Shadow Chancellor Ed Balls has proposed a set of five policies to stimulate growth. These are:

- preponing long-term investment projects
- to reintroduce the bank bonus tax in order to generate funds with which to support house construction and job guarantees
- a temporary suspension of employer contributions to national insurance for small firms that take on new workers.
- reducing VAT for a fixed period
- reducing VAT further for home maintenance and improvement

There is a mix of good and bad in these proposals. The first is needed, and is in any event in line with what some members of the government favour. The first half of the second bullet point deserves consideration as a means of raising funds; the second part is more suspect - why should the government be better at investing than the private sector? The proposal to cut national insurance has merit, though the requirement that it should be done for firms that take on extra workers might be hard to implement.

Then we come to VAT cuts. A temporary cut in VAT was introduced by the last government as a means of stimulating the economy. It is probably a costly way of having a limited impact. The last government did it because it was constrained by the political fall-out from its decision to scrap the 10 per cent rate of income tax. The present government is bound by no such constraints. If there are to be reductions in tax, they should take the form, not of a VAT cut, but of a hike in personal income tax allowances. That would put more income into the hands of the people most likely to spend it - and so it would likely be much more effective in stimulating the economy.

Reports that the government is considering injecting an additional £5 billion of expenditure on capital projects come hard on the heels of last Wednesday's speech by Deputy Prime Minister Nick Clegg at the LSE, and also follow Business Secretary Vince Cable's recent references to 'stimulus'. The economic situation has certainly taken a severe turn for the worse, and such stimulus should - at one and the same time - reduce the danger of falling back into recession and (so long as the capital projects represent sound investment) enhance our ability to reduce the budget deficit. The sum that is being considered would also bring coalition policy very much into line with (the then Chancellor) Alistair Darling's proposals at the time of the last general election. Political consensus would be welcome indeed.

In a coordinated move, five central banks, including the Bank of England and the Federal Reserve, have provided commercial banks with extra loans. This is in response to renewed reluctance on the part of the commercial banks to lend to each other.

In the UK, we have seen this reluctance reflected in the recent rise of the LIBOR - currently at 0.92, up from 0.85 a month ago. (It was 0.76 at the start of the year.) The banking system seems once more to be at risk of ossifying. At the root of this is the sovreign debt crisis in some European countries - while the possibility that Greece (in particular) might default on its public debt remains, banks that have lent to Greece are vulnerable, and other banks will not lend to them.

The fundamental problem is persistently put off rather than tackled. The extra loans will help, but only for the time being. One of two end points now looks inevitable. Greece defaults, or its problems are absorbed within a monetary, fiscal and political union of European states. Neither is particularly palatable. But it is time to stop kicking the can a little further on down the road and hoping that the underlying problems will go away (or come on someone else's watch).

Jose Manuel Barroso has proposed the issue of joint bonds by the group of 17 countries that have the euro as their currency. One might be forgiven for drawing the analogy between this and the type of derivative that became a toxic asset as the subprime crisis unravelled. As Ian Hunter once sang: once bitten twice shy.

Deputy Prime Minister Nick Clegg has today delivered an important speech at the London School of Economics.

