The Kerslake Review of the Treasury

This review, published today, was commissioned by John McDonnell but is entirely independent. Although it is ultimately Lord Kerslake’s review, it is the product of a small panel of which I was a member, and also reflects submitted evidence and meetings of invited experts. I can say that in my area, macroeconomic policy, this external evidence was very influential and let me thank again all those involved. This post just focuses on these macroeconomic aspects of this review of the Treasury. [1]

The obvious place to start is to think how the role of the Treasury has changed in the last two decades. In 1997 setting monetary policy was delegated to the Bank of England. In 2010 the forecasting aspects of fiscal policy were delegated to the OBR. To a government obsessed by cutting the size of the state that might suggest that the Treasury did not need to have a large macroeconomic capacity, But if you think about the major macroeconomic disasters if the last decade, that view is completely misguided.

One way of thinking about these disasters is that they reflect a failure to consider potential risks to the economy, and what might be done to both mitigate those risks and respond to them if they occurred. No one was ever going to predict the exact time and date of the financial crisis, but someone in government should have been thinking about what risks a rapidly expanding banking sector might pose. There were not many who warned about the risks, but enough to warrant a risk analysis. As I have said before, I doubt that this could have avoided a crisis - the banking lobby is too strong - but at least the government would have given some thought about what to do if it happened before it happened.

When it came to austerity, everything would have been relatively unproblematic if the economy had grown at the pace at first expected in 2010, because monetary policy would still have had control. (Interest rates would have been above their lower bound.) But someone should have been focusing on what happens if things turned out to be less rosy, and making sure ministers had to address these risks. At the very least that analysis would have pinpointed the need to change fiscal policy the moment that more pessimistic outcome came to pass, but perhaps also thinking about this risk might have injected a note of caution into policy before this happened. In a secret Treasury that might not have stopped a determined politician, but if this risk analysis had been made public?

Who in government should have been doing this risk analysis? The obvious institution is not the central bank, which can be far too tentative in the area of fiscal policy and too biased on financial policy, but the Treasury. The Treasury, to use a phrase suggested at one of our evidence gathering meetings, should be “the country’s risk manager of last resort”. The Treasury is uniquely capable of getting information from all the parts of government, including the Bank, and putting it together within a consistent macroeconomic framework.

But this isn’t the only reason why the Treasury still needs a strong macroeconomic capacity. It sets the rules by which fiscal and monetary policy operate, and the danger of not having this capacity is that the rules get determined by political whim, or don’t change through inertia. And it also needs the capability to undertake large pieces of complex analysis very quickly, as we have again seen over the last two decades.

What do I mean by capacity? Above all people: people who have the ability to do and understand state of the art macro analysis. If you compare the number of macroeconomists at the Treasury and the Bank there is a huge imbalance which is not conducive to good policy making. It is absurd to think that you need suites of models to set interest rates, but virtually nothing to set monetary and fiscal policy rules and analyse the impact of potential risks to the economy.

None of this is guaranteed to stop the Treasury become obsessed with the deficit and ignoring macro analysis, but the stronger the macro team is in the Treasury the less likely this is to happen. One other way that is often suggested of combating this danger, and which we considered, involves splitting off from the Treasury key aspects including macro policy into a new Economics ministry. My own view, which is similar to that expressed in the report, is that such a split just runs the danger of institutionalising the dominant role of balancing the budget in policy making.

There is one final benefit of enhancing the macro capacity of the Treasury, and that would be to provide the potential to increase openness. I take it as given that greater openness would be a good thing, and also being an essential way of utilising existing expertise around the country. It is far from clear why risk anaysis has to be secret. To take just two examples, the Bank makes a concerted attempt to find out what is being done in UK universities that might be useful to it, and it publishes a regular blog where their economists can flag interesting data and analysis. It would be good if the Treasury had the capacity to do something similar.

