Could independent central banks be advisory?

With fiscal councils (or Independent Fiscal Institutions) now commonplace in advanced economies, a natural question arises. Why are all these councils advisory, while independent central banks have control over monetary policy? For fiscal policy we seem to have delegated advice [1], while for monetary policy we have delegated control. In this post I want to focus on control over how policy instruments are changed, and not control of the goals of policy. For clarity assume that governments still control the ultimate goals of monetary policy (e.g. an inflation target) and fiscal policy (e.g. a target for the deficit in 5 years time).

As fiscal councils are the less familiar, it is natural to try and answer this question by asking why fiscal councils are not given control over fiscal policy. I am, of course, not talking about controlling the detail of government spending or taxes, but instead setting a target for the projected deficit which governments should aim to achieve in a budget. There are lots of potential answers to that question, which I have written about elsewhere.

However we could ask the question the other way around, and I cannot remember anyone asking it this way. Why are there no independent advisory central banks? In the UK, for example, imagine having the MPC meeting, and then immediately advising (in secret for a short time) the Chancellor of their recommendation for interest rates. The Chancellor would very quickly (within an hour or day?) decide whether to accept that recommendation or do something different. After that, the decision and the MPC’s recommendation would be announced.

Two straightforward points. First, a system of that kind could only work in the US if Congress gave the President the power to accept the Fed’s recommendation or impose the President’s own decision: perhaps not something we would want to contemplate right now. In the Eurozone the ECB would have to give recommendations to Ecofin, which might make it both impractical and perhaps undesirable. Second, this form of delegation is obviously weaker than giving complete control to the central bank, and that in itself may be a reason why it is not adopted.

Nevertheless, for a country like the UK, it would be a mistake to underestimate the political pressure the Chancellor would be under to accept the central bank’s public advice. The Chancellor or Treasury minister would be entirely responsible from deviating from the recommendation given to them, and if it went wrong they would incur a considerable political cost. In these circumstances, it would be understandable for governments to reason that there was little to be gained from having the power to overrule central bank advice. They would get it in the neck if they overruled this advice and turned out to be wrong, but equally if the MPC make mistakes they would also have ultimate responsibility for accepting this advice. If in practice nearly all of the time they are going to accept the central bank’s recommendations, why not give them complete control so that at least you are not implicated when things go wrong.

If this reasoning is correct, it raises a difficult question for those who argue against central bank independence but still accept monetary policy’s primary role in stabilising the economy outwith the ZLB. Of course many governments used to be happy to control monetary policy, as long as the advice they were getting was secret. But if that advice is public, as surely we all agree it should be, would even formally advisory central banks start to in effect control monetary policy because governments would never incur the risk of going against their advice? In which case, why so much fuss about independent central banks that do control monetary policy being undemocratic? I stress again that I’m talking about control of month to month interest rate changes, and not the goals of monetary policy (inflation targets or NGDP targets). I think those should be democratically decided (as in the UK, but not the US or EZ), and that central banks should be accountable in a meaningful way if they do not achieve these goals. But for the day to day business of setting rates, I cannot see that much would be gained by putting those under democratic control. 

[1] In the absence of delegating advice to an independent institution, advice would come from the the internal civil service. 

Is a flexible labour market a problem for central bankers?

Recessions and milder economic downturns are typically a result of insufficient aggregate demand for goods. The only way to end them is to stimulate demand in some way. That may happen naturally, but it may also happen because monetary policymakers reduce interest rates. How do we know we have deficient aggregate demand? Because unemployment increases, as a lower demand for goods leads to layoffs and less new hires.

A question that is sometimes posed in macroeconomics is whether workers in a recession could ‘price themselves into jobs’ by cutting wages. In past recessions workers have been reluctant to do this. But suppose we had a more prolonged recession, because fiscal austerity had dampened the recovery, and over this more prolonged period wages had become less rigid. Then falling real wages could price workers into jobs, and reduce unemployment. [1]

This is not because falling real wages cure the problem of deficient aggregate. If anything lower real wages might reduce aggregate demand by more. But it is still possible that workers could price themselves into jobs, because firms might switch to more labour intensive production techniques, or fail to invest in new labour saving techniques. We would see output still depressed, but unemployment fall, employment rise and stagnant labour productivity. Much as we have done in the UK over the last few years.

It is important to understand that in these circumstances the problem of deficient demand is still there. Resources are still being wasted on a huge scale. Quite simply, we could all be much better off if demand could be stimulated. How would central bankers know whether this was the case or not?

Central bankers might say that they would still know there was inadequate demand because surveys would tell them that firms had excess capacity. That would undoubtedly be true in the immediate aftermath of the recession, but as time went on capital would depreciate and investment would remain low because firms were using more labour intensive techniques. The surveys would become as poor an indicator of deficient aggregate demand as the unemployment data.

What about all those measures of the output gap? Unfortunately they are either based on unemployment, surveys, or data smoothing devices. The last of these, because they smooth actual output data, simply say it is about time output has fully recovered. Or to put it another way, trend based measures effectively rule out the possibility of a prolonged period of deficient demand. [2] So collectively these output gap measures provide no additional information about demand deficiency.

The ultimate arbiter of whether there is demand deficiency is inflation. If demand is deficient, inflation will be below target. It is below target in most countries right now, including the US, Eurozone and Japan. (In the UK inflation is above target because of the Brexit depreciation, but wage inflation shows no sign of increasing.) So in these circumstances central bankers should realise that demand was deficient, and continue to do all they can to stimulate it.

But there is a danger that central bankers would look at unemployment, and look at the surveys of excess capacity, and look at estimates of the output gap, and conclude that we no longer have inadequate aggregate demand. In the US interest rates are rising, and there are those on the MPC that think the same should happen here. If demand deficiency is still a problem, this would be a huge and very costly mistake, the kind of mistake monetary policymakers should never ever make. [3] There is a fool proof way of avoiding that mistake, which is to keep stimulating demand until inflation rises above target.