"This is about economics, not ideology, not stubbornness. And our plan doesn't put a straitjacket on policy ... Deficit reduction was only ever intended as a means to an end ... Our troubles have very much been a demand crisis. The banks’ sudden withdrawal of funds, asset price falls, volatility in the markets – all hit demand. And even if we had the least regulated, most skilled, most competitive economy on the planet, if no-one spends any money, that’s not enough. Clearly, with debt so high – private and public – we have to be realistic about the restraints on boosting demand ... Investment in infrastructure stimulates demand not overnight, but more quickly than many supply side measures. And it raises productivity well into the future too ... If you modernise this kind of infrastructure you stimulate activity in the shorter term and you build systems high growth industries can use for years to come ... Last year the Coalition produced the UK’s first ever National Infrastructure Plan to deliver the world-beating infrastructure our businesses need from High Speed Rail, to Cross Rail, to green energy, to the best superfast broadband network in Europe. And we’re galvanising around that plan with renewed energy. A gear shift in government to unblock the system and get the money out the door ... We’re drawing up new money-raising powers for councils to do that where they can borrow against future growth from locally raised business rates ... We’re going through the nation’s capital spending plans to hand-pick up to 40 of the biggest infrastructure projects, the ones most important to growth, which will be given new special priority status. Each will be rigorously examined by Ministers to make sure there are no delays, no blockages and the economy feels the benefits as quickly as possible. That includes, for example, high speed broadband rollout, work to transform the efficiency of the national grid, major improvements to the rail network, like Crossrail and Great Western Electrification and projects to reduce congestion on our road network."

This is certainly a change in rhetoric. It sounds as though it might also herald a change in the phasing of the government's budget deficit reduction plan - about which we may hear more in the autumn statement on 29 November.

The ring fence around retail banking that has been proposed by the Independent Commission on Banking should serve to protect the sector in future from the type of meltdown that occurred in 2007-08. By effectively separating out retail banking from highly leveraged activity in the investment banking sector, the risks generated by the latter sector remain largely within that quarter. This should help ensure that any future crises would necessitate salvage by the taxpayer only of the (now easily identifiable) retail banking arm of each banking company.

Some representatives of the banks have argued vociferously against the proposed reforms. Since the proposals serve to limit their degrees of freedom, this is not surprising. They argue that the proposals will lead to an increase in their costs - which they would pass on to their customers thereby jeopardising the economic recovery. The extent to which the banks could shift the burden of the new legislation onto their customers in this way depends on the extent of competition within the sector. The Commission's proposals for enhancing competition therefore deserve somewhat more comment than they have thus far received in the media. These are that mechanisms should be devised to make it easier for consumers to switch between banking accounts (through automatic transfer of information about direct debits etc.) and that the newly created Financial Conduct Authority should adopt a pro-competition stance. The Commission also notes that the divestitures currently planned and ongoing, respectively, in the Lloyds Banking Group and the Royal Bank of Scotland should serve to promote competition. These proposals are somewhat anaemic - where they go beyond a commentary on what is already going on they are vague - and they may need strengthening as they pass through the legislative process.

Subject to that caveat, there is much to commend about the Banking Commission's report. It should be welcomed.

The speed of the budget deficit reductions in the UK has been a matter of much debate since before the last general election. Extracts from Alistair Darling's new book, published over the weekend, highlight the middle path that he advocated. Now the argument for the government to ease back on the brakes comes from another, and rather surprising, source - Bill Gross, of Pimco, has argued that the austerity package needs adjusting in order to ensure that growth is delivered, and has suggested that this can and should be done without damage to the UK's credibility in the eyes of the markets.

The Chancellor claims that he has no Plan B; but Plan A can of course be morphed. As the economic outlook becomes increasingly worrying, and as the clamour for change increases, expect to see policy adjust sooner rather than later.

The last 24 hours have been dramatic on the world markets. News of the widening spread between Italian and core European rates generated alarm that Italy now looks likely to default on its national debt. Later in the day, Spain cancelled a planned sale of bonds scheduled for later this month - a sign that the Spanish authorities are concerned about their own ability to manage their debt. Subsequently stock markets tumbled. The economic outlook looks grave indeed.

Default is an emotive term. There are many ways in which a debt can fail to be repaid in full - complete default is at one extreme, but there are other measures such as restructuring, partial repayment, and abnormal levels of inflation that can be used to reduce the scale of the liability. It is now inevitable that a significant number of economies in Europe (at least - let's keep America out of the discussion for now) will, in some form or another, default.

