Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 5 July 2013

How knowledge transmission should work

The tenth anniversary of the UK’s 2003 decision not to join the Eurozone has just passed. With all my complaints about how bad macroeconomic policymaking has been recently, I thought it was worth analysing an example of a good decision. Good not just because it was the right decision given the events of the last few years, but good also because of how it was done, and the way academic knowledge was used.

If you want detail on the background and process itself, I recommend viewing or reading a recent lecture by Dave Ramsden, who was the civil servant who masterminded the process. Here is just a short summary. The UK opted out of being one of the founding members of the Eurozone, but the possibility of us joining shortly afterwards was always taken seriously. The Chancellor Gordon Brown announced 5 tests that would need to be passed if this were to happen, and the Treasury spent a couple of years doing extensive work on these five tests. It eventually published 18 studies, which I recommend to any students who want to take a serious interest in Optimal Currency Area (OCA) theory. Although there is some original work there (of which more later), they were mainly very good summaries of the relevant academic literature, and various academics were consulted to help ensure this was the case.

I should declare an interest here. I wrote one of those studies, which tried to assess what exchange rate the UK should join at, if the decision was yes. However I do not think this has any influence on what I have to say below, because in an important sense my study was secondary to the question of whether we should join. [1] In contrast, much more critical was modelling work done by Peter Westaway, at the time a Bank of England economist who had previously built the Bank’s core macromodel.

Now some will argue that these 18 studies, and the years of work that went into them, were window dressing for a decision that had already been made. I think that is simply incorrect. Some of the reasons I think that are described by Dave Ramsden: if the politicians involved had already made up their mind, they went to quite elaborate lengths to conceal the fact from those that worked for them. (Compare this to the Iraq war, for example, where a dodgy dossier sufficed.) Furthermore, the studies themselves contain some very strong arguments (probably too strong) why joining the Eurozone could be very beneficial, which is not the kind of thing you do if you want the analysis to back up a foregone conclusion.

As a result, I think the exercise was what it purported to be: an attempt by civil servants to give the best advice they could to politicians. What marks it out for me was the extent to which those civil servants involved academics, and placed academic work at the centre of their analysis. The merits or otherwise of the Euro did divide macroeconomists, but there was no attempt to just consult those who agreed with some predefined view. (See, for example, the space given to Andrew Rose’s empirical work of the benefits of OCAs.)

So why was this process close to what I consider an ideal of how academic knowledge should be used, when I have just written a post which is far more pessimistic about how these things are generally done? I should think about this some more, but here are three ideas. The first is that the decision, although it generated strong opinions on either side, was not fundamentally ideological. There was no existing political apparatus that was clearly aligned with potential winners and losers. The second is that you had a Chancellor who had a very strong respect for economic ideas, whatever else you may think of him as a politician. Third, the Chancellor had to convince the Prime Minister Tony Blair, and so whatever decision he came to needed to be backed up as strongly as possible.

Most people would now agree that the 2003 decision (only one the five tests were passed) was the correct one. [2] While the analysis, and particularly the work by Westaway, contained some of the elements that came to the fore in the Eurozone crisis, I think Ramsden in his 10 year retrospective is clear that the 18 studies also failed to foresee other elements of the crisis, perhaps not surprisingly as most macroeconomists missed these too. Yet the deeper point is this. The decision was based on the best analysis that macroeconomics at the time could provide. It is a shame that this way of making economic decisions now looks like the exception rather than the rule.  

[1] If anyone ever asks whether I can keep a secret, I always give this as evidence that I can. The original work I did for the study was done and written up in 2002. At the time the Euro/Sterling rate was at or near 1.6 E/£, and my analysis suggested something closer to £1.4 E/£ was sustainable. So for nearly a year I sat on information that was extremely market sensitive, and I received plenty of phone calls trying to extract any hint at what my analysis would be, and I’m glad to say no one got anything out of those calls. Alas I also felt it would be improper for me to bet on my own analysis, which had been funded by the Treasury - perhaps that just makes me an honest fool. (The morning my study was published - by which time the rate had fallen to much nearer my numbers, naturally - it did move the market by about one percent, but that is another story.)

