Comment of the Day: Sherman Robinson: On the Economics of BREXIT

Comment of the Day: Sherman Robinson: On the Economics of BREXIT: “I largely agree with Simon Wren-Lewis’s comments, and with the quote from Maurice Obstfeld…

…The trade-productivity links they discuss, as Wren-Lewis notes, “all make common sense”.

However, I think it is very important to sort out the empirical relevance of the different causal mechanisms—it is impossible to consider policy choices without doing so. I see four mechanisms at work:

  1. Ricardian movement of factors to exploit comparative advantage from opening to international trade. Clearly true, but forty years of work with computable general equilibrium (CGE) models, both single-country and global, indicates that pure Ricardian effects on productivity are very small. In conferences, we often cite a “theorem” due to Arnold Harberger: “triangles” are smaller than rectangles”.

  2. “Winds of competition” or “challenge/response” models. There is a large literature on such models, all arguing that opening up markets to competition forces firms to move to the production frontier and/or induces investment in technological change. These effects appear to be significant.

  3. Explicit backward linkages between exporting and “learning better techniques”. These are also significant effects in particular cases, but would seem to be limited in coverage and probably not large enough to have much effect at the national/global levels.

  4. Fragmentation of production processes that allows strong specialization and regional diversification of production of intermediate inputs. There are many examples of these value chains across economic activities: agriculture, manufacturing, and services. They allow producers to achieve “Smithian” gains in productivity through fine specialization. They are seen by later stages in the value chain as lowering input costs, which are not measured as, say, a TFP gain by the later-stage producer, but is very significant. I think that these Smithian productivity gains are very large and cover a wide range of economic activity for countries that have taken part in value chains.

These four mechanisms are not mutually exclusive—all are operating and are probably very complementary. For a nice discussion of the empirical importance of fragmentation of value chains, see the new book by Ricard Baldwin: The Great Convergence. He argues, and I agree, that this fragmentation has been a major driver of trade-linked productivity growth.

On Brexit. The UK is embedded in the EU and most of its trade involves imports and exports of intermediate inputs in complex value chains, so mechanism (4) is very important. Policies that interrupt value chains will be very damaging. For example, if the UK leaves the EU customs union, then the EU will have to impose rules of origin conditions that will impede trade. Firms may well prefer to move operations to the EU in order to keep the value chains operating smoothly. There are lots of other issues concerning how to support and foster value chains, beyond the scope of a short comment.

Must-Read: Tony Barber: A Renewed Nationalism Is Stalking Europe

Must-Read: Tony Barber: A Renewed Nationalism Is Stalking Europe: “Part of the appeal of rightwing populism is that it hammers away relentlessly on the theme that mainstream political parties…

…especially since the end of the Cold War, are almost indistinguishable from each other and offer no proper choice. Not without reason, the parties are depicted as corrupt and detached…. But… they have no economic policies beyond an iconoclastic rage at the euro, free trade and foreigners alleged to be parasites on the welfare state. The new nationalism, in its radical rightist colours, has no credible solutions for a modern Europe that, despite all its troubles, must pin its hopes for a better future on mutual co-operation and an open face to the world…

Brexit: I Think Paul Krugman Is Confused Here…

Interest Rates Government Securities Treasury Bills for United Kingdom© FRED St Louis Fed

Bearing in mind what has happened to me almost every single time since 1997 when I have concluded that Paul Krugman is wrong…

The key, I think, is something hidden in Paul’s column. It is the fact that the effect of pretty much any shock depends on what the private financial market and the public monetary and fiscal policy response to it is:

Paul Krugman: Still Confused About Brexit Macroeconomics: “OK, I am still finding it hard to understand the near-consensus among my colleagues…

…about the short- and medium-term effects of Brexit…. [While] Brexit will make Britain somewhat poorer in the long run, it’s not completely obvious why this should lead to a recession in the short run…. So let me give an example of the kind of analysis that I think should raise eyebrows: BlackRock…. “‘Our base case is we will have a recession’, Richard Turnill, chief investment strategist at the world’s largest asset manager, told reporters…. ‘There’s likely to be a significant reduction of investment in the UK,’ he said, adding that Brexit will ensure political and economic uncertainty remains high…