One argument against this wait and see policy is that policymakers need to be ‘ahead of the curve’, to avoid abrupt increases in interest rates if inflation did start rising. Arguments like this treat the Great Recession as just a larger version of the recessions we have seen since WWII. But in these earlier recessions we did not have interest rates hitting their lower bound, and we did not have fiscal austerity just a year or two after the recession started. What we could be seeing instead is something more like the Great Depression, but with a more flexible labour market.

[1] Real wages could also be more flexible because the Great Recession allowed employers to increase job insecurity, which might both increase wage flexibility and reduce the NAIRU. Implicit in this account is that lower nominal wages did not get automatically passed on as lower prices. If they had, real wages would not fall. Why this failed to happen is interesting, but takes us beyond the scope of this post.

[2] They also often imply that the years immediately before the Great Recession were a large boom period, despite all the evidence that they were no such thing outside the Eurozone periphery

[3] J.W. Mason has recently argued that such a mistake is being made in the US in a detailed report.

The academic consensus on austerity solidifies, but policymakers go their own sweet way

With yet another study showing how damaging austerity can be, you would think that at some point some politicians would eventually get it. This tepid economic recovery has been a huge vindication of Keynesian economics, which also happens to be mainstream economics. The textbooks and state of the art macroeconomics said cutting public spending while interest rates were stuck at their lower bound was a very bad idea. And sure enough pretty well every ex post analysis of this period finds that it was. It is particularly ironic that at a time when countless articles have appeared about the ‘crisis in economics’, a massive experiment by policymakers has seen an important part of it vindicated.

There were three countries or areas that adopted austerity in spades: the US, the UK and the Eurozone. Are any of these likely to recognise the error of their austerity ways anytime soon? The conventional wisdom is that this will happen in the US, but this is to confuse actions and the reasoning behind them. Any fiscal expansion in the US would not be for Keynesian reasons. This is partly for the obvious reason that interest rates are rising, and the central bank has shown no clear sign that they would not meet any further expansion with additional increases. There remains a clear and rather urgent need for a large increase in public investment financed by borrowing, but that seems unlikely to happen. What we are sure to get is tax cuts, particularly for the rich, because that is nowadays the main goal of Republican economic policy. Among Republicans, Keynesian economics remains the work of the devil.

In the UK there is also a desperate need for public investment. In addition, the NHS is crying out for a substantial tax financed fiscal expansion, which would help get interest rates off their lower bound. But UK policy makers only have one thing on their minds at the moment. It is Brexit at any cost. We know that because they show no interest in any other options. Right now God could reveal to climbers on Ben Nevis that Brexit would cost the average UK household 20% of their income, and policy would not change. [0] While some in the government may be tempted by fiscal expansion as a way to hide those costs, the Treasury seems to be keeping an iron grip on the purse strings. Never has the UK government seemed so politically secure, and never has it been further from sensible economics.

Not all of the Eurozone’s problems are due to a failure to recognise Keynesian macro. As Martin Sandbu argues here, what has been done and continues to be done to Greece is the age old story of the creditor refusing to admit that they have made bad loans, and therefore squeezing the debtor for every last drop and not realising that doing so only makes things worse. But even here a failure to understand Keynesian economics contributes to this lack of understanding. A country that is allowed to recover from a demand led recession will be far more able to find resources to pay back debt.

However if you look very hard there are signs that things might be improving in the Eurozone. Fiscal austerity at the aggregate level seems to have come to an end. Some key actors, even in EC institutions and governments, are beginning to see how austerity policies may only encourage the rise of the populist right. But that is a long way from the key reform that is required, which is replacing the existing fiscal architecture with something more Keynesian that recognises the mistakes of the past.

If anything is going to happen at all, I doubt if it will be the abandonment of the stability pact and fiscal compact, desirable though that would be. What seems more likely is a gradual adaptation of the mess that all these rules already are. The adaptation does not even need to look like Keynesian policy. National fiscal and macroprudential policies need to focus on inflation differentials between the individual country and the Eurozone average. This focus could be embodied in a rule, which still allowed debt or the deficit to be guided by a target when inflation was at the zone average. This rule has to be symmetric in inflation differentials, prescribing fiscal expansion if a country’s inflation is lower than average.

Equally disappointing has been the complacency of independent central banks. We have had the most prolonged recovery from recession, with lasting damage to long run supply, but you might be forgiven for thinking that we were still in the Great Moderation. Central banks should be busy comparing the four main ways of avoiding another Zero Lower Bound episode: a higher inflation target, negative nominal rates, nominal GDP targets or helicopter money. They also have to stop being so discreet about fiscal policy. Keeping quiet itself makes another ZLB episode more dangerous.

Occasionally people ask why my blogs seem to be as much about politics as economics these days. I agree, there has been a change since 2015. Before that, I would have greeted a new paper on fiscal multipliers by comparing it to the existing literature, and examining its strengths and weaknesses. These days there just seems so little point. I do hope all this knowledge will one day see the light of day among policymakers, but right now I wonder if there is an equally good chance that policy makers will stop paying for knowledge they have no intention of using. [1] Sometimes writing about the finer details of estimated multipliers can seem like rearranging the deckchairs on the Titanic.

[0] Here are some man-made estimates

[1] U.S. U.K.

A General Theory of Austerity

“If we cannot puncture some of the mythology around austerity … then we are doomed to keep on making more and more mistakes”

Barack Obama, New York Times, April 2016

I have just completed a working paper based on my talk to the Royal Irish Academy at the end of last year. (Yes, I know, that was six months ago - it’s all the media training I have to do :-)) It has the title of this post: in part an allusion to Keynes who had been here before, but also because its scope is ambitious. The first part of the paper tries to explain why austerity is nearly always unnecessary, and the second part tries to understand why the austerity mistake happened.