[2] Will Hutton disagrees. In his counterfactual where we joined, the UK not only does better before the crisis because sterling stays at a competitive rate, but also the UK’s benign influence provides a counterweight to Germany. This alternative history deserves a proper analysis which I do not have space for here, but my initial take is that it involves a lot of wishful thinking. 


  1. I know that Krugman wrote in 1998 what would happen when a 'normal' recession hit the Eurozone, with the northern countries chiding the profligate and lazy southerners.

    That the debate needed to be had shows how far down the pecking order sticky prices and wages had fallen since the 1980s, let alone the concept of banking union.

    I would also say that English Tabloidia was very much against joining the Euro, and while Blair was in favour, he was nothing if not a man of the gutter press.

  2. Living in Europe now, as I did at the time, I perhaps have a different perspective. At the time I thought that joining would have been a good thing, but that those in Britain with influence or power to choose consistently overvalued the Pound. With Sterling not having exceeded €1.30 in the last five years, and mostly falling below €1.20, perhaps even your €1.40 figure fell into this "island that used to run an Empire and won the War" trap.

    I agree with Will Hutton though, with the UK impeding both France and Germany when they were the first countries to ask to break the 3% spending limit, the southerners may not have copied such profligacy and results may have been much different. Certainly the UK would not have been allowed to increase spending so much in the later Blair/Brown years.

    Politics being politics though, we'd have probably given in to the two main protagonists in exchange for a higher budget rebate. That in itself could have been a benefit for us.

    As you say, all this is wishful thinking; I just know that if you change the variables in an equation, or add a new component in, the results are always different.

  3. The present day UK shows very clearly that it would not have provided any counterweight top Germany on the most important issue in the EU at the moment: austerity.

  4. The studies you mentioned are still available through the UK's webarchive. EMU Studies

    1. Thanks - I thought they must be somewhere. I've change the text to contain the link and deleted my complaint.

  5. I think the UK joining the Euro would have accelerated a significant amount of EU integration. I would say that most of the slowing down of the EU level began with the rebate, which was then mimicked. If even the UK was in, it would have been hard for others to say no, and there might be a less distinct separation between Eurozone and European union. Its pointless to speculate at this point, but I don't know how I feel about this "we were right" mantra spreading in the UK. Also, Economists should focus on flexbility, trade and symmetry. Focusing on things like jobs just seems similar to the free trade protectionism.

  6. Didn't Douglas Hurd, not a man noted for rash statements, predict the other day that Britain would likely apply to join in the next ten years? There's nothing wrong with the Euro concept which can benefit both the stronger and weaker members. The problem arises when membership is abused and this is why some of these southern peripherals have got into trouble. No other reason. Once you've joined you can't leave but despite this people are still lining up for membership. Slovenia and Poland are the latest and I've little doubt only one or two EU members will still be outside the zone in ten years time. As to whether it was a good or bad decision for Britain this is really impossible to say. I'm not arguing against method but really so much action takes place in the political sphere that is not amenable to method. Had we been members would the PSBR got so completely out of control in the later Blair/Brown years. Hard to say.

  7. There is a tremendous tendancy to look only at the last few years when examining the Euro decision. It's obviously bad to be in the Euro right now if you're a net debtor, without a strong history of export - but if you're a creditor with successful export history then not so much. It's always amused, as well as disappointed, me to see how both popular press and academic commentators (including Krugman who in other respects can do no wrong as far as I'm concerned) assume Britain would be in the Greece-Portugal camp rather than the Germany-Netherlands camp. Unfortunately, they are probably right!

    But on the historical perspective, if you look at 1999 to 2008 then on inflation, growth and even employment the argument is by no means obvious. Even since, while UK has had much better performance on unemployment (for reasons that are still a bit obscure but may be worrying in the long term) growth and inflation are not so very much better.

    So taking it all together, even the ex-post arguments do not seem to me to be as cut and dried as generally assumed. And while I absolutely accept that the process Simon partipated in was conducted honestly from his perspective, I can't forget that it was widely believed ex-ante that the five tests had been designed by Gordon Brown and the Treasury to ensure that Britain would not enter the euro.

  8. I think that the best argument against joining is never mentioned - the ECB itself. An international currency cannot be run by a central bank; to work, it would have to be a true fiat currency with an inflation target of zero. It should be controlled by a central issuing authority which would tell each country how much new currency they were allowed to issue in response to economic growth in their area, with tight controls against manipulation by the finance sector.

