July 2014 newsletter – Annual Conference Report 2014

The Society’s Annual Conference took place this year at the University of Manchester from 7th to 9th April. This report was compiled by Ryan Avent of The Economist.

April is a transitional month, and as I rode the train north from London to Manchester I noted the transition from cold and wet to colder and wetter. Inundation had proved good for the British economy, however, which was undergoing its own shift: from a halting and uncertain recovery to rip-roaring growth. GDP expanded at 0.8 per cent in the first quarter of 2014, and one could just about discern the sound of muffled cheering from beneath the layers of rain gear.

Indeed, the world economy as a whole seemed to be shaking off the economic troubles of the last half decade as economists converged on the University of Manchester for the annual conference of the Royal Economic Society. That promised to make the gathering an interesting one. Economists continue to explore how things went so badly wrong in the five years from 2008, while also turning their attention to a new set of questions and challenges. In the weeks leading up to the conference an active and public debate built over questions of rising inequality, the effects of new technologies, and the possibility of prolonged ‘secular stagnation’. I was interested to see what light the economists in Manchester might shed on these and other burning issues.

I did not have to wait long. In the conference’s opening act, the Hahn Lecture, economist Sendhil Mullainathan of Harvard University described the remarkable ways in which technology was beginning to change the practice of economics itself.

The robot theorist
As Mr Mullainathan pointed out, econometric analysis is constrained by the imagination of the researcher. Economists can use theory to guide statistical analysis, choosing particular relationships in the data to test. But this process is not amenable to the discovery of unknown unknowns: meaningful relationships in the data that have not yet been described by theory. Before the development of germ theory, he pointed out, medical scientists were left groping for explanations for why some patients developed infection and died while others did not. Baffled researchers grasped at straws, like the links between patient health and a positive mental outlook. Only when patient data was carefully searched through for correlations did it emerge that doctors who washed hands between patients lost fewer of them. Artificial intelligence techniques and ‘Big Data’ offer a similar opportunity, to find interesting new empirical relationships, which may in turn suggest theoretical constructions economists had not previously considered.

How? Mr Mullainathan described using machine learning through a process of cross-validation. The technique works best when researchers have access to really big data: datasets that are both deep, containing many entries for each variable, and wide, containing many variables. The researcher can then divide the data into many subsamples and set the computer to going through them one by one, divining relationships from one and testing the results on another to eliminate spurious correlations. In this way the machine can learn to detect meaningful patterns in the data.

A researcher can then test how her theories stack up against the machine’s results by comparing an analysis of the data which includes the researcher’s theories against one which does not. If the explanatory power of the analysis is no better with the researcher’s pet theories, the machine may be picking up a more important or fundamental relationship in the data than existing theory had managed to detect: an economic equivalent to handwashing. Mr Mullainathan went on to suggest that the theorization process itself could ultimately be automated, and machines left to build up robust models of the data that best the human competition in terms of predictive power. Of course machine intelligence is only as powerful as the data are deep. Yet as the amount of information collected explodes such techniques will become more useful, giving savvy researchers a means to boost up their analytical strength.

With that to mull over, participants broke for the first round of paper sessions. As always, the conference provided a bonanza of intriguing new research across a dazzling array of subfields, including my personal favourite, economic history. A fascinating paper by Luigi Pascali, of the University of Warwick, used the introduction of a new shipping technology — the steamship — to assess the importance of trade growth to industrialising economies. Steamships had a differential effect on market potential across economies; those favoured by trade winds enjoyed negligible improvements in effective distance from other markets compared to those disfavoured by the winds. That pattern allows Mr Pascali to estimate fairly directly the causal impact of increased trade. He reckons that the steamship deserves significant credit for launching the first great wave of globalisation in the second half of the 19th century, but also that economies with poorer institutions benefitted remarkably little from greater trade.

A political economy
Quite a lot of the research presented focused more heavily on live economic issues, including a British productivity puzzle that has survived the uptick in growth and hiring. A special session sponsored by the Bank of England and the National Institute of Economic and Social Research (NIESR) focused on ways in which financial market disruptions might account for the dramatic shortfall in productivity (of about 15 per cent relative to the pre-crisis trend). Work by NIESR scholars Rebecca Riley, Chiara Rosazza-Bondibene, and Garry Young examined whether banks tightened lending standards during the crisis, disproportionately harming bank-dependent businesses and thereby weakening productivity growth. Lending did dry up, they note, but productivity declines did not appear to be concentrated among the businesses most dependent on bank financing. The puzzle deepens.

