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The Economic Truman Show Samuel Brittan speech Bath 20/03/09 I don't know if any of you recall a film which was all the rage ten years ago called the Truman Show. Truman is a straightforward ordinary guy who lives an uneventful, happy life in a small American town. What he does not realise is that his whole life is a fake as the people around him are all actors and the streets all around him consist of painted scenery. There is, however, a danger that all hell will break loose when he discovers how he is being deceived. Analogies are never perfect and in this case Truman stands for masses of people - ordinary citizens, politicians, officials, and many others. The actors consist of the American academic economic community who are putting up a show for the rest of us who mistakenly believe that we are being told how to run our economic policy. If you find all this a little mystifying please listen further and I will tell you how I came to this realisation. The first event was my seeing a paperback which dealt with the American academic rat race. In fact most of the examples came from sociology rather than from economics. But never mind: the point was that an applicant for a job at a US university had to list a whole lot of publications and papers. Most of these added little to human knowledge but were there to testify to the applicants' worthiness. The contributions were judged mainly by the number of references to other publications which the applicants included. So many forests were felled in the production of these candidates' work, and the pile of paper was so high, that there was no prospect of their work being properly assessed. In truth they were weighed rather than read. The author of the paperback remarked that all this intense competition was often for lectureships which carried a smaller salary than that of a typical US truck driver. The next event occurred in the late 1970s and was indeed concerned with economics. It was a conference in Vancouver on the relationship between the dole and the unemployment rate; or more exactly, the effect of the "replacement ratio" people received when out of a job on their efforts to find work. This is clearly an important subject. If incentives matter then a high level of social security benefit would make finding a job less urgent and applicants much more choosey about which jobs they take. On the other hand, it is inhuman to try to starve the jobless into work and some tradeoff has to be drawn up between generosity of benefit and the political goal of high employment. To this end it is important to try to estimate how large the disincentive effects of various replacement ratios actually are; and also to see if there are ways of adjusting the social security system to make the choice less brutal. Clearly this is both an important humanitarian topic but also a highly technical one when it comes to measuring disincentive effects. And to be fair the conference did discuss these issues, if sometimes in an abstruse and roundabout way. There was one very impressive young academic who showed an enviable mastery of the technical analysis. But when it came to conclusions there was a big letdown. For his punchline referred not to policies or even to measurements, but advice on how to "make the JPE". This was a reference to the Journal of Political Economy which was regarded as the most prestigious North American economic journal. He advised his listeners that if they wanted to achieve the all important career step of getting their work published in the JPE they should do x or y. On the other hand, if they did z or w they could forget all prospect of such publication with all the damage that this would do to their ambitions. The thought that dawned on me that labour market analysis was merely a pretext or part of the scenery and that the real action was concerned with climbing the academic ladder. I must elaborate a little. The first and most ferocious stage is the battle to secure what these young men and women called "tenure". If and when that is achieved, life becomes a bit more normal and they can concentrate on teaching students and making slight advances in knowledge through the usual refereed articles. But then for the more ambitious there comes a third stage, which only a few can reach. This is to establish guru status when they are interviewed by the media, called in as presidential advisers and if they are lucky, begin to earn far more than the truck drivers already mentioned. Another avenue open to them is to write textbooks which will be prescribed at a sufficient number of universities and institutes. In their final stage of take off they become famous or notorious enough to take well paid assignments in business conferences at which they will arrive by helicopter with trophy girlfriends. (I assure you I am not making this up.) But if any of you are thinking of taking this path, I must warn that such success is achieved by a small minority of the academic community. Most will have to be content with professorships and perhaps membership of the administrative bodies of universities deep in the American Midwest. There is one variant of this game which is highly topical. This is to make a seemingly radical attack on the conventions of mainstream economics, which the originators hope will attract wider public attention and entertain people who have no idea of what is really being attacked. It may indeed be the case that mainstream US macroeconomics leans too heavily on the idea of rational and knowledgeable self-interested economic actors who soon establish a state of equilibrium among themselves. One version of this, which has recently come under so much attack, is the efficient markets theory which I shall not attempt to outline here, as it has been discussed all over the place. How far American academic economics is in thrall to such ideas is difficult to say and would require a subtle and extensive empirical investigation which I am not sure would be worth undertaking. I suspect that it is possible to prosper in the academic world either by supporting or opposing the efficient markets theory or all stations in between, so long as this is done with enough mathematics and enough references to the so called literature. My point is that is real or imagined state of affairs gives a jumping off ground to the soi-disant radicals who will then attack the supposedly orthodox ideas in their most extreme and vulnerable form for the entertainment of people without first hand knowledge. One of the most recent examples comes from a much praised book entitled Animal Spirits by two genuinely distinguished American economsts, George Akerlof and Robert Shiller. Like many such books it claims to be following in the footsteps of Lord Keynes, now once again fashionable. Unfortunately the way they do this is often by claiming the authority of Keynes for whatever notion they happen to be playing with. I do not want to be too harsh. Although Keynes was normally an extremely good writer, this was not the case for the General Theory which contains his main contribution to economic thought but which is often arid, involved and difficult to interpret. Akerlof and Shiller have decided, like some others, to go to town on so called "animal spirits" - an aspect of the General Theory which appeals to many who do not find the economic analysis congenial. Unfortunately this is the wrong way to humanise Keynes, especially at the present stage of the economic cycle. These authors widen animal spirits to cover ideas such as confidence, fairness, corruption, and anti-social behaviour. In fact there is only a brief reference to animal spirits in the General Theory after the chapter