Bringing Economists in From the Cold?
By Paul Wallace

Frankfurt: Monday 14th September 1992. Two top economists turned top officials fly in from London on a top secret mission. One is bearded - but it's no disguise. The other wears spectacles - but it's no disguise. Their mission: to convince the Bundesbank that sterling can hold at 2.95DM. As Alan Budd and Mervyn King enter the German central bank's forbidding building, a storm rages directly overhead, complete with thunder and lightning. A portent for the fate of the pound?

Swansea: Tuesday, 2nd April 1996. One economist turned official - the one with spectacles - tells the story of his abortive mission with the Treasury's chief economic adviser - the one with the beard - to save the pound. Two days later, it collapsed in the chaos of Black Wednesday. What Mervyn King, the Bank of England's chief economist, doesn't mention in his address to the annual conference of the Royal Economic Society is that Swansea is about to upstage the Wagnerian Donnerblitz of Frankfurt with a total eclipse of the moon. A portent for the fate of economists and economics? Economists are by nature the least superstitious of people, but if they were that way inclined the delegates gathered in Swansea could draw just such a disquieting message. Wrenching changes in the global economy are destroying old

social certainties and creating a pervasive sense of insecurity. Who better placed to exploit - and profit from - the demand for guidance than practitioners of the dismal science? And yet no one could claim that the eyes of the country were fixed on the annual RES conference, even though this is the national showcase of the profession's work.

None of the 350 economists who met there could fail to have noticed the increasingly unattractive public profile of the discipline. As Ronald Amann, chief executive of the ESRC, recently wrote, there is "an emerging public debate about whether social scientists are today addressing the big questions or the right questions." He pointed as an example to an article in the Financial Times after last year's RES conference "in which economics was portrayed as an introverted discipline increasingly preoccupied by minor technical problems and, for that reason, alienating new recruits both at school and at university."

As if to make the point, the conference was preceded by a vintage hammer and tongs row between two of the Chancellor's "wise men", Patrick Minford and Tim Congdon, over their advice on economic policy to Kenneth Clarke. Whatever the rights and wrongs of the argument, their clash served only to add to the public perception of a wilfully disputatious profession.

As it happens, Patrick Minford, whose zest for a scrap is surpassed only by his zest for economics, was there to introduce that speech by Mervyn King. After sharing with us his recurring nightmare - an independent Bank of England - the professor with lip introduced the man "who puts our money where his mouth is." But on this occasion, Mervyn King set on one side his thoughts on monetary policy - maybe because he was speaking on the eve of one of the key monthly meetings between the Chancellor and Governor which sets interest rates. Instead he chose to discuss the role of economists in government. The provocative title of his speech - "The Ivory Tower, Academics and Policy Making" - suggested delegates were in for a rough ride.

But the king across the water had come not to bury academic economists but to praise them. His experience of the UK's peculiarly closed system of government had convinced him that there was no substitute for a good idea. Officials, crisis junkies to a man, were not the best source of inspiration when you were in a tight corner. The bureaucratic machine was designed to implement policies, not to invent the concepts behind them. The door was wide open to good ideas from outside the charmed circle.

One example Mervyn King gave was the way in which the theory of optimal contracts had helped in the formulation of a more accountable and transparent economic policy in the wake of Britain's exit from the ERM in September 1992. This had helped turn "Black Wednesday" into what Mr King, hedging his bets, now euphemistically termed "Grey Wednesday." There was no better incentive for getting your advice right than having to defend it in public, said the man "who puts our money where his mouth is."

And so to the final twist in the tale: if any way of life deserved to be called an ivory tower, it was not academic but public life, cloistered from everyday realitities by the cosy certainties of lifetime employment. But there was also a sting in the tail for economists: a little more thought and a little less cointegration, suggested Mervyn King, would go a long way.

This mix was certainly on offer in Tony Atkinson's presidential speech. Entitled "Bringing Income Distribution in from the Cold", no one could accuse the RES President of failing to address a big idea. As if to hammer home the timeliness of the theme, the address coincided with a special summit held in Lille by the Group of Seven leading industrial countries, which highlighted the exclusion of more and more people from the mainstream of economic prosperity.

Compared with these countries, however, said Tony Atkinson, the rise in income inequality in the UK in the 1980s had been "unparalleled." A widening dispersion in earnings had been exacerbated by the effects of discretionary public policies, particularly in the second half of the decade. This in itself cast doubt on the standard explanation which invokes a structural shift in demand towards skilled and away from unskilled labour - and then shuts the book on the issue.

