Knowing and Making

I don't have time to write a detailed post today so let me do something slightly unfair by picking holes in somebody else's. Stephanie Flanders writes about (among other things) the risk to UK exports posed by the slowing eurozone economy. Germany seems to have had no growth at all, the Italian economy shrank by another 0.2%, and Spain by 0.1%. Between them, those three countries accounted for 15% of UK exports in 2008. Sounds terrible. But wait, there is a little bit of good news to partly make up for it: British exports to China were 53% higher last month than in January 2009. But they start from a very, very low base: just 2% of our exports went to China in 2008. In total, about 12% went to the Brics - with about 75% going to advanced economies, primarily the the US and the EU. Solid growth in Europe is a necessary condition for a healthy recovery in the UK. So the latest weak numbers from across the channel have given the MPC one more reason to keep the door to further...

Stephanie Flanders points out some huge discrepancies in the labour market between older and younger workers, and between the current recession and that of the early 90s. But of the 16-17-year-olds not in full-time education, nearly 41% were economically inactive during the last quarter of 2009. Back in 1992, the figure was less than 15%. ...consider the following astonishing fact. In the second quarter of 1992, two-thirds - 65% - of 16-17-year-olds who were not in full-time education were reported to have a job. Now the figure is 35%. These figures are startling and, especially having got used to economic statistics measured in increments (unemployment 2% higher, inflation 1% lower), really worrying. What's more - though Stephanie surprisingly does not point this out - there is a very clear suspect here: the minimum wage. Like all card-carrying bleeding-hearted liberals, I was in favour of the UK's minimum wage when it was introduced in 1997. I did have some minor rese...

For a while, I've been storing up lots of links to interesting pages from blogs and other places. I keep meaning to weave many of them into an interesting narrative, but some of them don't quite seem to fit, and yet are still on topics that I'm interested in, namely: expectations (and related, rational expectations theory) sentiment and whether it is real, and can be modelled macroeconomic theory and in particular, under what behavioural or market conditions Keynesian stimulus is efficient Here are some of those links which I'm, realistically, never going to get around to to analysing in detail: Rajiv Sethi on rational expectations and equilibrium paths . A good insight into why the rational expectations model is unlikely to reflect reality. But aren't rational expectations the only way to achieve a stable equilibrium in many models? Yes indeed. The conclusion must be that either those models are incorrect (a cop-out) or that the economy cannot be stable . Th...

I'd like to write a full article on each of today's links, but I may never get around to it. In the meantime, you may have your own conclusions to draw: Tim Haab has a good defence of economics as a mathematical discipline. While the particular maths we have to use will evolve, as we incorporate more psychology, theory of organisations and financial institutions into the orthodoxy, economics will and should still use lots of mathematics - because that's the only way we can build and apply successful models. In this review of Create Your Own Economy , Henry Farrell starts to build an argument that the internal mental orderings which add value to our own lives, can also add value to other people's. My own review (not out yet) touches on the converse idea - can ready-made (or at least part-cooked) mental orderings be provided to us as a service? A mini-Easterlin paradox from Stephanie Flanders : as a country, are we more interested in comparative measures of GDP (against ...

How interesting. The Bank of England, whose notional target is a 2% inflation rate (CPI), is now looking at cash GDP in deciding its quantitative easing policy. That's according to Stephanie Flanders, who has an intelligent writeup of the Bank's considerations in deciding whether to print another £25 billion to purchase government and corporate bonds. Scott Sumner will surely be pleased to hear it: he has been advocating for a while that central banks should target nominal GDP . What's more, they are looking not at the rate of change, but at: ...the Bank's expected path for cash GDP in the next year or two... implying that the target is an absolute level, so if there's a shortfall this year they may even try to make it up next year. Now there's some way to go from using NGDP as one of the considerations in guiding this month's policy, to setting a formal rising path at 5% a year, trading a futures index and giving up inflation targets altogether. But this i...

Some of these articles have been lingering in my spare browser tabs for weeks, so it's time to link to them and explore a few thoughts that they have stimulated. Chris Dillow asks if economics is like Feynman's onion . It's a good analogy. People, much more than physical particles, are complex. This isn't to say we can't build models of how they behave: we can and should. And while there are lots of people decrying the state of economics (having been given permission to do so again this week by The Economist ), those who think model-building is a bankrupt approach are wrong. Model-building is the essential activity of economics and perhaps its greatest contribution to the social sciences. Indeed this is why it is to similar with physics: the best physicists know, as Feynman did, that they are not looking for an ultimate answer and even if they found one, they wouldn't know it. All we can ever seek is a model that describes the world well, and keep testing it...

Adam Posen's submission to the Treasury Select Committee - in advance of his appointment to the Bank of England's MPC - are reported by Stephanie Flanders today. Some interesting thoughts. The first is that: The bottom line, he says is that economists just don't understand deflation very well: "I think these facts call for some degree of humility. The Bank of England is right to be engaged in quantitative easing to address our current problem. But I think we should stay away from very mechanistic monetarism that, 'Oh, boy, they've printed a lot of money so at some point that has to turn into inflation.' Or, 'If we do this specific amount of quantitative easing, so it will lead to this result.' Looking at Japan, it is clear that their quantitative easing measures had the right sign, in the sense of being stimulative, but did not have a predictable or even large short-term result, let alone cause high inflation." An intriguing comment and one th...