When we say ‘uncertainty’, what do we mean? The best answer I’ve gotten is that for a while, until things have shaken out, firms won’t be sure where the good investment opportunities in Britain are, so there will be an option value to waiting… Brexit might have seriously adverse effects on service exports from the City of London. This would mean that investment in, say, London office buildings would become a bad idea. On the other hand, it would also mean a weaker pound, making investment in industrial properties in the north of England more attractive. But you don’t know how big either effect might be. So both kinds of investment are put on hold, pending clarification.

OK, that’s a coherent story, and it could lead to a recession next year. At some point, however, this situation clarifies. Either we see financial business exiting London, and it becomes clear that a weak pound is here to stay, or the charms of Paris and Frankfurt turn out to be overstated, and London goes back to what it was. Either way, the pent-up investment spending that was put on hold should come back. This doesn’t just mean that the hit to growth is temporary: there should also be a bounce-back…. But that’s not what BlackRock, or almost anyone else, seems to be saying; they’re projecting lower growth as far as the eye can see. They could be right. But I still don’t see the logic. It seems to me that ‘uncertainty’ is being used as a catchall for ‘bad stuff’.

When asset managers–indeed, when anyone anywhere in the world who is not a trained economist–uses the phrase “more uncertainty”, they do not mean what me trained (or mistrained) economists mean: they do not mean that the future distribution of the random variable has a larger variance but the same mean. What they mean, instead, is that the distribution has a larger and longer lower tail. The variance is up and the mean is lower. The principal thing they see as pushing down investment in the near future is the fear of this lower tail–not capitalizing on the option value of waiting until more knowledge comes in.

Back in 1992 Britain exited the ERM. ERMexit had two effects: (1) a small reduction in the desirability of locating in Britain to serve the continental European market because one now faced exchange rate risk, and (2) a large easing of conventional monetary policy and thus lower interest rates and a lower value of the pound because the Bank of England no longer had to maintain the pound at an overvalued parity. The result: boom.

Today Brexit looks to have two effects: (1) a large reduction in the desirability of locating in Britain to serve the continental European market, and (2) ???? (we are not going to get a large easing of conventional monetary policy):

Interest Rates Government Securities Treasury Bills for United Kingdom© FRED St Louis Fed

In a proper neoclassical flex-price zero-debt world that was, somehow, at the zero lower bound on nominal interest rates, the response to Brexit would be to bounce the real value of the pound down and to bounce the internal price level down and follow that bounce with higher inflation. The much more strongly negative real interest rate produced by the price level bounce-down-followed-by-inflation would cushion the decline in investment. And the boost to exports from the bounced-down real value of the pound would soak up workers exiting investment-goods industries and maintain full employment.

Of course, the proper neoclassical flex-price zero-debt world is one in which the full operation of Say’s Law is a metaphysical necessity, and so full employment is always attained. We, however, do not live in a proper neoclassical flex-price zero-debt world. It is the job of fiscal and monetary authorities to follow policies that push real prices–real exchange rates, real interest rates, real wage levels–to the values that would obtain in such a world, and so preserve full employment. We can imagine:

*1. Expansion of government purchases: preserve full employment by replacing I with G. Not going to happen in any Britain ruled by anything like this generation of Tories.
2. A helicopter drop: the Bank of England buys bonds for cash, cancels the bonds, and the government cuts taxes by the amount of cancelled bonds. Might happen even with this generation of Tories if they were less thick. But they seem to be very thick indeed.
3. Continued whimpers from Mark Carney that he would not chase away the Inflation-Expectations Imp were she to somehow appear. Not likely to be effective.
4. Everybody becomes so terrified about the safety of their assets in Britain that the real value of the pound bounces low enough that expanding exports soak up all of labor exiting from investment-goods industries.

Paul seem to be betting that (4) is a real live high-probability possibility: the short-term safe real interest rate is pinned at -2%/year for the foreseeable future, but the pound will bounce low enough for expanded exports to preserve full employment. It could happen–the world is a surprising place. But that possibility seems to me to be a tail possibility, not something that should be at the core of one’s forecast.

