Complexity, modesty and economic policy

NAECLex Hoogduin, University of Groningen and GloComNet

Societies and economies are complex systems, but the theories used to inform economic policies predominantly neglect complexity. They assume for example representative agents such as a typical consumers, and they also assume that the future is risky rather than uncertain. This assumption allows for the application of the probability calculus and a whole series of other techniques based on it.

In risk situations, all potential outcomes of a policy can be known. This is not the case in situations of uncertainty, but human beings, policy makers included, cannot escape having to take their decisions and having to act facing an uncertain future. The argument is one of logic. Human beings cannot know now what will be discovered in the future. Future discoveries may however impact and shape the consequences of their current decisions and actions. Therefore, they are unable to come up with an exhaustive list of potential outcomes of a policy decision or action.

Properly taking into account the complexity of the economy and the uncertainty of the future implies a paradigm shift in economics. That paradigm does not need to be developed from scratch. It builds on modern complexity science, neo-Austrian economics (in particular Hayek and von Mises), as well as the work of Keynes and Knight and certain strands of cognitive psychology (for example, Kahneman 2011). There is no room here to elaborate on the theory and the claim that it entails a paradigm shift. Rather, I will discuss the implications for economic policy that follow from this paradigm.

This starts with the recognition that the future cannot be predicted in detail. We should be modest about what can be achieved with economic policy. This is the “modesty principle”. Economic policy cannot deliver specific targets for economic growth, income distribution, inflation, the increase of the average temperature in four decades from now, etc. Economic policy makers would be wise to stop pretending that they can deliver what they cannot. This insight implies that many current policies should be discontinued. To mention just one example: inflation targeting by central banks does not pass the modesty test.

This principle also implies refraining from detailed economic forecasts as a basis for policy making and execution. Policies should not be made on the assumption that we know the value of certain variables which we cannot know. An example here is the income multiplier in relation to changes in fiscal policy. The modesty principle also flashes red for risk-based regulation and supervision.

What economic policy can do is contribute to the formation and evolution of a fit economic order, and avoid doing harm to such an order, what I would call the “do no harm principle”, and be as little as possible a source of uncertainty for private economic agents.

Order is a central concept in the alternative paradigm, replacing the (dis)equilibrium concept in mainstream economics. An order is the set of possible general outcomes (patterns, like growth, inflation, cyclicality, etc.) emerging from purposefully acting and interacting individuals on the basis of a set of rules in a wide sense (laws, ethics, conventions…), together called a regime. Economics can analyse the connection between changes in regime and changes in economic order. Economic policy can influence the economic order through changing the regime.

However, this knowledge is not certain. There is always the potential for surprises (positive and negative; opportunities and threats) and unintended consequences. Policy can therefore not be designed first and then just be executed as designed. Policy making and execution have to evolve in a process of constant monitoring and adaptation. This would also allow for evolutionary change. An economic order that is not allowed to evolve may lose its fitness and may suddenly collapse or enter a crisis (as described by Scheffer for critical transitions in society). This mechanism may have played a role in the Great Moderation leading up to the financial crisis of 2007/2008 and in the crisis of fully funded pension systems. It is also a warning against basing sustainability policies on precise temperature targets decades in the unknowable future.

Fitness of an order has five dimensions. The first is an order in which agents are acting as described in the previous paragraph – policymaking involves a process of constant monitoring and adaptation. In addition to that, fitness is determined by alertness of agents (the ability to detect mistakes and opportunities); their resilience (the ability to survive and recover from mistakes and negative surprises); adaptive capacity (the ability to adjust); and creative capacity (the ability to imagine and shape the future). Policies may be directed at facilitating economic agents to improve these capacities, although constrained by the “modesty” and “do no harm” principles. Note that the concept of stability does not appear in the definition of fitness. This marks a difference with current policies which put much emphasis on stability.

In its own actions the government should be transparent and predictable. The best way to do that seems to be to follow simple rules. For example in fiscal policy, balance the budget, perhaps with clearly-defined, limited room for automatic stabilisers to work.

This alternative paradigm places highlights some methods and analytical techniques, including narrative techniques), network analysis), evolutionary logic), qualitative scenario thinking, non-linear dynamics (Scheffer), historical analysis (development of complex systems is path dependent) and (reverse) stress testing.