on "the marginal efficiency of capital". This is roughly the prospective yield on new investment after taking into account interest payments. Keynes remarks that the basis of knowledge for the estimated yield of long term investment in say a railway, a copper mine, or a building in the city of London "amounts to little and sometimes to nothing". A decision to risk one's capital on a project whose consequences will only be discovered after a long period "can only be taken as a result of animal spirits and not as a weighted average of benefits multiplied by probabilities." These remarks can be interpreted as a colourful way of stating the uncertainties surrounding all long-term decisions, which cannot be conjured away by any mathematical formula. A more radical interpretation, however, is that Keynes in the 1930s thought that profitable investment opportunities coldly considered, were much too low in relation to attempted savings to secure full employment. Whether he was right or wrong in the longer run, he is indeed right for periods like the present when we are threatened with a severe slump of 1930s dimension. The fact is that the General Theory is not a treatise on animal spirits but an analysis of effective demand and how it could be deficient. Keynes himself wanted to fill the gap mainly by state sponsored investment. One could with equal logic prefer to put the emphasis on a consumption boost instead. In any case, he did not rely on attempts to foster an over optimistic psychology to fill the gap; and nor should we. But the part of the Kerlof and Shiller book which enraged me most was that which asserted that there was a long run tradeoff between unemployment and inflation. This is probably the matter to which I have given more thought than any other topic in macroeconomics. Indeed I was for several years an economic "expansionist". I believed that by maintaining a high and rising level of aggregate demand we could not merely knock a few decimal points off the unemployment percentage, but by the effects on expectations and investment induce a faster rate of economic growth from which all could benefit. Of course I was familiar with something called the Phillips Curve which purported to show an inverse relation between inflation and unemployment. In other words if you tried to run the economy at a higher pressure of demand there would a faster rate of wage and price inflation. Or to put it the other way round, if you wanted low inflation you had to accept a higher unemployment rate (or in contemporary parlance "output gap"). As I believed that wages and prices were influenced by market forces, I accepted without too much reflection that we would have to accept a higher rate of inflation as the price to pay - although I hoped that faster productivity growth might mitigate some of this effect. I was awoken from these slumbers by Milton Friedman's 1967 address to the American Economic association when he denied that there was any such long run tradeoff. This influenced me far more than of any of Friedman's technical monetary doctrines. His basic argument was straightforward. The original Phillips curve assumed "money illusion". This means that if you increased the demand for labour you would indeed have a once-for-all increase in wage inflation; but that workers would ignore the continuing erosion of their purchasing power in a tight labour market. But this was ultimately unconvincing. It was far more likely that they would claim and receive still further pay increases to offset higher inflation. But these would themselves lead to still higher inflation and still greater pay rises at each successive pay round. So the price of trying to run the economy at too high a pressure was not just high inflation, but accelerating inflation. The upshot was that there was one rate of unemployment consistent not merely with stable prices, but with any stable rate of inflation. Outside influences, such as exchange rate shocks or import price explosions complicate the analysis but do not destroy the main conclusion. This had the effect of my moving much nearer to "sound finance" in normal times and reserving support for Keynesian stimuli to serious slumps like the present. None of this meant that nothing could be done to reduce long term in secular unemployment, but the emphasis had to shift to what are now called "supply side" measures. This new analysis, so far from being a monopoly of the far right was accepted, wrapped up in a lot of obscure phraseology by the present British Labour Government and the Clinton Administration in the USA. Shiller and Ackerlof have now come back to assert that there is after all a long term tradeoff between unemployment and inflation. Their main evidence is one study of Canadian unemployment which rose above the US rate around the turn of the century. What is supposed to follow from this? You can argue that the "temporary" rise in unemployment from too determined an anti-inflationary policy can last a few years and may or may not be worthwhile. It could be that the learning process when inflation rises from a low level may be rather slow. This is all legitimate. But our authors do not draw any overt policy conclusions at all. Do they think that economic agents will be fooled indefinitely by inflation? Let us suppose that unemployment is slightly lower at a 4 percent than a 2 percent inflation rate? Do our authors believe that they can repeat the process again by going up to 8 percent inflation and then to 16 percent? And do they not suspect that people will try to protect themselves against high inflation by iunedxation and other devices. And will not such devices eventually undermine any initial gains in employment. If I can be technical for just one second, have not the authors some duty to discuss what the shape of the long run Phillips curve might be, after being so emphatic that there is such a thing?. At the moment they merely assert that there is a long term tradeoff so that they can thumb their noses at the corpse of Milton Friedman. I will close with another characteristic of fashionable economics books. This is that they too often claim to be relevant to whatever topic is making the headlines, whether they are or not. This may be as much due to the publishers trying to market these books as the authors themselves, who all too often connive at these attempts. The authors of Animal Spirits give the game away by mentioning that an outline of their work was presented as early as 2003. The section on what should be done about the current financial crisis is obviously a last minute insertion. My own view is that wisdom will not come from academics trying to cash in on the latest headline topic and that they would be better employed pursuing their own work. When the former Chinese prime minister Chou En Lai was asked what he thought about the French Revolution, he said that it was much too early to judge. May I as a journalist dare to say the same about the present credit crunch? One could be a bit harsher and say that fools rush in where angels fear to tread. Thus if you have come to hear me on the credit crunch or the recession or whatever you choose to call it, you may have come on false pretences. I may well have something to say about it in the concluding panel as I am sure you do not expect me to stick too rigorously to my own prescriptions. But I am perfectly serious about the excessive influence of American academia on the way we look at the world and the need to go back to underlying economic ideas rather than the criticisms made by Doctor X of Professor Y's comment on the latest paper being passed around on some American campus. Thank you for your toleration.
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