I start by making a distinction which helps a great deal. It is between fiscal consolidation, which is a policy decision, and austerity, which is an outcome where that fiscal consolidation leads to an increase in aggregate unemployment. If you understand why monetary policy can normally stop fiscal consolidation leading to austerity, but cannot when interest rates are stuck near zero, then you are a long way to understanding why austerity was a mistake. Fiscal consolidation in 2010 was around 3 years too early. A section of the paper is devoted to showing that the idea that markets prevented such a delay in consolidation is a complete myth.

I say that austerity is nearly always unnecessary because (given the title) I also cover the case of an individual monetary union member that has an unusually (relative to the rest of the union) large government debt problem. Here some austerity is required, but not for the reason you might think. It has nothing to do with markets: the Eurozone crisis from 2010 to 2012 was a result of mistakes by the ECB. If a union member’s government debt is not sustainable, there needs to be some form of default (Greece). If it is sustainable, then the central bank should back that government, as the ECB ended up doing with OMT in 2012. The reason some austerity is necessary is that to support financing this unusually high debt, the union member needs a real depreciation, and in a monetary union that has to occur via lower wages and prices relative to other union members.

None of this theory is at all new: hence the allusion to Keynes in the title. That makes the question of why policy makers made the mistake all the more pertinent. One set of arguments point to an unfortunate conjunction of events: austerity as an accident if you like. Basically Greece happened at a time when German orthodoxy was dominant. I argue that this explanation cannot play more than a minor role: mainly because it does not explain what happened in the US and UK, but also because it requires us to believe that macroeconomics in Germany is very special and that it had the power to completely dominate policy makers not only in Germany but the rest of the Eurozone.

The set of arguments that I think have more force, and which make up the general theory of the title, reflect political opportunism on the political right which is dominated by a ‘small state’ ideology. It is opportunism because it chose to ignore the (long understood) macroeconomics, and instead appeal to arguments based on equating governments to households, at a time when many households were in the process of reducing debt or saving more. But this explanation raises another question in turn: how was the economics known since Keynes lost to simplistic household analogies.

This question can be put another way. Why was this opportunism so evident in this recession, but not in earlier economic downturns? There are a number of reasons for this, which I also discuss here, but one that I think is important in Europe is the spread of central bank independence, coupled with a phobia that European central bank governors have about fiscal dominance. In the UK, for example, the Bank of England played a key role in 2010 in convincing policymakers and the media that we needed immediate and aggressive fiscal consolidation. Keynesian demand management has been entrusted to institutions whose leaders (but not those who work for them) threw away the manual. But as Ben Bernanke showed, it does not have to be this way. [1]

If my analysis is right, it means that we cannot be complacent that when the next liquidity trap recession hits the austerity mistake will not be made again. Indeed it may be even more likely to happen, as austerity has in many cases been successful in reducing the size of the state. My paper does not explore how to avoid future austerity, but it hopefully lays the groundwork for that discussion.

[1] Here is Bernanke is October 2010 saying “indeed, premature fiscal tightening could put the recovery at risk”, although no doubt he could have said it louder.

Why are some central banks so coy about the impact of fiscal policy?

The Bank of England’s inflation report is a mine of information about what has and might happen to the UK economy. There are fifty pages on the prospects for demand, supply and inflation. Yet when it comes to fiscal policy, the latest report contains just one paragraph:

“The MPC’s projections are conditioned on the tax and spending plans outlined in the March 2015 Budget, which incorporates continued fiscal consolidation. The Institute for Fiscal Studies estimates that a little over half of the Government’s planned fiscal consolidation, relative to the March 2008 Budget, had taken place by the end of the 2014/15 fiscal year. The remaining consolidation is expected to be achieved primarily through reductions in government consumption.”

The report does not even say the obvious, which is that fiscal policy will therefore act as a significant drag on growth over the next few years. How much of a drag? The OBR estimate that past fiscal consolidation has reduced GDP by around 2%. We could therefore infer from this paragraph that future consolidation will tend to reduce future GDP by a similar amount. But this assumes that the Bank agrees with the OBR’s assessment about the past, and the Bank says nothing on this.

There is a lot more that could be said. If fiscal consolidation comes in the form of cuts to welfare rather than government spending on goods and services, will this make a difference to the demand impact? If, given the promises made during the election campaign, some of this deficit reduction does not take place, how much earlier would we expect interest rates to rise? These are at least as important as the other issues considered at length in the report.

So why the silence on the impact of fiscal policy? I guess it is deemed politically sensitive to talk about such things. But silence is not a neutral position in the current political context. Silence suggests that the demand impact of fiscal policy is somehow unimportant, or perhaps particularly uncertain: both of which the Bank knows are untrue. This is not about monetary policy makers trying to avoid treading on the toes of fiscal policy makers. It is about monetary policy makers supporting a political position which chooses to be economical with the truth about the impact of fiscal policy. The Bank being coy is the Bank colluding with those who are being economical with the truth.   

When central bank losses matter

This is a post about why the taboo against helicopter money or money financed fiscal stimulus is irrational once we have Quantitative Easing, but might nevertheless be in the interest of some groups.

Many macroeconomists have argued that we shouldn’t think about central banks in the same way as private banks. A central bank can never be insolvent, at least as long as people use the currency it issues. It can cover losses by creating more money. All that matters, from a macroeconomic point of view, is whether it has the ability to do its job, which is to control inflation. 

I do not want to talk about controlling inflation here. Instead I want to talk about these losses, and in particular who gains when these losses are made. Macroeconomists tend to focus on the controlling inflation point, so let me avoid that by imagining a really simple world. There is a constant price level target, and base money velocity (nominal GDP/money) is constant in the long run, so base money must return to some constant value in the long run to meet the target. In the short run velocity is not constant and we can have recessions due to demand deficiency in the usual way.