The easy money that has flowed in from the rapidly developing economies will no longer be so easy - investors in these emerging economies will have diminished confidence in the developed economies. In the medium term, it will become harder for the developing economies to live with debt. This further limits the wiggle room that governments in these economies have to manage the transition to a more stable path. We're in for some turbulent, and pretty horrible, times.

In 2008, output per worker fell by 0.8 per cent. In 2009, this same measure of productivity declined by a massive 3.1 per cent. This is not normal during recessions, where the shake-out of labour typically causes productivity to rise. Following relatively minor dips in 1980 and 1989, productivity rose during the recessions of the early 1980s (substantially) and 1990s.

One reason for the perverse figures observed in the recent past may be the very severity of the recession: real wages fell in 2009, and this may have enabled firms to retain workers that would otherwise have been shed, despite stagnation in output. With price inflation continuing at above 4 per cent over the year, there is still a lot of downward pressure on real wages.

This suggests that the simple relationship between changes in unemployment and the rate of output growth which underpins Okun's analysis is misspecified - consideration also needs to be taken of movements in wages. In this respect, the true relationship may be closer to what Tom Hyclak and I once dubbed the 'Fisher curve' - in honour of Irving Fisher's work in the 1920s.

Over the long run, technological progress determines change in productivity. The decline in productivity will be temporary and we will see a return to growth in both productivity and real wages. When this happens, we can expect the Okun relationship to be restored.

Johnes, G. and T.J. Hyclak (1995). The determinants of real wage flexibility Labour Economics, 2 (2), 175-185 DOI: 10.1016/0927-5371(95)80052-Y

The graph below shows the unemployment rate series for three European countries - the UK, Germany and Spain.

In the aftermath of the Great Recession, it is clear that unemployment has fallen in Germany while it has risen in the other countries - most severely so in Spain.

An interesting explanation for the relative success of Germany comes in a recent paper by Michael Burda and Jennifer Hunt. They argue that working time accounts - which allow employers to avoid paying overtime by averaging individuals' hours worked over a relatively lengthy period - have resulted in less hiring during the upturn and less firing in the downturn. This interesting finding suggests that such accounts are an institution that might be worth introducing elsewhere.

My last post on this blog concerned Okun's law. In the graph below, I report on the level of growth that is needed to maintain stable unemployment, calculated using 20 year windows from UK data from 1972-2010 and based on the model referred to in my earlier post. Over most of this period growth has needed to be just a whisker under 2 per cent per year to ensure that unemployment does not rise. In the last two periods illustrated on the graph, this has fallen dramatically - to just a little over 1 per cent.

It is not clear why, and it is certainly not clear that this drop represents a permanent shift.

In 1962, Arthur Okun wrote his famous article about the relationship between the change in the unemployment rate and the growth rate of real output. This included the statistical estimation of an equation that relates changes in the unemployment rate to the growth rate of GDP. With some rearrangement of the terms in this equation, it is straightforward to evaluate the extent to which the economy needs to grow in order to ensure that unemployment does not rise. This relationship has come to be known as Okun's law - and it indicates that, in Western economies, somewhat over 2 per cent growth per annum is needed just to keep the unemployment rate steady. In the absence of such growth, advances in productivity will mean that output can be produced with fewer labour resources than were previously required.

Recent data to emerge from the UK suggest that this law is being repealed. Output has been flat in recent months, but unemployment (far from rising, as Okun's law would predict) has been falling. In some respects this is easy to explain: workers are accepting wage settlements that are below inflation, so that the brunt of adjustment appears in the form of falling real wages rather than rising unemployment. Several factors may account for this: communication about the extent of the global readjustments required may have given workers a hefty reality dose; the union legislation of the 1980s, now really being tested for the first time, may have proven itself to be effective.

Increased union militancy challenges this last possible explanation. And however strong the reality dose might be, it is more likely than not that at some point resistance to real wage cuts will strengthen. Okun's law has been one of the more durable statistical regularities in economics over the years, and growth remains the most promising way of avoiding large increases in unemployment.

