The strong case against independent central banks

I personally think giving central banks the power to decide when to change interest rates (independent central banks, or ICBs) is a sensible form of delegation, provided it is done right. I know a number of the people who read this blog disagree. Sometimes, however, arguments against ICBs seem to me pretty weak. This is a shame, because there is I believe quite a strong case against ICBs. Let me set it out here.

In the post war decades there was a consensus, at least in the US and UK, that achieving an adequate level of aggregate demand and controlling inflation were key priorities for governments. That meant governments had to be familiar with Keynesian economics, and a Keynesian framework was familiar and largely accepted in public discourse. Here I am using Keynesian in its wide sense, such that Milton Friedman was also a Keynesian (he used a Keynesian theoretical model).

A story some people tell is that this all fell apart in the 1970s with stagflation. In the sense I have defined it, that is wrong. The Keynesian framework had to be modified to deal with those events for sure, but it was modified successfully. Attempts by New Classical economists to supplant Keynesian thinking in policy circles failed, as I note here.

The more important change was the end of Bretton Woods and the move to floating exchange rates. That was critical in allowing the focus of demand management to shift away from fiscal policy to monetary policy. The moment that happened, it allowed the case for delegation to be made. Academics talked about time inconsistency and inflation bias, but the more persuasive arguments were also simpler. Anyone who had worked in finance ministries knew that politicians were often tempted and sometime succumbed to using monetary policy for political rather than economic ends, and the crude evidence that delegation reduced inflation seemed strong.

That allowed the creation of what I have called the consensus assignment. Demand management should be exclusively assigned to monetary policy, operated by ICBs pursuing inflation targets, and fiscal policy should focus on avoiding deficit bias. The Great Moderation appeared to vindicate this consensus.

However the consensus assignment had an Achilles Heel. It was not the global financial crisis (which was a failure of financial regulation) but the Zero Lower Bound (ZLB) for nominal interest rates. Although many macroeconomists were concerned about this, their concern was muted because fiscal action always remained as a backup. To most of them, the idea that governments would not use that backup was inconceivable: after all, Keynesian economics was familiar to anyone who had done Econ 101.

That turned out to be naive. What governments and the media remembered was that they had delegated the job of looking after the economy to the central bank, and that instead the focus of governments should be on the deficit. Macroeconomists should have seen the warning signs in 2000 with the creation of the Euro. There monetary policy was taken away from individual union governments, but still the Stability and Growth Pact was all about reducing deficits with no hint at any countercyclical role. When economists told politicians in 2009 that they needed to undertake fiscal stimulus to counteract the recession, to many it just felt wrong. To others growing deficits presented an opportunity to win elections and cut public spending.

Macroeconomists were also naive about central banks. They might have assumed that once interest rates hit the ZLB, these institutions would immediately and very publicly turn to governments and say we have done all we can and now it is your turn. But for various reasons they did not. Central banks had helped create the consensus assignment, and had become too attached to it to admit it had an Achilles Heel. In addition some economists had become so entranced by the power of Achilles that they tried to deny his vulnerability.

From 2010, as austerity began, the damage caused by ICBs became clear. One ICB, the ECB, refused to back its own governments and allowed a Greek debt financing crisis to become a Eurozone crisis. The subsequent obsession with austerity happened in part because governments no longer saw managing demand as their prime responsibility, and the agent they had contracted out that responsibility to failed to admit it could no longer do the job. But it was worse than that.

Economists knew that the government could always get the economy out of a demand deficient recession, even if it had a short term concern about debt. The fail safe tool to do this was a money financed fiscal expansion. This fiscal stimulus paid for by the creation of money was why the Great Depression could never happen again. But the existence of ICBs made money financed fiscal expansions impossible when you had debt obsessed governments, because neither the government nor the central bank could create money for governments to spend or give away. Central banks were happy to create money, but refused to destroy the government debt they bought with it, and so debt obsessed governments embarked on fiscal consolidation in the middle of a huge recession.

The slow and painful recovery from the Great Recession was the result. Economists did not get the economics wrong. Money financed fiscal expansion does get you out of a recession with no immediate increase in debt. But by encouraging the creation of ICBs, economists had helped create both the obsession with austerity and an institutional arrangement that made a recession busting policy impossible to enact.

I have tried to put the argument as strongly as I can. I think it is an argument that can be challenged, but that will only happen if macroeconomists first admit the problem it exposes.

Europe’s other taboo: reform of the ECB

At a recent meeting of European economists I remarked that there were two big taboo subjects when discussing how the Eurozone might be improved. The first, which I have talked about before, is countercyclical national policies, which could include macroprudential monetary policies but which also must include fiscal policy. It is blindingly obvious that such policies, if implemented, would have put the Eurozone in a much better position before the 2010 crisis, but despite this the subject remains ‘off the agenda’.

The second taboo subject is reform of the ECB. Once again, it is pretty clear to anyone outside the Eurozone that since 2010 ECB decisions have been very poor, both in absolute terms and relative to their counterparts in the US, Japan and the UK. The three big errors are well known:

1. A failure to introduce OMT in 2010, delaying it to September 2012
   
   
2. Raising interest rates in 2011
   
   
3. Delaying Quantitative Easing until 2015

No one disputes (2). Some say that (1) and maybe (3) were because the ECB had to wait until it was clear that particular countries were serious about undertaking ‘reforms’. This explanation raises more questions than it answers. The ECB’s remit does not extend to dictating national economic policies, but sometimes the ECB appears to think otherwise.

Alongside these big errors are many examples of ECB actions which are highly questionable, the most recent involving Greece. Imagine the Bank of England cutting off the supply of cash to Scotland if negotiations between the Scottish and UK governments were not going the way the UK wanted. Those who say the ECB was only following its rules neglect to observe that the ECB makes up its rules as it goes along. Even in more minor matters, actions of ECB officials which would do more than raise eyebrows elsewhere go on for years without anyone finding out.