Think about Quantitative Easing (QE). [4] The central bank creates money to buy government debt in the market at a time when that debt is expensive, because it only does QE when interest rates are low. [1] Suppose it just so happened that all this government debt that the central bank buys comes from pension funds. These funds sell their debt, take the money and keep it as money. After some time, the economy recovers, interest rates rise and the price of this government debt falls. The central bank no longer needs the debt, and it wants to reduce the money stock to get to the price level target, so it sells the debt back to the market, or more specifically to the same pension funds it bought it from. As the price of these assets has fallen, the central bank makes a loss. The pension funds gets back the debt they originally sold, but they have some money left. They have gained.

Good for them you might say - why should I care? Well the central bank is concerned that it has not got all its money back (it made a loss), and to control inflation it needs to take more money out of the system. It asks the government to recapitalise it, which the government does by raising taxes. What has in effect happened is that money has passed from the taxpayer to the pension fund.

My purpose in pointing this out is not to make some distributional point. Instead it is to note that QE in this case involves the central bank giving money away to pension funds. So why is this considered kosher, but the central bank giving the same amount of money (its loss on QE) directly to the public is considered deeply problematic? [2] Why would it be thought completely wrong for the central bank to voluntarily give the same amount of money to the government so that they could help stimulate the economy by some fiscal means (a money financed fiscal stimulus)? [3]

If you think that my assumption about price level targets and constant long run velocity was somehow critical here, imagine the case where to meet its inflation target the money newly created in the long run (the loss on QE) did not need to be taken out of the system. The pension funds gain but no one seems to lose. But if the expansion of money had been via a helicopter, then every citizen would gain instead. So why is acceptable to create new money and give it to pension funds (through losses on QE), but not create money to give to ordinary people or the government? The former is called monetary policy and is OK for a central bank to do, but the latter is called fiscal policy and this the central bank cannot do.

Why does this matter, apart from the distributional point? Because as a means of stimulating the economy in the short run the effectiveness of QE is highly uncertain compared to the effectiveness of direct transfers to citizens or public works. We seem to be stuck with an ineffective form of stimulus, because something more effective is taboo, or goes by a different name. To repeat it in a simple but more provocative way: a central bank giving money to people or governments is out of the question, but a central bank giving money to parts of the financial sector is just fine. That is a very convenient taboo for some.  

[1] Suppose this is government debt issued many years ago, when interest rates were 5%. So debt with a nominal value of £100 pays 5% interest. If interest rates are now 2.5%, then this debt is more valuable than its nominal value - indeed someone would pay you something near £200 for it if it had a long maturity. However if interest rates go back to 5%, the value of the debt would fall back to £100.

[2] Assume Ricardian Equivalence does not hold, so giving money away now is expansionary even though that money has to eventually come back when the central bank is recapitalised.

[3] If the money financed fiscal stimulus was in the form of additional but temporary government spending, and when the central bank was recapitalised the Treasury paid for this by temporarily reducing government spending, we get what I call a ‘pure’ money financed spending stimulus. I know of no theory which says that would not be expansionary. 

[4] If you want to be topical, you could think about creating money to buy foreign currency instead.

What does the end of the Swiss Peg tell us about central banks?

A lot of the discussion in blogs about the end of the Swiss exchange rate peg has focused on whether the original peg, which started in September 2011, was a good idea in the first place. [1] This post asks a rather different question, which has wider relevance.

First some facts, which you can skip if you have already read some of those posts. The safe haven status of the Swiss Franc meant that during the Eurozone crisis people wanted to buy the Swiss currency, and the resulting appreciation was in danger of driving some Swiss producers out of business. [2] The chart below plots competitiveness, measured as relative consumer prices, in Switzerland and in the UK. [4]

      

The appreciation problem in 2011 was real and the exchange rate cap fixed that, but to prevent the exchange rate appreciating beyond the 1.2 Swiss Francs (CHF) per Euro mark the central bank had to create lots of money to buy Euros. You can think of it as Quantitative Easing (QE) that buys foreign currency rather than domestic government debt. [3]

The interesting question is why the central bank ended the cap. Perhaps the cap was always meant to be a transitional measure, to allow firms time to adjust to a loss in competitiveness. (Here is the official explanation.) This is not that convincing. If the central bank was worried that its producers were becoming too competitive, it could have changed the cap from, say, 1.2 CHF per Euro to 1.1 CHF per Euro. Removing the cap completely would only make sense if you thought your safe haven status had reached some kind of equilibrium, and with the Greek elections and other things currently happening that seems unlikely. Even if you did think this, caution might suggest testing the market with a more appropriate cap and seeing how much defending you had to do.

As a result of ending the peg, the Swiss Franc has appreciated substantially, from 1.2 CHF per Euro to around 1 CHF per Euro, even though the central bank has lowered the interest rate on sight deposit account balances that exceed a threshold to −0.75%. There seem to be two alternative interpretations.

The first is that the central bank simply made a serious mistake. For some, the mistake was to impose the cap in the first place. If you do not take that view, and assuming the market’s immediate move is not a very temporary overreaction, the large appreciation partly undoes the benefits of the original peg. Either way, a major mistake has been made at some point. This can be added to what is now a seriously long list of recent major central bank mistakes: see in particular Sweden and the Eurozone. Does the fact that central banks in the UK and US seem rather less error prone have something to do with the greater influence of economists (inside and outside) on those banks? [5]

The second interpretation is that the open ended money creation that the policy implied just became too much for the central bank. In theory the central bank could go on creating money and buying Euros forever. As long as the exchange rate peg was reasonable this policy could be consistent with its inflation target (the target is ‘below 2%’, while actual inflation is currently negative). If it ever decided it was not and there was too much Swiss money around, the policy could be reversed by selling Euros. The central bank might make a loss when this was done, but economists generally dismiss this as a non-problem (a central bank is not like a commercial bank), just as they dismiss the same problem with conventional QE. But perhaps central banks do not see things this way (HT MT), because they worry about the political consequences of such losses. If this is the case, then this is something that economists need to respond to in one way or another.  