Whether obstacles to resource reallocation might play a role was also examined, but results were less conclusive. The first set of authors reckon the crisis impaired the reallocation of resources across firm but did not turn up much evidence that this breakdown was a major factor behind Britain’s disappointing productivity growth. Another piece of research, by Alina Barnett, Ben Broadbent, Adrian Chiu, Jeremy Franklin and Helen Miller reckoned the matter was worth further study. The authors argue that dispersion in output, prices, and returns across sectors has been on the rise, even as capital levels across sectors have not changed very much, making the flow of investment (or lack thereof) look more a potential culprit in the case of the missing productivity growth.

Britain’s productivity conundrum made the perfect example of the desperate need for solid economic analysis in government. That very subject, in turn, was the focus of the Government Economics Service (GES) plenary discussion on the most poignant of topics: had the economics profession managed to contribute to better policy-making since the creation of the GES 50 years before?

Leading off the discussion was Nick Macpherson, Permanent Secretary to the Treasury, who gave economics good marks, all things considered. Over the past half century, he noted, dismal scientists regularly steered policymakers in the right direction: in urging government to rethink macroeconomic policy in the 1970s, in arguing that a fixed exchange rate was not needed as a nominal anchor, in outlining the limitations of price stability in guaranteeing a healthy economy, and in setting out a new agenda for productivity growth. Economists also seem set to play critical roles on looming issues, he reckoned, related to the economic approach to climate change policy and in balancing the pursuit of economic growth with measures of well-being.

Yet Nick Crafts, of Warwick University, warned that economists ought not overstate their own importance. Yes, he noted, economists could claim some credit from a move away from costly industrial subsidies and toward a policy of embracing competition and globalisation. But there are lots of things economists know are good ideas — sensible supply-side reforms — that rarely make it onto the political agenda because they are vote-losers. Maybe, Mr Crafts reckoned, it was time for both economists and politicians to think about new institutional architectures, which duplicate the successful experience of monetary policy in turning over some choices to relatively independent technocrats.

Of course, as Wendy Carlin of University College London (UCL) pointed out, the rather gentle assessment of the policy contributions made by economists glossed over the disaster of 2007-9, when the world economy teetered on the brink of a new Depression thanks to a near financial meltdown. The bitter truth is that economists simply did not understand the financial system before the crisis struck, she mused. Economists must learn from recent failures, to investigate how the ‘financial cycle’ shapes the business cycle, and how the banking system reacts to economic changes and government policy in accumulating massive piles of leverage.

What seems clear, concluded Richard Blundell, of UCL and the Institute for Fiscal Studies, is that government economists and academics need each other. Both bunches benefit from their interaction, as does society as a whole. That is true even though, as Professor Crafts noted, society often enough ignores the best advice of economists. A number of research sessions focused on major questions of national governance — on the possibility of Scottish independence from the United Kingdom and on the benefits of European Union membership — reiterated the ways in which sensible economic judgments may be cast aside amid populist fervour.

A special session on the macroeconomic challenges that would confront an independent Scotland underlined how economically fraught the decision to rupture the Union could be. The currency question might prove most vexing in the short run. Work by Angus Armstrong and Monique Ebell emphasised that while an independent Scotland would have several currency options available to it, each involves a troubling balance between costs and benefits. Remaining within a sterling zone (informally, if the UK government declines to accept a formal currency union) would minimise transaction costs within Britain and the need to build new Scottish financial institutions. But it would also mean sacrificing the possibility of an independent monetary policy and would tie the Scottish government’s hands in the event of financial instability. Scotland would also need to run large budget surpluses to maintain the credibility of its continued used of the pound-especially if, as is likely to occur, Scottish borrowing costs rise above those for the rest of the UK.

An independent Scottish currency would provide more flexibility. But it would require Scotland to build new financial institutions and financial markets, and transaction costs would rise. The new central bank might struggle to build monetary credibility; the more the bank felt the need to pursue hard money to establish that credibility the less monetary freedom it would consequently enjoy. Joining the euro zone, another possibility, would entail fewer transaction costs, but also less monetary and fiscal flexibility. And Scotland would probably not be able to join the currency area immediately upon its independence.

