Do economists ever get it right?

There is one example when they did . . .

According to popular belief, economists rarely manage to predict correctly the consequences of important policy actions. Nevertheless, the case of the European Economic and Monetary Union (EMU) is one of those instances which economists did get it right.

Indeed, as far back as 1977, the MacDougall Report to the European Commission concluded that because the European Economic Community budget was very small, “… in present circumstances monetary union is impracticable.” Moreover, many economists on both sides of the Atlantic were cautioning against the planned single currency in the absence of a significant fiscal redistribution facility and/or the ability to run countercyclical fiscal policy.

Nevertheless, the political bandwagon prevailed, and the Delors Report threw caution to the wind and assumed that EMU could proceed without significant increases in the size of the EU budget, which was hovering around 1% of GDP (the 1977 Report was deeming it as necessary that the federal budget be as large as 10% of GDP). The only “concession” to economists’ concerns was the Maastricht Treaty rules imposing limits on government debts and deficits — as encapsulated in the Stability and Growth Pact (SGP).

However, the precedence given to moral-hazard considerations (and the defective way they were applied) over countercyclical fiscal policy — due to the fear that profligate governments would be too keen to run large budget deficits in recessions but very reluctant to run offsetting budget surpluses in booms — proved detrimental. Since the main focus of the SGP was on deficit limits, the resulting reduction (due to the euro) in real interest rates and concomitant boom experienced by some of the ‘periphery’ countries of the Eurozone made it very easy for governments to run (or to claim that they do) budget deficits below the 3% (of GDP) limit. Yet, this semblance of fiscal prudence — when in fact governments should be running budget surpluses — undermined their ability to conduct appropriately expansionary fiscal policy, when the boom ended, without running excessively large budget deficits.

To a large extent the semblance of fiscal prudence was aided by the very large current account deficits which some of the periphery countries were allowed to run during the Euro’s first decade. Although this appears to run counter to the well-known “twin deficits hypothesis” (i.e. that a larger budget deficit leads to a larger current account deficit), the experience of the periphery countries suggests that it is possible the direction of causality to be from a larger current account deficit to a smaller budget deficit.

For the periphery countries, EMU participation facilitated international borrowing at lower interest rates, allowing for a huge deterioration in the current account while the budget deficit improved. The reason is that imports, which become possible through international borrowing, need not fully displace spending on domestically produced goods (they may even increase it!). Moreover, they can create a revenue boon for the government. For example, car imports generate immediate tax revenue (VAT, registration taxes, etc.). They also allow for increases in domestic value added (e.g. services related to sales, advertising, and repairs of automobiles), thus allowing for second-round increases in income tax revenue. In the same vein, foreign loans (intermediated through the domestic banking sector) allowed for housing booms and created unsustainable increases in tax revenue.

The upshot of the above is that cynical governments may “achieve” a seemingly strict adherence to the SGP limits on budget deficits (they may even run budget surpluses as Spain and Ireland did), for some years, by running current account deficits; however, once foreign capital dries out the lack of fiscal space for countercyclical fiscal policy becomes evident. With the benefit of hindsight we know that the SGP provided the wrong signals about the exercise of countercyclical fiscal policy. It also failed to provide a replacement for the lack of market discipline. The moral is that the warnings of economists about the ability of the SGP to provide a framework for “monetary and fiscal stability” should have been heeded.

George Economides and Thomas Moutos, Guest Editors of the CESifo Economic Studies Special Issue on ‘EMU: The Way Forward’, are Professors of Economics in the Department of International and European Economic Studies, Athens University of Economics and Business, and CESifo Research Fellows.

CESifo Economic Studies publishes provocative, high-quality papers in economics, with a particular focus on policy issues. Papers by leading academics are written for a wide and global audience, including those in government, business, and academia. The journal combines theory and empirical research in a style accessible to economists across all specialisations.