Economic policies developed along these lines help people to live their lives as they wish. They are good policies for good lives.

Useful links

The OECD is organising a Workshop on Complexity and Policy, 29-30 September, OECD HQ, Paris, along with the European Commission and INET. Watch the webcast: 29/09 morning29/09 afternoon30/09 morning

Complexity and Economic Policy

NAECAlan Kirman, École des hautes études en sciences sociales Paris, and Aix Marseille University

Over the last two centuries there has been a growing acceptance of social and political liberalism as the desirable basis for societal organisation. Economic theory has tried to accommodate itself to that position and has developed increasingly sophisticated models to justify the contention that individuals left to their own devices will self organise into a socially desirable state.  However, in so doing, it has led us to a view of the economic system that is at odds with what has been happening in many other disciplines.

Although in fields such as statistical physics, ecology and social psychology it is now widely accepted that systems of interacting individuals will not have the sort of behaviour that corresponds to that of one average or typical  particle or individual, this has not had much effect on economics. Whilst those disciplines moved on to study the emergence of non-linear dynamics as a result of the complex interaction between individuals, economists relentlessly insisted on basing their analysis on that of rational optimising individuals behaving as if they were acting in isolation. Indeed, this is the basic paradigm on which modern economic theory and our standard economic models are based.. It dates from Adam Smith’s (1776) notion of the Invisible Hand which suggested that  when individuals are left, insofar as possible. to their own devices, the economy will self organise into a state which has satisfactory welfare properties.

Yet this paradigm is neither validated by empirical evidence nor does it have sound theoretical foundations. It has become an assumption. It has been the cornerstone of economic theory although the persistent arrival of major economic crises would seem to suggest that there are real problems with the analysis. Experience suggests that amnesia is prevalent among economists and that, while each crisis provokes demands for new approaches to economics, (witness the birth of George Soros’ Institute for New Economic Thinking), in the end inertia prevails and economics returns to the path that it was already following.

There has been a remarkable tendency to use a period of relative calm to declare victory over the enemy. Recall the declaration of Robert Lucas, Nobel Prize winner and President of the American Economic Association in his Presidential Address in 2003 in which he said: “The central problem of depression-prevention has been solved.”

Both economists and policy makers had been lulled into a sense of false security during this brief period of calm.

Then came 2008 and, as always in times of crisis, voices were raised, mainly by commentators and policy makers enquiring as to why economists had anticipated neither the onset nor the severity of the crisis.

When Her Majesty the Queen asked economists at the London School of Economics what had gone wrong, she received the following reply: “So in summary your majesty, the failure to foresee the timing, extent and severity of the crisis … was principally the failure of the collective imagination of many bright people to understand the risks to the systems as a whole.”

As soon as one considers the economy as a complex adaptive system in which the aggregate behaviour emerges from the interaction between its components, no simple relation between the individual participant and the aggregate can be established. Because of all the interactions and the complicated feedbacks between the actions of the individuals and the behaviour of the system there will inevitably be “unforeseen consequences” of the actions taken by individuals, firms and governments. Not only the individuals themselves but the network that links them changes over time. The evolution of such systems is intrinsically difficult to predict, and for policymakers this means that assertions such as “this measure will cause that outcome” have to be replaced with “a number of outcomes are possible and our best estimates of the probabilities of those outcomes at the current point are…”.

Consider the case of the possible impact of  Brexit on the British economy and the global economy. Revised forecasts of the growth of these economies are now being issued, but when so much depends on the conditions under which the exit is achieved, is it reasonable to make such deterministic forecasts? Given the complexity and interlocking nature of the economies, the political factors that will influence the nature of the separation and the perception and anticipation of the participants (from individuals to governments) of the consequences, how much confidence can we put in point estimates of growth over the next few years?

While some might take the complex systems approach as an admission of our incapacity to control or even influence economic outcomes, this need not be the case. Hayek once argued that there are no economic “laws” just “patterns”. The development of “big data” and the techniques for its analysis may provide us with the tools to recognise such patterns and to react to them. But these patterns arise from the interaction of individuals who are in many ways simpler than homo economicus, and it is the interaction between these relatively simple individuals who react to what is going on, rather than optimise in isolation that produces the major upheavals that characterise our systems.