One major error alone might not be enough to indicate reform, but three suggests that structural reform is essential. Yet the one structural reform no one in the Eurozone will talk about is at the heart of the Eurozone itself. The reason of course is also why no one will talk about countercyclical fiscal policy: it does not fit in with the dominant German narrative. What is a shame is that this taboo among policy makers is infectious: at the meeting where I talked about this taboo only one or two others mentioned the ECB.

This is a shame, because some imagination is required in thinking about ECB reform. A reasonably obvious change to make is to take monetary policy decisions away from the exclusive control of central bankers, along UK lines. But who would appoint any external members? Here we have a tricky problem - the lack of political union means that any political accountability may be too diffuse to be effective (as it is at present). But the point of this post is not to offer solutions, but to complain that not enough people are talking about the problem.

The ECB as sovereign lender of last resort

Understandably the element of my talk at the Royal Irish Academy which generated most discussion was the role of the ECB. (Here is a media report, but ignore the last two paragraphs which are confused/wrong. Abstract for the talk is here. Paper will follow.) The proposition I put forward was that the ECB’s OMT programme should have been put in place in 2010, and if it had been countries outside Greece could have implemented a more efficient austerity programme (one that produced less unemployment) and might have retained market access (interest rates on government debt would have remained reasonable). [1]

There are two serious and related arguments against this view. The first is that it is unrealistic for the ECB to act as a sovereign lender of last resort because of the transfers between countries that this might lead to. (A sovereign lender of last resort is a central bank that is always willing to buy its government’s debt.) [2] The second is that in practice OMT is bound to be coupled with a requirement for austerity programmes that might have simply duplicated what was actually put into place by national governments. Both arguments speak to a real problem that remains unresolved within the Eurozone, but do not nullify the argument that things should have been done much better.

Government debt in advanced economies is regarded as a safe asset for two reasons. The first is that most governments that borrow in their own currency rarely default. The second is that an individual investor does not need to worry about market beliefs, because if the market panics and refuses to buy the government’s debt the central bank will step in (hence sovereign lender of last resort). If the central bank did not do this, the government might be forced to default because it cannot roll over its existing debt.

It makes sense for the central bank to act as a sovereign lender of last resort, because it avoids self-fulfilling market panics. Doubly so because such panics will be more likely to occur after a large recession when the social value of government borrowing is particularly high. The complication in the case of the ECB is the following. If the market panic is so great that the ECB was forced to actually buy a ‘distressed’ government’s debt (normally the threat to do so is enough), it is possible that this government might choose to default even with ECB support. If it did that, the ECB would make losses which would be born by the Eurozone as a whole (the transfer risk).

Partly for this reason, the ECB has to have the ability not to act as a sovereign lender of last resort, or withdraw support if circumstances change. If that ability exists (a point I will come back to), then the transfer risk associated with the ECB acting as a sovereign lender of last resort are tiny. It represents the kind of minimal risk that should always be offset by the trust and solidarity that comes with the territory of being in a monetary union. I suspect those that suggest otherwise are often trying to hide other motives.

A government that is receiving ECB support of this kind will naturally want to know what it has to do to maintain it, because the threat of its withdrawal is so great. It would be unreasonable to withhold that information. Does that in practice amount to nothing more than the kind of conditions that have in practice been imposed on Ireland and Portugal anyway? Absolutely not. Just as the market does not worry about the build up of debt in a recession in countries like the UK or Japan, a rational ECB would have no reason to impose fiscal consolidation at the time it would do most damage. The time a rational ECB might withdraw its support is once a recovery is complete and the government refuses to embark on fiscal consolidation.

So a sovereign lender of last resort in a monetary union must have the ability not to provide that support. In other words it has to sort Greece from Ireland. That decision is a huge one, because in effect it is a decision about whether the country will be forced to default. It is natural that the ECB wants to share that responsibility with member governments, but as we have seen with Greece member governments are hopeless at making that decision (particularly when their own banks may be compromised by any default). We have also seen that European central bankers are far from rational on issues involving government debt (compared with at least one of their anglo-saxon counterparts), so giving the decision to someone else other than the current ECB would seem like a good idea. However at present there is no institution that seems capable of doing this job.

In this post I suggested contracting out this task to the IMF, although that presumed a reduction in the political influence of European governments on that institution. I have also wondered about whether a body like the newly created network of European fiscal councils could play this role. Another possibility is to reform the ECB so that it is not subject to deficit phobia, and is more accountable. It seems to me that this is where current research and analysis should be going, rather than into schemes involving greater political union.

The existence of various alternatives here means that we should not take what has actually happened in the Eurozone as some kind of immutable political constraint beyond which economics cannot go. There is no intrinsic reason why the OMT that was introduced in September 2012 could not have been introduced in 2010. There is no intrinsic reason why any conditionality that went with that could not have been much more efficient in terms of unemployment costs. Beyond Greece, the Eurozone crisis happened because the ECB thought it could avoid undertaking one of the essential functions of a central bank. This was perhaps the most important of the many errors it has made.

[1] For a country within a monetary union which needs to reduce debt more rapidly than does the union as a whole, a gain in competitiveness relative to the rest of the union is required to offset the deflationary impact of fiscal consolidation. That ‘internal devaluation’ probably requires some increase in unemployment, but it is much more efficient to obtain that increase in competitiveness gradually.

[2] It could be argued that the Fed does not provide lender of last resort services to individual member states. But state debt is typically lower relative to GDP and income than for Eurozone governments. Before 2000, Eurozone governments were able to borrow more because they were backed by their central bank. That means that they are inevitably subject to a greater risk of suffering from a self-fulfilling market panic. The architects of the Eurozone might have initially believed that the SGP might avoid the need for a sovereign lender of last resort, but after the Great Recession they would have known otherwise.

Should central bankers stick to talking about monetary policy?

