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.
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We're racing towards another private debt crisis - so why did no one see it coming?

The Office for Budget Responsibility failed to foresee the rise in household debt. 

This is a call for a public inquiry on the current situation regarding private debt.

For almost a decade now, since 2007, we have been living a lie. And that lie is preparing to wreak havoc on our economy. If we do not create some kind of impartial forum to discuss what is actually happening, the results might well prove disastrous. 

The lie I am referring to is the idea that the financial crisis of 2008, and subsequent “Great Recession,” were caused by profligate government spending and subsequent public debt. The exact opposite is in fact the case. The crash happened because of dangerously high levels of private debt (a mortgage crisis specifically). And - this is the part we are not supposed to talk about—there is an inverse relation between public and private debt levels.

If the public sector reduces its debt, overall private sector debt goes up. That's what happened in the years leading up to 2008. Now austerity is making it happening again. And if we don't do something about it, the results will, inevitably, be another catastrophe.

The winners and losers of debt

These graphs show the relationship between public and private debt. They are both forecasts from the Office for Budget Responsibility, produced in 2015 and 2017. 

This is what the OBR was projecting what would happen around now back in 2015:

This year the OBR completely changed its forecast. This is how it now projects things are likely to turn out:

First, notice how both diagrams are symmetrical. What happens on top (that part of the economy that is in surplus) precisely mirrors what happens in the bottom (that part of the economy that is in deficit). This is called an “accounting identity.”

As in any ledger sheet, credits and debits have to match. The easiest way to understand this is to imagine there are just two actors, government, and the private sector. If the government borrows £100, and spends it, then the government has a debt of £100. But by spending, it has injected £100 more pounds into the private economy. In other words, -£100 for the government, +£100 for everyone else in the diagram. 

Similarly, if the government taxes someone for £100 , then the government is £100 richer but there’s £100 subtracted from the private economy (+£100 for government, -£100 for everybody else on the diagram).

So what implications does this kind of bookkeeping have for the overall economy? It means that if the government goes into surplus, then everyone else has to go into debt.

We tend to think of money as if it is a bunch of poker chips already lying around, but that’s not how it really works. Money has to be created. And money is created when banks make loans. Either the government borrows money and injects it into the economy, or private citizens borrow money from banks. Those banks don’t take the money from people’s savings or anywhere else, they just make it up. Anyone can write an IOU. But only banks are allowed to issue IOUs that the government will accept in payment for taxes. (In other words, there actually is a magic money tree. But only banks are allowed to use it.)

There are other factors. The UK has a huge trade deficit (blue), and that means the government (yellow) also has to run a deficit (print money, or more accurately, get banks to do it) to inject into the economy to pay for all those Chinese trainers, American iPads, and German cars. The total amount of money can also fluctuate. But the real point here is, the less the government is in debt, the more everyone else must be. Austerity measures will necessarily lead to rising levels of private debt. And this is exactly what has happened.

Now, if this seems to have very little to do with the way politicians talk about such matters, there's a simple reason: most politicians don’t actually know any of this. A recent survey showed 90 per cent of MPs don't even understand where money comes from (they think it's issued by the Royal Mint). In reality, debt is money. If no one owed anyone anything at all there would be no money and the economy would grind to a halt.

But of course debt has to be owed to someone. These charts show who owes what to whom.

The crisis in private debt

Bearing all this in mind, let's look at those diagrams again - keeping our eye particularly on the dark blue that represents household debt. In the first, 2015 version, the OBR duly noted that there was a substantial build-up of household debt in the years leading up to the crash of 2008. This is significant because it was the first time in British history that total household debts were higher than total household savings, and therefore the household sector itself was in deficit territory. (Corporations, at the same time, were raking in enormous profits.) But it also predicted this wouldn't happen again.

True, the OBR observed, austerity and the reduction of government deficits meant private debt levels would have to go up. However, the OBR economists insisted this wouldn't be a problem because the burden would fall not on households but on corporations. Business-friendly Tory policies would, they insisted, inspire a boom in corporate expansion, which would mean frenzied corporate borrowing (that huge red bulge below the line in the first diagram, which was supposed to eventually replace government deficits entirely). Ordinary households would have little or nothing to worry about.

This was total fantasy. No such frenzied boom took place.

In the second diagram, two years later, the OBR is forced to acknowledge this. Corporations are just raking in the profits and sitting on them. The household sector, on the other hand, is a rolling catastrophe. Austerity has meant falling wages, less government spending on social services (or anything else), and higher de facto taxes. This puts the squeeze on household budgets and people are forced to borrow. As a result, not only are households in overall deficit for the second time in British history, the situation is actually worse than it was in the years leading up to 2008.

And remember: it was a mortgage crisis that set off the 2008 crash, which almost destroyed the world economy and plunged millions into penury. Not a crisis in public debt. A crisis in private debt.

An inquiry

In 2015, around the time the original OBR predictions came out, I wrote an essay in the Guardian predicting that austerity and budget-balancing would create a disastrous crisis in private debt. Now it's so clearly, unmistakably, happening that even the OBR cannot deny it.

I believe the time has come for there be a public investigation - a formal public inquiry, in fact - into how this could be allowed to happen. After the 2008 crash, at least the economists in Treasury and the Bank of England could plausibly claim they hadn't completely understood the relation between private debt and financial instability. Now they simply have no excuse.

What on earth is an institution called the “Office for Budget Responsibility” credulously imagining corporate borrowing binges in order to suggest the government will balance the budget to no ill effects? How responsible is that? Even the second chart is extremely odd. Up to 2017, the top and bottom of the diagram are exact mirrors of one another, as they ought to be. However, in the projected future after 2017, the section below the line is much smaller than the section above, apparently seriously understating the amount both of future government, and future private, debt. In other words, the numbers don't add up.

The OBR told the New Statesman ​that it was not aware of any errors in its 2015 forecast for corporate sector net lending, and that the forecast was based on the available data. It said the forecast for business investment has been revised down because of the uncertainty created by Brexit. 

Still, if the “Office of Budget Responsibility” was true to its name, it should be sounding off the alarm bells right about now. So far all we've got is one mention of private debt and a mild warning about the rise of personal debt from the Bank of England, which did not however connect the problem to austerity, and one fairly strong statement from a maverick columnist in the Daily Mail. Otherwise, silence. 

The only plausible explanation is that institutions like the Treasury, OBR, and to a degree as well the Bank of England can't, by definition, warn against the dangers of austerity, however alarming the situation, because they have been set up the way they have in order to justify austerity. It's important to emphasise that most professional economists have never supported Conservative policies in this regard. The policy was adopted because it was convenient to politicians; institutions were set up in order to support it; economists were hired in order to come up with arguments for austerity, rather than to judge whether it would be a good idea. At present, this situation has led us to the brink of disaster.

The last time there was a financial crash, the Queen famously asked: why was no one able to foresee this? We now have the tools. Perhaps the most important task for a public inquiry will be to finally ask: what is the real purpose of the institutions that are supposed to foresee such matters, to what degree have they been politicised, and what would it take to turn them back into institutions that can at least inform us if we're staring into the lights of an oncoming train?