Currency issues aside, Scotland would face significant fiscal challenges, according to work by Gemma Tetlow, and by David Bell. Its fiscal position is worse than that of the rest of the UK, entailing less revenue and more spending per person. Meanwhile, revenues from North Sea oil production are declining. Mr Bell reckoned Scotland could work with the rest of the UK to pursue new constitutional arrangements, involving hybrid fiscal regimes. But Scotland is unlikely to enjoy terms nearly as favourable as those it does now, thanks to the large gap in size, in terms of population and economy, between Scotland and England. A hard-nosed analysis of the independent question suggests Scotland has a tough road ahead of it should it vote to separate. Yet it is far from clear that economics will have a deciding say in the matter.

Another session included fascinating work by Nauro Campos of Brunel University, Fabrizio Coricelli of the Paris School of Economics, and Luigi Moretti, of the University of Padua. The authors used an intriguing technique-synthetic counterfactuals-to assess the benefits of membership in the European Union. For every economy that has acceded to the union, they build a shadow economy consisting of a weighted average of non-EU economies which closely tracked the new member's performance prior to its joining the EU. Then then compare the performance of the new member after joining up with that of the synthetic alternative to gauge how membership affects economic performance.

With the exception of Greece, the benefits are strikingly large. Real GDP per capita in Britain, for example, is estimated to be more than 20 per cent higher as a result of its participation in EU. Yet counterfactuals are as difficult for the public to appreciate as they are to assess empirically; despite this clever analysis anti-EU sentiment remains all too common across the UK electorate.

Hollowing out 
On Tuesday afternoon, participants gathered in the auditorium to hear MIT economist David Autor deliver the Economic Journal Lecture, and to provide grim news on labour markets in grim detail. Mr Autor presented results from his efforts to untangle the effects of automation and offshoring on labour markets. The two processes are often seen as linked, if not practically identical, in their influence on workers, not least since statistically separating their effects can be tricky. The two forces often operate alongside each other and may reinforce each other; new technologies often make offshoring of particular tasks easier. In some cases they are effective substitutes; firms may have the option to either ship costly tasks abroad or turn them over to a machine.

But in fact, trade and technology operate in different ways and on different parts of the economy at different times. Studying these differences yields insights on the nature of recent labour-market dislocations. Mr Autor used measures of susceptibility to automation-his Routine Task Intensity index-and the degree of exposure to foreign imports to analyze trends across American metropolitan areas.

In fact, exposure to trade is much more geographically concentrated than exposure to automation; the effects of the former are felt considerably more keenly in manufacturing and export hubs, which represent a relatively small share of metropolitan areas. While both trade and technology are highly disruptive to labour markets, only trade seems to generate meaningful disemployment effects — including large departures of prime-age workers from the labour force. Automation effects, by contrast, are more apparent in wages and the composition of employment.

The balance of disruption has also changed over time. In manufacturing industries automation had its biggest effect in the 1980s and 1990s; computerization became less disruptive over time while trade-particularly with China, loomed larger. In non-manufacturing industries, however, the menacing hand of automation has grown over time: a striking datapoint given the criticality of non-manufacturing industries in generating recent employment growth.

Amid the forces, economic and political, that are buffeting rich countries it is easy to forget about the truly encouraging transitions elsewhere in the global economy. Wednesday morning’s IGC Plenary yielded a discussion of one of the most surprising: the improving economic prospects of Africa. Among other unexpected (and perhaps unlikely) developments in recent economic news is the rather impressive growth performance of African economies from the 1990s, back to rates last seen during the optimistic 1960s and 1970s. The Africa boom is often dismissed as yet another unsustainable commodity-driven phenomenon, but the panelists in Manchester reckoned there might be more at work.

Paul Collier noted that resource wealth is indeed part of the African story, but he provided an extraordinary statistic. In the OECD, there are roughly $300,000 in known sub-soil resource assets per square mile. In Africa, by contrast, the figure is just $60,000. That is not because Africa is uniquely bereft of mineral wealth-on the contrary, given the enthusiasm with which rich countries have plundered their own land over the past three centuries it seems probable that Africa has considerably more resource wealth per mile. Yet what is there is largely unknown thanks to a poverty of infrastructure, data, and attention. Or rather, Mr Collier, noted, to a lack of capacity. For Africa to succeed now where it has failed in the past, he argued, Africa doesn’t simply need to develop its resource assets but to build the capacity to do it well. It must ‘invest in investing’, developing the institutions and known-how to take advantage of its advantages.