Few disagree that the recent remarks on corporate governance and investment made by Andy Haldane (Chief Economist at the Bank of England) are interesting, and that if they start a debate on short-termism that would be a good thing. As Will Hutton notes, Hillary Clinton has been saying similar things in the US. The problem Tony Yates has (and which Duncan Weldon, the interviewer, alluded to in his follow-up question) is that this is not obviously part of the monetary policy remit.

Haldane gave an answer to that, which Tony correctly points out is somewhat strained. Perhaps I could illustrate the same issue by going down a better route that Haldane could have used. He could say that the causes of low UK productivity growth are clearly under his remit, and one factor in this that few dispute is low investment. If he was then asked by an interviewer what might be the fundamental cause of this low investment, Tony would argue that his reply should be that he couldn’t really comment, because some of those reasons might be too political.

I have in the past said very similar things to Tony when talking about the ECB, and their frequent advice to policymakers on fiscal rectitude and structural reforms. My main complaint is that the advice is wrong, and I puzzle over “how the ECB can continue to encourage governments to take fiscal or other actions that their own models tell them will reduce output and inflation at a time when the ECB is failing so miserably to control both.” But I have also said that in situations where fiscal actions have no impact on the ability of monetary policy to do its job (which is not the case at the moment), comments on fiscal policy are “crossing a line which it is very dangerous to cross”.

However I am beginning to have second thoughts about my own and Tony’s views on this. First, it all seems a bit British in tone. Tony worked at the Bank, and I have been involved with both the Bank and Treasury on and off, so we are both steeped in a British culture of secrecy. I do not think either of us are suggesting that senior Bank officials should never give advice to politicians, so what are the virtues of keeping this private? In trying to analyse how policy was made in 2010, it is useful to have a pretty good idea of what advice the Bank’s governor gave politicians because of what he said in public, rather than having to guess. (Of course private advice to politicians is never truly private, but this hardly helps, because with secrecy it allows politicians to hint that advice of a particular kind was given when it might not have been.)

The issues of MPC external member selection that Tony worries about are real enough, but perhaps that illustrates problems with the selection process. My guess is that the Treasury would be inhibited about choosing an MPC member who had previously been strongly critical of the government on other issues anyway. As I said my main complaint about the ECB is the nature and context of the advice they give, and at least by making it public we know about this problem.

It is often said that central bankers need to keep quiet about policy matters that are not within their remit as part of an implicit quid pro quo with politicians, so that politicians will refrain from making public their views about monetary policy. Putting aside the fact that the ECB never got this memo, I wonder whether this is just a fiction so that politicians can inhibit central bankers from saying things politicians might find awkward (like fiscal austerity is making our life difficult). In a country like the UK with a well established independent central bank, it is not that clear what the central bank is getting out of this quid pro quo. And if it stops someone with the wide ranging vision of Haldane from raising issues just because they could be deemed political, you have to wonder whether this mutual public inhibition serves the social good.

The non-independent ECB

Imagine that the Scottish National Party (SNP) had won the independence referendum. The SNP starts negotiating with the remaining UK (rUK) government over issues like how to split up national debt. On some issue the negotiations get bogged down. Rumours start circulating that this might mean that rUK will not form a monetary union with Scotland, and that Scotland might have to create its own currency. People in Scotland start withdrawing money from Scottish banks.

Now it is almost the definition of a private bank that if everyone who has an account at the bank wants to withdraw their money, the bank will run out of cash and go bust. That is why bank runs are so dangerous. It is also why one of the key roles of a central bank is to supply an otherwise solvent private bank with all the cash they need, so they will never deny depositors their money. (To be a lender of last resort.) If they did not do this, anyone could start a rumour that a bank was insolvent, and as people withdrew their cash just in case the rumour was true, the bank would run out of money and go bust anyway.

So in my hypothetical story, as people started withdrawing cash from Scottish banks, the Bank of England should supply these banks with all the cash they need. Except suppose it did not. Suppose it put a limit to the amount of cash it would supply. The Scottish banks would protest - you agreed we were solvent before independence, they would say, so why are you rationing our liquidity? The Bank of England replies that although they might have been solvent before independence, if there is no agreement solvency is less clear. The Bank of England says that the limit on cash will remain until the Scottish and rUK government come to an agreement.

This announcement of course leads everyone in Scotland to try and get their money out, and the Scottish Banks have to close. The Scottish economy begins to grind to a halt. The English media report that Scotland is running out of money because the Bank of England will not ‘lend’ any more to the Scottish banks. The Scottish government is forced to agree to the rUK’s terms. The English media say look what happens when you elect a radical government. In Scotland they call it blackmail. What would you call it?

If it sounds to you like the Bank of England is taking sides and putting impossible pressure on Scotland, then you will know what it feels like in Greece right now. When, on 28th June, the ECB stopped providing emergency funding to Greek banks, it took sides. Part of the ECB’s logic is that Greek banks may be insolvent if there is no agreement between the Troika and Greece (even though it is the Central Bank of Greece, and therefore the Greek people, which stands to suffer losses from defaults by commercial banks).

Why should the failure to reach an agreement influence the solvency of the Greek banks? Is it because without an agreement there would be a Greek exit? But Greece does not want to abandon the Euro, and the other Eurozone countries have no formal grounds to expel Greece. Greece will only leave the Eurozone if the ECB stops supplying Euros. We reach exactly the same self-fulfilling logic of a bank run. Is it because without an agreement the Greek government would default on some of its debts, and that might adversely influence the solvency of Greek banks? But the fact that the Greek government will not get money from the Troika to pay back the Troika seems to have no implications for the underlying solvency or either the Greek state or its banks. (Paul De Grauwe discusses this further.) If the Troika can make Greece insolvent by itself withholding money we have another self-fulfilling justification.   

The real explanation for the ECB’s actions is much simpler. Limiting funding on 28th June was the Greek government’s punishment for failing to agree to the Troika's terms and calling a referendum the day before. The ECB was not, and never has been, a neutral actor just following the rules of a good central bank. It has always been part of the Troika, and right now it is the Troika’s enforcer.