[1] The discussion in the media, as often with mediamacro, is obsessed with the markets. The Guardian had a link entitled “Swiss franc - what the economists say”. What you got were 6 City economists, who wrote the kind of thing City economists write. Now I’m sure the Guardian will say they needed something fast, and academics - even academic bloggers - are unreliable in that respect. But please label this properly: you are getting the reactions of City economists, whose primary concern is what this all means for the markets, and not what it means for ordinary people.

[2] Economists have a theory, Uncovered Interest Parity (UIP), which says that short term capital flows like this should not influence exchange rates, because the market will keep rates close to fundamentals. It does not work too well, partly I suspect because the market has little idea what the fundamentals are, and partly because no one in the market is prepared to take bets that last years rather than days.

[3] Switzerland has a really large current account surplus, which since 1997 has averaged 10% of GDP. The reason for this surplus is complex, but it suggests that there is scope for a gradual real exchange rate appreciation over time.

[4] Source: OECD Economic Outlook. The level is arbitrary, at 2010=100. A rise is an appreciation, which means a loss of competitiveness. The average level of this measure of Swiss competitiveness was around 96.5 from 1998 to 2004.

[5] However the suggestion by Tony Yates that every blogger should be given a job at the SNB seems to be going too far.

On the Stupidity of Demand Deficient Stagnation

In my last post I wrote about “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.” I suspect I often write stuff that is meaningful to me as a write it but appears obtuse to readers. So this post spells out what I meant.

First a preliminary. If you do not understand why economies can suffer from deficient demand, and why this is a needless waste of resources, then to be honest your best bet is to read a few chapters of a popular book on macro, like Tim Harford’s latest. If you have done a macro course and do not believe prolonged demand deficiency is possible, just tell me how you get out of a liquidity trap in a world with inflation targets after reading this post (and maybe this).

Demand deficiency when inflation is persistently below target (the stagnation of the title) should not occur, because it is easy to solve technically. If I was a benevolent dictator in charge of both monetary and fiscal policy instruments, stagnation would never persist in my economy. The way I would ensure this most of the time is by varying interest rates, but if nominal interest rates hit zero (a liquidity trap) I have a whole range of alternative instruments, ranging from cutting various taxes to increasing transfers or raising public spending. I know of no macroeconomic theory on earth which tells me that everyone of these instruments will fail to raise demand.

Whatever instrument I use to raise demand in a liquidity trap, I need to finance it. I can do this by issuing bonds (increasing government debt) or creating money. A higher stock of government debt or money is the only legacy (apart from happier people) of my successful operation to remove demand deficiency. We generally prefer governments to use bond finance, for reasons I will come to. But supposing there is some constraint (real or imagined) on issuing bonds. As a benevolent dictator I can just create money, which we call money financed fiscal stimulus. Money financed fiscal stimulus is a sure way of ending demand deficiency in a liquidity trap.

If that higher stock of money proves too great later on when the economy has recovered, I can reduce it by various means. There will be no subsequent above target inflation. There are no technical problems that I as a benevolent dictator need to worry about here. Of course creating lots of money on a temporary basis is exactly what central banks in the UK, US and Japan have recently done (QE - Quantitative Easing). The problem is that they have not been accompanied by sufficient tax cuts, increased transfers or increased government spending. Creating money to buy financial assets is by comparison to money financed fiscal stimulus an unreliable way of raising demand.

So that is it. Demand deficient stagnation is easy to prevent technically. The huge waste of resources that we see in the long and incomplete US recovery, the even slower UK recovery and the absence of recovery in the Eurozone are all unnecessary, because we know how to fix them. [1]

What stops this happening in the real world is that we have become fixated by the labels ‘monetary’ and ‘fiscal’ policy, and created an independent institution to handle the former. Central banks do monetary policy (varying interest rates and creating money) but are not allowed to give money directly to the people (helicopter money, or John Muellbauer’s QE for the people). Governments run fiscal policy, so can do bond financed fiscal stimulus, but are not allowed to create money. So a self-imposed institutional setup prevents either central banks or governments doing money financed fiscal stimulus alone.

A major reason why this institutional arrangement exists is to discourage non-benevolent governments creating inflation through fiscal profligacy, or more recently in order to increase policy credibility. Of course during a period of stagnation there is no danger of rampant inflation. Unfortunately this institutional arrangement creates a problem when governments – in my view for largely imaginary reasons - put a priority on reducing deficits. Money financed fiscal stimulus is not available to get you out of a liquidity trap. So we get this huge waste of resources.

Within the existing institutional framework, there is plenty to be done to convince fiscal policy makers that reducing deficits should not be a priority in the short term, or in trying to improve the monetary policy framework so liquidity traps happen less often. Yet it would be better still if we had an institutional framework which was a little more robust to failures on either front. We need to regain the possibility of money financed fiscal stimulus in a liquidity trap.

[1] What I say here has a lot in common with the advocates of Modern Monetary Theory. However, it also appears to be perfectly standard macroeconomics to me, so here I will simply commend them for highlighting these aspects of mainstream thought. 

Why central banks use models to forecast

One of the things I really like about writing blogs is that it puts my views to the test. After I have written them of course, through comments and other bloggers. But also as I write them.

Take my earlier post on forecasting. When I began writing it I thought the conventional wisdom was that model based forecasts plus judgement did slightly better than intelligent guesswork. That view was based in part on a 1989 survey by Ken Wallis, which was about the time I stopped helping to produce forecasts. If that was true, then the justification for using model based forecasting in policy making institutions was simple: even quite small improvements in accuracy had benefits which easily exceeded the extra costs of using a model to forecast.