    Of course, Britain and Germany would never agree to that.

  9. Problem with the present EZ policies vis-a-vis advice of economists on that is that the latter simply misses the first step (or the preliminary step if you want). It starts assuming a first step has already been taken in a certain way.

    If the 'macros' had started with inventory of unbalances in all countries (including which ones affect other members) and the legal and political set up of the EZ they would have had a much better case. One that might even have been followed.
    Alternative policies suggested were however simply not on the table as an alternative. About equal with Miss World solving problems with 'worldpeace'. Would be great but is not going to happen only make you look silly. The latter will not be the case here, but s policy suggestion it is nearly as useless.

    Staying out of the Euro was something that was sellable politically at that time. Massive stimulus paid by the North for the South (directly or indirectly via say ECB) simply is not sellable in the North. Similar to say if now the UK would want to join the Euro (even when conditions would be met) simply political suicide for the one taken that decision. No use coming up with research on that. Interesting for an academic in real life totally irrelevant. No UK politician would do it at the moment.

    Next to Brown working with some system (not very usual in today's politics), the situation was completely different in that respect. Probably the macro-crowd partly had a lucky shot on that. In the way that the political situation was pretty irrelevant for the decisionmaking on Euro-joining.
    Politics could decide that on Euro-joining without too much fuss. (Either because public will accept that without changing votes or pro vs cons is a draw or the decisionmaker's side is pro).
    Compare that again with the situation that now all criteria would be met. Would most likely not lead to a joining. And the advice would have been irrelevant. The political background has become relevant.

    From Merkel's perspective it has been the right decision. She doesnot want the zone to break up. Even worse she doesnot want a country to leave as she doesnot oversee the consequences thereof. Plus a Southern stimulus would not have solved the main problem for the North: unsustainable structural CA deficits in the South.
    Stimulus would not have solved that. Stimulus even putting the unpalatable transfer issue aside would bring the situation back to say 2007. In which all PIIGS had seen with hindsight had an unacceptable increase in debt (next to unsustainable CA deficits). A situation which will not work anymore. Overborrowing is no longer a policy option.

    1. Greece or Cyprus leaving the EZ doesn't mean it's breaking up, in fact it would probably have the effect of strengthening it. The Germans clearly didn't give a damn if Cyprus left, they'd probably try a bit harder to keep Greece in but a Grexit is certainly not terminal.

    2. You might be right, however miss one point that could be a real party killer.
      If exit was easy, I mean legally easy, I would agree with you. Basically any of the PIIGS CS FB leaving the EZ would make it a more 'logical' club and strengthen it.
      There might however be a contagion effect to other weak states. Difficult to judge how big this will be, could likely depend on market sentiment of the moment it actually happens.
      Another issue is very likely that any exit will mean an OSI (debt owned by other governments and official institutions will have to be written off). Debtlevel should be lowered anyway plus you have a devaluation effect (by moving to another currency). This means that the losses on those loans will for a large part for the first time will start to run over national budgets. Now nearly everything is done via Off BS guarantees. Meaning subsequently that national deficits will be higher. And subsequently thereon that cuts have to be made in national budgets for spending in the home countries. This will be extremely unpopular and could derail the whole thing.
      Overall an exit imho as well would make the zone stronger.

      Now the legal stuff. Which will likely spoil things in my idea. Start with some important points that economist usually donot pay any attention to.
      -Euro exit cannot happen seperately from EU exit.
      -There is one procedure for that art 50.
      -To do it otherwise you need basically all 27 to agree (as the stuff is dealt with in the 'overall' treaty, basically you need a treaty change for that.

      EU exit is technically extremely difficult as it involves 1000s pieces of legislation. It would also kill off the economy of the leaving country as importduties would be due for exports to the smaller EU and a lot of other formalities have to be met.
      Quick exit to limit move to a local currency would be required, but this makes a proper EU exit with keeping tradelinks in tact simply impossible.

      Treatychange is highly complicated and costs a lot of time (biting again a quick transition to a new currency).

