Ireland’s (and Britain’s, and Italy’s…) long recession

Jeff Frankel has a terrific piece here on the unsatisfactory way in which recessions and recoveries are called in Europe.

The current European definition of a recession (two successive quarters of declining GDP) is particularly unsuitable in Ireland, given its dodgy and volatile GDP statistics — looking at a broader range of indicators over a longer period of time would surely make more sense here.

There is an additional cost to the two-quarter rule of thumb in the Irish and Eurozone context: it implies that Ireland is periodically proclaimed to be out of recession. This then allows Eurozone politicians and central bankers to defend the status quo monetary and fiscal policies prolonging the economic crisis in Ireland and elsewhere. (And to express “surprise” when Ireland tips into recession “again”, despite its model pupil status.)

Update: the CEPR’s Euro area business cycle dating committee does not use the “two-quarter GDP decline” rule of thumb. Details of their methodology are available here.

What would it take to make the EU admit the strategy isn’t working?

We know that rising unemployment is not something that will make the EU admit that their current macroeconomic policy mix isn’t working.

We know that two successive years of GDP contraction is not something that will make them admit it either. Even though some of them denied at the time that this could be a consequence of austerity.

Will spiralling debt/GDP ratios do the trick? This is, after all, the number they have been fixated on since 2010, and the figures show that, even on its own terms, the current strategy has not been working.

This is where dodgy GDP forecasting becomes so pernicious: no matter how much of a basket case the Eurozone becomes, over-optimistic forecasts — notice how good we expect 2014 will be!! — will always make it possible for discredited politicians, central bankers and eurocrats to cling on to the hope that good times are just around the corner. The risk is that they will wake up one day and find that it is too late to change course, both for themselves and for the euro.

More on self-defeating adjustment

Ashoka Mody offers another thoughtful perspective on Ireland’s crisis resolution effort on today’s This Week programme on RTE radio (audio here; scroll down to last item).    Although he covers a good deal of ground, much of which I agree with, his main recommendation is that Ireland should consider scaling back its fiscal adjustment effort.   As I note in a piece for the Business section of today’s Sunday Independent, reasonable people can disagree on the optimal speed of the adjustment given the tradeoffs involved.   But Ashoka raises the old issue of the adjustment effort being self defeating.   At the risk of repetition of past posts, I cannot see how the evidence in the Irish case bears this out.   There is, of course, wide agreement that fiscal adjustment lowers growth.  But it is a significant step from here to a claim that the adjustment is self defeating on its own terms of improving the fiscal situation.   I think it is worthwhile to continue to scrutinise this claim.   

The self-defeating hypothesis comes in a number of forms depending on the focal outcome variable.   For convenience I label the main forms as: the strong form (underlying primary deficit); the semi-strong form (debt to GDP ratio); and the weak form (creditworthiness).   Ashoka’s main focus is on the semi-strong version, but it is worthwhile to briefly review the case for each.  

Ireland’s underlying General Government primary deficit has fallen from a peak of 9.3 percent of GDP in 2009 to a projected 2.5 percent this year.   This occurred despite the massive non-austerity related headwinds the economy faced.   All else equal, if there had been no adjustment from 2009, simulations show the underlying primary deficit would have reached 14.5 percent of GDP this year.   The underlying actual deficit and debt to GDP ratio would have been 20.5 and 160 percent of GDP respectively.    Of course, something would have given before these ratios were reached, but it is useful to consider the crude counterfactual in assessing what has been achieved.  (These simulations assume a reduced-form deficit multiplier of 0.5 and an automatic stabiliser coefficient of 0.4.  The underlying model being used is sketched here. ) 

Turning to the semi-strong form (Ashoka’s main focus in the interview), it is well known that for multipliers around unity fiscal adjustment can lead to a short-run rise in the debt to GDP ratio.   The reason is that the negative effect on the denominator can swamp any positive effect on the numerator.   But this static analysis can give a very misleading picture of the impact of the adjustment on the path of the debt to GDP ratio.  