[1] There is a great deal more in the report, both about macro policy and issues around devolution, working with other departments, the overall goals of policy and much more. I also feel I need to note one area where I disagree with how Bob talked about the report yesterday (on Peston’s show and to the Guardian). While I’m sure it is true that the Treasury has lost trust as a result of its incorrect pre-referendum short term forecast, by highlighting this in the context of this report you inevitably give the impression that it did something unprofessional. But both assessments were signed off by Charlie Bean. and the Treasury were hardly alone in expecting negative short term impacts from Brexit. Worse still, it risks suggesting that their long term analysis is suspect.

Policy, risks and public discourse

Another post where I use the UK as an example to illustrate a more general point

Along with their normal forecast, the National Institute has also used their model NIGEM to analyse the macroeconomic impact of the different political parties fiscal plans post 2015, which is published in the latest Review. (Chris Giles has a FT write-up.) There is no great surprise here: the more fiscal austerity you undertake, and if monetary policy fails to perfectly offset the impact on demand, the lower output will be.

This is not the main reason why I am against further fiscal consolidation post 2015. If you go back to 2010, the OBR’s main forecast didn’t look too bad: the recovery was continuing, and interest rates were able to rise as a result. But good policy does not just look at central projections, but it also looks at risks. Then the risks were asymmetric: if the recovery became too strong, interest rates could always rise further too cool things, but if the recovery did not happen, interest rates would be stuck at their lower bound and monetary policy would be unable to keep the recovery on track.

In 2010 and beyond that downside risk came to pass, and the recovery was delayed. Fiscal policy put the economy in a position where it was particularly vulnerable to downside risks, which is why it was an entirely foreseeable mistake. Quite how large a mistake is something I discuss in my article in the same Review (see also this recent post). Exactly this point applies to 2015 and beyond. The problem with further fiscal consolidation while interest rates remain at their lower bound is that it makes the economy much more vulnerable to downside risks.

This is something that all economists understand, and economists do their fair share of complaining about how difficult it is to get policymakers, let alone the public, to recognise the importance of risk analysis. However in writing about the role of fiscal policy in creating a weak recovery not just in the UK but the world generally, I was struck by how little public model based quantification of this there was even after the event, let alone before. (For some of the few ex post studies related to the Eurozone, see here.) Central banks nearly all maintain models capable of doing the kind of risk analysis I am talking about, but how much of that work gets into the public domain, or is even seen by fiscal policymakers? In the UK there has definitely been technological regress in this respect, as I note here.

So we have a paradox. In academic macro there has never been so much quantified model based policy analysis, some of it analysing just the kind of robustness to risks that I have been talking about. Yet in public discussion of macro policy, it is quite rare to see this. Central banks tend to keep what they do to themselves, and they appear to have a taboo on analysing alternative fiscal policies. In the UK the OBR, which does the government’s fiscal forecasting, is not allowed to look at alternative fiscal policies in the short term. I think I know why this paradox has arisen, but that will have to wait for a later post.

  

UK 2015: 2010 Déjà vu, but without the excuses

Things can go wrong when policymakers do not ask the right questions, or worse still ask the wrong questions. Take my analysis of alternative debt reduction paths for the UK following the 2015 elections. There I assumed that the economic recovery would continue as planned, with gradually rising interest rates, achieving 4% growth in nominal GDP each year. I set out a slow, medium and fast path for getting the debt to GDP ratio down, and George Osborne’s plan. On the latter I wrote: “I cannot see any logic to such rapid deficit and debt reduction, so it seems to be a political ruse to either label more reasonable adjustment paths as somehow spendthrift, or to continue to squeeze the welfare state.”

Ah, said some, that is all very well, but you are ignoring what might happen if we have another financial crisis. That will send debt back up again. The implication was that the Osborne plan might make sense if you allowed for this kind of occasional but severe shock. In a subsequent post I showed that this was not the case. However this also illustrates a clear example of asking the wrong question. Rather than setting policy today on the basis of something that might happen in 30+ years time, we should be worrying about much more immediate risks.

