Helicopter money and fiscal policy

Both John Kay and Joerg Bibow think additional government spending on public investment is a good idea, and that helicopter money (HM) is either a distraction (Bibow) or fiscal policy by subterfuge (Kay). They are right about public investment, but wrong about HM.

We can have endless debates about whether HM is more monetary or fiscal. While attempts to distinguish between the two can sometime clarify important points (as here from Eric Lonergan) it is ultimately pointless. HM is what it is. Arguments that attempt to use definitions to then conclude that central banks should not do HM because its fiscal are equally pointless. Any HM distribution mechanism needs to be set up in agreement with governments, and existing monetary policy has fiscal consequences which governments have no control over.

Here is where Kay and Bibow are right. At this moment in time, even if a global recession is not about to happen, public investment should increase in the US, UK and Eurozone. There is absolutely no reason why that cannot be financed by issuing government debt. Furthermore, in the event of a new recession, increasing ‘shovel ready’ public investment is an excellent countercyclical tool. Indeed there would be a good case for bringing forward public investment even if monetary policy was capable of dealing with the recession on its own, because you would be investing when labour is cheap and interest rates are low.

Where Bibow is wrong is that the existence of HM in the central bank’s armory in no way compromises the points above. HM does not stop the government doing what it wants with fiscal policy. Monetary policy adapts to whatever fiscal policy plans the government has, and it can do this because it can move faster than governments.

This goes part of the way to answering Kay, but he also suggests that HM is somehow a way of getting politicians to do fiscal stimulus by calling it something else. This seems to ignore why fiscal stimulus ended. In 2010 both Osborne and Merkel argued we had to reduce government borrowing immediately because the markets demanded it.

HM is fiscal stimulus without any immediate increase in government borrowing. It therefore avoids the constraint that Osborne and Merkel said prevented further fiscal stimulus. To put it another way, they did not say that increasing government spending or cutting taxes were bad in itself, but just that they were extremely unwise because they had to be financed by adding to government debt. HM is not financed by increasing government debt.

Many argue that these concerns about debt are manufactured, and that in reality politicians on the right pushing austerity are using these concerns as a means of achieving a smaller state: what I call here deficit deceit. HM, particularly in its democratic form, calls their bluff. If we can avoid making the recession worse by maintaining public spending, financed in part by creating money while the recession persists, how can they object to that? Politicians who wanted to use deficit deceit will not like it, but that is their problem, not ours.

There is a related point in favour of HM that both Kay and Bibow miss. Independent central banks are a means of delegating macroeconomic stabilisation. Yet that delegation is crucially incomplete, because of the lower bound for nominal interest rates. While economists have generally understood that governments can in this situation come to the rescue, politicians either didn’t get the memo, or have proved that they are indeed not to be trusted with the task. HM is a much better instrument than Quantitative Easing, so why deny central banks the instrument they require to do the job they have been asked to do.

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.     

Can central banks make 3 major mistakes in a row and stay independent?

Mistake 1

If you are going to blame anyone for not seeing the financial crisis coming, it would have to be central banks. They had the data that showed a massive increase in financial sector leverage. That should have rung alarm bells, but instead it produced at most muted notes of concern about attitudes to risk. It may have been an honest mistake, but a mistake it clearly was.

Mistake 2

Of course the main culprit for the slow recovery from the Great Recession was austerity, by which I mean premature fiscal consolidation. But the slow recovery also reflects a failure of monetary policy. In my view the biggest failure occurred very early on in the recession. Monetary policy makers should have said very clearly, both to politicians and to the public, that with interest rates at their lower bound they could no longer do their job effectively, and that fiscal stimulus would have helped them do that job. Central banks might have had the power to prevent austerity happening, but they failed to use it.

Monetary policy makers do not see it that way. They will cite the use of unconventional policy (but this was untested, and it is just not responsible to pretend otherwise), the risks of rising government debt (outside the ECB, non-existent; within the ECB, self-made), and during 2011 rising inflation. I think this last excuse is the only tenable one, but in the US at least the timing is wrong. The big mistake I note above occurred in 2009 and early 2010.

What could be mistake 3

The third big mistake may be being made right now in the UK and US. It could be called supply side pessimism. Central bankers want to ‘normalise’ their situation, by either saying they are no longer at the ZLB (UK) or by raising rates above the ZLB (US). They want to declare that they are back in control. But this involves writing off the capacity that appears to have been lost as a result of the Great Recession.