This is most easily seen using the classic equation for the evolution of the debt to GDP ratio: ∆d = (i – g)d-1 + pd, where d is the debt to GDP ratio, i is the interest rate, g is the growth rate, and pd the primary deficit as a share of GDP.   The debt to GDP ratio may rise initially due to the adverse effect on g.   But the effect of this year’s adjustment on g should be temporary while the impact on the primary deficit should be permanent.   The permanent effect should quickly swamp the temporary effect, leading to an improvement in the debt to GDP profile as a result of this year’s adjustment.   (One thing that could overturn this result is that today’s adjustment leaves a long negative shadow on the level of GDP (what is known as hysteresis), but that would again require that today’s adjustment causes the primary deficit to rise rather than fall.) 

Simulations for Ireland show that an additional €1 billion of adjustment in 2014 would only lead to a higher debt to GDP ratio in 2015 for values of the reduced-form deficit multiplier greater than 2.3 – above any reasonable estimate for the highly open Irish economy.   Reduced austerity might well improve growth performance, but it seems highly unlikely that it would improve Ireland’s debt dynamics as Ashoka claims. 

Turning finally to the weak form, it is possible the direct adverse growth effects from fiscal adjustment on investor confidence could swamp any positive effect through the deficit and debt.   This might happen, for example, if investors worry that the deeper recession would undermine political support for the adjustment effort.   It is thus possible that despite the positive fiscal impacts, creditworthiness (as measured by secondary market bond spreads) might deteriorate.  This is ultimately an empirical question.   But the fall in Ireland’s 10-year bond yield from 14 percent in mid 2011 to below 4 percent today hardly suggests that Ireland’s fiscal adjustment effort has been self-defeating on even this weak definition.  

NYT – Let’s Shake Up the Social Sciences

And now for something completely different!  Nikolas Cristakis has a fascinating opinion piece in the New York Times advocating a fundamental restructuring of the social sciences. His proposal involves jettisoning the Standard Social Science Model (SSSM), in which people are assumed to be infinitely malleable computing machines limited only by their environment. Instead he proposes that the social sciences take seriously the links to the natural sciences in areas such as brain chemistry and evolutionary biology. In financial economics there have been some moves in this direction, notably at MIT and Cal Tech.  It would be much to the credit of Irish universities if they could be on the forefront of this new approach.

The boom, not the slump, is the right time for austerity

Alan Taylor has a piece on Vox today that is a nice contribution to the debate on the output effects of austerity. That debate has largely been about the endogeneity of fiscal policy: the more you take this into account, the more contractionary austerity becomes. He and Oscar Jorda show that if you give less weight to episodes where the austerity/no austerity policy choice was more predictable (i.e. more endogenous) and more weight to episodes where the policy choice was less predictable (i.e. more exogenous) then you find that austerity was extremely contractionary in slumps. This does not mean that fiscal consolidation is never necessary, but that the time for consolidation is when times are good, not when times are bad. It would be nice if Austerians could display a similar recognition that context matters.

Irish Times on Mortgage Arrears Deals

An interesting article on property debt restructuring deals by Mark Hilliard in today’s Irish Times, “Secret Deals on Mortgage Arrears Raise Concerns.” For many of us it will bring back our graduate school days studying Stiglitz, Rothschild, Ackerlof, Spence et alia on information revelation and efficient contracts. The laudable goal of the Irish mortgage debt arrears policy is to ensure that almost all householders who cannot pay their mortgages can keep their family homes. The difficulty is that it is virtually impossible to distinguish can’t-pays from won’t-pays except at untenable cost and personal privacy intrusion. So the unwritten “policy” is to restrict the flow of information to consumers regarding restructuring terms and conditions. This is intended to limit the flow of potential won’t –pays into the system. In the article, Noeline Blackwell of FLAC is quoted lamenting the lack of a clear detailed list available to consumers in terms of debt restructuring options. She is correct, but this lack of information is not a bug, it is a feature of the evolving Irish system.

Behavioural Economics and Public Policy

I have posted a few times on the implications of the emerging literature on behavioural economics and public policy for Irish policy. Some readings from a previous post are available here and three others posts with links are available here. For those interested in this area, the following links may be of interest:

(i) Cass Sunstein, who is one of the main figures in this area, recently released a new book called “Simpler: The Future of Government“. It outlines an approach to government that emphasises making regulations, laws and taxes less confusing and more robust. It is partly based on academic work and partly on his time as a senior regulator in the Obama administration. It follows on from some of the ideas in the work Nudge that he co-authored with Richard Thaler. I recommend this book to anyone involved in designing regulation, taxation and policy. It is short and written clearly by someone with experience both as a high-profile academic and a senior policy-maker.