Finally, in trying to stabilise such systems it is an error to focus on one variable either to control the system or to inform us about its evolution. Single variables such as the interest rate do not permit sufficient flexibility for policy actions and single performance measures such as the unemployment rate or GDP convey too little information about the state of the economy.

Useful links

OECD-EC-INET Oxford Workshop on Complexity and Policy, 29-30 September, OECD HQ, Paris: Click here to register

New Approaches to Economic Challenges – Complexity of the Economy (October 2015 OECD Workshop)

Economic outlook, analysis and forecasts at the OECD

Environmental Policies and Economic Performance

NAECShardul Agrawala, OECD Environment Directorate and Tomasz Koźluk, OECD Economics Department

A dirty, rundown environment has quantifiable costs for the economy and the well-being of societies. For example, the welfare costs of air pollution from road transport alone are estimated to amount to around 1.7 trillion USD in OECD countries, 1.4 trillion USD in China and 0.5 trillion in India. Without adequate policy action, costs will continue to increase, and can have tangible effects on economic growth, for instance via reduced labour productivity. Similarly, the prospects for long-term growth are under stress – for example, climate change is projected to decrease global GDP by 1 to 3.3 % by 2060.

These are of course, but a microcosm of all the environmental challenges we face. Yet, action to address environmental pressures often proceeds too slowly. Policymakers have long feared that stringent environmental policies may constrain competitiveness and growth. For example, a number of studies attributed a significant part of the 1970s productivity slowdown in the United States to the tightening of environmental policies. Such fears also underlie the so-called Pollution Haven Hypothesis, which sees a flight of industrial activity and pollution leakage to countries with laxer environmental standards. Moreover, arguments against tightening of environmental policies have re-emerged in the context of an increasingly globalised world with fragmented production and mobile capital.

At the same time, there are solid indications that the future is not necessarily a race to the bottom and that environmental protection and growth are not an “either-or” dilemma. A counter argument is that more stringent environmental policies will encourage changes in behaviour by firms and households, reduce inefficiencies, and encourage the development and adoption of new technologies that may be good for the environment, and for the economy as well. After all, growth did not collapse following the implementation of numerous environmental policies over the years. Moreover, when scrutinised, the claims of negative effects of environmental policies have found little backup in the data.

Empirical evidence from the OECD clarifies this. Based on analysis of two decades of data on the stringency of a subset of environmental policies and economic outcomes in 24 OECD countries, it shows that productivity has generally not been negatively affected by the introduction of more stringent environmental policies. Yes, there have been some temporary adjustments, but these tend to disappear within a couple of years.

To be clear, there will be winners and losers  The most productive and technologically advanced firms (and industries) tend to actually gain from tighter environmental policies, an outcome likely reflecting their superior ability to grasp the new opportunities by innovating and improving their products, but also potentially by relocating part of their production abroad. In contrast, the least productive firms – which generally use their resources less efficiently – may see a temporary fall in their productivity growth, possibly as they require more investments to cope with the more stringent environmental requirements. Some of the least productive firms may cease to operate. Still, if resources are swiftly reallocated to young and expanding firms, the overall impacts will not necessarily be negative and can be positive, both for the economy and the environment, particularly if policies are in place to enable entry and exit of firms into and out of markets and to support employment.

Follow-up work on international trade and environmental policies adds another perspective to this picture. Taking a global value chain perspective on the Pollution Haven Hypothesis, OECD work finds some confirmation of the hypothesis itself. However, there is no overall loss of competitiveness of economies attributable to environmental policies. More stringent environmental policies do have significant effects on comparative advantages – countries with more stringent policies tend to lose competitive edge in more pollution-intensive activities. However, this loss is compensated by a gain in less pollution-intensive activities – hence an overall shift in specialisation patterns. Still, while significant, the effects are very small, for instance with respect to those of trade liberalisation. They are in line with other recent evidence on competitiveness effects and on the potential of affecting countries’ specialisation in so-called environmental products – a rapidly expanding global market. Increased trade in such products can spur global improvements in environmental quality. In fact, when combined with stringent, well-designed environmental policies, open trade can form a vital channel for reducing pollution and spurring growth both globally and domestically.

