The lesson monetary policy needs to learn

It seemed obvious to write a post about the Peterson Institute’s recent conference on ‘Rethinking Macroeconomic Policy’, but nowadays I find it more efficient to let Martin Sandbu do the job. We agree most of the time, and he does these things better than I do. It allows me to write something only in the unlikely event that I disagree, or if I want to take the discussion further.

I only have one quibble with Martin’s column yesterday. I think Bernanke’s suggestion that following a large recession (where interest rates hit their lower bound) central banks revert to a temporary price level target is rather more than the tweak he suggests. In addition, as Tony Yates pointed out, level of NGDP targets do not resolve the asymmetry problem that Bernanke’s suggestion is designed to address.

I also thought I could illustrate Martin’s final point that “admitting one has got things badly wrong is a prerequisite for doing better” by looking at some numbers. If we look at consumer prices, average inflation between 2009 and 2016 was 1.1% in the Euro area, 1.4% in the US and 2.2% in the UK. The UK was a failure too: average consumer price inflation should have been higher than 2.2%, because we had a large VAT hike and depreciation that monetary policy rightly saw through. If we look at GDP deflators we get a clearer picture, with 1.0%, 1.5% and 1.6% for the EZ, US and UK respectively.

You might think errors of that size are not too bad, and anyway what is wrong with inflation being too low. You would be wrong because in a recovery period these errors represent lost resources that, as the Phillips curve appears to be currently so flat, could be considerable. Or in other words the recovery could have been a lot faster, and interest rates could now be well off the lower bound everywhere, if policy had been more expansionary.

What I really wanted to add to Martin’s discussion was to suggest the main problem with monetary policy over this period, particularly in the UK and the Eurozone. It is not, in my view, the failure to adopt a levels target, or even the ECB raising rates in 2011 (although that was a serious and costly mistake). In 2009, when central banks would have liked to stimulate further but felt that interest rates were at their lower bound, they should have issued a statement that went something like this:

“We have lost our main instrument for controlling the economy. There are other instruments we could use, but their impact is largely unknown, so they are completely unreliable. There is a much superior way of stimulating the economy in this situation, and that is fiscal policy, but of course it remains the government’s prerogative whether it wishes to use that instrument. Until we think the economy has recovered sufficiently to raise interest rates, the economy is no longer under our control.”

I am not suggesting QE did not have a significant positive impact on the economy. But its use allowed governments to imagine that ending the recession was not their responsibility, and that what I call the Consensus Assignment was still working. It was not: QE was one of the most unreliable policy instruments imaginable.

The criticism that this would involve the central bank exceeding its remit and telling politicians what to do is misplaced. Members of the ECB spent much of the time telling politicians the opposite, Mervyn King did the same in a more discreet way, while Ben Bernanke eventually said in essence something milder than the above. Under the Consensus Assignment we have invested central banks with the task of managing the economy because we think interest rates are a better tool than fiscal policy. As such it is beholden on them to tell us when they can no longer do the job better than government.

A better criticism is that a statement of that kind would not have made any difference, and we could spend hours discussing that. But this is about the future, and who knows what the political circumstances will be then. It is important that governments acknowledge that the Consensus Assignment no longer works if central banks believe there is a lower bound for interest rates, and this has to start by central banks admitting this. Economists like Paul Krugman, Brad DeLong and myself have been saying these things for so long and so often, but I think central banks still have problems fully accepting what this means for them.       

The OBR’s risk assessment lacks context

In its recent report on fiscal risks, the OBR talks a lot about all the shocks that could make the government debt to GDP ratio rise again. It then says the following:

“None of this should be taken as a recommendation to refrain from particular spending increases or tax cuts, or to avoid particular fiscal risks – that would lie beyond our remit. And there are those who believe fiscal policy is still too tight, given the pace of economic growth and the looseness of monetary policy. But ….”

Should I be grateful for the second sentence, being one of ‘those’ who think that way?

I think the reverse is true. The OBR has played the tune the government wanted, but it is the wrong tune, and this now mature and independent organisation is capable of much better than this. I will first deal with a particular issue to do with monetary policy, and then talk more generally about the concept of ‘fiscal risks’.

Our macroeconomic institutional architecture is based around what I have called the consensus view about macroeconomic policy. This consensus involves what economists call an assignment. The stabilisation of output and inflation is assigned to independent central banks operating monetary policy. Fiscal policy should be confined to managing the government’s deficit and debt, and to help it with that task there should be a combination of fiscal rules and independent fiscal institutions (aka fiscal councils, like the OBR).