Must-Read: Narayana Kocherlakota: Three Antidotes to the Brexit Crisis

Must-Read: Correct, IMHO, from the very sharp Narayana Kocherlakota. Now perhaps his successor Neel Kashkari and the other Reserve Bank presidents not named Charlie Evans might give him some back up?

The one thing I do not like is Narayana’s “Granted, there is a risk that such steps will spook markets by signaling that the Fed is concerned about the state of the U.S. financial system.” That sentence seems to me to misread market psychology completely. As I see it–and as the people in markets I talk to say–right now markets are fairly completely spooked by their belief that the Federal Reserve is unconcerned, and takes that lack of concern as a sign of Federal Reserve detachment from reality. Narayana’s following sentences seems to me to be highly likely to be the right take: “I’d say the markets are already pretty spooked” and “By demonstrating that it is paying attention to these obvious signals, the Fed can help to bolster confidence in its economic management”.

Let me stress that, at least from where I sit, that confidence in Federal Reserve economic management is, right now, lacking.

The people I talk to in financial markets tend to say that they believe markets took Stan Fischer on January 5 to be something of a wake-up call with respect to Fed groupthink:

Liesman: When I looked at where the market is priced, the market is priced below where the Fed median forecast is. Quite a bit. Two rate hikes really, if you count them in quarter points. Does that concern you that the market needs to catch up with where the Fed is or is it a matter of you think the Fed needs to recalibrate to where the market is?

Fischer: Well, we watch what the market thinks, but we can’t be led by what the market thinks. We’ve got to make our own analysis. We make our own analysis and our analysis says that the market is underestimating where we are going to be. You know, you can’t rule out that there is some probability they are right because there’s uncertainty. But we think that they are too low.

For eight straight years now the Federal Reserve has been more optimistic than the markets. And for eight straight years now the markets have been closer to being correct. And yet the Federal Reserve still believes that it “can’t be led by what the market thinks” and has “got to make our own analysis”? Why?

Narayana Kocherlakota: Three Antidotes to the Brexit Crisis: “The Fed should ensure that banks have enough loss-absorbing equity capital…

…not allow them to return equity to shareholders…. The measure should apply to all banks, so markets won’t read it as a signal about individual institutions’ relative strength. Second, there’s a risk that investors’ flight to safe assets could develop into a broader credit freeze. To mitigate this, the Fed should lower its short-term interest-rate target…. Finally, the Fed should consider reviving the Term Auction Facility, which allows banks to borrow funds from the central bank with less of the stigma…. Granted, there is a risk that such steps will spook markets by signaling that the Fed is concerned about the state of the U.S. financial system. That said, as an outsider who gets much of his information from Twitter, I’d say the markets are already pretty spooked. By demonstrating that it is paying attention to these obvious signals, the Fed can help to bolster confidence in its economic management. One important lesson of the last financial crisis is that the guarantors of stability must be proactive if they want to be effective. It’s time for the Fed to put that lesson into practice.

Must-Read: Duncan Weldon: Five Thoughts on Brexit

Must-Read: Duncan Weldon: Five Thoughts on Brexit:

  1. British politics now has a big dose of Syriza thinking. ‘Respect our democratic mandate’ doesn’t work when you’re dealing with 27 other democratically elected governments.
  2. I have no idea what the final settlement looks like. No one does.
  3. We won’t get any clarity in the next few months. The Tory leadership contest will at best give a small signal, but really it’s noise. The next PM will be selected by a membership of leave supporters and the candidates will pitch to that. All will offer a fantasy that the EU is unlikely to agree to.
  4. British politics is in flux. The next Tory leader faces having to make a tough choice: disappoint the membership and traditional Tory voters or lose the City. The broad coalition of social conservatives and economic liberals that form the party may not be able to survive this choice. Labour faces similar pressures. Handled badly, this go see a UKIP surge – not into power but into a much stronger position in Parliament.
  5. Finally – I think the UK’s actions will ultimately be good for EU unity. Others will be less inclined to follow our example if it is painful (and that’s without the additional problems of leaving Schengen or the euro). It isn’t hard to imagine the Eurozone doubling down now and building the kind of institutions that the zone needs to work.