However, when ‘putting pen to paper’ I obviously needed to check that this was still the received wisdom. Reading a number of more recent papers suggested to me that it was not. I’m not quite sure if that is because the empirical evidence has changed, or just because studies have had a different focus, but it made me think about whether this was really the reason that policy makers tended to use model based forecasts anyway. And I decided it was probably not.

In a subsequent post I explained why policymakers will always tend to use macroeconomic models, because they need to do policy analysis, and models are much better at this than unconditional forecasting. Policy analysis is just one example of conditional forecasting: if X changes, how will Y change. To see why this helps to explain why they also tend to use these models to do unconditional forecasting (what will Y be), let’s imagine that they did not. Suppose instead they just used intelligent guesswork.

Take output for example. Output tends to go up each year, but this trend like behaviour is spasmodic: sometimes growth is above trend, sometimes below. However output tends to gradually revert to this trend growth line, which is why we get booms and recessions: if the level of output is above the trend line this year, it is more likely to be above than below next year. Using this information can give you a pretty good forecast for output. Suppose someone at the central bank shows that this forecast is as good as those produced by the bank’s model, and so the bank reassigns its forecasters and uses this intelligent guess instead.

This intelligent guesswork gives the bank a very limited story about why its forecast is what it is. Suppose now oil prices rise. Someone asks the central bank what impact will higher oil prices have on their forecast? The central bank says none. The questioner is puzzled. Surely, they respond, higher oil prices increase firms’ costs leading to lower output. Indeed, replies the central bank. In fact we have a model that tells us how big that effect might be. But we do not use that model to forecast, so our forecast has not changed. The questioner persists. So what oil price were you assuming when you made your forecast, they ask? We made no assumption about oil prices, comes the reply. We just looked at past output.

You can see the problem. By using an intelligent guess to forecast, the bank appears to be ignoring information, and it seems to be telling inconsistent stories. Central banks that are accountable do not want to get put in this position. From their point of view, it would be much easier if they used their main policy analysis model, plus judgement, to also make unconditional forecasts. They can always let the intelligent guesswork inform their judgement. If these forecasts are not worse than intelligent guesswork, then the cost to them of using the model to produce forecasts - a few extra economists - are trivial.

How to avoid the austerity mistake next time

In recent posts (e.g. here) I have been rather pessimistic about what might happen the next time we have a large negative demand shock that puts interest rates to their zero lower bound (ZLB). In theory fiscal policy can come to the rescue, and we can avoid a severe recession. But many of the reasons that did not happen this time persist. The political right will see rising debt as a chance to shrink the state. The financial sector will argue a funding crisis (the ‘bond vigilantes’) are just around the corner. Central banks will do what central banks have nearly always done: advise either privately or publicly that we need fiscal restraint.

We can hope that, as recent lessons are learnt, economists speak with more of one voice on what should happen. I like to think this will occur to some extent, as the influence of the anti-Keynesians fades, but the importance of ideology in the discipline is such that economists will never be united on this issue. And in any case, will the majority of economists have more influence than the financial sector and the central bank? I think not, particularly if there is another Greece.

What I think macroeconomists can do is start talking about fiscal rules, and the importance of fiscal councils. This is what Jonathan Portes and I try to do in a new paper (here or here). The paper discusses a number of issues involved in formulating fiscal rules (which I will write about in subsequent posts), and it also stresses the importance that fiscal councils can have in supporting (or modifying) these rules. It also has something very clear to say about what should happen the next time we experience a large negative demand shock. (With unchanged inflation targets and perhaps a lower natural real interest rate, this may happen rather more often than we would like.)

Suppose, for the sake of argument, that the fiscal rule involves some target for the deficit in five years time. A negative demand shock hits, and the central bank judges there is more than a 50% chance that interest rates could end up at the ZLB. At that point, the deficit target would no longer apply. Instead the central bank and fiscal council would be obliged to cooperate in formulating a fiscal stimulus package that would enable interest rates to rise just above this lower bound. Both institutions would then recommend this package to the government. The central bank and fiscal council would continue to cooperate in this way (suggesting modifications to the package as new data became available) until the central bank expected interest rates to rise. Call this the ZLB procedure.

Why do we propose cooperation between the central bank and fiscal council? The central bank should be involved for four reasons. First, they probably have more resources working on short term forecasting. Second, they could help design a package that was effective at raising demand, rather than one that pandered to political preferences. (Fiscal councils on their own would be wise to avoid making judgements about how deficit targets should be achieved.) Third, a government would find it difficult to go against these two institutions acting together. Forth, the central bank would also probably want to implement some form of unconventional monetary policy, and the size of any fiscal stimulus would need to allow for that.

Now you could say that a central bank would be reluctant to make this call, for the reasons I gave at the beginning of this post. However, the central bank bears responsibility here. If interest rates did go to zero, they will clearly have made a mistake, and can be held accountable for that. And once interest rates had hit the lower bound, the ZLB procedure would operate anyway.

Why should the fiscal council be involved? Because part of the package would be an assessment by the fiscal council of what should happen to deficits and debt once interest rates did rise above the lower bound. The previous deficit target would have to be revised. A government that accepted the stimulus package would be asked to sign up to meeting any new deficit target after the recession was over.

This ZLB procedure should be part of any ‘fiscal rule’. This may seem odd, because it is really an account of how the normal rule should be suspended and what should replace it in ‘exceptional’ circumstances. Why not instead simply say that the normal rule should no longer apply when interest rates hit the ZLB and leave it at that? The reasons are those given at the start of this post. Making up policy in a crisis is fraught with dangers, and macroeconomic rationality can easily give way to vested interests and biases, as we discovered in 2010. The whole point of fiscal rules and fiscal councils is to overcome those interests and biases, and they apply at least as much in a crisis as in normal times.  