In a consensus assignment world, the job of a fiscal council is to stop deficit bias: the tendency clearly observable in some countries before the global financial crisis for deficits to creep up over time. In particular, when all is going well and the deficit appears not to be an issue, it is their job to tell the government to 'fix the roof while the sun shines’.

As I and others have noted many times, this consensus assignment has an Achilles Heel, which is that nominal interest rates cannot go below a number close to zero, the so-called Zero Lower Bound (ZLB). In the absence of some mechanism to allow interest rates to become significantly negative, that ZLB problem means that sometimes fiscal policy makers have to help monetary policy in its stabilisation role. The simple consensus assignment breaks down.

Although most academic macroeconomists recognise that, our institutions find it hard to do so. Monetary policymakers in the UK and Eurozone find it very difficult to say that they have lost their main instrument, and that therefore they can no longer reliably do their job. It seems that our fiscal council, the OBR, has similar problems.

We are currently at the ZLB. The most immediate risk we therefore face is that we are hit by a negative shock and monetary policy is unable to respond effectively. Hence the quote from their document above. But as far as I can see that is it. In their section in the Executive Summary on the risk due to a recession I would have thought the ZLB problem was worth at least mentioning, but it does not appear. Indeed I’m not sure the term ZLB or liquidity trap appear anywhere in the document.

I’m sure the OBR would in defence say two things: assessments of fiscal risks generally look at risks to fiscal sustainability not macroeconomic stabilisation, and their remit precludes them from talking about alternative fiscal policy paths. This is all true. The Treasury wanted a report that would enable them to say we must continue with austerity because of all the risks identified by the OBR. The Treasury also wrote the OBR’s current remit. 

But the OBR is supposed to be independent. Just because the government tries to pretend that there is no Achilles Heel to the consensus assignment, that does not mean it has to go along with that act. In particular, it will (I hope) have noted that the main opposition - which came close to defeating the current government - has a fiscal rule that explicitly says that fiscal policy needs to switch from stabilising debt to stabilising the economy when interest rates are at their lower bound (like now). In this context, I think something beyond a single sentence alluding to the ZLB would have been appropriate.

Tony Yates said similar things yesterday. He also made another important point: a key role of government in many areas is to be a risk absorber. It assumes risks, because it is beneficial to take risks away from individuals or individual generations and spread them more widely, and often the state is the only institution that can do this. In addition, its deficit and debt should be a macroeconomic shock absorber. Given all that, why exactly should we be concerned if various shocks increase government debt? That is what is supposed to happen!

To put the term risk and attach it to some level of debt or deficit, giving us ‘fiscal risks’, is questionable. It is a bit like saying their is a risk that your central heating will come on if it gets cold: that is not a risk, but why it is there. The OBR would no doubt respond that the government has a mandate in terms of a deficit or debt target, and it has been asked to look at risks that this may not be met. But that should not stop an independent OBR from asking more fundamental questions.

Implicit in the idea of ‘fiscal risks’ is either a belief that there is an optimal level of debt which is below current levels, or a view that there is some level of debt so high that markets would start worrying about the government choosing to default. If we are worried about a debt burden on future generations, does it make sense to put all that burden on a current, already disadvantaged, younger working generation? Unless these key issues are addressed, all the risk assessment the report undertakes is meaningless, or worse still just provides support for the government’s misguided policy. It is time the OBR stopped being constrained by its remit, and started providing the public with a useful framework in which to think about ‘fiscal risks’.

Why recessions followed by austerity can have a persistent impact

Economics students are taught from an early age that in the short run aggregate demand matters, but in the long run output is determined from the supply side. A better way of putting it is that supply adjusts to demand in the short run, but demand adjusts to supply in the long run. A key part of that conceptualisation is that long run supply is independent of short run movements in demand (booms or recessions). It is a simple conceptualisation that has been extremely useful in the past. Just look at the UK data shown in this post: despite oil crises, monetarism and the ERM recessions, UK output per capita appeared to come back to an underlying 2.25% trend after WWII.

Except not any more: we are currently more than 15% below that trend and since Brexit that gap is growing larger every quarter. Across most advanced countries, it appears that the global financial crisis (GFC) has changed the trend in underlying growth. You will find plenty of stories and papers that try to explain this as a downturn in the growth of supply caused by slower technical progress that both predated the GFC and that is independent of the recession caused by it.