Economic dynamism and flexibility are crucial to ensure such positive outcomes, and the design of environmental policies can do a lot to contribute. The keywords are flexibility and competition: market-based instruments, such as green taxes, that leave the choice to the firm as to which clean technology to use, tend to have more robust positive effects on productivity. On the contrary, while rules to spur markets are important, policies that lead to excessive and unnecessary “green tape” or provide advantages to incumbents, such as laxer norms or subsidies that prop up dirty and inefficient firms, can prevent both environmental and economic progress. One of the crucial findings of recent work is that in general there is no correlation between the stringency of environmental policies in OECD countries and the regulatory burdens they impose. In other words, more stringent environmental policies can be designed while limiting the burdens such policies may impose.

Finally, countries can also do much more to align policies across many different areas, such as taxation, investment, land-use or sectoral policies, to be more consistent with environmental goals . Obviously, this is not easy, and more work linking the environment, environmental policies and economic outcomes is on the way.

Useful links

Pollution havens: Just a delusion? Christina Timiliotis, and Tomasz Kozluk, OECD Economics Department, on the OECD Ecoscope blog

Environment and trade: Do stricter environmental policies hurt export competitiveness? (Data, articles, interactive presentations)

Koźluk, T. and C. Timiliotis (2016), “Do Environmental Policies Affect Global Value Chains? A New Perspective on the Pollution Haven Hypothesis”, OECD Economics Department Working Paper N°1282

Sauvage, J. (2014), “The stringency of environmental regulations and trade in environmental goods”, OECD Trade and Environment Working Papers 2014/3

Resilience of Economies to Exogenous Shocks

NAECAida Caldera Sanchez and Giuseppe Nicoletti, OECD Economics Department

Countries are subject to economic shocks originating from long-term trends such as demography and short-term events such as financial crises, but healthy economies should be resilient to both. It is important to understand the factors that shape a country’s economic resilience, defined broadly as a country ability to contain long and short-term vulnerabilities as well as its capacity to resist and recover quickly when shocks occur. Ideally, whatever the shock, policies should be such that they help the economy remain close to its welfare potential in a sustainable way, notably in terms of jobs, incomes and quality of life.

Sources of short-term vulnerabilities include financial crises, sovereign debt crises, commodity price fluctuations or volatility. Longer term issues include ageing, declining dynamism, rising inequalities and environmental degradation. Resilience to short-term shocks also has implications for long-term sustainability because large shocks can lead to significant upheaval (as witnessed by the recent financial crisis), increasing risk and uncertainty for households, investors and governments and have negative effects on the potential for increasing welfare that cannot be easily reversed.

Countries can strengthen the resilience of their economies to shocks through better detection and analysis of structural trends, for instance with an increased focus on long-term scenarios, as well as a better monitoring of macroeconomic and financial vulnerabilities; and by strengthening policy settings to address long-term challenges and mitigate the vulnerabilities that can lead to costly shocks, as well as strengthening policy settings that can help to mitigate the shock impact and speed the recovery.

The OECD identifies five types of short-term vulnerabilities that are most often linked to severe financial crises, deep downturns in economic activity or both:

  1. Financial sector imbalances, e.g. excessive leverage, maturity and currency mismatches, high interconnectedness of banks and their common exposures.
  2. Non-financial sector imbalances, such as imbalances in the balance sheets of households and non-financial corporations.
  3. Asset market imbalances, most notably equity and real estate busts.
  4. Public sector imbalances, in particular doubts about the sustainability of public finances that can lead to high risk premiums on government debt.
  5. External sector imbalances, such as persisting current account deficits.

Monitoring these country-specific vulnerabilities can be useful in warning of severe recessions and crises and should be an essential part of a country strategy to strengthen resilience. To assist countries, the OECD systematically reports vulnerability indicators in both the Economic Outlook and country Economic Surveys. Vulnerability indicators should be and are complemented with other monitoring tools and in-depth assessments that provide a holistic view of country risks, as even countries without significant domestic or external imbalances can be affected by external shocks through spillovers and contagion via trade, financial and confidence channels.

From a longer-term perspective, the OECD has pointed at three major factors that could continue to generate difficult challenges for the global economy:

  1. A slowdown in global growth, mainly related to ageing and deceleration in emerging economies, but also due to uncertainties concerning the rate of innovation and skill development.
  2. A tendency for inequalities to continue to rise, partly due to the nature of technical progress that raises the demand for the highly-skilled.
  3. Rising economic damages from environmental degradation due among others to climate change.