Central bank advice on austerity

As I wrote recently, the economic debate on the impact on austerity is over bar the details. Fiscal contraction when interest rates are at their zero lower bound is likely to have a significant negative impact on output. Of course the popular debate goes on, because of absurd claims that recovering from austerity somehow validates it. Next time you get a cold, celebrate, because you will feel good when it is over! Which means more articles like this will have to be written.

An interesting question for an economist then becomes why austerity happened. There are some groups who have a clear self interest in promoting austerity: those who would like a smaller state, for example. While arguments for ‘less government’ are commonplace among the more affluent in the US, in Europe there is much less natural antagonism to government. As a result, as Jeremy Warner said, you can only really make serious inroads into the size of the state during an economic crisis. Large banks also have a direct interest in austerity, because they need low debt to make future bank bailouts credible, enabling them to carry on paying large bonuses from the implicit state subsidy that this creates. So, from a cynical point of view, for this and other reasons those close to finance will always talk up the danger of a debt funding crisis just around the corner.

However there is a large middle ground who genuinely believes austerity was required to prevent the chance of a funding crisis, particularly after Greece. Yet Quantitative Easing (QE) fundamentally changes this. If the central bank makes it known that QE drastically reduces the chance of a debt funding panic, and anyway they have the means to offset its impact if it occurred, any contrary advice from the financial sector might be defused. The middle ground might be persuaded that fiscal stimulus is possible after all.

Now this was never going to happen at the ECB. It takes every opportunity to promote austerity. It took two years of continuing crisis to get it to introduce OMT. I do not follow the US closely enough to know what, if anything, the Fed said about the impact of QE on the prospect of a bond market panic, but I do know Bernanke was not afraid to warn of the dangers of excessive austerity in his final days in charge of the Fed. Which brings us to the UK, and the coalition agreement of 2010. The Conservatives may well have advocated their austerity programme whatever the Bank of England had said: it was a golden opportunity to reduce the size of the state. However their coalition partners, the LibDems, had campaigned on a more gradual deficit reduction plan similar to Labour. Mervyn King’s advice during this period is often credited with helping persuade the LibDems to accept the Conservatives’ proposals. (See, for example, Neil Irwin, or for more detail Andrew Lydon).

So why did King advocate austerity, rather than telling politicians that with QE in place, a funding crisis was both much less likely and less damaging. We may get a clue from something recently published by the Bank, as part of its stress test scenario for UK banks (HT Britmouse). The application is to 2014 rather than 2010, but it may still indicate what the Bank’s thinking might have been four years earlier. It talks about “concerns over the sustainability of debt positions” leading to a “sharp depreciation in sterling and a build-up of inflationary pressures in the UK.” As a result, monetary policy is tightened and long term interest rates rise - presumably because QE stops.

In one of my first blog posts two and a half years ago I wrote that “austerity is not even a sensible precautionary policy when we have QE”. Does this scenario give me cause to doubt that verdict? It does not, for two reasons. First, what makes a funding crisis so scary when you cannot print your own currency is that it is a bit like being blown off a cliff. Once interest rates start rising because of fears of default, this in itself makes default more likely. We have a clear nonlinearity, such that it may become too late to retrieve the situation once the process begins, as periphery Eurozone countries found out. Depreciation in the exchange rate when rates are floating is not like that. The further the exchange rate falls, the more attractive the currency becomes, because trade in goods ties down the medium term level of the currency.

The second reason why a loss of confidence in a currency is not like a debt financing crisis is that the former cannot force default, whereas the latter can. That makes all the difference. Without QE the markets have to worry about what others in the market think. The government may not intend to default, but if they cannot roll over their debt, they do not get that choice. With QE the government cannot run out of money, so the markets no longer need to worry about a self-fulfilling market imposed default. All that matters is what the government will do, and there was never any serious chance that the UK would default on its debt whoever won the election.

However it is possible to see why the Bank might still have worried in 2010. Output had only just stabilised after the worst recession since WWII. They wanted to keep interest rates as low as possible to help a recovery. Yet inflation was more than 1% above target, partly as a result of the depreciation of 2008. The MPC believed their remit was to target 2% inflation two years ahead. If sterling had fallen further, they would have found it very difficult not to raise rates. Yet Mervyn King would not have wanted to go down in history as the Governor who raised rates during the depths of a recession.

I think this says a lot about whether we had the appropriate monetary policy framework. (For further discussion of the economics see this post and links therein.) But my main point is this. It is all speculation, because as far as I am aware the Bank said very little officially. The Governor let his views be known in private, and publicly endorsed the government’s austerity plan after the election (much to the annoyance of some MPC members), but there was no open debate about the issues. The Bank could have initiated this debate, but chose not to.

So when the next recession hits, and interest rates go to zero and budget deficits increase, will anything be different? The central bank is in a position to make it clear what the risks of a market panic really are when QE is in place - indeed you could say that it has a responsibility to do that. Or instead it can publically argue that it still has all the tools it needs to manage the economy, and advocate austerity in private. Mervyn King once said (pdf) “Central banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy.” Is this always going to be the case? 

Leading Macroeconomist Leaves Central Bank

Maybe not the most compelling title for a post, but the news that Lars Svensson is not renewing his term as Deputy Governor of Sweden’s central bank (HT Saroj Bhattarai) will be of great interest to academic macroeconomists. What I want to suggest here is that it should also be of wider interest.

Apart from making major contributions to the discipline, Svensson has also been extremely influential among policymakers, and is often associated with the idea of flexible inflation targeting. (Here is just one example.) It is interesting news because of why he is leaving. He says: "I have failed to find support for a monetary policy that I believe would lead to better performance, with both a higher inflation rate closer to the target of two percent and a lower unemployment rate." He has for some time been fighting a losing battle to persuade his colleagues that current Swedish monetary policy is too deflationary (see for example Britmouse), and he has decided to give up the fight.