As Charles Wyplosz recounts, this is not the first time the ECB has chosen to bow to political pressure. There will be some on the left who will say of course - what else do you expect of a central bank? In response, let me go back to my hypothetical example involving Scotland and the Bank of England. I may be wrong, but I think in that case the Bank of England would have supplied unlimited cash to the Scottish banks. I may be naive, but I believe it would have realised that to do anything else was an overtly partisan political act, and recoiled from doing that. Just as I do not think it was inevitable that the Eurozone committed itself to austerity, I also think it was possible that the ECB could have been a more independent central bank. The really interesting question is why it has turned out not to be such a bank.  

After Oxi, what next?

A lot of the commentary on Greece fails to see why the Greek No vote changes anything. This view tends to see the stance of the Eurozone group as simply expressing their own voters’ preferences which will not be changed by what happened yesterday. Here is an alternative reading.

It starts from a simple observation. The Troika will get far less of its money back (if any!) if Greece is forced out of the Eurozone. (I say forced out because Greece does not want to leave, so Greek exit is first and foremost an ECB decision: if you think otherwise read Karl Whelan and Matthew Klein and Paul De Grauwe. [1]) That is why creditors are generally weak in negotiations of this kind. Things are different in this case only because the creditors include the ECB, and Greece wants to stay in the Eurozone. The Troika has played this for all it is worth. They were relying (you could say gambling) on the Greek people, one way or another, deciding that they would agree to the Troika’s demands because they feared Greek exit more.

So far this strategy has failed. First they pushed Tsipras further than he could possibly go, hoping perhaps that Syriza would collapse in recriminations. Tsipras’s response was a unifying referendum. They then gambled that Greece would say no, and they lost that too. Tsipras continues to offer the Troika the chance to be more reasonable. He followed the referendum not with triumphalism but by removing his finance minister. This was both a signal - I really want a deal, even though it will in all probability inflict further (unnecessary) pain on Greece - and a lifeline, because the Troika can now say that an important obstacle to a deal has been removed. (An obstacle, because Varoufakis was too open - something politicians and much of the press hate - and too honest about the other side’s lack of economics.)

Now the Troika seem to face a simple choice. Agree a deal and get a little more heat from your political opponents at home for ‘giving in’, or force Greek exit with the risk that you will get a lot more heat when Greece defaults and people realise you have lost all their money. If they are really just interested in getting as much of their money back as possible, it would seem crazy to throw away their best card by forcing Greece out of the Eurozone.

Of course rationality may not prevail, or interests may be rather different. The IMF may continue to be an unhelpful nuisance. (If you think my criticism of their role was harsh, read this from Peter Doyle.) Some within the Troika will be happy to go for Greek exit because they think nationalist sentiment can overcome any kickback from the subsequent Greek default. Others may fear a deal may encourage anti-austerity sentiment in their own indebted countries.

Unfortunately there is a third possibility, which is probably the worst possible outcome. To prevent any loss of face, the Troika may continue to gamble, waiting for days or even weeks, and watch ECB pressure, together with reluctance by Tsipras to introduce a new currency, gradually bring chaos to the Greek economy. Only then will it negotiate, allowing any deal to be portrayed as the result of desperation by the Greek government. In which case, recent European politics will have reached a new all time low.    

[1] Postscript: Martin Sandbu provides a very clear account.

Why Sen is right about what is being done to Greece

At first sight the negotiations between Greece and the Troika seem to be simply a battle about resources: how much of the pie that is Greek national income their creditors should receive. There have been many similar types of battle over the years - what makes this one unusual is that the creditors have a unique weapon on their side. With primary surplus approximately achieved, Greece’s bargaining position would normally be extremely strong. The Eurozone creditors would be desperate to salvage what they could from their foolish decision to effectively buy some privately owned Greek government debt. The only reason the Troika is able to call the shots is that it can threaten to eject Greece from the Eurozone. [1]

Part of the deliberate mystification that goes on here is to present Eurozone exit as if it somehow automatically follows if there is a Greek default. But of course Greece has already defaulted, and it remains in the Eurozone. Greece wants to remain in the Eurozone. What will stop them if they do default will be a run on their banks, and a refusal of the lender of last resort for their banks - the ECB - to act in that capacity. Again this will be presented by the ECB as inevitable given the ECB’s own rules. But as Karl Whelan points out, the ECB in reality has considerable discretion, and it has been using that discretion in its role as part of the Troika.

Still, even if the sides are a little unequal in their power, is it still just a battle over resources? One side advocates left wing/populist/humanitarian policies and the other side policies that are more of the consensus/neoliberal/tough variety. [2] One side has suffered a massive fall in GDP partly as a result of previously agreements, while the other is negotiating over what is to them peanuts. So there is plenty of opportunity to pick sides based on preferences. Both sides would almost certainly be better off with an agreement, so it also makes sense for people to appeal for flexibility, which is why I signed this letter.

But to pick sides, or to call for flexibility from both, misses the main point. Yes, this is a battle over resources, but it is a battle where one side is using its power to pursue a policy that is very short-sighted, involving incredible hubris, and which is ultimately self defeating. The Troika are not acting in the long term interests of those they represent. This is I believe what Amartya Sen was saying when he compared these negotiations to the Versailles agreement. 

The most obvious example of this are the Troika’s continuing demands for positive primary surpluses and the austerity measures required to achieve them. This is just stupid. It continues to waste large amounts of valuable resources, as well as inflicting real suffering. It certainly is not in the interests of Greece, but it is almost certainly not in the interests of the creditors either. If you shrink the pie, you are less likely to get the amount of pie you have a claim to. (Martin Sandbu goes through the maths here.) It is disgraceful that key parts of the IMF plays along (or worse) with this. In the past I have described how heterogeneous the IMF is, but taking absolutely no notice of what your own research department says about austerity is crazy. Ambrose Evans-Pritchard talks about the Fund's own credibility and long-term survival being at stake. Keynes, who helped found the organisation, would be turning in his grave.