To raise awareness about these long-term challenges, the OECD has developed long-term scenarios and has increasingly focused on forward-looking analysis in various areas, including productivity, income and wealth inequality and the environment, for example in The Future of Productivity and The Economic Consequences of Climate Change.

Policies should be geared towards mitigating the build-up of vulnerabilities and prepare the economy to deal with structural challenges, combining both structural and macroeconomic dimensions and including international coordination in some areas.

For instance, preventing or soothing the effects of financial crises requires macro-prudential regulation to limit banking sector instability and excessive pro-cyclicality; tax policies that avoid special treatment of housing or corporate debt, to help reduce the risk of asset price bubbles; and monetary and fiscal policies that mitigate the impact of shocks. Structural policies can facilitate worker mobility (e.g. active labour market policies and flexible housing markets) and the turnover of firms (e.g. lifting barriers to entry and competition) thereby improving resilience by accelerating the reallocation of resources across firms and sectors in response to shocks.

Similarly, addressing longer-term challenges requires structural policies – such as those affecting innovation, market experimentation, labour force participation and skill formation – that inject dynamism in markets and make the most of the knowledge economy to sustain both productivity and employment growth in the context of ageing. Policies should also target redistributive mechanisms and education systems to improve equality of opportunities and contain the tendency for inequality to rise. Finally, early action is needed via a policy mix of carbon pricing, reduction of fossil fuel subsidies and other targeted measures to avoid environmental damage that affects future growth potential and welfare.

More international co-operation will also be needed to support global supply chains and trade, to boost the provision of global public goods that are increasingly important – such as basic research, intellectual property rights legislation, competition policy and the climate – and to tax bases that are increasingly mobile across borders, thereby limiting tax avoidance. Cooperation in these areas will help address long-term challenges with positive repercussions on innovation, growth and welfare.

Identifying policy tools to enhance overall resilience is complicated by the existence of trade-offs among policy objectives and interactions in both macroeconomic and structural policy settings. In times of crisis, macroeconomic policies that aim at reducing the severity of the downturn and stimulate the recovery may have unintended consequences by increasing vulnerabilities down the road, for instance by increasing public debt ratios or building-up central banks’ balance sheets and generating ample liquidity. Structural policies aimed at sustaining dynamism and knowledge-based growth could at the same time tend to increase earning gaps and favour continued structural adjustment. The consequences for inequality and workers’ well-being will have to be addressed including via fiscal measures, which however will be increasingly constrained by the need to manage public debts.

Useful links

OECD work on economic resilience

Structural Policies and Distributional Consequences

NAECChristian Kastrop, Director of the Policy Studies Branch, Economics Department, OECD

In a majority of OECD countries, growth over the past three decades has been associated with growing disparities in household income. This suggests that some of the forces driving GDP have also fuelled inequalities. As a result, gains in household disposable incomes generally have not matched those in GDP per capita and the gap has been particularly large among poorer households and the lower-middle class. An important policy question is whether some of the policy changes driving GDP may in addition play a “hidden” role on inequality. New empirical evidence produced by the OECD on the effects of structural policies on households’ incomes across the distribution scale has identified potential policy trade-offs and complementarities between efficiency and equity.

Labour market policy reforms

Labour market policy reforms are often designed to boost aggregate employment through behavioural effects such as labour supply incentives, and via this channel, GDP per capita. At the same time, these policies also affect income inequality through their impact on the earnings distribution. For some reforms, these two impacts on measures of inequality may be offsetting each other. For example, reducing unemployment benefits and lowering the statutory minimum wage relative to median wages are associated with both higher wage dispersion and higher employment rates among low-skilled workers. This may result in a very small net change in inequality among the working-age population, while the impact on overall inequality is uncertain. For other reforms, however, wage and employment effects may reinforce each other, resulting in both stronger growth and less inequality. This could be the case of policy reforms aimed at easing the strictness of job protection on regular contracts as a way to tackle labour market duality, i.e. the existence of separate segments where comparable workers enjoy different wage conditions and job protection.