Interest rates in Sweden are low, at 1%, but according to Svensson they should have got there faster and should now be even lower. Here is a plot of inflation (blue, left hand scale) and unemployment.

Inflation is currently zero, so well below the 2% target. GDP growth was 1.2% last year. Unemployment rose in the recession, came down a bit, but has begun to rise again. The case for lower interest rates over the last two or more years looks pretty clear.

So why have most of Svensson’s colleagues not been following his advice? Their concern is that low interest rates are encouraging Swedes to borrow too much. Now of course one of the ways monetary stimulus is supposed to work is that it encourages more borrowing, but the worry is that borrowing in Sweden is dangerously high, and could threaten financial stability. There are echoes here of doubts expressed by some members of the Fed (see here and here) and international organisations (Tim Taylor here). However so far these have been just concerns, which do not seem to have had a major impact in preventing expansionary policy. Except in Sweden.

Svensson’s arguments against such concerns are persuasive (pdf), and I find the argument that there are better financial instruments available to deal with these problems particularly strong. However I want to draw a slightly different parallel, with policy at the ECB. At first sight similarities appear slight: although both central banks are resisting a cut in interest rates from low to very low levels, in the Eurozone growth is negative rather than just slow, and inflation is currently only a little below target rather than zero (although the ECB itself expects it to fall to nearly 1%). In addition, the ECB has not focused on financial stability as a reason for not cutting rates. Yet the parallel is this. In both cases we have central banks making decisions that appear to contradict the wisdom of mainstream macroeconomics. So what, you may say, but in both cases the cost is being measured in unnecessary unemployment, and below target inflation. Compute the cost in terms of lost output, and they are the kind of losses that could cost a politician their job. The cost in terms of human misery is greater still. You may be pretty skeptical of the wisdom of macroeconomists, but do you really think that these central bankers know better?   

Is academic macroeconomics flourishing?

How do you judge the health of an academic discipline? Is macroeconomics rotten or flourishing? Stephen Williamson is right that in one sense it is flourishing: many interesting avenues are being explored, and lots of interesting papers are getting written. Furthermore there is a common language. Of course there are pronounced local dialects, but there is mobility to, so having a freshwater dialect does not stop you giving a seminar that will be appreciated in a saltwater department, or indeed working in a saltwater department. So as an intellectual pursuit, one could claim that times have never been better for academic macro.

Society does fund some academics to engage in purely intellectual pursuits, but macroeconomics is not one of these. Yet much of the flourishing of ideas and research that is currently taking place has been inspired by recent events, and is directly or indirectly policy relevant. However having lots of ideas that are relevant to policy is not sufficient to make an academic discipline useful. It also needs to respond to the evidence in sorting out what ideas are helpful and what are not, so that it can be a progressive endeavour. In this respect, academic macroeconomics appears all over the place, with strong disputes between alternative schools.

Is this because the evidence in macroeconomics is so unclear that it becomes very difficult to judge different theories? I think the inexact nature of economics is a necessary condition for the lack of an academic consensus in macro, but it is not sufficient. (Mark Thoma has a recent post on this.) Consider monetary policy. I would argue that we have made great progress in both the analysis and practice of monetary policy over the last forty years. One important reason for that progress is the existence of a group that is often neglected - macroeconomists working in central banks.

Unlike their academic counterparts, the primary goal of these economists is not to innovate, but to examine the evidence and see what ideas work. The framework that most of these economists find most helpful is the New NeoClassical Synthesis, or equivalently New Keynesian theory. As a result, it has become the dominant paradigm in analysing monetary policy.

That does not mean that every macroeconomist looking at monetary policy has to be a New Keynesian, or that central banks ignore other approaches. It is important that this policy consensus should be continually questioned, and part of a healthy academic discipline is that the received wisdom is challenged. However, it has to be acknowledged that policymakers who look at the evidence day in and day out believe that New Keynesian theory is the most useful framework currently around. I have no problem with academics saying ‘I know this is the consensus, but I think it is wrong’. However to say ‘the jury is still out' on whether prices are sticky is wrong. The relevant jury came to a verdict long ago.

It is obvious that when it comes to using fiscal policy in short term macroeconomic stabilisation there can be no equivalent claim to progress or consensus. The policy debates we have today do not seem to have advanced much since when Keynes was alive. From one perspective this contrast is deeply puzzling. The science of fiscal policy is not inherently more complicated. What I have called a pure countercyclical increase in government spending (higher government spending now, financed by debt which is paid off by lower government spending once we are no longer at the Zero Lower Bound) can hardly fail to be expansionary in a New Keynesian framework if that debt can be sold.

What has been missing with fiscal policy has been the equivalent of central bank economists whose job depends on taking an objective view of the evidence and doing the best they can with the ideas that academic macroeconomics provides. This group does not exist because the need to use fiscal policy for short term macroeconomic stabilisation is occasional either in terms of time (when the Zero Lower Bound applies) or space (countries within the Eurozone). As a result, when fiscal policy was required to perform a stabilisation role, policymakers had to rely on the academic community for advice, and here macroeconomics clearly failed. Pretty well any outside observer would describe its performance as rotten.

The contrast between monetary and fiscal policy tells us that this failure is not an inevitable result of the paucity of evidence in macroeconomics. I think it has a lot more to do with the influence of ideology, and the importance of what I have called the anti-Keynesian school that is a legacy of the New Classical revolution. The reasons why these influences are particularly strong when it comes to fiscal policy are fairly straightforward.

Two issues remain unclear for me. The first is how extensive this ideological bias is. Is the over dominance of the microfoundations approach related to the fact that different takes on the evidence have an unfortunate Keynesian bias? Second, is the degree of ideological bias in macro generic, or is it in part contingent on the particular historical circumstances of the New Classical revolution? These questions are important in thinking how this bias can be overcome.