Brexit shows the value of scenarios

When the result of the UK referendum on exiting the EU (Brexit) was announced, the FTSE 100 immediately fell by 8.7% and sterling fell around 8% relative to the dollar, and down 5% against the Euro. Clearly, markets were surprised. But why? Even though opinion polls and betting markets indicated that "Remain" would win, it was hardly like Leicester winning the Premier League. I think the problem comes down to mindset.

The debate between opinion polls and prediction markets is essentially a debate about forecast techniques. Although useful, they drive attention to narrow outcomes. Billions of pounds were clearly hinging on a a few percentage points spread. This implies that in future we need better quality opinion polls and better functioning prediction markets, and lots of money can be made from better probability values.

However I'm pleased that the failure of forecasting has generated increased attention and utilisation of the scenario method. A scenario planner doesn't care what the probability of Brexit is. We simply didn't know. What we did know, was that one of two possible outcomes could happen - a Leave vote, or Remain. Therefore plans should be made around both. As an economist, I was routinely asked in the buld up to the vote "do you think we'll leave?" This is based on a forecasting mindset. I tried to say "I don't know", but it's hard not to weigh in with a (flawed) prediction. The better question would be "what should we do if we leave, and what should we do if we remain?"

Now that the result is in, the uncertainty is not over. The manner in which Brexit will occur, if at all, is the topic for discussion. And thus far no one has asked me "what do you think the most likely arrangement will be?" At heightened uncertainty, you only really have scenarios. Hence newspapers are discussing "The Norway option" or "Article 50 isn't triggered" or "Scotland has another referendum". Scenarios are the go to framework.

I don't meen to disaparage polls or markets. Both tell us different things, and are useful. But it's clear that too much money was riding on their predictive power, and we should be humbled by that. I am encouraged that people are thinking in terms of scenarios, and hope the economics professsion does the same.


Hayek and Friedman in Chile

I gave a talk last night on the role of economist as public policy advisor. In particular, I was interested in challenging the prevelent conspiracy theory that economic crises lead to neoliberal policies, which lead to bad outcomes.

I think this theory rests on two important pieces of ignorance about economics. The first is the conflation of neoclassicism (a method) and neoliberalism (an ideology). I explain more in this IEA blog post. The main point:

To the extent that ‘neoliberalism’ has come to dominate western policy making, it isn’t liberal. To the extent that ‘neoliberalism’ is extreme free market dogma, it’s of negligible impact.

The second area of ignorance is Public Choice theory. I argued that treating neoliberalism as being synonymous with corporatism simply ignores what "neoliberals" actually believe - we don't think that unemployment is due to individual weakness, but to instutitional barriers such as labour markets rigidities and occupational licensing. In other words "we" have a very clear theory of regulatory capture and crony capitalism. 

Notice that I am claiming the term "neoliberal". Indeed this brings us to Friedman and Hayek in Chile, because if this is an example of neoliberal intervention it is worth pondering what happened and challenge whether it's the smoking gun that critics to often claim. After documenting the role of Friedman and Hayek, I mentioned a great paper by Bob Lawson and J.R. Clark. They make the following definitions:


    • Economic freedom – 0.5 standard deviations higher than average on the Economic Freedom Index
    • Political freedom – 1 standard deviation higher than average on the Freedom House Index (and average of “political rights” and “civil liberties”)

This produces a 2x2 matrix where we can not only assign countries to various quadrants, but also map how they move between quadrants over time. I used this as a basis for "The Economic Freedom Parlour game" and it seemed to go down well.

According to Hayek and Friedman, you can’t have political freedom without economic freedom, which implies that quadrant B is unstable. According to Lawson & Clark's data, less than 10% of the data set is contained in quadrant B. In 1980, for example, there were 12 cases, and typically these were "high income Western nations who were in the final stages of their most socialist periods”. The fact that 11 of them (with the exception of Venezuela) subsequently becamer more economically free (B->A) seems to support their thesis.

We can also bring in the Road to Serfdom, where Hayek claims that when democratic socialism fails planners will move toward totalitarianism (i.e. B ->D). If we consider this to be a prediction (i.e. that it will necessarily happen) it looks to have been refuted. 11 of the 12 avoided that path. But if we consider it to be a warning, the sole example of Venezuela is validation. In other words, those European countries didn’t let the planners continue their planning, and neoliberalism saved the day.

According to Lawson and Clark the key findings are as follows:

  1. Chile's drastic increase in economic freedom was soon followed by increases in political freedom
  2. Israel's lack of political freedom in the 1970s/1980s didn't last, and relatively free-market policies have coincided with a steady increase in political freedom
  3. Venezuela really began to lose economic freedom from 1990-1995 and since then political freedom has fallen (and is falling).