What about all the reforms that the Troika is insisting on? It is tempting to look at each in turn, and apply our economics expertise to come to an evaluation. If a reform demanded by the Troika might tend to increase the long run pie, then perhaps they are right to insist on it. This neglects one small issue: democracy. The Greek people have elected a government with a mandate. The Troika appear to be acting as if this is neither here nor there, and that is deeply worrying, at least to those of us who are very weary of yet further economic and political integration. (For those who have that integration as their ultimate goal, Greece can be seen as an annoying obstacle that should be thrown aside. [3])  

The hubris of the Troika is incredible. They have convinced themselves that they must override the democratic wishes of the Greek people because the Troika have the wisdom about what is good for the Greek economy. This is the same body that with its superior wisdom prevented full default, and imposed ridiculously strong austerity on Greece and crashed the economy as a direct result. To cover up these errors they play to stories in the media about the lazy and privileged Greek people, stories that largely disintegrate when confronted with evidence. Now they shrug their shoulders and say I have to keep on the same disastrous path because my electorate gives me no choice!

Amartya Sen is right. This is our Versailles treaty moment. It could be so very different. No doubt some of Syriza’s mandate may be unwise, but their own economists may recognise that and welcome the excuse to shelve them. The Troika and Syriza’s negotiating team could be cooperating in that endeavour, but I’m pretty sure that is not what is happening. On austerity the priority of the Troika should be to eliminate the Greek output gap, which means in the short term less rather than more austerity. This would not just be in the interest of the Greek people but also the interests of the rest of the Eurozone.

[1] This is why I think these negotiations are less like bargaining over a mutually beneficial exchange (rolling over lending in exchange for reforms), and more like a discussion with a mugger over which of your personal possessions you hand over.

[2] Or add any other description you prefer - my point is that they differ and people have strong views about them both in principle and practice, and therefore pick sides accordingly.

[3, postscript] Karl Whelan shows here that Giavazzi’s piece is as grounded in facts as some other FT op-eds. 

Austerity as a Knowledge Transmission Mechanism failure

In this post I talked about the Knowledge Transmission Mechanism: the process by which academic ideas do or do not get translated into economic policy. I pointed to the importance of what I called ‘policy intermediaries’ in this process: civil servants, think tanks, policy entrepreneurs, the media, and occasionally financial sector economists and central banks. Here I want to ask whether thinking about these intermediaries could help explain the continuing popularity amongst policy makers of austerity during a liquidity trap, even though there is an academic consensus behind the idea that austerity now would harm output.

In this post I looked at various reasons for thinking there was such a consensus, and one of them was that the framework generally used to analyse business cycles was the (New) Keynesian model. In this Keynesian framework cuts in government spending when interest rates are stuck at their lower bound clearly reduce output, with multipliers around one or more.

Where are these models used in anger? Among academics studying business cycles of course, but also within central banks. As far as I know, pretty well all the core models used by central banks to do forecasting and policy analysis are (New) Keynesian. (This includes the ECB.) An important point about the delegation of stabilisation policy to independent central banks is that expertise on business cycles has tended to shift from civil servants working in finance ministries to economists working in central banks.

Suppose you are a policy maker, who is genuinely concerned about what impact cuts in government spending might have in the period after the Great Recession. Where would you, or your civil servants, go to find expertise on this issue? Given the above, one obvious source, and perhaps the main source, would be independent central banks. One big advantage that independent central banks have over academics as a source for the received wisdom on this issue is that they are a single point of reference. No need to ask the many economists working in the central bank - just ask the central bank governor, who you would expect to distil the wisdom of their own economists.

Following this logic, you might expect to find central banks shouting the loudest about the dangers of austerity. After all, they get the rap for deflation, so anything that makes their job more difficult and uncertain when interest rates have hit their lower bound they should perceive as especially unwelcome. In front of committees of congress/select committees and the like, they should be banging on about how they cannot be expected to do their job if politicians continue to make life difficult by deflating demand. If they did this, some politicians (particularly on the centre left) would have had ammunition with which to counter homilies about Swabian housewives and maxed out credit cards. 

Of course this does not happen. The extent to which it does not happen varies among the major banks. In the US Bernanke did very occasionally (and somewhat discretely) say things along these lines, but he seemed reluctant to do so in any way that might prove influential. In the UK Mervyn King is believed to have actively pushed for greater austerity, and the Bank of England has never to my knowledge suggested that austerity might compromise its control of inflation. The ECB, of course, always argues for austerity. It is one of the great paradoxes of our time how the ECB can continue to encourage governments to take fiscal or other actions that their own models tell them will reduce output and inflation at a time when the ECB is failing so miserably to control both.

So what is going on here? I think there are two classes of explanation, related to the distinction between the roles of interests and ideas in political economy (see Campbell here, for example). The first class talks about why the interests of the elite might favour austerity, and how these interests could be easily mediated through senior central bankers. It could also explore the interests of finance, and their close connections to central banks.

The second class might focus on ideas involving perceived threats to central bank independence. In the US, this might be nothing more than a desired quid pro quo whereby central bankers avoided mentioning fiscal policy so that politicians steer clear of comments on monetary policy. More seriously, amongst other central bankers it may represent a primal (and in the current context quite unjustified) fear of fiscal dominance: being forced to monetise debt and as a result losing both independence and control of inflation. In this context I often quote Mervyn King, who said “Central banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy.”

These ideas are in conflict with the message on fiscal policy coming from the central bank’s own models. In the UK and US, this contradiction is partly resolved by an excessive optimism about unconventional monetary policy. But it can also be resolved through overoptimistic forecasts, given that inflation targeting is in reality targeting future inflation. Although both these mechanisms come with a limited shelf life, they only need to operate for as long as austerity and the liquidity trap last.