(ii) The US have now set up a version of the UK Behavioural Insights team. Details of that are here.

(iii) One of the researchers in our group has put together a data-base of studies employing what can loosely be called “Nudges” in various areas of policy. He has currently summarised 80 studies and adds to them every week or so. There are some very interesting examples across many areas of policy.

(iv) It is in the list in one of the previous links but the book I most recommend for a wide overview on behavioural science perspectives on policy is Shafir’s “Behavioural Foundations of Public Policy“. A bit heavy (in both senses of the word) if you are looking for beach-reading but I can’t recommend it more highly to people wanting a grounding in this area.

(v) I have also put together a fairly detailed reading list on behavioural economics and public policy, including legal and ethical issues.

(vi) Apologies for blatant plug but we have started our own graduate programme in this area. Queries welcome.

(vii) Added from the comments, Kevin Denny has a list of behavioural economics resources

Finally, would be interested in people’s thoughts on this agenda in the area of Irish public policy. Are there areas where changing of default options could bring defined improvements in public services? Are there environmental changes in areas like taxation, education, health, waste management that could be enacted to improve outcomes in these areas? What areas of public policy would most benefit from reducing complexity of rules and regulations? And on the other hand, are these types of policies a distraction from real macroeconomic and social issues? How much should economics education take on board new models emerging from behavioural economics?

Forthcoming Conference on The Developmental Origins of Health

The Developmental Origins of Health Conference

Keynote Address by Professor James J Heckman


9.00 am-3.30 pm Thursday 10th October 2013

Royal College of Physicians of Ireland, No 6, Kildare St, Dublin 2

On Thursday October 10th, 2013, UCD Geary Institute will host a conference entitledThe Developmental Origins of Health. This conference presents the mid-term results emerging from a major European Research Council Advanced Investigator project led by Professor James Heckman at the University College Dublin, in partnership with the University of Bristol and the University of Essex.

Understanding the origins and the evolution of health inequalities is key to developing policies to promote human development. The conference highlights the work of aninterdisciplinary team of researchers who are active at the frontier of their disciplines ineconomics and epidemiology. This team is working together to create an integrated developmental approach to health which will allow us to understand the socio-biological determinants of health.  The conference presents innovative findings on the role of cognition, personality, genes, and the environment on health across the life course and across generations. Speakers will include Professor Frank Windmeijer(University of Bristol), Dr. Neil Davies (University of Bristol), Professor Steve Pudney (University of Essex), Dr. Orla Doyle (University College Dublin). The keynote address will be given by Professor James Heckman (University College Dublin & University of Chicago).

To register for the conference, please email: Carol Ellis at geary@ucd.ie. Advance registration is essential for attendance at the conference, as numbers are strictly limited. There is no charge for the conference. Tea/Coffee and lunch will be provided.The deadline for registration is Friday 20 September 2013. For further details see UCD Geary Institute Website

Why economics needs economic history

The beauty of the internet is that sometimes you come across papers like this one that you might otherwise have missed (H/T Greg Mankiw). As you would expect, I agree with Temin that economic history has a fundamental role to play in economic education, and MIT is a great example. To repeat a point I have made on the blog before, several superstars who have emerged from that department have a historical sensibility that has made them much better economists. Obstfeld and Rogoff are best known for their path-breaking work in open economy macro, but both have written important books on economic history (Obstfeld with Taylor, and Rogoff with Reinhart), and I don’t think it’s a coincidence that Obstfeld-Rogoff style open economy macro tends to be far more grounded in the real world than some closed economy equivalents. Paul Krugman regularly displays an interest in and knowledge of history, which he uses to good effect; don’t even get me started on Ron Findlay; and so on.

There are many reasons to think that we need more history on the economics curriculum, not less. The current economic and financial crisis has given rise to a vigorous debate about the state of economics, and the training which graduate and undergraduates economics students are receiving. Importantly, among those arguing most strongly for a change in the way that young economists are trained are the ultimate employers of these students, in both the private and the public sector. Employers are increasingly complaining that young economists don’t understand how the financial system actually works, and are ill-prepared to think about appropriate policies at a time of crisis.