This was emphatically not the end of the story, said the RES President. Social norms could temper the widening in wage differentials between the skilled and unskilled. Earnings gaps could also widen across generations as access to education was polarised between those who could afford it and those who couldn't. And you might just as well play Hamlet without the Prince of Denmark as seek to explain income distribution without politics and public choice theory. Why for example had voters had gone along with the reduction in the relative level of unemployment benefit at a time when the likelihood of needing benefit was rising?

One political solution to low pay that will be on the table at the next election is the minimum wage, arguably New Labour's only controversial new economic policy. It certainly aroused a heated debate at the conference. The conventional wisdom that it would hurt employment was unwarranted, argued Alan Manning of the London School of Economics. A huge act of faith with a potentially devastating effect on unemployment, countered his feisty opponent. Yes, you guessed it: that wise man was back in the ring.

Alan Manning presented the theoretical case in favour of the minimum wage with bravura - and much heavy shaking of his head and sucking of teeth on the part of Patrick Minford. The conventional wisdom rested on the implausible assumption of perfect competition in the labour market, said Manning: take that away and it collapsed. In practice, employers often exercised power, particularly in the non-traded sector, so it paid them to employ fewer workers at lower rates of pay rather than hire more; if they took on more staff, the effect would be to drive up wages which they would then have to pay to all their employees. Imposing a minimum wage could thus increase employment, since employers might then just as well take on the extra workers.

Most of the empirical evidence on the effects of the minimum wage has come from the US and some fascinating insights into that rapidly expanding body of research were presented by John Schmitt of the Economic Policy Institute. In particular, he cast fresh light on the controversy that continues to rage over that study of New Jersey fast food restaurants. In 1992, New Jersey increased its minimum wage; neighbouring state, Pennsylvania, didn't. Economists, Card and Krueger, subsequently conducted a telephone poll of fast food employers in both states to guage the effect in New Jersey. What they found, so it has generally been reported, is that the rise in the minimum wage boosted employment.

Only within limits, corrected Mr Schmitt: the findings were not statistically significant. All that Card and Krueger really established was that there was no evidence that the minimum wage reduced employment.

Since then, the telephone survey - a foray into experimental economics - has come under fierce criticism for its methods. Payroll data, Neumark and Wascher have argued, were more reliable; what they showed was that a minimum wage did indeed cut jobs. However, Mr Schmitt pointed out that a large part of the data used by these authors came through self-selection: the owner of a fast food restaurant chain contacted the EPI, which handed the data over to Neumark and Wascher. Strip this non-random sample out the calculation and their results, too, ended up not statistically significant.

The emerging consensus in the US, based on these and several other studies, was that moderate increases in the minimum wage would have no more than a small impact in cutting employment. By implication, the UK stood to lose little by introducing a minimum wage.

Not so, retorted Patrick Minford: the conventional wisdom was not so easily shaken. The proponents of the minimum wage reminded him of Don Quixote: they were tilting at an exceedingly rugged windmill. If firms exercised this degree of power in the labour market, why didn't rival companies enter the arena and undercut them?

Professor Minford approached the problem from an entirely different direction, using the Liverpool macro-economic model to simulate the effect of imposing a minimum wage. The trick he played was to use unemployment benefits - the de facto wage floor - to simulate the effect of introducing the policy. The results were stark. Over a period of three years, a minimum wage set at half median male earnings would raise average real wages by 4 per cent and make half a million people unemployed. The resulting loss in output would drive up the budget deficit.

There was something of an irony in the story Patrick Minford told, given that he supports the payment of in-work benefits as an alternative way of mitigating poverty wages. One fear about the extension of family credit is that employers will push down wages, so leading to a spiralling cost to the Exchequer. The solution that's increasingly canvassed for this problem? That's right, the minimum wage.

This was a good debate, ringing to a resounding clash of models, methods and measures. But there was more to it than that. No one could have left the session labouring under the illusion that economics was a value-free zone. And no bad thing, too: attempts to depict economics as a sterile laboratory manned by technicians in white coats strip away the guts of the discipline.

Another topical issue that stirs up strong feelings is inward direct investment, which poured in at a record rate in 1995. The influx of foreign companies and the expansion of their existing operations here is now generally seen as a boost to the economy. Yet not far below the surface, lurking doubts remain about a loss of national control and the quality of production transferred to the UK by overseas corporations - the "screwdriver plant" complaint.