Tax policy

Many tax policies raise well-known trade-offs with respect to growth and equity objectives. Economic theory and empirical evidence suggest that the tax structure influences macroeconomic efficiency. In particular, that direct taxes have relatively more distortionary effects by reducing incentives to work and invest. One of the highest ranked growth-friendly tax reforms, shifting the tax burden away from income taxes to consumption and property taxes, may in principle have adverse effects on inequality through various channels. For instance, reform-driven positive employment effects can be counterbalanced by increased income dispersion resulting from lower tax progressivity. Also, empirical evidence suggests that consumption taxes can be regressive, at least in the short run. There is ambiguity with respect to the distributional effects of property taxes. On the one hand, depending on how they are designed, recurrent taxes on immovable property can be regressive with respect to disposable incomes; on the other hand, inheritance and capital gains tax clearly reduce wealth inequality.

Product market regulation

Relaxing anti-competitive product market regulation can bring productivity and employment gains in the long run, therefore spurring economic growth. However, the impact on income inequality is uncertain and empirical evidence generally inconclusive. This is because employment gains may be at least partly offset by changes in the wage dispersion, as more intense product market competition tends to reduce the bargaining power of workers. Recent evidence has shown however that reducing barriers to competition is found to lift incomes of the lower-middle class by more than GDP per capita. Research also shows that linking well-tailored employment and product market reforms could bring additional gains on growth and equality.

Globalisation and technological progress

There is some consensus, in both developed and, to a lesser extent, developing countries, that globalisation is a growth-enhancing force. But there is no consensus, and mixed empirical evidence, about the distributional implications. Economic globalisation involves increased exposure to international trade and financial and capital movements, increased mobility of production factors (workers and capital) and increased fragmentation of the production process in Global Value Chains (GVC). The effects of globalisation on overall income inequality have mainly focused on the earnings dispersion channel as opposed to the employment channel. Available evidence would seem to suggest that globalisation-induced inequality effects are mainly driven by greater wage dispersion, in particular arising from changes in the skill and industry composition of labour demand.

Stronger export intensity based on sound and dynamic competitiveness is found to boost long-run GDP per capita and average household disposable income. Such effects hold across the distribution of household income, with stronger estimated gains for the poor – implying reduced inequality. Overall, these findings signal synergies across policy objectives, i.e. that reforms enhancing competitiveness aimed at encouraging exports among domestic firms could boost efficiency and equity.

Globalisation may also affect income distribution insofar as increased trade and international capital flows facilitate the diffusion of technology, increasing thereby wage dispersion via mechanisms such as skill-biased technological change. To the extent that skill-biased technological change shifts demand of labour towards higher skills and especially when this increase in demand is not matched by a sufficient increase in the supply of skilled workers, technical progress may increase wage inequality. The implications of this hypothesis for inequality have found empirical support for many OECD countries. Going further, recent evidence strongly suggests that skill-biased trade specialisation is associated with higher wage inequality, even accounting for technological change.

Technological progress, as measured by the share of investment in communication technology (ICT) in overall investment, is found to boost long-run GDP per capita and average household disposable incomes. Average household income gains hold across the distribution and as a result, there is no evidence of inequality effects.

Taking these findings into account, the OECD is following up designing general but also country tailored policy frameworks which avoid and minimise trade-offs in the short and long run. This encompasses the right mix and sequence of employment and product market reforms, together with science, innovation, education and redistribution systems with taxes and benefits in cash or kind.

Useful links
Economic Policy Reforms: Going for Growth

Connecting the dots on income inequality: what do official sources suggest when adjusted for top incomes?  Nicolas Ruiz, on OECD Economics Department, on OECD Ecoscope blog

OECD work on labour markets, human capital and inequality

Economic Models used in the OECD Economics Department

In case you’ve ever wondered what an Ornstein-Uhlenbeck process satisfying the stochastic differential equation dX = dB – 5X dt looks like

This month marks the centennial of the birth of mathematician Alan Turing, the “father” of modern computing and artificial intelligence. To celebrate the occasion, we’ll be publishing a series of articles on modelling and economics. In today’s article, Dave Turner, Head of the Macroeconomic Analysis Division in the OECD’s Economics Department, gives a personal view of the models we use here. 

Macroeconomics and, more specifically, economic models have come in for widespread criticism for their failure to predict the financial crisis. Informed criticism often focuses on so-called “Dynamic Stochastic General Equilibrium” models (mercifully abbreviated to DSGE models), which had become the dominant approach to macroeconomic modelling in both academic and policy circles. Such models based on assumptions of “efficient markets” and “optimising agents” with “rational expectations”, seemed to rule out the possibility of financial crises by the very nature of their assumptions.