I have, from time to time, posted on this blog forecasts of the UK economy that come from a neural network model using monthly index of production data. The latest forecast - based on data up to April of this year - appears in the red line of the graph below. The blue line are historic data, while the forecast looks ahead 24 months.

This forecaster has, for many months now, consistently predicted a dip in economic activity towards the end of this summer. Like any economic forecasts - indeed more so than most, given its simple nature - it comes with a 'health warning'. While some economic indicators - most recently the drop in the unemployment rate - provide welcome news, there is still some way to go before we can be confident that growth has been restored.

The International Monetary Fund has reported on its mission to the UK. The report argues that the 'curent settings of fiscal and monetary policy remain appropriate in the central scenario', but that 'risks and uncertainty around this central scenario are significant'. In particular, if growth remains weak and if unemployment remains high, the automatic stabilisers that are built into fiscal policy - including lower tax take and higher spending on benefits - should be allowed to operate freely.

As early as May of last year, there were signs that the government intended to be flexible in the way in which it implemented the fiscal retrenchment. The Chancellor of the Exchequer has made much of the idea that there is no plan B, But the rhetoric is now changing - a plan B seems to be embedded within a plan A that is more permissive than the government's own rhetoric has often implied. For the sake of those who bear the brunt of this ever-so-slow recovery, let's hope so.

In the beginning, there were real business cycle models of the kind pioneered by Kydland and Prescott. These attempted to provide a rationale for the existence of smooth business cycles by examining how rational, utility maximising economic agents respond to random shocks by redistributing their activity over time. Eventually these models developed into what we now call dynamic stochastic general equilibrium (DSGE) models. These models initially adopted the market clearing assumptions made in the original real business cycle models. More recently, models have become more general and have introduced the notion of staggered price adjustments. The latter models are often referred to as new Keynesian variants, and the work of Michael Woodford is typical of this endeavour.

All of the models referred to above are designed to build up a story of macroeconomic behaviour using a strong set of microeconomic foundations. They are based on individual economic agents that are acting rationally. By drilling right down to the preferences of agents, the macroeconomic behaviour of the models is supposed to finesse the problem raised by the Lucas critique - the notion that, since a change in policy might change the way in which people respond to policy, models based on these responses cannot be used as forecasting tools. (But since people's preferences don't change in response to policy - only their behaviour does - models built on what we know about people's preferences are deemed to be robust.) In consequence, DSGE models have attracted much interest amongst central bankers.

But DSGE models are difficult to work with. Studying individual decision making in a dynamic environment - where attention has to be given to the way in which people form, and respond to, expectations about the future as well as how they respond to the past - involves a lot of complicated analysis. Simplifications have to be made. This being so, early DSGE models have focused on output and prices. While results from some of the models have been encouraging, many economists - myself included - have been underwhelmed by the general approach. This is because the models have failed to consider a world in which some people are unemployed. In other words, they have failed to consider anything that looks, even remotely, like the real world.

All that is set to change. Jordi Galí, one of the pioneers of new Keynesian DSGE models, has recently published work that accommodates the existence of unemployment. This has been built upon in further work done in collaboration with Frank Smets and Rafael Wouters. It's still early days, but the promise of DSGE modelling looks as though it may well be realised.



Galí, J. (2011). THE RETURN OF THE WAGE PHILLIPS CURVE Journal of the European Economic Association DOI: 10.1111/j.1542-4774.2011.01023.x
Kydland, F., & Prescott, E. (1982). Time to Build and Aggregate Fluctuations Econometrica, 50 (6) DOI: 10.2307/1913386
Lucas Jr, R. (1976). Econometric policy evaluation: A critique Carnegie-Rochester Conference Series on Public Policy, 1, 19-46 DOI: 10.1016/S0167-2231(76)80003-6
Woodford, M., & WALSH, C. (2005). INTEREST AND PRICES: FOUNDATIONS OF A THEORY OF MONETARY POLICY Macroeconomic Dynamics, 9 (03) DOI: 10.1017/S1365100505040253

Much applied work in economics concerns the problem of which came first: chicken or egg. In a recent paper, Michael Hilmer and Christina Hilmer consider this problem as it applies to the context of PhD students. They investigate the early success of PhD graduates in publishing their work, and ask whether this is due to the eminence of their supervisor - or rather is it the case that supervisors with good reputations tend to attract intrinsically more able students?