But what matters to regions like Wales, where traditional industries have atrophied, is how to continue attracting the big multinationals. In the past fifteen years, Germany has been the second most important source of investment into Wales, so a paper from the National Institute of Economic and Social Research on why and where German manufacturers locate abroad was particularly apposite. Nigel Pain highlighted a key faultline in the behaviour of German companies. Outside the European Union, they were mainly intent on exploiting their R&D advantages. By contrast, within the EU, investment was most heavily influenced by growth in demand throughout the common market, with changes in relative labour costs also playing a major role.

But what role do incentives like low taxes play in encouraging FDI? In a special session sponsored by the Welsh Development Agency, Harry Grubert, a US Treasury official, produced what he himself described as "startling" evidence on the lure of low taxes. Using Treasury data on American multinationals' manufacturing affiliates, he showed that the choice of location was heavily influenced by the tax regime - and nowhere more so than in rich countries, even when low tax havens were excluded.

One up for the Conservatives' slogan of Britain as the enterprise centre of Europe? Only up to a point, Lord Copper - for this was also the week in which Kenneth Clarke dropped his dogged opposition to a referendum on European Monetary Union, so lengthening still further the odds on a Conservative government ever turning that famous "opt-out" from EMU into an opt-in. There may be a price to pay: an implication of the research into German FDI, warned Nigel Pain, was that outside EMU the UK could become less of a magnet for inward investment.

The sheer scale of international capital flows in the modern global economy is rapidly taking us back to the future. A long way back: to the world we lost when the lights went out in Europe in 1914. When such seismic transformations are under way, the insights of economic historians have much to contribute. Indeed Brian Reading, who works alongside "wise man", Tim Congdon - that other sparring partner of Patrick Minford - at Lombard Street Research, recently suggested in the Financial Times that the Chancellor would do well to recruit one to his panel of independent advisers. Sadly, economic historians were thin on the ground at Swansea - with one notable exception.

That exception was Nick Crafts from the LSE who gave a knockout presentation of the findings of a major cross-European investigation into the "golden age" of European growth in the 1950s and 1960s. Introducing the work as a "new bible", Richard Portes was understandably unable to resist plugging the enterprise as a testament to the effectiveness of the pan-European approach made possible through the Centre for Economic Policy Research.

The research established that there was far more to the postwar European economic miracle than high levels of routine physical investment. As early as the 1960s, capital productivity was falling across OECD Europe. But the golden age of growth was also much more than simple technological catch-up. It required what Crafts called "social capability": institutions and policies that provided strong incentives to innovate. An expansion in market size came about through trade liberalisation. Technology transfer was promoted by a new receptivity to inward investment. In most countries, social contracts between employers and employees rewarded investments incorporating technological innovation. The UK was the odd man out mainly because its adverse structure of industrial relations deterred innovation. Social incapability made it the sick man of Europe.

Nick Crafts drew some telling implications for policy makers. The promotion of capital investment for its own sake through taxes or subsidies was likely to prove fruitless. Gordon Brown, are you listening? Instead what was needed was a much wider range of policies to galvanise innovation, in areas as diverse as competition, trade policies and company law. A similar approach was also overdue in Europe if the creation of a single market was to fulfil its potential of boosting long-term growth.

One debate Nick Crafts did not touch upon was the role of different structures of corporate governance in determining growth performance. These range from the bank-led system of "noyeaux durs", the hard-core key shareholders common in mainland Europe, to the freewheeling Anglo-Saxon market in corporate control. In the Review of Economic Studies Lecture, Patrick Bolton from ECARE in Brussels cast light on their respective strengths and weaknesses. The German system ensured monitoring and guaranteed intervention when required. The price for shareholders was a loss of liquidity and risk diversification. On the other hand, the Anglo-Saxon system of dispersed ownership was left to rely upon takeovers, and they didn't necessarily work.

Professor Bolton presented an economics of remuneration packages which essentially endorsed the effectiveness of bonus schemes and share options. For example, he argued that the current drive for greater disclosure - highlighted in the Greenbury report and its controversial call for full transparency about the cost of final pensions - was economically well-founded: it helped shareholders smoke out the amount of pay senior executives could hope to earn elsewhere.

With both Daimler Benz and Deutsche Bank - the very kernel of German-style corporate governance - poised to introduce share options, things might seem to be going the British way. But a well-known problem with the Anglo-Saxon system is the difficulty of rallying a diverse number of shareholders to a common cause. As if to prove the point, the lecture-hall emptied rapidly after Professor Bolton's talk despite pleas for RES members to attend the AGM. Shirking - that buzzword of economic theorists working in this area - was the order of the day, even though a carefully worked out incentive scheme was on offer in the form of a free glass of wine.