In a previous post I looked at recent empirical evidence that told a different story: that the recession that followed the GFC appears to be having a permanent impact on output. You can tell this story in two ways. The first is that, on this occasion for some reason, supply had adjusted to lower demand. The second is that we are still in a situation where demand is below supply.

The theoretical reasons why supply might adjust to demand are not difficult to find. (They are often described by economists under the jargon word 'hysteresis'.) Supply (in terms of output per capita) depends on labour force participation, the amount of productive capital in the economy, and finally technical progress, which is really just a catch all for how aggregate labour and capital combine to produce output. A long period of deficient demand can discourage workers. It can also hold back investment: a new project may be profitable but if there is no demand it will not get financed.

However the most obvious route to link a recession to longer term supply is through technical progress, which connects to the vast literature under the umbrella of ‘endogenous growth theory’. This can be done through a simple AK model (as Antonio Fatas does here), or using a more elaborate model of technical progress, as Gianluca Benigno and Luca Fornaro do in their paper entitled ‘Stagnation traps’. The basic idea is that in a recession innovation is less profitable, so firms do less of it, which leads to less growth in productivity and hence supply. Narayana Kocherlakota has promoted this idea: see here for example.

The second type of explanation is attractive, in part because the mechanism that is meant to get demand towards supply - monetary policy - has been ‘out of action’ for so long because of the Zero Lower Bound (ZLB). (The ZLB also plays an important role in the Benigno & Fornaro model.) However for some this type of explanation currently seems ruled out by the fact that unemployment is close to pre-crisis levels in the UK and US at least.

There are three quite different problems I have with the view that we no longer have a problem of deficient demand because unemployment is low. The first, and most obvious, is that the natural rate of unemployment might be, for various reasons, considerably lower than it was before the GFC. The second is that workers may have priced themselves into jobs. In particular, low real wages may have encouraged firms to use more labour intensive techniques. If that has happened, it does not mean that the demand deficiency problem has gone away, but just that it is more hidden. (For anyone who has a conceptual problem with that, just think about the simplest New Keynesian model, which assumes a perfectly clearing labour market but still has demand deficiency.)

The third involves the nature of any productivity slowdown caused by lack of innovation. A key question, which the papers noted above do not directly address, is whether we are talking about frontier research, or more the implementation of innovation (for example, copying what frontier firms are doing). There is some empirical evidence to suggest that the productivity slowdown may reflect the absence of the latter. This is very important, because it implies the slowdown is reversible. I have argued that central banks should pay much more attention to what I call the innovation gap (the gap between best practice techniques, and those that firms actually employ) and its link to investment and aggregate demand.

All this shows that there is no absence of ideas about how a great recession and a slow recovery could have lasting effects. If there is a problem, it is more that the simple conceptualisation that I talked about at the beginning of this post has too great a grip on the way many people think. If any of the mechanisms I have talked about are important, then it means that the folly of austerity has had an impact that could last for at least a decade rather than just a few years.

Still not getting it after all these years

I met Nick Macpherson, the most senior civil servant at the UK Treasury from 2005-16, for the first time (I think) a few weeks ago. It was at a conference about, among other things, getting economic ideas across to the public. He is also on twitter, and I saw the following exchange between him and Tony Yates.

To be fair to Nick, I get many people saying the same thing: we are at full employment, so we should not be running deficits. Let’s not on this occasion discuss how we can be at full employment when nominal wage growth is so weak, or into the distinction between current and total deficits. The main point that Tony makes above is that you cannot discuss what an appropriate fiscal policy setting should be without thinking about monetary policy.

There was one reason, and one reason alone, that we had fiscal stimulus in 2009. It was because nominal interest rates had hit their lower bound. A recession in itself is not a sufficient condition for a fiscal stimulus if monetary policy can do all the work of getting us out of the recession. [1] But when interest rates are stuck at their lower bound, monetary policy has lost its ability to regulate the economy, which means we are either stuck in a recession or are vulnerable to any negative demand shock. Unconventional monetary policy, although better than nothing, is far, far less reliable than conventional monetary or fiscal policy.

It is therefore a prime duty of government to ensure that, if interest rates have hit their lower bound, fiscal policy is solely directed at allowing monetary policy to raise rates. This idea is not new. It was always implicit in New Keynesian theory and what I call the Consensus Assignment. Paul Krugman, Brad DeLong and others have been going on about it at least since the financial crisis. The idea should be part of any fiscal rule, as Jonathan Portes and I suggest here, and this is still part of Labour’s fiscal credibility rule.