The story I like to use about the Great Recession is that it exposed an Achilles’ heel with the consensus assignment that helped give us the Great Moderation. Yes, it was best to leave monetary policy to independent central banks, but the Achilles’ heel is that this would not work if interest rates hit their lower bound. In that situation fiscal policy had to come in as a backup for monetary policy. But if the analysis above is right the creation of independent central banks may have helped make that backup process much more difficult to achieve. By concentrating macroeconomic received wisdom in institutions that were predisposed to worry far too much about budget deficits, a huge spanner was thrown into the (socially efficient) working of the knowledge transmission mechanism.

  

Alternative Eurozone histories

I missed this paper by Philippe Martin and Thomas Philippon when it came out last October, but thanks to Francesco Saraceno I have now read it. There is also a VoxEU post by the authors. It is particularly interesting for me because it undertakes analysis (using a model which is itself interesting but which would make this post too long to discuss) of a couple of alternative histories for the Eurozone which are related to two claims that I have made in the past:

1)    It is now widely accepted among macroeconomists (but not politicians or the media) that fiscal profligacy was only the major cause of subsequent problems in Greece, while elsewhere private excess was the main problem. I have argued that aggressive countercyclical fiscal policy before 2008 would have reduced subsequent problems.

2)    If the ECB’s OMT programme had been implemented in 2010, rather than September 2012, this would have substantially reduced the degree of austerity required outside Greece. As a result, these countries would have had a better recovery from the Great Recession. [2]

Put the two claims together and I would argue that the 2010-12 Eurozone crisis (rather than just a Greek crisis) need not have happened. OMT would have limited fears of contagion, allowing a quicker and more complete Greek default. There would have been no funding crisis outside Greece, and no need for the core Eurozone economies to immediately embark on austerity.

How does the paper address these arguments? In terms of fiscal policy, it imagines reaction functions for government spending and transfers that contain a (common) countercyclical element, but also a (country specific) positive drift term, in Greece, Ireland, Portugal and Spain. One counterfactual eliminates the drift. This does not exactly fit the scenario I had in mind, because I see actual policy as not being countercyclical but (Greece apart) having less drift. However the end result is the same: a counterfactual with much more fiscal tightening before the recession. An interesting result is that tighter fiscal policy could have substantially reduced the rise in interest rates spreads in Ireland and Spain. The pre-2008 employment boom would not have happened in Greece, and would have been substantially reduced in Ireland, but the impact in Spain would have been smaller but non-negligible.

It conducts another counterfactual which imagines macroprudential policies that eliminated the household leverage boom in each country. This has a significant effect in reducing the boom in Ireland and Spain. (There was no actual employment boom in Portugal.) By inference a combination of countercyclical fiscal policy with no drift, plus macroprudential policies, would have been ideal.

So claim (1) seems to hold up fairly well. Of particular interest is what would have happened to employment from 2008 under a purely countercyclical fiscal policy. In Spain it would have fallen as a result of the recession, but subsequently stabilised rather than continuing to fall as it did in reality. In Ireland employment would have fallen in the recession, but would have risen again from 2010 rather than continuing to fall. This is partly because countercyclical fiscal policy would have helped, but also because lower levels of debt going into the recession would have reduced the increase in interest rate spreads, easing monetary policy.

With a pure countercyclical fiscal policy the debt to GDP ratio in Greece would have stayed flat (because there would have been no boom), suggesting that the Greek crisis was essentially a result of fiscal profligacy. In Spain the debt to GDP ratio would have fallen to nearly 20% of GDP, rather than staying above 40% of GDP in reality. In Ireland public debt would have been largely eliminated. This indicates the substantial amount of countercyclical policy that was required to tackle what were very large domestic booms. (Fiscal policy would presumably have been less contractionary if combined with macroprudential controls.) It also tells us how foolish it was to have a Stability and Growth Pact which essentially ignored the need for such countercyclical fiscal policy.

Claim (2) is examined in its own counterfactual, which essentially eliminates the increase in interest rate spreads that occurred from 2008. The beneficial effects on all four periphery countries are substantial. This counterfactual is unrealistic for Greece, because OMT should never have been implemented for Greece - immediate default was the better and more sustainable option. However I think it is highly credible that, despite Greece, if OMT had existed in 2010 spreads in other countries would have stayed low. [1]

Francesco Saraceno draws the lesson that the real problems with the Eurozone are institutional, and I agree. The Stability and Growth Pact was misconceived (as some of us argued before the Eurozone was created), because it ignored the need for countercyclical fiscal policy. The ECB delayed acting as a sovereign lender of last resort for two years, creating a Eurozone crisis out of what should have been just a Greek problem. The conclusion I draw, unlike many economists, is that the concept of a European Monetary Union was not inherently doomed to fail. It was the way it was implemented that caused the crisis.

It would be very nice if this was all about history. Unfortunately exactly the same mistakes are continuing, with equally damaging effects. Fiscal policy continues to be pro-cyclical, meaning that we had a second Eurozone recession and no real recovery from that. Monetary policy is either perverse (2011), or 6 years too late (!) and continues to openly encourage fiscal austerity. That most policy makers in the Eurozone have still not understood past errors remains scandalous.

[1] The paper attributes this to the reduced risk of union break up. I suspect it does so because it wants to make interesting comparisons between Eurozone countries and US states. My own analysis has instead focused on the danger of a self-fulfilling funding crisis when there is no lender of last resort. That danger presumably exists for US states.

[2] An interesting question which I have not examined is whether, even if OMT had existed in 2010, it would still have been better for both Ireland and Spain to have written off some of their debt. 

The Eurozone Scandal

Imagine that it was revealed that 10% of the European Union budget (the money that goes to the EU centre to fund the common agricultural policy and other EU wide projects) had been found to be completely wasted as a result of actions by EU policymakers. By wasted I do not mean spent on things that maybe it should not have been spent on (rich farmers, inefficient farmers, infrastructure projects whose costs exceed benefits etc), but literally money that went up in smoke. Imagine the scandal. Heads would roll, and some might find themselves in jail.