However, there was no shirking in the turnout for a lecture on "The Econometrics of Ultra-high Frequency Data." An ultra-attentive audience heard Professor Robert Engle from San Diego explain how economists had broken one sound barrier after another, moving from years to quarters, from quarters to months and now to transactions within days. They were now approaching the ultimate limit - a sound barrier that couldn't be broken - by analysing all individual recorded data.

Irregular spacing was the salient feature of such transactions - for example, share trades. A new econometrics was needed to estimate the actual timings of share deals and their accompanying characteristics, such as volume and price. The results of an exercise conducted on 15,000 IBM transactions cast revealing insight into market lore, suggesting that the adage "no trades is no news" was a better one to follow than the saying "no trades is bad news."

Professor Engle's research introduced the arresting concept of seasonal adjustment for the time of day. He also deserved full marks for managing to roll the phrase "magical realism" into a discourse on econometrics. And the medical analogy he drew with the timing of trades - the different rates at which people undergo the course of a disease - would have been music to the ears of President Jacques Chirac who enlivened last year's G7 economic summit by comparing currency speculation to AIDS. Andrew Chesher, Professor of economics at Bristol, spoke for many when, concluding the meeting, he said that UHF econometrics opened up "a fascinating new research agenda."

Andrew Chesher himself trespassed into the field of health by using what he called a "sly" statistical approach, backed up by formidable computing power, to work out just how much we really eat in the privacy of our homes. Usual estimates of food intakes based on direct observation were liable to mislead as over-eaters shamefacedly under-recorded their gluttony. However, such bias was unlikely to affect the UK's long-running National Food Survey, used to help calculate food-related elements of the retail price index. This survey records household food acquisitions, which could then be converted into nutrient equivalents. But sophisticated statistical methods were then needed to tackle "exceptionally noisy data" and get inside the household and estimate how much of each nutrient is going to men, women and children at different ages. What Andrew Chesher established was that middle-aged women, in particular, were eating a lot more than they were letting on.

In an abrupt gear-change that bore witness to the eclectic nature of modern economics, this particular econometrics session went on to hear about the wind direction in Moscow. Which way does it blow and what can it tell us about the way the wind blowing in the transition from a command to a market economy in Russia? Quite a lot, according to some pioneering micro-research by Yasushi Toda of Florida University.

If Andrew Chesher found new information in an extensive existing source of data, Yasushi Toda went and collected his information the hard way, trekking round auctions of apartments in Moscow in the early 1990s. Borrowing an approach often used to model the effects of noise pollution and disturbance from an airport on house prices, he and his fellow researchers, Maddala and Nozdrina, worked out what the prices of the apartments should have been, given their location and quality. That's where the prevailing wind direction comes in: it's south-westerly making the north-eastern part of the city the least favoured because of air pollution. When predicted prices were compared with actual prices achieved at the auction, the effects of the price liberalisation in January 1992 stood out, showing that the market quickly asserted itself.

New experimental approaches and technical advances, aided by the power of modern computing, are thus clearly expanding the domain of economics. The conference bore witness to the expanding range of the subject. But is this necessarily a welcome development?

In a special session exploring the legacy of Keynes, on the occasion of the fiftieth anniversary of his death and the sixtieth anniversary of that book, Sheila Dow of Stirling University lobbed some well-aimed hand grenades into the ring, expressing real worries about the direction of the discipline. She said that there was insufficient discussion about whether the inexorable expansion of formal theory and techniques was warranted. Keynes saw social systems as essentially organic, which was why he believed there were strict limits to the reach of formal models and the use of mathematical techniques. Were we to believe that the way people behaved had changed, thus allowing greater application of such methods, or had economics taken a wrong turning?

The same point was made by Geoff Harcourt from Cambridge University in his sneak preview of the "second edition" of The General Theory. This promises to be a major event in this year's economic calendar: a modern reinterpretation of Keynes's magnum opus by a number of outstanding scholars. One of the two editors of the book, Harcourt described recent developments in the links between Keynes's contributions to philosophy and his economics as "one of the most profound developments in Keynes scholarship". He argued that we have much to learn from them "especially today, when formal methods tend completely to dominate, so impoverishing our discipline and deepening its crisis."

The session on Keynes was disappointingly attended, but the question posed by Sheila Dow and Geoff Harcourt won't go away. Economists, like most other professionals, are under much greater pressure to be accountable for what they do. That must involve some genuine soul-searching into the underlying philosophy and methodology of the discipline. The RES conference certainly presented some highly relevant research, but a fascination bordering on obsession with technique was never far from the surface. Until economists focus more on the actual findings of their research - and why they matter - they will remain a long way from coming in from the cold.