In this example, the direction of causality can be inferred by examining the relative performance of students studying with different supervisors in the same doctoral programme, and by examining the relative performance of students who share the same supervisor where the supervisor works in more than one programme (usually in different institutions).

The results suggest that success is due more to the individuals' innate abilities than to the supervisors. Good supervisors tend to attract good students, but the early career publishing performance of a given supervisor's students is higher in doctoral programmes with a higher quality (that is, in programmes which likely attract more able students).

For universities, therefore, getting the programme right - attracting the right students - is a clear prerequisite for success. Understanding which comes first - chicken or egg - is crucial.

More broadly, the chicken and egg question is key to understanding a wide range of policy issues. Which causes which: class size or scholastic performance? risky behaviours of depression? investment or output?



Hilmer, M., & Hilmer, C. (2011). Is it Where You Go or Who You Know? On the Relationship between Students, Ph.D. Program Quality, Dissertation Advisor Prominence, and Early Career Publishing Success Economics of Education Review DOI: 10.1016/j.econedurev.2011.04.013

I have occasionally on this blog referred to a neural network forecasting model of the UK economy that I like to use. I most recently reported on forecasts from this model in January of this year. At that time, the model was predicting a fall-off in growth towards the end of summer of this year. The most recent experiments that I have run with this model use data up to February 2011, and they still indicate that growth will falter towards the end of summer.

The caveats surrounding this model are many: it's based on industrial production data (since this is available monthly), and doesn't include information about other variables - notably policy. But for a simple model it has a rather good track record. While the pessimism in the model's forecasts may not be widely shared, these figures do serve to emphasise just how fragile is the recovery.

The graph below shows the actual data back to just before the downturn - the forecasts are at the right of the graph (where the line turns red) and look forward 18 months.

The growth figures announced today indicate that the UK's economy grew by 0.5% over the first 3 months of this year. In the last 3 months of last year, it fell by 0.5%. So we are not yet quite back to where we were in the third quarter of 2010. (A fall of 5% followed by a rise of 5% nets out as a fall of 0.25%, not zero, because the second 5% is calculated from a lower base.) The contraction in the last quarter of 2010 was, we were told, due to poor weather. If that were really the case (and the evidence suggests that, in part at least, it was), then the improvement in the first quarter of this year is surely due to the absence of poor weather - and nothing more fundamental than that. As the Chancellor of the Exchequer said yesterday, 'we are not out of the woods yet'; the recovery, such as it is, remains very fragile.

That said, from this low base, there are now some signs that offer encouragement. It remains essential for the government, in its zeal to attack the budget deficit, to pay heed to the impact that its policies has on growth.

Are we seeing some signs of life? Consumer confidence up,retail sales up, unemployment down...

One would hope so. But the improvement in these statistics is slight, and in each case the data follow on from very bad figures in the previous month. If indeed we are seeing the first indications of recovery, that recovery remains very fragile. Whatever one's views might be about the speed with which the budget deficit is being cut, the policy shock that still has to be played out is likely to result in a bumpy ride over the coming months.

Many observers have noted that the financial situation facing the UK is different from that in Greece, Ireland, or Portugal. The rates of interest which the latter countries have had to offer in order to sell their Treasury bills illustrate this. While six month T bills can be sold by the UK at an interest rate of around 0.7%, Portugal has today auctioned off six month T bills at a mammoth 5.1%. This figure makes the terms of any prospective bail-out attractive to the Portuguese authorities, and such a bail-out is now surely inevitable.