10% of the EU budget is about 0.1% of EU GDP. Yet sums at least ten times that figure are currently being wasted in the Eurozone, as a result of actions by Eurozone policymakers. Here is the latest OECD assessment of output gaps across eleven Eurozone countries, for both 2013 (blue) and 2014 (red).

A negative output gap means that output could be the amount of the gap higher without raising inflation above target. Of course Greece is a nightmare, and things in the other PIIGS are really bad, but the output gap in the Netherlands is around 3%, in France over 2% in 2014, and even in Germany the output gap exceeds 1%. Estimating output gaps is an imprecise science, but gaps of at least this size are consistent with inflation well below target (currently 0.3%). So output could be at least 1% higher across the Eurozone with no ill effects. This is the equivalent of the entire EU budget going up in smoke.

Sometimes negative output gaps are the result of shocks which were not anticipated by policymakers (like the financial crisis). Sometimes they are engineered by policymakers to bring inflation down. It is unfortunate that these things happen, but they always have. However the output gaps we have in the Eurozone today are neither of these. Instead they have been created by policymakers for no good reason. That is why they can be called a scandal.

At this point you might think I’m being unfair. Surely this is all about tight fiscal policy required to bring down government debt. I agree that it is all about fiscal policy, and in particular the crazy fiscal rules imposed within the Eurozone. However where is the urgent need to bring down debt outside the periphery? The OECD estimate that the primary structural budget balance in the Eurozone will be a surplus at around 1% of GDP in 2014 compared to a deficit in the OECD as a whole of just over 1%. So even if you think that we need austerity to bring deficits down rapidly - which I do not - why should policymakers in the Eurozone be doing this so much more quickly than in the UK, US or Japan? To achieve this goal, they are wasting resources on a colossal scale.

If you think anything has changed as a result of Juncker’s ‘E315 bn’ investment plan, you should read this post from Frances Coppola. As she makes clear, there is not a penny of new EU money in this proposal. Instead money earmarked for existing projects is being used to provide insurance to private sector investment (which may or may not happen). There are so many issues with this kind of stimulus. Besides those raised by Frances, there is also the question of how to prevent firms simply getting insurance for schemes they would have undertaken anyway, and how exactly will the Commission select when to allocate its insurance. Those of a neoliberal persuasion who think government is bad at spending its money cannot feel any more comfortable with the government selecting what private sector projects to back. However a scheme like this will come as no surprise to someone like George Monbiot, who thinks states are increasingly being used to serve corporate ends. 

Equally embroiled in this scandal are those making monetary policy decisions at the ECB. Here I can simply defer to an excellent post by Ashoka Mody. In particular he points out why it is misleading to simply look at the ECB’s balance sheet as an indicator of the force of unconventional monetary policy. There is an important difference between creating money to bail out failing banks, as the ECB has done, and creating money to buy bonds to force down long term rates, which is Quantitative Easing (QE). He argues that the “ECB is set to remain—by far—the central bank with the tightest, most conservative monetary policy among the major central banks.” I thought I would quote the following paragraph in full, for reasons that will be clear to regular readers.

“Others play by the rules of the cognitive frame. Thus, despite the serious concerns with the June 5th measures—documented carefully by my Bruegel colleagues—journalists have no interest in asking ECB officials: “What exactly are we waiting for?” The financial markets have no interest in public policy: once the rules are set, they seek opportunities for short-term bets. On July 9th, the International Monetary Fund’s Executive Board somewhat incredulously concluded: “Directors welcomed the exceptional measures recently taken by the European Central Bank (ECB) to address low inflation and strengthen demand, as well as its intention to use further unconventional instruments if necessary.” Belatedly, on November 25th, the OECD became a lone official voice calling for more urgent steps.“

To those who say that QE, as operated by the BoE or Fed, would have limited effectiveness in the Eurozone, I have a lot of sympathy. However there is a relatively simple way of making QE much more effective and predictable, and that is for central banks to create money not to buy financial assets but to transfer directly to citizens, which Friedman called helicopter money. John Muellbauer calls this QE for the people. Conventional QE involves buying a large amount of assets with potential losses for the central bank (if the asset price falls) but uncertain effects on demand. Helicopter money involves small transfers with a certain loss to the central bank but much more predictable positive demand effects. [1]

As an institutional innovation, helicopter money has two major drawbacks in countries with their own central bank. [2] First, why innovate when you can implement exactly the same policy through existing means: in macroeconomic terms helicopter money is equivalent to QE plus tax cuts when you have inflation targeting. Second, a fiscal stimulus in the form of temporary additional government spending is likely to be more predictable in its impact than transfers or tax cuts, because you eliminate the uncertainty caused by how much of the transfer or tax cut will be spent.

But if countercyclical fiscal policy is effectively illegal in the Eurozone, these objections do not apply. QE for the people may have additional legal merits within the Eurozone. The ECB is constrained to some (uncertain) extent in its ability to buy government debt. But, as John Muellbauer suggests, mailing a cheque to every EZ citizen using electoral registers would seem to circumvent these legal difficulties.

One objection to the ECB embarking on ‘QE for the people’ is that it goes well beyond the remit of a central bank. [3] Yet the ECB appears to have no qualms on that score: besides routine references for the need for fiscal consolidation and ‘structural reform’, the letter discussed by Paul De Grauwe here shows the ECB requiring detailed changes to labour market regulations and institutions in Spain. So you have to ask why is it OK for the central bank to override the democratic process in this way, but giving money directly to the people is somehow beyond the pale.

If you think that mailing a cheque to every voter in the Eurozone as a solution to continuing recession sounds too good to be true, then you have just rediscovered why recessions caused by demand deficiency when inflation is below target are such a scandalous waste. It is a problem that can be easily solved, with lots of winners and no losers. The only reason that this is not obvious to more people is that we have created an institutional divorce between monetary and fiscal policy that obscures that truth. It was a divorce that did a reasonable job in steering the economy in normal times, and it might discourage fiscal profligacy when demand is strong, but since 2010 it has led to a scandalous paralysis in the Eurozone.  