The UK and US situations are different. In the UK core inflation is below target, but some measures of capacity utilisation suggest there is no output gap. In the US core inflation is slightly above target, but a significant output gap still exists. In the UK the output gap estimates are being used to justify not cutting rates to their ZLB [1], while in the US it is the inflation numbers that help justify raising rates above the ZLB. (The ECB is still trying to stimulate the economy as much as it can, because core inflation is below target and there is an output gap, although predictably German economists [2] and politicians argue otherwise.)

I think these differences are details. In both cases the central bank is treating potential output as something that is independent of its own decisions and the level of actual output. In other words it is simply a coincidence that productivity growth slowed down significantly around the same time as the Great Recession. Or if it is not a coincidence, it represents an inevitable and permanent cost of a financial crisis.

Perhaps that is correct, but there has to be a fair chance that it is not. If it is not, by trying to adjust demand to this incorrectly perceived low level of supply central banks are wasting a huge amount of potential resources. Their excuses for doing this are not strong. It is not as if our models of aggregate supply and inflation are well developed and reliable, particularly if falls in unemployment simply represents labour itself adjusting to lower demand by, for example, keeping wages low. The real question to ask is whether firms with current technology would like to produce more if the demand for this output was there, and we do not have good data on that.

What central banks should be doing in these circumstances is allowing their economies to run hot for a time, even though this might produce some increase in inflation above target. If when that is done both price and wage inflation appear to be continuing to rise above target, while ‘supply’ shows no sign of increasing with demand, then pessimism will have been proved right and the central bank can easily pull things back. The costs of this experiment will not have been great, and is dwarfed by the costs of a mistake in the other direction.

It does not appear that the Bank of England or Fed are prepared to do that. If we subsequently find out that their supply side pessimism was incorrect (perhaps because inflation continues to spend more time below than above target, or more optimistically growth in some countries exceed current estimates of supply without generating ever rising inflation), this could spell the end of central bank independence. Three counts and you are definitely out?

I gain no pleasure in writing this. I think a set-up like the MPC is a good basic framework for taking interest rates decisions. But I find it increasingly difficult to persuade non-economists of this. The Great Moderation is becoming a distant memory clouded by more recent failures. The intellectual case that central bank independence has restricted our means of fighting recessions is strong, even though I believe it is also flawed. Mainstream economics remains pretty committed to central bank independence. But as we have seen with austerity, at the end of the day what mainstream economics thinks is not decisive when it comes to political decisions on economic matters. Those of us who support independence will have to hope it is more like a cat than a criminal.

Postscript (11/04/16). If you think that those who are antagonistic to central bank independence are only found on the left, look at the Republican party, or read this. 

[1] Unfortunately I think some of this survey data is not measuring what many think it is measuring. More importantly, not cutting rates after the Conservatives won the 2015 election was a major mistake. That victory represented two major deflationary shocks: more fiscal consolidation, plus the uncertainty created by the EU referendum. So why were rates not cut?

[2] But not all German economists, as this shows.         

The 'strong case' critically examined

Perhaps it was too unconventional setting out an argument (against independent central banks, ICBs) that I did not agree with, even though I made it abundantly clear that was what I was doing. It was too much for one blogger, who reacted by deciding that I did agree with the argument, and sent a series of tweets that are best forgotten. But my reason for doing it was also clear enough from the final paragraph. The problem it addresses is real enough, and the problem appears to be linked to the creation of ICBs.

The deficit obsession that governments have shown since 2010 has helped produce a recovery that has been far too slow, even in the US. It would be nice if we could treat that obsession as some kind of aberration, never to be repeated, but unfortunately that looks way too optimistic. The Zero Lower Bound (ZLB) raises an acute problem for what I call the consensus assignment (leaving macroeconomic stabilisation to an independent, inflation targeting central bank), but add in austerity and you get major macroeconomic costs. ICBs appear to rule out the one policy (money financed fiscal expansion) that could combat both the ZLB and deficit obsession. I wanted to put that point as strongly as I could. Miles Kimball does something similar here, although without the fiscal policy perspective

Of course many macroeconomists do see the problem, but the solutions they propose are often just workarounds. Things like Quantitative Easing, or NGDP targets, or a higher inflation target. [1] None completely remove the basic difficulty created by the ZLB. (One proposal that does is negative interest rates coupled with eliminating paper money, which I will come back to.) As a result, these workarounds mean that in response to a sharp enough recession, we would still regret no longer having the possibility of undertaking a money financed fiscal stimulus.