Strikingly, many employers and policy makers are also arguing that knowledge of economic history might be particularly useful. For example, Stephen King, Group Chief Economist at HSBC, argues that “Too few economists newly arriving in the financial world have any real knowledge of events that, while sometimes in the distant past, may have tremendous relevance for current affairs…The global financial crisis can be more easily interpreted and understood by someone who has prior knowledge about the 1929 crash, the Great Depression and, for that matter, the 1907 crash” (Coyle 2012, p. 22). Andrew Haldane, Executive Director for Financial Stability at the Bank of England, has written that “financial history should have caused us to take credit cycles seriously,” and that the disappearance of subfields such as economic and financial history, as well as money, banking and finance, from the core curriculum contributed to the neglect of such factors among policy makers, a mistake that “now needs to be corrected” (Coyle 2012, pp. 135-6). In a recent Humanitas Lecture in Oxford, Stan Fischer (another MIT graduate) said that “I think I’ve learned as much from studying the history of central banking as I have from knowing the theory of central banking and I advise all of you who want to be central bankers to read the history books” (http://www.youtube.com/watch?v=5Y-ZhFbw2H4, 43.48 minutes in).

Knowledge of economic and financial history is crucial in thinking about the economy in several ways. Most obviously, it forces students to recognize that major discontinuities in economic performance and economic policy regimes have occurred many times in the past, and may therefore occur again in the future. These discontinuities have often coincided with economic and financial crises, which therefore cannot be assumed away as theoretically impossible. A historical training would immunize students from the complacency that characterized the “Great Moderation”. Zoom out, and that swan may not seem so black after all.

A second, related point is that economic history teaches students the importance of context. As Robert Solow (yes, that department again, although a Harvard PhD) points out, “the proper choice of a model depends on the institutional context” (Solow 1985, p. 329), and this is also true of the proper choice of policies. Furthermore, the “right” institution may itself depend on context. History is replete with examples of institutions which developed to solve the problems of one era, but which later became problems in their own right.

Third, economic history is an unapologetically empirical field. Doing economic history forces students to add to the technical rigor of their programs an extra dimension of rigor: asking whether their explanations for historical events actually fit the facts or not. Which emphatically does not mean cherry-picking selected facts that fit your thesis and ignoring all the ones that don’t: the world is a complicated place, and economists should be trained to recognise this. An exposure to economic history leads to an empirical frame of mind, and a willingness to admit that one’s particular theoretical framework may not always work in explaining the real world. These are essential mental habits for young economists wishing to apply their skills in the work environment, and, I would argue, in academia as well.

Fourth, even once the current economic and financial crisis has passed, the major long run challenges facing the world will still remain. Among these is the question of how to rescue billions of our fellow human beings from poverty that would seem intolerable to those of us living in the OECD. And yet such poverty has been the lot of the vast majority of mankind over the vast majority of history: what is surprising is not the fact that “they are so poor”, but the fact that “we are so rich”. In order to understand the latter puzzle, we have to turn to the historical record. What gave rise to modern economic growth is the question that prompted the birth of economic history in the first place, and it remains as relevant today as it was in the late nineteenth century. Apart from issues such as the rise of Asia and the relative decline of the West, other long run issues that would benefit from being framed in a long-term perspective include global warming, the future of globalization, and the question of how rapidly we can expect the technological frontier to advance in the decades ahead.

Fifth, economic theory itself has been emphasizing – for well over twenty years now – that path dependence is ubiquitous.

Finally, and perhaps most importantly from the perspective of an undergraduate economics instructor, economic history is a great way of convincing undergraduates that the theory they are learning in their micro and macro classes is useful in helping them make sense of the real world. Far from being seen as a “soft” alternative to theory, economic history should be seen as an essential pedagogical complement. From experience, I know that there is nothing as satisfying as seeing undergraduates realize that a little bit of simple theory can help them understand complicated real world phenomena. Think of Obstfeld and Taylor’s use of the Mundell-Fleming trilemma to frame students’ understanding of the history of international capital market integration over the last 150 years; or Ronald Rogowski’s use of Heckscher-Ohlin theory to discuss political cleavages the world around in the late nineteenth century. The Domar thesis that Temin refers to in his paper is a great way to talk to students about what drives diminishing returns to labour. Economic history is replete with such opportunities for instructors trying to motivate their students.

Coyle, D., ed. (2012), What’s the Use of Economics?: Teaching the Dismal Science After the Crisis, London Publishing Partnership.

Solow, R. (1985), “Economic History and Economics,” American Economic Review 75, 328-31.