Commodities cannot be Africa’s sole focus, however, and John Sutton examined the prospects for African industry. There, too, the continent’s governments need to focus on building a proper foundation. Africa has manufacturing, Mr Sutton pointed out, but much of it is not particularly productive and not linked into global supply chains and markets. Working up to highly productive, high-wage industry is the right goal for Africa, he argued, but historically a broad industrial base has been a precursor to the development of high-value industry. Africa needs foreign direct investment, and lots of it, to begin building its industrial capabilities. Happily, multi-national corporations are for the first time taking a hard look at the opportunities presented by sub-Saharan Africa.

Plenty of obstacles remain, however. In the modern global economy supply chains are draped across many different countries, each of which adds a relatively small share of the final product's value. That makes cheap and efficient movement of goods in an out of individual economies absolutely critical. In Africa, where infrastructure is often rickety or absent, customs and trade finance a mess, and corruption endemic, participating in global supply chains is difficult. But by the same token, a little investment and reform could make an enormous difference.

A giant pool of money
Looming over so many policy debates, in rich and developing world alike, is the question of whether the financialisation of the global economy has served the purpose economists hoped it would. Among the most incisive critics of financial globalisation has been Hélène Rey, of the London Business School, who delivered Wednesday’s Sargan Lecture on the robustness of the international monetary system in a world of massive capital flows. Ms Rey’s presentation represented a strong challenge to conventional views on the virtues of open financial flows. Among economists, financial integration is widely assumed to deliver meaningful economic benefits, by enabling broader sharing of risk and by directing capital to its most productive uses, wherever in the global economy those may be found.

Yet despite years of work estimating the magnitude of these benefits, empirical agreement is hard to come by. Results vary enormously across countries and time periods. The literature suggests that net gains from opening to financial flows are possible but certainly cannot be taken for granted, reckoned Ms Rey.

To try to get a better sense of whether and how financialisation might yield benefits, Ms Rey has worked to build a general equilibrium model for the integration of a set of emerging economies into the global financial system. She began with a model without risk in order to focus on the benefits of capital reallocation. Openness yields a flow of capital toward emerging economies, where returns are higher. That shift does produce benefits. But, she cautions, they are transitory, and because they are shared between the developed and emerging world they are relatively small-especially when the effect of capital flows on the interest rate in the developed world (they increase it) is taken into account. In the model, welfare gains are surprisingly limited.

Introducing risk does not much change the picture. In a risky world, and in which emerging economies are more volatile, initial inflows reverse in the medium-run as emerging markets buy safe assets for precautionary savings purposes. In effect, Ms Rey notes, the gains available from reallocation of capital to higher yielding investments are a substitute for the gains available from greater risk sharing. What’s more, her model naturally yields growth in global imbalances as a result of precautionary saving in emerging economies.

Against the possibly modest benefits to openness comes a set of costs: in particular, Ms Rey emphasized, an exposure to the global financial cycle. The wave of financial integration that began in the 1990s led to massive growth in economies’ external balance sheets. The global economy became characterized by large capital flows, which were highly correlated with growth in asset prices and leverage and negatively correlated with volatility. At the heart of the system sits America’s Federal Reserve, the monetary master of the world’s reserve currency and manager of the worl’s favored safe assets: American government debt. As a result, Fed policy shifts appear to have sizable effects on measured volatility.

The world therefore finds itself in a tricky position, in which looser American monetary policy can launch a global boom in asset prices and borrowing that smaller economies struggle to manage. And when Fed policy reverses, tightening credit can lead to a sharp retrenchment, and occasional crashes and crises. Economists should recognize these dynamics, Ms Rey argued. A great deal of further research is needed, she said, to investigate whether the benefits of financial openness are substantial enough to offset the potential costs of integration-and whether there are policy steps that can be taken to maximize the benefits of global capital flows while minimizing potential harm.

And a great deal of research there will be. As my train rolled southward toward London and into clearing skies I reflected on how different the mood of the economics profession seems now from that of the past few years. Then a bunker mentality often held sway, as economists fended off populist criticism while struggling to understand and fix the crises battering the world. The world economy has not necessarily grown any cuddlier. But the questions now facing the profession are profound and testing, and economists are stretching themselves to answer them. I would wager that RES conferences will prove plenty lively in years to come.