This article first appeared on blog.oup.com, and is republished here with permission

A statue outside the European Commission. Photo: Getty
George Economides and Thomas Moutos, Guest Editors of the CESifo Economic Studies Special Issue on ‘EMU: The Way Forward’, are Professors of Economics in the Department of International and European Economic Studies, Athens University of Economics and Business, and CESifo Research Fellows.
Photo: Getty Images
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Why are boundary changes bad for Labour?

New boundaries, a smaller House of Commons and the shift to individual electoral registration all tilt the electoral battlefield further towards the Conservatives. Why?

The government has confirmed it will push ahead with plans to reduce the House of Commons to 600 seats from 650.  Why is that such bad news for the Labour Party? 

The damage is twofold. The switch to individual electoral registration will hurt Labour more than its rivals. . Constituency boundaries in Britain are drawn on registered electors, not by population - the average seat has around 70,000 voters but a population of 90,000, although there are significant variations within that. On the whole, at present, Labour MPs tend to have seats with fewer voters than their Conservative counterparts. These changes were halted by the Liberal Democrats in the coalition years but are now back on course.

The new, 600-member constituencies will all but eliminate those variations on mainland Britain, although the Isle of Wight, and the Scottish island constituencies will remain special cases. The net effect will be to reduce the number of Labour seats - and to make the remaining seats more marginal. (Of the 50 seats that would have been eradicated had the 2013 review taken place, 35 were held by Labour, including deputy leader Tom Watson's seat of West Bromwich East.)

Why will Labour seats become more marginal? For the most part, as seats expand, they will take on increasing numbers of suburban and rural voters, who tend to vote Conservative. The city of Leicester is a good example: currently the city sends three Labour MPs to Westminster, each with large majorities. Under boundary changes, all three could become more marginal as they take on more wards from the surrounding county. Liz Kendall's Leicester West seat is likely to have a particularly large influx of Tory voters, turning the seat - a Labour stronghold since 1945 - into a marginal. 

The pattern is fairly consistent throughout the United Kingdom - Labour safe seats either vanishing or becoming marginal or even Tory seats. On Merseyside, three seats - Frank Field's Birkenhead, a Labour seat since 1950, and two marginal Labour held seats, Wirral South and Wirral West - will become two: a safe Labour seat, and a safe Conservative seat on the Wirral. Lillian Greenwood, the Shadow Transport Secretary, would see her Nottingham seat take more of the Nottinghamshire countryside, becoming a Conservative-held marginal. 

The traffic - at least in the 2013 review - was not entirely one-way. Jane Ellison, the Tory MP for Battersea, would find herself fighting a seat with a notional Labour majority of just under 3,000, as opposed to her current majority of close to 8,000. 

But the net effect of the boundary review and the shrinking of the size of the House of Commons would be to the advantage of the Conservatives. If the 2015 election had been held using the 2013 boundaries, the Tories would have a majority of 22 – and Labour would have just 216 seats against 232 now.

It may be, however, that Labour dodges a bullet – because while the boundary changes would have given the Conservatives a bigger majority, they would have significantly fewer MPs – down to 311 from 330, a loss of 19 members of Parliament. Although the whips are attempting to steady the nerves of backbenchers about the potential loss of their seats, that the number of Conservative MPs who face involuntary retirement due to boundary changes is bigger than the party’s parliamentary majority may force a U-Turn.

That said, Labour’s relatively weak electoral showing may calm jittery Tory MPs. Two months into Ed Miliband’s leadership, Labour averaged 39 per cent in the polls. They got 31 per cent of the vote in 2015. Two months into Tony Blair’s leadership, Labour were on 53 per cent of the vote. They got 43 per cent of the vote. A month and a half into Jeremy Corbyn’s leadership, Labour is on 31 per cent of the vote.  A Blair-style drop of ten points would see the Tories net 388 seats under the new boundaries, with Labour on 131. A smaller Miliband-style drop would give the Conservatives 364, and leave Labour with 153 MPs.  

On Labour’s current trajectory, Tory MPs who lose out due to boundary changes may feel comfortable in their chances of picking up a seat elsewhere. 

Stephen Bush is editor of the Staggers, the New Statesman’s political blog. He usually writes about politics.