I also think there is a grain of truth in the argument that ICBs created an environment where deficit obsession became easier. Take the UK for example. In the 2000s the organisation that came to dominate budget analysis was the IFS. They are excellent on both the microeconomics of particular budget measures and their costing. Before the Great Recession that meant that all the IFS needed was a macro forecast (of which there are many) and they had all they required to provide excellent budget analysis. The IFS did not have strong macro policy expertise, and sometimes this shows, but as long as the consensus assignment worked that did not matter.

One of the those working at the IFS during this Labour government period was Rupert Harrison. In 2006 he became chief of staff to George Osborne. He helped introduce, perhaps reflecting his IFS experience, two important and positive policy innovations: setting up the OBR (with some minor assistance from a certain UK academic), and a form of fiscal rule (a five year deficit target) which allowed debt to be a shock absorber. But he also appeared to bring the received wisdom on the consensus assignment untroubled by the ZLB, which meant that Osborne could give a speech in 2009 outlining the macroeconomic basis of his strategy in which the ZLB was not mentioned.

This is an example of a more general point, which Robert in comments reminded me I could have made to strengthen the strong argument still further. With ICBs, macroeconomic expertise can move from finance ministries to central banks, leaving finance ministries unprepared for what they may need to do in a major recession.

But this grain of truth runs up against a real difficulty, which is the major flaw in the ‘strong argument’ I set out in the earlier post. To see the flaw ask the following question: in the absence of ICBs, would our deficit obsessed governments actually have undertaken a money financed fiscal stimulus? To answer that you have to ask why they are deficit obsessed. If it is out of ignorance (my Swabian syndrome), then another piece of macro nonsense that ranks alongside deficit obsession is the evil of printing money in any circumstances. I suspect a patient suffering Swabian syndrome would also be subject to this fallacy. If the reason is strategic (the desire for a smaller state) the answer is obviously no. We would simply be told it could not be done because it would open the inflation floodgates.

Following my grain of truth idea you might counter that without ICBs the knowledge within or outside government that these excuses were without foundation would be greater, and so governments could not get away with them so easily. But you would still have plenty of economists from the financial sector telling you that not only did you need to reduce debt rapidly to appease the markets, but also that any government printing money would scare the markets even more. Indeed, would governments alone have had the courage to undertake the scale of QE that we have seen ICBs undertake?

As for the argument that macroeconomic expertise gets concentrated in central banks, surely the answer here is to allow that expertise into the public domain by making central banks more open, and to directly combat the forces that make some central bank leaders routinely argue for austerity when they can no longer effectively combat deflation.

The basic flaw with my strong argument against ICBs is that the ultimate problem (in terms of not ending recessions quickly) lies with governments. There would be no problem if governments could only wait until the recession was over (and interest rates were safely above the ZLB) before tackling their deficit, but the recession was not over in 2010. Given this failure by governments, it seems odd to then suggest that the solution to this problem is to give governments back some of the power they have lost. Or to put the same point another way, imagine the Republican Congress in charge of US monetary policy.

But if abolishing ICBs is not the answer to the very real problem I set out, does that mean we have to be satisfied with the workarounds? One possibility that a few economists like Miles Kimball have argued for is to effectively abolish paper money as we know it, so central banks can set negative interest rates. Another possibility is that the government (in its saner moments) gives ICBs the power to undertake helicopter money. Both are complete solutions to the ZLB problem rather than workarounds. Both can be accused of endangering the value of money. But note also that both proposals gain strength from the existence of ICBs: governments are highly unlikely to ever have the courage to set negative rates, and ICBs stop the flight times of helicopters being linked to elections.

      

These are big (important and complex) issues. There should be no taboos that mean certain issues cannot be raised in polite company. I still think blog posts are the best medium we have to discuss these issues, hopefully free from distractions like partisan politics.  

   

[1] Please do not misunderstand what I mean by workarounds. The workaround may be still be useful in its own right (I have argued that monetary policy should be guided by the level of NGDP), but it does not completely remove the problem of the ZLB.

 

The strong case against independent central banks

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

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

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

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

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

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

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

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

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

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

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

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

Is OMT a bluff?

Tony Yates yesterday commented on my two recent pieces on Germany. The second issue he raises, on countercyclical fiscal policy, is I think quite easy to deal with. He may be right that there was general unhappiness with how fiscal freedoms had been abused in the past. But if so, that suggested something very similar to the SGP (i.e. rules designed to reduce debt policed by Brussels), but with an additional countercyclical element. That in particular would have applied pressure on the Irish and Spanish governments before the recession, pressure that the actual SGP notably failed to do.