In the UK, at this very moment, we are once again at the lower bound for interest rates. That means fiscal policy is currently too tight. Whether we are at full employment is neither here nor there. Interest rates are at their lower bound because the negative influences on aggregate demand are more than monetary policy can handle. One of those negative influences is fiscal consolidation. That fiscal consolidation should wait [2] until interest rates are safely clear of their lower bound.

This is not one particular theory of monetary and fiscal policy interaction. It is the consensus theory. That it is not understood by the public is understandable given mediamacro. But not being understood by senior civil servants (and I doubt Nick is alone here) when they are free to speak their minds is much more surprising.

[1] I’m using consensus theory here, and abstracting from uncertainty.

[2] It can wait because there is no problem in financing the deficit, and because we print our own currency there has never been any such problem.  

Its ideology, stupid

Wolfgang Münchau takes to task in today’s FT the latest example of German opposition, and in particular opposition from finance minister Schäuble, to ECB policies. However I think he ends up missing the obvious target. He discusses the particular problems negative rates pose for Germany’s financial sector, and in his last paragraph writes

“This episode is a reminder that the collective spirit that was so strongly present in the first years of the eurozone has gone. That — not the presence of imbalances or other technical problems — constitutes the single biggest danger to the long-term viability of Europe’s monetary union.”

I would suggest this has the causality wrong. Any collective spirit has gone because of these ‘technical problems’. The biggest technical problem is an obsession with inappropriate collective fiscal consolidation (austerity). In the Eurozone the ECB is being forced to try negative interest rates because it is having to undo the impact of fiscal consolidation. And the man most responsible for this obsession is Schäuble.  

Gavyn Davies nicely sums up my own view about negative interest rates. Without radical institutional and social changes (which may not be desirable), bank profitability puts a limit on how far central banks can go, and for that reason exploring these frontiers could be counterproductive. But the alternative of more QE, possibly directed at other assets besides government debt, is way down the list of effective and reliable instruments for managing aggregate demand right now. Helicopter money is a much better way of giving central banks more ammunition. But the focus right now should not be on any of this, if we are genuinely concerned about social welfare. As John Kay says, “we need less financial ingenuity and more common sense”.

What we should be talking about is why governments are not doing much more public investment. Yet in the US, Germany and the UK any dramatic increase in public investment seems out of the question. Barry Eichengreen, in an article entitled “Confronting the Fiscal Bogeyman”, writes of Germany:

“The ordoliberal emphasis on personal responsibility fostered an unreasoning hostility to the idea that actions that are individually responsible do not automatically produce desirable aggregate outcomes. In other words, it rendered Germans allergic to macroeconomics.”

In the US, antagonism to the Federal government rooted in the past has meant Republican leaders are  

“antagonistic to all exercise of federal power except for the enforcement of contracts and competition – a hostility that notably included countercyclical macroeconomic policy. Welcome to ordoliberalism, Dixie-style. Wolfgang Schäuble, meet Ted Cruz.”

He ends

“Ideological and political prejudices deeply rooted in history will have to be overcome to end the current stagnation. If an extended period of depressed growth following a crisis isn’t the right moment to challenge them, then when is?”

He does not mention the UK, where the antagonism to public investment seems to lack any deep historical explanation, and may just reflect stupidity or an ideology imported from the US.

When I talk about public investment people normally think about big projects, like HS2 in the UK. I like to point out that simpler and perhaps more boring things, like repairing roads, are at least as important, and can be done immediately. But if there is one area above all else where much more needs to be done right now it is investment in renewable energy.

The recent news on climate change is not good. It is foolish to read too much into one or two months figures, but this chart is nevertheless quite scary. It is scary because we know of various possible ‘tipping points’ (like the melting of all Arctic ice or the mass release of methane from permafros) which could accelerate global warming. Most climate models assume we will control carbon emissions in time to stop that happening, but we cannot be sure of that, because we are in uncharted territory.

We know we need a massive expansion of renewable energy, but one problem that has so far stopped that being a complete solution to climate change has been that sometimes the wind neither blows nor the sun shines. We need to be able to cheaply store electricity, but our current battery technology is not good enough. Battery technology is also crucial in making electric cars as attractive as petrol based cars. But technology could come to the rescue. Existing batteries could be made much more efficient, or completely new battery technologies could be made viable. Much more efficient transmission could also help. And if you look at all three links, you may notice one common factor. These potential breakthroughs have all come from research undertaken in the public sector. As Mariana Mazucato has argued, the state is “better able to attract top talent and pursue radical innovation”.   