Must-Read: Ryan Avent: Everything Is Not OK

Must-Read: Ryan Avent: Everything Is Not OK: “Things might or might not be ok in the long run….

…[But] in the short run, there is plenty to worry about…. Yields around the world were already extraordinarily low before the Brexit vote. In the days immediately after they plummeted. While equities have risen, bond yields have not. The yield on the 10-year US Treasury is 30 basis points below where it was on June 23rd. The real yield is close to zero. The 10-year gilt yield is below 1%. The yield on 10-year bonds in Germany, France and the Netherlands are basically zero. Falling yields on safe assets indicate some combination of falling expectations for growth, falling expectations for inflation and a rising risk premium….

The range of possibilities has widened, and the odds of quite a bad outcome have increased. Worryingly, central banks have very little room to respond…. Neither short- nor long-term rates can be pushed much lower. The best hope for effective monetary stimulus is asset purchases designed to weaken a country’s currency. But not everyone can depreciate simultaneously…. Quantitative easing everywhere could help if it boosted expectations for growth and inflation. But at the zero lower bound and with little hope of massive fiscal stimulus, central banks might well struggle to raise animal spirits. In a world of very low inflation and very low interest rates, people only have to cling a little more tightly to their money to tip economies into recession…

Must-Read: Kevin O’Rourke: Markets and States are Complements

Must-Read: Kevin O’Rourke: Markets and States are Complements: “Globalisation produces both winners and losers… can lead to an anti-globalisation backlash… [in the] late 19th… the late 20th… [and] the early 21st century…

…What, if anything, [can] governments… do[?]… Dani Rodrik’s finding that more open states had bigger governments in the late 20th century comes in…. Markets expose workers to risk, and that government expenditure of various sorts can help protect them…. Michael Huberman showed that this correlation between states and markets was present before 1914 as well: countries with more liberal trade policies tended to have more advanced social protections of various sorts, and this helped maintain political support for openness…. If the Tories had really wanted to maintain support for the EU, investment in public services and public housing would have been the way to do it…. It wouldn’t have satisfied the xenophobes, but not all anti-immigrant voters are xenophobes…. If the English want continued Single Market access, they will have to swallow continued labor mobility. There are complementary domestic policies that could help in making that politically feasible. We will have to wait and see what the English decide. But there are also lessons for the 27 remaining EU states…

Must-Read: James Pethokoukis: The Magical Thinking of America’s Pro-Brexit Conservatives

Must-Read: James Pethokoukis: The Magical Thinking of America’s Pro-Brexit Conservatives: “Lawrence Kudlow called Brexit a ‘Thatcher moment’ that could put Britain ‘on the pro-growth path of free-market supply-side policies’…

…The Wall Street Journal … explained… ‘now more than ever Britain will need supply-side economic policies that reassure investors and make Britain a growth model for Europe.’… By detaching from the EU regulatory superstate, an unchained Britain would return to its risk-taking, free-trading roots. London would become a sort of Hong Kong on the Thames, England a Texas on the North Sea. With the Voldemort of Brussels vanquished, free-market magic could be unleashed. Economicus growthus leviosa! Or not.

This is the sort of magical, fantastical thinking all too common in the Republican Party and among American conservatives… why Donald Trump can offer a $10 trillion tax cut plan that would need to quintuple GDP growth to break even–all with scant criticism from many leading voices on the right…. Even if you doubt the potential for long-term damage–permanently slower economic growth, the disintegration of the EU–the short-term post-Brexit picture is pretty ugly…. A 2017 recession as likely. Not to mention that disentangling from the EU might consume British politics and policy for years. And all for what, exactly? The U.K…. ranks ninth for global competitiveness, says the World Economic Forum. And it ranks 10th… on the Index of Economic Freedom…. Britain is already a relatively well-run, free-trading nation…. Never has so much been risked for potentially so little.