His discussion of OMT (the ECB acting as a sovereign lender of last resort) suggests OMT is a bluff. The argument is that if, under the protection of OMT, the market still refused to buy a government’s debt, the ECB would be forced to buy it, and because there was the possibility of a loss for the ECB they would not do so. I think this is unlikely in practice and is certainly wrong if it is true.

OMT is not extended to any Eurozone country that gets into difficulties. The ECB has to have the right to say no, leading to almost certain immediate default. The test is whether the government is willing and able to stay solvent. The ECB also has to have the right to withdraw support if conditions change sufficiently to put its earlier judgement in question. That is a good argument for why OMT support should come with some form of conditionality, so as to give the country fair warning that support might be withdrawn.

If the ECB gets that judgement right, then there are no implications for inflation. Just as with QE, the central bank will have created money to buy assets which it will at some point sell off again. In fact the central bank makes profits, because the interest it receives from the government on that debt will exceed the interest it pays on reserves. If the ECB gets it wrong there will be costs, but they are not unlimited: they are simply the amount of debt it bought until it decided to withdraw support. The benefits that OMT provides surely outweigh the expected value of those costs, although I agree with Tony that some in countries that are never likely to require OMT may take a more narrow view. Even then there are no necessary implications for inflation, as Eurozone governments should make good the ECB’s losses.

The most worrying thing in Tony’s post is his suggestion that limits should be applied to the amount central banks outside the Eurozone should provide as a sovereign lender of last resort. Such limits can only do harm. They are based on a myth that independent central banks can stop a highly profligate government from raising inflation. It is a myth because the first thing such a government would do is abolish those limits. More generally, a government that is so profligate that future default was inevitable would have no hesitation in abolishing central bank independence. You cannot stop a government of central bank nightmares. Such limits are therefore either meaningless, or could do harm.  

Political economy assignments

Suppose you have two objectives for monetary policy: financial sector stability and real economy stability. You have two main instruments: interest rates and macroprudential policy (things like changing the capital requirements of banks, or making it less easy to get a mortgage; often called macropru for short). Should you assign one instrument to one objective (often called an assignment), or try and achieve both goals with both instruments?

As Tony Yates points out, assignments are rarely optimal from a purely macro point of view. Even if, say, interest rates are less effective at achieving financial stability than macropru, you would still want interest rates to contribute something to that objective. An exception is when one instrument completely dominates the other: then assignment is optimal. An example of this exception in a certain class of model is monetary over fiscal policy as means to achieve real stabilisation, as discussed here and here (less technical discussion here). But this type of result is unusual, and even when you get a result like this for a certain class of models it is not hard to add real world complications that remove the result.

If assignment in the case of real and financial stabilisation is not optimal, does this imply that those setting interest rates should take financial stability into account? It is important to understand what we are talking about here. We are not talking about how financial conditions might influence what interest rates need to be to achieve real stabilisation, which is the kind of issue discussed in this post by Bianca De Paoli for example. Nor is it talking about allowing for risk as I discussed here. Instead it would be saying that institutions like the US Fed should have a triple mandate when setting interest rates, where the third mandate was financial stability. Interest rates could be changed if financial stability was a concern, even if this had no implications for inflation or output. Equivalently, interest rates could move to help financial stability even if this took output and inflation away from target.

However we already have assignments that are clearly suboptimal from a purely macro perspective. Fiscal policy is assigned to the control of government debt, and reducing debt is certainly not a monetary policy objective. But in standard models this assignment is clearly suboptimal: when debt is high, reducing interest rates can be quite effective in reducing debt (particularly if government debt is mostly short term), and undesirable knock on effects on output and inflation can be countered by fiscal policy. Yet the mainstream consensus is that monetary policy should not be used to reduce debt.

The reason for this suboptimal assignment is most probably because of political economy concerns. Or to put it another way policy is mainly concerned about knowingly sub-optimal decisions. Reducing interest rates to reduce debt sounds too much like fiscal dominance. There is a fear that if there is no institutional assignment, politicians will depart from optimal policy and by keeping rates too low to reduce debt they will allow excessive inflation.

