if you expect a prolonged downturn?  Can you know you'll fill it?

A central emphasis when the Coalition began was that bond markets were soon likely to turn on the UK - our debt is too high, and our deficit is too high - as high as Greece!  Such talk is based on expectations: Expectations that the expectations of investors are that the UK will default like Greece.

Much has passed under the water since.  Not least, interest rates on long-term government debt have been falling - i.e. it's been getting cheaper for the UK government to borrow.  Kind of runs against what the Coalition had asserted.  The voices of austerity such as the Coalition have been mocked by various sources, not least Nobel Prizewinner Paul Krugman.  Another Nobel Prizewinner, Joseph Stiglitz, has attacked this panic in the face of financial markets: Who is governing, Robert Skidelsky has asked, is it the government, or is it the financial markets?

Of course it's far too soon to judge the coalition; even if I say bond market rates have fallen, there's no reason why they won't rise in the future.  Other unexpected events may mean that despite the austerity, the UK escapes a recession, and unemployment doesn't rise above 3m - something that looks odds on currently.  And even if we have a recession, it still will be too early to judge the coalition - it may be that the cuts are necessary to secure a longer term prosperity for the UK.  I have my doubts, but this may well be the case...