This latter case - Venezuela - is the Road to Serfdom before our eyes. And I think the framework is a very interesting one to think about the dynamics of transition. Should we focus on moving from D -> B and hope that political freedom begets economics freedom (and run the risk of lapsing into the Road to Serfdom?); or should we aim for D -> C and risk getting "stuck" in an authoritarian but prosperous country like Hong Kong or Singapore. To help with this, I presented some of the key findings from my 2009 book on neoliberalism in Eastern Europe, and also shared Anders Aslund's point that it may be a false choice. The tradeoff may not be D -> C or D -> B but between D -> Cor nothing. After all,


    “Market economic reforms have been highly successful, whereas democratisation has only been partially auspicious, and the introduction of the rule of law even less so” (2007, p.305)

    “At present, we seem to understand how to build a market economy, whereas the ignorance of democracy building and the construction of a legal system are all the more striking” (2007, p.311)


For me, Eastern Europe is an example of the success of neoliberalism. However the success could have been greater still.

The left falsely identify Friedman (rather than Hayek) as leader of the neoliberal revolution because they can pin more on him. But it’s Friedman’s neoclassicism (i.e. method) that dominated the economic and public policy debate, not his neoliberalism (ideology). We need more of it. 



The Upper Turning Point

In 1979 Jeff Hummel published an important critique of Austrian business cycle theory. I'm biased, but I felt it's received insufficient attention amongst Austrians. Especially in terms of the unsustainability of the boom - how inevitable is the upper turning point?

I think that many Austrians take it as a given that at some point an increase in the money supply will begin to accelerate, couched under the claim that "X is necessary for the boom to continue". But what about if you don't want a boom to continue? What if, after a boom, you just want a soft landing? Can you avoid a recession? At this point my inner Austrian resorts to hand waiving and saying things like "structure of production" and "relative price effects". But I also find it interesting how many explanations revert to political economy claims.

I thought a good way to approach this issue would be to present the ABC textbook style, side-by-side with alternative explanations. David Romer uses illustrative path dynamics, and Mishkin's textbook analysis presents the following scenarios for monetary expansion:

In 2013 I wrote up a working paper and have decided to release it now as a special report.

Must an increase in the money supply lead to an increase in the growth rate of the money supply? According to Hayek (1934) this would be necessary to sustain the boom, and this is true. But what if you don’t want to sustain the boom? What if you want the structure of production to be maintained at its existing level?

I point to "capital heterogeneity" effects and the Ricardo effect as distinctly Austrian explanations. However the literature review is incomplete and there are some serious flaws and problems.

The main reason for not taking it any further is that back in 2013 I became aware of a working paper by Larry White and George Selgin, on the same topic. Their stylised paths of money paths of the money stock, nominal interest rate, and real interest, approximated what I felt had been missing in the Austrian literature. And, interestingly, they suggest that a slowdown in the growth of money supply is not a necessary turning point. In fact, they criticise Hayek (and others) for the same reasons Hummel does, as far as I can tell. Their article is called "The Austrian Theory of the Business Cycle in a Fiat Money Regime" and I look forward to reading it in print.


UK economic update - June 2016

I spent this morning populating the monetary dashboard, and thought I'd write up why my current view of the UK economy is "meh".

Monetary growth is reasonably strong and consistent. M3 has fallen from 2.7% to 2.3% and M4ex has fallen from 4.8% to 4.2% but narrower measures have grown - MAex is 7.8% (from 7.3%) and household Divisia 8.9% (up from 7.4%). Inflation measures remain subdued - CPI has fallen from 0.5% to 0.3%, RPI is down from 1.6% to 1.3%, input prices are -0.7% and output prices -6.5%. From a monetarist perspective there's no sign of impending return to the inflation target - indeed inflation expectations over the coming year have fallen from 2% to 1.8% and the Fed 5 yr be rate is 1.45%. We are still a long way from "normal" inflation.

It's important to take a broader look at inflationary pressure, but the picture doesn't change. Although the House Price Index jumped from 7.6% to 9% last month the Nationwide measure fell to 4.7% and Halifax remains elevated at 9.2%. IMF's measure of commodity prices is 4.7%. Stock market indicators are up over the last 3 months but the FTSE 100 is down 7.6% since last year. NGDP grows at a modest 2.5% and altough the PMI index has risen (slightly) above 50, Industrial Production is down 0.3% and business investment fell by 0.5%

The unemployment rate is 5.1% and the ratio between vacancies and unemployment for Jan-Mar at 0.45. Average Weekly Earnings have risen slightly, but are under 2%. The HM Treasury survey of forecasts shows that growth of 2.1% is expected next year, and inflation of 1.9%. Interest rates have fallen slightly, sterling is down, yields are down. With so much uncertainty due to the possibility of Brexit it would be wise to be cautious. And with inflation so low, policymakers hands are pretty tied.


MAex growth at 7.81%

A recent update to MAex has revealed that narrow money growth is a robust 7.81%, up slightly from 7.33% in March. It's been in the 6%-9% range for over a year.

Here's the data.