Can such political economy concerns be applied to financial stability and monetary policy, particularly as the same actor - an independent central bank - is in charge of both? My instinct is that it can, because central bankers are heavily influenced by pressures from the financial sector. As a result, there is a danger that if interest rates are set with both objectives in mind, central bankers will depart from optimal policy and, for example, needlessly raise interest rates before the real economy requires them to rise. The recent experience of Sweden is a clear example where this happened. For this reason I rather like the UK institutional set-up, with a separate MPC and FPC and a clear assignment for each.

Central bankers and their irrational fear

Mervyn King said

“Central banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy.”

As an academic turned central banker, King knew of what he spoke. The fear is sometimes called fiscal dominance: that they will be forced to monetise government debt in such a way that means inflation rises out of control.

I believe this fear is a key factor behind central banks’ reluctance to think seriously about helicopter money. Creating money is no longer a taboo: with Quantitative Easing huge amounts of money have been created. But this money has bought financial assets, which can subsequently be sold to mop up the money that has been created. Under helicopter money the central bank creates money to give it away. If that money needs to be mopped up after a recession is over in order to control inflation, the central bank might run out of assets to do so. A good name for this is ‘policy insolvency’. [1]

There is a simple way to deal with this problem. [2] The government commits to always providing the central bank with the assets they need to control inflation. If, after some doses of helicopter money, the central bank needs and gets refinanced in this way, then helicopter money becomes like a form of bond financed fiscal stimulus, but where the bond finance is delayed. In my view that delay may be crucial in overcoming the deficit fetishism that has proved so politically successful over the last five years, as well as giving central banks a much more effective unconventional monetary instrument than QE. [3] But central banks do not want to go there, partly because they worry about the possibility of a government that would renege on that commitment.

The fear is irrational for two reasons. First, central banks already face the possibility that they may make sufficient losses on QE that they may require refinancing by the government. The Bank of England has requested and been given a commitment to cover those losses. There is no conceptual difference between this and underwriting a helicopter drop except probabilities.

The second reason is more basic. In today’s world, where in the major economies it is now well understood that interest rates need to rise in a boom to control inflation, it is hard to imagine a government that would make its central bank impotent by refusing to provide it with assets. If such a government ever existed, it would have long before ended central bank independence because it wanted to stop it increasing interest rates with the assets it already had. Under the government of central bank nightmares, the central bank would lose its independence before it could complain that the government was reneging on an earlier commitment to underwrite helicopter money.

The fear of fiscal dominance is itself not irrational, although it seems increasingly unlikely it would happen in a modern democracy. What is irrational is thinking that allowing helicopter money in a recession would make fiscal dominance more likely to happen. [4]

I have also argued that this irrational fear has already been costly. I have described how the widespread adoption of austerity at the beginning of the recovery represents the failure to politicians to follow basic macro. Here central banks become a policy intermediary between academia and politicians: they have the knowledge of how costly austerity can be when rates are zero. But what politicians heard from senior central bankers was not these costs, but encouragement to pursue austerity. An irrational fear of budget deficits may be one explanation for central banks being economical with the truth.

Central banks overcame one big psychological barrier when they undertook Quantitative Easing. That was the first, and perhaps the more important, stage in ending their primitive fear of fiscal dominance. They now need to complete the process, so we can start having rational discussions about alternatives to QE.

[1] A central bank cannot actually become insolvent, as this post explains.

[2] No one to my knowledge has ever proposed giving the central bank the legal power to collect a poll tax.

[3] A key feature of deficit fetishism is a concern about deficits in the short term. Politicians seem happy to take measures that cut deficits in the short term even if debt becomes higher in the longer term. Indeed the analysis presented by DeLong and Summers argues that hysteresis forces would not have to be that large before austerity would raise long run debt to GDP levels. We also know that deficit fetishism is specific to increases in debt caused by recessions: over the longer run if anything deficit bias implies rising rather than falling levels of government debt. So any form of fiscal stimulus that avoided an increase in debt in the short run but not in the long run would avoid deficit fetishism. That is what a money financed fiscal stimulus aka helicopter money aka People’s QE could do.

[4] Why am I confident that a government could not be so obsessed with its debt that it might renege on an underwriting pledge? It is because deficit fetishism is only politically attractive in a recession when individuals are themselves cutting back on their borrowing, and therefore feel the government should do the same. This will not apply when the recovery has taken place and inflation is in danger of exceeding its target.

Central Bank Independence and MMT

This is a follow up to my last post on Corbyn and central bank independence (CBI). No apologies for returning to this topic: not often do you get to talk about policies that are in the process of being formulated. One of the influences that is said to be important for John McDonnell (the new shadow Chancellor) and his advisors is Modern Monetary Theory (MMT).