      Practically way around it could be all 28 agreeing with some procedure that solves these problems. However that is unlikely to happen. One of the 28, now, could spoil that possibility.
      Anyway a lot of countries will make demands for cooperation.
      But say the UK will likely demand ( the full reneg dealt with). Otherwise the Conservative backbenchers will likely force their government to do so.
      Spain will likley be a problem as the way a exit followed by an direct rejoining will mean that Catalunya could join directly. A thing that Spain wants to make as difficult as possible. Anyway first after approval the show can start to run.

      Highly complicated situation with probably 30 or more parties at the table and hard to see that going smoothly.

      The problems (except the write off as mentioned above) are mainly for the exit country. Hard to see many Finns having sleepless night because Cypriotc goods from now on trigger 10% importduties.

  10. Part 2
    For the UK the situation is a bit different. But still questions remain unanswered (from both sides btw, but this is about stimulus).
    Why stimulus in China and Japan is not really working and has brought the countries in danger? What would be a max debtlevel that is sustainable? Not only in the present low interest climate but also in the 'exit-phase', with higher interests and less flight to safety.
    Combined with proper suggestions how the stimulus could be done and later be undone again. Not like Ba partly dressing up the new social policies pig as stimulus lipstick (but very difficult to reverse). Read: stimulus now means not only higher taxes for paying off things but also structural higher taxes on top of that as stimulus policies cannot be reversed. This kind of questions should be answered as well as simply giving the basic policy suggestion. And the questions have to be answered by the macros as nobody else is doing that (or able to).

    Summarized from another angle the Euro-joining stuff was a proper product with which politicians at that time could do something. Present stimulus advice is simply not. As a consequence there is no proper political discussion on this. Have you seen anything on the priority setting which unbalances should be tackled first. In the EZ leading to eg a 'one size fits all' policy. With eg as you mentioned before moronic policies in order to meet conditions that are in the present situation not relevant for a specific country or bring any other country in danger (as earlier Southern policies had done). Another one even worse is that if you go for the CA unbalance first as the EZ effectively does (logically seen the set up of the beast) it is beyond moronic to wait with reforms (read also cutting government expenditure), that has to be taken anyway. The longer it takes to get to the bottom (= the start of new growth) the higher the debtlevel will be at that new start. And very likely the worse the businesssentiment and the country's reputation on the market will be.

  11. Simon - many thanks for an interesting post. My question is: were 18 studies really required in this process? Would appreciate your thoughts.

    1. Adrian. Yes, I think so. The problem with OCA theory is that it involves a lot of elements, and I think it was not obvious before the work was done which elements would turn out to be critical. To take an obvious example, my study was clearly unnecessary to make the decision, but would have been very important if the answer had been yes. More generally, although its easy to say that a currency union is OK as long as shocks are symmetric across countries and these countries have similar structures, working out the extent to which either is true (as they clearly are not exactly true) is not easy.

  12. 1. The 5 tests are probably also a good guidline for other countries. And probably even more important a good guideline to see if the present members fit in the present monetary union.
    It is not completely the same joining or an exit have also their own dynamic.

    2. On the papers and their communicationstyle.

    Like the 4.6.3 stuff. I did some research 2-3 decades befor it simply works much better than just plain text and long chapters. Easier to get back and pick something up.

    Rather difficult language but looks fully appropriate for the people for whom the thing is written.

    Build up. Good it is tried to integrate them. Bad not very successfully. 5 questions (plus summary answers) should be much more highlighted (a proper summing up in a logical place and clearly numbering them) now you really have to look for them in the text. Which eg also makes the summary a bit confusing. Title doesnot agree with the set up of the summary.
    As such this kind of summary is much better as communication tool than the 'standard' summary in economic papers. The latter simply sucks from a communication pov as the important stuff is usually not or not properly described in that summary.
    People have limited time they start with scanning the stuff. If the message donot get through here (as eg summary and title donot fit properly together) they put it on the to read (but most will never be read) pile.
    5 questions as such is as said imho a great way to communicate but they should be easier to find.

  13. As David Sweet suggests, wasn't Brown always fairly firmly opposed to entry? That's not to say that he didn't, as you say, have a healthy respect for economics. But wasn't his economic mind already made up? If not Brown then surely Ed Balls, who had written an excellent Fabian pamphlet against the single currency back in 1992.

    The Guardian had an interesting short piece about "the 5 men most responsible for keeping Britain out":

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