  

[1] These losses are notional only, as the central bank is not in the business of making money. They matter only if they compromise the ability of the central bank to do its job of controlling inflation in the future. There are various ways that danger can be avoided, but my point here is that costs to the central bank can arise with any form of QE.

[2] Central banks routinely pass the profits they make (through seigniorage) to governments. So the innovation is that the central bank rather than the government decides how to disperse this money.  

[3] Another objection is that, because the ECB is free to define its own targets, changing the monetary policy framework to target the level of nominal GDP would be a better innovation. I agree this would be a useful innovation. I would argue that it would be better still to allow countercyclical fiscal policy, because only this can deal with country specific shocks. But if, for whatever reason, these changes are ruled out, then a helicopter drop should be implemented. If you are a market monetarist, think of it as an insurance policy.

    

Defining price stability

Price stability is the primary objective of the ECB, as laid down in the Treaty on the Functioning of the European Union, Article 127 (1). The ECB gets to choose how to interpret price stability, and it does this as “inflation rates below, but close to, 2% over the medium term.” Why ‘below but close to’? If this means 1.8% or 1.9%, it would seem very odd. How do the ECB know that 1.8% inflation is the right target?

I suspect the answer is that this formulation is a compromise, between those who wanted a commitment to inflation below 2% (which could mean zero) and those that wanted just 2%. Is this constructive ambiguity? I cannot see how it can be. The whole point about inflation targeting is to provide a clear signal about the objectives of the monetary authority.

Now this would not matter much if everyone involved in ECB monetary policy was of one mind. However they clearly are not. Here is Jürgen Stark, who was sometimes referred to as chief economist of the ECB until he left at the end of 2011, talking about the current conjuncture:

“The current inflation rate of 0.3% is due to the significant decline in commodity prices and the painful but unavoidable adjustment of costs and prices in the peripheral countries. Only Greece currently has a slightly negative inflation rate. In other words, price stability reigns in the eurozone. This strengthens purchasing power and ultimately private consumption. The ECB has fulfilled its mandate for the present and the foreseeable future. There is no need for policy action in the short term.”

Are these views of the past? Or do some who continue to sit on the Governing Council still have sympathy for these views? Is this about principle, or national interest: ECB rates were cut substantially when the German economy was weak in 2002-5, rather than let inflation fall below 2%. Speculation of this kind is fine for those who make money from it, but inflation targets should be clear and unambiguous. Allowing people to believe that maybe the ECB is not too bothered about below 2% inflation could be very dangerous because of the zero lower bound.

The solution to this problem seems terribly straightforward. All the academic discussion is about whether inflation targets should be higher than 2%, not lower, because the chances of hitting the zero lower bound are clearly greater than had been thought. With Stark and others no longer there, perhaps the ECB can agree (by majority vote if necessary) to target just 2%, and those that cannot abide by that decision can leave - as Stark officially did - for 'personal reasons'. If the ECB cannot do this by themselves, then Eurozone governments should tell them to do this. I have never understood why the inflation target itself should be something that is decided behind the closed doors of central banks.

One final thought on the Stark article. He too uses the phrase “Anglo-Saxon economists”. I am at a loss to know what this is meant to signify. For a few who comment on my posts it means that we are part of a plot to ensure the Eurozone fails, but is this what Stark means? Perhaps there is some reason why the theories of economics developed in the UK and US do not apply in the Eurozone. However the work I have seen done by ECB economists would not look out of place if done at the Fed or IMF, and from his experience Stark must know this. Some people refer to ordoliberalism. But if ordoliberalism differs from Anglo-Saxon neoliberalism in theory rather than practice, it seems to me this is because it takes more rather than less notice of mainstream economics. If it means disagreeing with almost everything in the paragraph of his quoted above, then I think many non-Anglo-Saxon economists would be in that group. Perhaps, like the phrase ‘below but close to 2%’, we will never know quite what it means.

The ECB and the Bundesbank

There can be no doubt that some of the responsibility for the current Eurozone recession has to be laid at the feet of the ECB. Some of that might in turn be due to the way the ECB was set up. Specifically

1) That the ECB sets its own definition of price stability

2) This definition is asymmetric (below, but close to, 2%)

3) No dual mandate, or even acknowledgement of the importance of the output gap

4) Minimal accountability, because of a concern about political interference

It is generally thought that the ECB was created in the Bundesbank’s image. Tony Yates goes even further back in this post. Yet the irony is that the ECB abandoned the defining feature of Bundesbank policy, which could be providing significant help in current circumstances.

The defining feature of Bundesbank policy was a money supply target. Whereas the UK and US experience with money supply targeting was disastrous and short lived, the Bundesbank maintained its policy of targeting money for many years. There is little doubt that this was partly because the Bundesbank was in practice quite flexible, and the money target was often missed. Nevertheless the Bundesbank felt that maintaining that money target played an important role in conditioning expectations, and there is some evidence that it was correct in believing this.

When the ECB was created, it adopted a ‘twin pillar’ approach. The first pillar was the inflation target, and the second pillar involved looking at money. It was generally thought that the second pillar was partly a gesture to Bundesbank practice, and subsequently most analysis has focused on the inflation target.

There are very good reasons for abandoning money supply targets: they frequently send the wrong signals, and are generally unreliable in theory and practice. However a monetary aggregate should be related to nominal GDP (NGDP), and you do not need to be a market monetarist to believe there are much better reasons for following a NGDP target. What a NGDP target does for sure is make you care about real GDP, which would go a long way to correcting points (2) and (3) above. What it can also do, if you target a path for the level of NGDP, is provide a partial antidote for a liquidity trap, as I discuss here. More generally, it can utilise most effectively the power of expectations, which is why perhaps the most preeminent monetary economist of our time has endorsed them.

So do not blame the Bundesbank for the flawed architecture of the ECB. The ECB abandoned the critical aspect of Bundesbank policy, which was to target an aggregate closely related to nominal GDP. ECB policy has suffered as a result.