Most economists agree that some of the effect of fiscal (and monetary) expansion arises from expectations. There are arguments about how strong the effect is, but expectations of future policy almost certainly have some effect on current decisions on both investment and consumption. I believe that a hyperbolic discounting effect occurs here, and thus expectations of the next couple of years are disproportionately more powerful than expectations of the years following. This is one reason why the theory of Ricardian equivalence does not work. Mostly the supposed future tax increases are far enough in the future - and also uncertain enough - that they are almost completely discounted by most decision makers. So it's interesting to see the competition that Stephanie Flanders highlights between Gordon Brown, Andrew Lansley and the NHS Confederation. Lansley is at pains to stress that the Tories will cut spending, while Brown is keen to point out that Labour will not. Of course as Steph...

The relative economic strength of the last eight years has for me contained one abiding mystery: why isn't there more business investment? Paul Krugman's current lecture series emphasises the contribution of a housing boom (exacerbated by cheap secured home loans); there's a consensus that debt-financed consumer spending has been the other driver of growth. Worldwide saving has fallen and, with it, investment. And yet, as Martin Wolf points out today , returns on physical capital have been excellent - above 13% for several years. So why aren't more people investing? A shallow answer is that consumers are focused on the short term and prefer the instant gratification of consumption to the long-term returns of investment. But this isn't really a question for consumers. The mystery is why savers have accepted miserable returns on consumer, mortgage and government debt instead of earning more that twice as much money by investing. You might think that there are few vali...

Paul Mason points out that world trade (more precisely exports from the developed world) is down by 40% on an annualised basis. We can imagine rational reasons for people to trade less with each other - for example an increased desire for saving reduces the resources available to devote to the slightly risky activity of exchanging with distant parties. But what appears at first sight not to be rational is the distinction between local and foreign trade. Trade within the UK, for example, is certainly not down by 40%. Of course the idea of "trade" within a country is not a very well-defined concept - one could perhaps look at interstate trade in the US, but I assume that such data is not collected comprehensively. But if we generalise to the idea of economic exchange in general, then GDP is essentially the measure we are looking for. And GDP, of course, has not fallen by 40% or anywhere close. So why has international trade fallen so much more? There are several proximate reas...

Robert Peston is revisiting the argument for the Bank of England buying shares in private companies - proposed by me in December and (the slightly more eminent) Roger Farmer in January. He points out that the Hong Kong government did this in the late 1990s, during the Asian financial crisis, and succeeded in both supporting the market and making a big profit when they resold the stakes a couple of years later. Stephanie Flanders has a good piece about Tim Geithner's position and particularly about the IMF and other possibilities for fiscal burden-sharing between G20 countries. Meanwhile Paul Mason has an excellent summary of the issues to be dealt with by the G20 conference in a few weeks: Far from the emergence of a harmonised and increasingly unified world economy [globalisation] has produced a lopsided and malformed structure that is now falling apart. The low paid worker in Detroit cannot buy his new pair of trainers unless the low paid worker in Shenzhen a) makes them, b) d...

Robert Peston is a bit torn today as to whether the markets are being rational or irrational - are they taking into account a future potential fall in gilt prices in this week's trading, or are they focusing only on a short-term rise in demand and ignoring the future? My take is that they are following a plausible model of bounded rationality: being rational within the reasonable scope of the foreseeable consequences of their actions, but not beyond. Traders can see a certain distance into the future with reasonable certainty. They can see the immediate consequences of the Bank of England's policy: that a fair proportion of available bonds are going to be bought up, and thus the price should increase in the short term. There are basic reasons that people need to buy government bonds (e.g. pension funds selling annuities) and so regardless of long-term returns, a temporary shortage can push up prices. They can also foresee the likely short-term effects for the economy of additi...

Via Stephanie Flanders, the IMF starts to give us a way to estimate the return on investment of recent financial bailouts from various countries. Apart from anything else, this may help to silence some of the complaints from people offended at us "giving" money to banks to "bail them out". There are two different ways to calculate ROI: first, what is the cost and benefit to the state as an entity, and second, what is the cost and benefit to the economy as a whole. Note that the 'cost' here does not refer to the entire cost of the crisis in lost economic output or reduced asset prices - because most of that is a sunk cost and our decisions can have no impact on it. It refers to costs specifically incurred by explicit decisions taken to rescue financial institutions. In the case of the UK, the cost to the state (according to the IMF) of the bailouts is about 9% of GDP or £130 billion. The return will include: Whatever is gained from selling off government sta...

Well, it's (almost) official. The Bank of England today is likely to start a formal policy of quantitative easing, buying British government bonds from the private sector in order to increase the money supply. Stephanie Flanders has a useful post outlining the issues and questions, in which she references (but does not really answer) the most important question: what effect will it have on behaviour? This is a question that can be considered using three theory bases: macroeconomic models microeconomic incentives psychology, behavioural theory and cognitive biases The macroeconomic models in the current situation give a direction but not a magnitude: QE should increase the money supply and stimulate demand. We are so far outside normal conditions that it's impossible to gauge from the models how strong the boost will be. Understanding the microeconomic incentives also gets us only so far. More money will be in private actors' accounts; it won't be earning any real retur...

Some commenters on Stephanie Flanders' blog (and of course in other places) are suggesting the banks simply be liquidated - no nationalisation, no bailouts. This has the appeal of being fair - creditors who made bad decisions lose money. But it may not make the system work well. If it destroys liquidity and causes people to become irrationally risk-averse, then justice may be served at the expense of the common good. By forcing a subset of creditors to take a hit to their assets - particularly those which are liquid and immediately available - we might cause knock-on effects which would destroy far more economic value than the counterfactual, the cost of a bank bailout. This is what the phrase 'cut off your nose to spite your face' was invented for. It's impossible to know for sure what would happen if we did let banks fail. Some people are working out ideas on this. But the feeling in government is clearly that the damage would be so great that it's worth putting ...