China put over $80 billion into the renewable energy sector in 2014. That is nearly 1% of its GDP. It has committed to spend 25 times that amount over the next 15 years on clean energy. Both the US and Europe spent much smaller amounts ($38 and $58 billion respectively), even though their economies are much larger (the US figure is around 0.07% of its GDP). In dollar terms, the Chinese government also spent more on Green R&D than Europe or the US. [1] The scope for US and European governments to spend more on researching and help with developing green technology is huge. Yet in the UK the government has recently cut back its support for renewable energy, even though the UK’s need for renewable energy is urgent.

Climate change may be the most important example, but it is not alone. It is absurd that when the potential for technological change leads people to write about robots taking over, actual productivity growth is slowing everywhere. As an IMF report says, "innovation [is] highly dependent on government policies." I think Brad DeLong, in commenting on Eichengreen’s article, has it exactly right when he writes “it is long past time for a frontal intellectual assault on the[se] dangerous and destructive ideologies”.   

 

[1] If we include corporate R&D, Europe moves ahead of China in $ spend, but China is still ahead of the US.       

Central bank mistakes: more on count 2

Martin Sandbu in the FT picks up on my post on central bank mistakes. While he says that the first and third I identify are “on point”, he says the second is simply wrong. I think this is because he (and many others) misunderstand the point I am making, which in turn probably means I’ve failed to be clear about it. But it is really important.

My second criticism is that central banks did not make it clear what the impact of reaching the zero lower bound (ZLB) was, and as a result were too quiet about the adverse impact of fiscal austerity. That is not the same as saying there is nothing central banks can do at the ZLB, or that unconventional monetary policy is impotent. As I said in the post, what the ZLB meant is that central banks could no longer do their job effectively, and that unconventional policy “was untested, and it is just not responsible to pretend otherwise”.

Take three instruments: interest rate changes, fiscal policy changes, and unconventional monetary policy. The first two are tried and tested. There is still much uncertainty, but we can have a good guess at orders of magnitude when it comes to working out how much we need to do to achieve some end result (particularly when interest rate changes will not undo fiscal policy’s effects). Unconventional monetary policy has some impact, but we have little prior knowledge of how big that effect will be (or equivalently, how much we need to do to achieve some end result.) Given lags between instrument changes and results, this is a very serious disadvantage.

A simple analogy. The central heating is broken, and it is freezing outside. It can be fixed quickly with the right kit. You ring two plumbers to come and fix it. One says he can be there immediately, the other says they can come in two hours. You are getting very cold, so you naturally choose the plumber who can come straight away. However when they arrive, they tell you their equipment required to fix the problem quickly is broken, but they can nevertheless probably bodge something within the next day or two. You ring the other plumber, and they do have the right equipment. What would you do? Would you not get cross at the first plumber for not telling you their equipment was not working properly when you first contacted them? Now suppose the first plumber did not tell you anything, and you only found out about the kit that could have fixed the problem quickly later on. Would you employ that plumber again, particular when you discover that since his ‘repair’ your central heating is not working as well as it used to?

In a way this strikes at the core of the independence issue. Without independence, the government would be able to choose the best instrument available, which at the ZLB is fiscal policy. But central banks have been made independent and the task of stabilising the economy has been delegated to them. This institutional change should not mean that we no longer use the best instrument to do the job. [1] But if the central bank fails to be frank, perhaps because it feels bad about admitting that it no longer has the best tools to do the job, that is a clear mistake on its part. In this respect it is not important whether the central bank being honest and clear would have actually made a difference on this occasion. That it might have done is all that matters.

I think central banks can at this point get confused with political neutrality. But pointing out the facts as they see it about their own relative competence should never be seen as ‘political’. Here Tony Yates makes a good suggestion, which is that the central bank should be mandated to comment “on whether its ability to meet the inflation target [or whatever its objectives are] was being hampered by government fiscal policy.” 

Advocacy blogging is so ubiquitous that some presume that in pointing out this and other mistakes I must be arguing against central bank independence (CBI). To repeat, I am not. What I think is indisputable is that CBI done badly can be worse than no independence. It does not serve the cause of well designed and well implemented central bank independence to gloss over past mistakes.

[1] Suppose you erroneously think concerns about government debt were valid. Was that a justification for central bankers to argue against fiscal expansion? Absolutely not. With QE, any fiscal expansion could have been money financed. What central bankers should have said is that short term concerns about excessive government debt were unfounded, because they were acting as a lender of last resort. They did not say this.