The approach to economic modelling within the OECD is, however, much more eclectic with a large number and wide variety of different models used for different purposes. This can be illustrated by a few examples of the models which are currently used within the Economics Department at the OECD to generate the twice-yearly projections published in the OECD Economic Outlook.

The projections produced for the OECD Economic Outlook place a high weight on the judgment of country specialists rather than relying on numbers mechanically generated by a single econometric model.  On the other hand, these country specialists increasingly have the option to compare their projections with what econometrically estimated equations would produce. Additionally, simulations from a conventional large-scale macro model provide further information on the effect of changes since the previous forecasting round n variables including oil and other commodity prices, and fiscal and monetary policy settings. Moreover, importance is attached to ensuring that the set of country projections are globally consistent, in particular that growth in world exports is in line with growth in world imports (so avoiding implicit exports to the Moon) and estimated trade equations often play a role in ensuring this global consistency.

With the onset of financial turmoil, further guidance for the Economic Outlook projections has been provided through the development of financial conditions indices for the major OECD countries. These capture the effect of broadly defined financial conditions on economic activity and include not only standard text-book measures of policy interest rates and exchange rates, but also survey measures of bank lending conditions and interest rate spreads (the difference between government interest rates and the rates at which companies can borrow). The latter, less conventional, components have been crucial in tracking the adverse effects of the financial crisis.  In addition to providing input to the main projections, these financial conditions indices have also been used as the basis for constructing upside and downside scenarios in relation to the ongoing financial and sovereign debt crisis.

Other models are used in the Economic Outlook projections to situate the current state of the main OECD economies, by using high frequency data. Thus “Indicator models” use estimated combinations of monthly data on hard indicators, such as industrial production and retail sales, as well as soft indicators such as consumer and business surveys to make forecasts of GDP over the current and following quarter.  Even here, treating the model predictions with caution is often warranted, especially, for example, if recent indicators have been affected by unusually unseasonal weather.

At the other extreme of the projection horizon, a model has recently been developed to extend the Economic Outlook projections over a further 50 years. While such projections are inevitably “heroic” and subject to many qualifications, such a long-term horizon is needed to address a number of important policy issues that will only play out over a period of decades. Such issues include the implications for government debt of current high fiscal deficits; the impact of ageing populations on growth and government budgets; the impact of structural policy changes on how economies catch-up with the technological leaders; and the growing importance of China and India in the global economy.

Beyond the Economic Outlook projections, much of the other empirical work undertaken in the OECD Economics Department can be described as using economic models, if “economic models” are defined more loosely to include any quantitative (usually estimated) relationship between economic outcomes and variables which are readily amenable to policy influence. Such models are often characterised by the construction of summary indicators which try to capture and contrast some salient features of member country economies and relate them to policy levers and/or economic outcomes.

Examples of such approaches include quantifying the effect of product market regulation on productivity, tax policy on R&D spending, or the design of pension systems on retirement decisions. Such specialised “models” are usually small, and do not pretend to provide a universal approach to economics or provide answers to questions across many different policy fields.

Moreover, work is ongoing to evaluate the impact of structural policies on macroeconomic performance, an area the OECD has been pioneering and in which it has already contributed significantly to the G20 process. In exploiting its access to a rich cross-country information set made available by its member countries, it is this type of modelling where the OECD is uniquely well placed to play a role in providing policy advice to its member countries, rather than attempting to develop the next generation of all-encompassing whole economy models with a fancy new acronym.

Useful links

OECD economic outlook, analysis and forecasts

Inequality, the crash and the crisis. Part 3: The Limit to Inequality

Click to see the book

Today we publish the last of three articles on inequality and the crisis by Stewart Lansley, visiting fellow at The Townsend Centre for International Poverty Research, Bristol University and the author of The Cost of Inequality: Why Economic Equality is Essential for Recovery, Gibson Square, 2012. He was one of the speakers at the 2012 OECD Forum session: How Is Inequality Holding Us Back?