A comment I sometimes get on my posts is that my arguments are similar to those put forward by followers of MMT. I have not read much MMT literature, but in what I have read I have normally not found anything I take great exception to. On some issues, like the way monetary policy continues to be presented in textbooks, they definitely have good reason to complain about the mainstream. However their account of the way monetary and fiscal policy work seems quite a close match to what many mainstream economists think, which I guess is why my arguments can be similar to theirs.

One area of apparent difference, however, is CBI. You will sometimes hear MMT people talk about CBI being a ‘sham’, whereas mainstream macro attaches great importance to CBI. So which is right? Part of the problem here is that CBI in the UK (where the government decides the goal the Bank has to achieve) is rather different from that in the US (where the Fed has much more discretion over the choice of targets) and the Eurozone (where the ECB is largely unaccountable and has huge power). I’m just going to talk about the UK set up. (For a MMT perspective on the US, see here.)

CBI in the UK, established by Gordon Brown and Ed Balls in 1997, is no sham. The Monetary Policy Committee (MPC) decides when and by how much to change interest rates, and government has no influence on the MPC. How do I know this? From observation and from a huge number of conversations with MPC members. Since 2009 the MPC has decided when and by how much to do QE. Any Treasury authorisation to do QE was a formalisation that essentially followed Bank wishes, but it never specified when and how much QE should happen. So a fair description of the UK set up is that the government defines the goals and instruments of policy, and the MPC decides how to use those instruments to best meet those goals.

I would agree with the comment that this set up leaves the government taking big strategic decisions, like what the target should be. But CBI as defined in the UK still has two major advantages over the pre-1997 alternative

1. party political motives for changing interest rates are ruled out. I know such motives influenced at least the timing of rate changes before 1997. (How do I know - same answer as before.)
   
   
2. it forces governments to be explicit about their goals, and the relative priorities among these. I personally believe this has an important role in conditioning (but not determining) expectations, which is very useful. (Yes you can call me a New Keynesian for this reason.)
   
   

You could add time inconsistency and credibility issues in there as well if you like. (Giving this to secondary importance perhaps makes me less of a New Keynesian.)

Are there any negatives to set against this? One argument you often hear is that CBI is anti-democratic, but I really think this is just nonsense in the UK context. Government delegates technical decisions all the time, and as long as there is strong accountability (which in the UK there is), the right people are on the MPC and they are truly independent (from government or the financial sector) this works well. When governments only face elections every 5 years and elections are won or lost over a whole range of issues, quite why a Chancellor deciding when to change rates following secret advice is more democratic is unclear. It also improves democracy because, as Chris points out, the Chancellor is not held to account for the technical mistakes of his advisors.

A more important argument against CBI is that it makes money financed fiscal expansion much more difficult. A government that is obsessed by the size of its deficit might not undertake a bond financed fiscal expansion when a fiscal expansion is needed. It might have undertaken a money financed fiscal expansion, but CBI prevents it doing this because the central bank controls money creation. However this problem can be easily avoided by (a) taking a more sensible view of government deficits and debt, as MMT would also advocate, or (b) allowing helicopter money.

It is (a) that makes the debate over Corbyn’s QE particularly ironic. A National Investment Bank can be set up perfectly well based on borrowing from the market, and you can ensure it gets the funds it needs by a government guarantee. The only reason you would avoid trying to do that is because the NIB debt would count as part of the government’s deficit, and you were worried about the size of the deficit. The last people who should be worried in this way are followers of MMT.

Scott Fullwiler has an elaborate discussion of why Corbyn’s QE does not interfere with CBI, but concludes: “As such, government guaranteed debt of the NIB would be effectively the same thing as plain vanilla deficits, which as shown above is not different in a macroeconomically significant way from Overt Monetary Financing of Government via People's QE.” Which begs the question, why not go with plain vanilla deficits to fund the NIB. If it is because you are worried about the political costs of higher deficits, that will be as nothing compared to the political costs of instructing the Bank to finance a NIB.

So where does this apparent antagonism for CBI come from? Perhaps it comes from a tendency of some from the mainstream to make too much of CBI. To imply that the more independent a central bank is the better, regardless of who determines goals, whether there is accountability and who makes the decisions. Proof that independence is not all that matters is provided by the ECB. But we should not let the bad drive out the good. If Labour abandons the innovations made by Brown and Balls, I think it will be a classic example of the triumph of ideology over both good economics and self interest.