The key lessons of the 2008 Crash are now becoming clear. For the last thirty years, some of the world’s most important economies have been applying a faulty theory on the way the economy works. Demand in most large economies is wage-led not profit-led. That is, a lower wage share leads to lower growth. This is also true in aggregate of the global economy.

The evidence from the last 100 years is that more equal societies soften, and more polarized ones intensify, the gyrations of the business cycle. Inequality is not just an issue about fairness and proportionality, it is integral to economic success. A capitalist model that allows the richest members of society to accumulate a larger and larger share of the cake merely brings a lethal mix of demand deflation, asset appreciation and a long squeeze on the productive economy that will end in economic turmoil.

Yet that model has survived the second deepest recession of the last 100 years largely intact. In contrast, the economic crisis of the 1930s was to give way to a very different model of political economy, one that eroded the extremes of wealth that had helped create the crisis.

Today, it is largely business as usual. The world’s rich have been the main winners from the global recession. In the United States, profits and dividends have risen since 2008 while real wages have fallen. According to the American economist, Emmanuel Saez, average real family income declined by a remarkable 17.4 per cent between 2007 and 2009.

Profits and dividends are up largely because wages are down. As JP Morgan Chase chief investment officer, Michael Cembalest, has documented. “U.S. labor compensation is now at a 50-year low relative to both company sales and U.S. GDP.”

A key consequence of this trend is that all income growth in the US in 2010 went to the wealthiest 10 percent of households, and 93 percent to the wealthiest one per cent.

In the UK, there has been a similar, if less extreme pattern. Real wages have fallen on average by seven per cent in the last two years and are set to continue to fall. Indeed, the independent Office for Budget Responsibility (the OBR ) has forecast that the wage share will have fallen by a further four percentage points between 2010 and 2006. In contrast, incomes at the top have continued to rise through the slump. In 2007, the ratio of the median earnings of FTSE 100 top executives to median wages stood at 92:1. By 2011, it had risen to 102:1. Not only did executive pay greatly outstrip average earnings growth up to 2007, apart from a slight blip in 2009, it has continued to do so.

There has been much talk about the need to tackle growing inequality, but little real action. Ending the present crisis and building a sustainable global economy requires a much more fundamental leap that accepts that there is a limit to the level of inequality – one that is still being breached in a majority of nations – that is consistent with stability.

The successful management of economies depends especially on securing a more equal distribution of market incomes, before the application of taxes and benefits. Tackling the unequal “pre-distribution” of incomes means elected governments taking more responsibility for both the distribution of factor shares and of relative levels of pay.

It is a role that most, if not all, governments have been and remain reluctant to play. For most national governments – and global institutions from the IMF to the OECD – reducing inequality has not been a central economic goal alongside say, controlling inflation, or tackling fiscal deficits.

In the US, the UK and most rich nations, the economic role and impact of inequality has been at best a side-issue in economic decision-making. Too many governments have, by default, allowed the relationship between wages and output to become dangerously imbalanced. They have permitted remuneration practices to emerge that have distorted incentives and sanctioned business activity geared more closely to wealth diversion than wealth creation.

Translating talk into action requires governments to set clear targets for a number of key economic relationships. These should include the balance between wages and profits, the pay gap between top and bottom and the degree of income concentration. In a majority of countries, the wage share is too low and heading lower; the pay gap, already at historic highs, is heading higher while income concentrations are above the limit consistent with stability.

Meeting these targets means ditching many of the failed economic shibboleths – that inequality leads to faster growth, that allowing the rich to keep more of their own money boosts growth and tax revenue, that a larger pay gap reduces unemployment – of the last thirty years. It will require much tougher policy measures aimed at keeping economic elites in check. National governments need to develop a new contract with labour that raises the wage floor, bolsters the middle and lowers the ceiling. This means the taming of excessive corporate power and a rebalancing of bargaining power in favour of the workforce. It means moving towards more progressive tax regimes with much tougher global action on tax havens.

None of this will be easy. Despite the accumulated evidence that fairer societies and economic success go hand in hand, and the mounting pressure for change, the political and economic consensus remains rooted in the past. Radical change will be heavily opposed by those with most to lose. Yet a model of capitalism that fails to share the proceeds of growth more proportionately is not sustainable.

Useful links

Divided We Stand: Why Inequality Keeps Rising

Growing Unequal? Income Distribution and Poverty in OECD Countries