The question that should have been asked is what happens if we have a rather more modest negative economic shock in the next five years. The list of possibilities is endless: deflation in the Eurozone, the crisis in Iraq and Syria gets worse, Ukraine blows up, things go wrong in China etc. We can hope that they do not happen, but good macroeconomic policy needs to allow for the fact that they might.

That is the question that was not asked in 2010. The forecast attached to the June 2010 budget didn’t look too bad. GDP growth was between 2% and 3% each year from 2011 to 2015 - not great given the depth of the recession, but nothing too awful. But suppose something unexpected and bad happened, and economic growth faltered. The question that should have been asked is what do we do then. The normal answer would be that monetary policy would come to the rescue, but monetary policy was severely compromised because interest rates were at 0.5%. So 2010 was a gamble - there was no insurance policy if things went wrong. And of course that is exactly what came to pass.

As I have always said, there was an excuse for this mistake. In 2010 there was another risk that appeared to many to be equally serious, and that was that the bond vigilantes would move on from the Eurozone periphery to the UK. This was a misreading of events, but an understandable confusion. By 2011, as interest rates on government debt outside the Eurozone continued to fall, it was clear it was a mistake. Policy should have changed at that point, but it did not - instead we had to wait another year, and then we just got a pause in deficit reduction rather than stimulus.

Today, there is no excuse. There are no bond vigilantes anywhere to be seen. No one, just no one, thinks the UK government will default. This means we are free to choose how quickly we stabilise government debt. However what is very similar to 2010 is monetary conditions. Interest rates may have begun to rise by 2015, but any increase is expected to be slow and modest. So there will again be little scope in the first few years for monetary policy to come to the rescue if things go wrong. A negative demand shock, like another Eurozone recession, will quickly send interest rates to their zero lower bound again, and we will have little defense against this deflationary shock. The tighter is fiscal policy after 2015, the greater the chance that will happen. In that sense, it is just like 2010.

So the right question to ask potential UK fiscal policymakers in 2015 is how will you avoid 2010 happening again? If their answer is to do exactly as we did in 2010 and keep our fingers crossed, you can draw your own conclusions.

Why Inflation is not falling

There has been considerable interest in the recent IMF study that found that the responsiveness of inflation to the output gap (or equivalent measure) falls at low levels of inflation. But if the econometrics is right (and Nick Rowe has some cautionary tales here), what is the explanation for this? I start with two standard stories, but then suggest other possibilities that are specific to current financial conditions.

One standard explanation which the paper itself gives is based on the menu cost model of price inertia. The idea is that firms do not change their prices that often because there are costs to making any change (which economists call menu costs, perhaps betraying how often they spend in restaurants rather than buying food in supermarkets), and that often this cost might be higher than any benefit to profits in making a change. If you derive the aggregate relationship between inflation and the output gap from a model of this kind, the coefficient on the output gap will depend on how frequently prices are changed. So if price changes become more infrequent at low levels of inflation, the sensitivity of inflation to the output gap will fall.

Another quite plausible story which has solid empirical backing is that workers particularly resist nominal wage cuts. That actually implies an asymmetry in response rather than a general reduction in sensitivity (if the output gap was positive workers would happily see wages rise), but it will affect the average response in an econometric study that does not allow for asymmetry, and in current circumstances it is an entirely appropriate story.

You might think that enough, but I have a UK-centric reason for wanting more. In the UK, the ‘wages’ Phillips curve does not seem to be showing any reduction in sensitivity - indeed perhaps the opposite (although any additional sensitivity seems to predate the recession). That does not mean workers are not resisting nominal wage cuts, but the overall impact of this has either been small, or has been offset by something else.

The story I want to tell involves firms’ pricing behaviour, and the role of more risk averse banks. Suppose a firm sees demand for its output fall. Its profits are lower, but it calculates that it can reduce that decline in profits by cutting its price, if that price cut increases demand. There are two risks involved in doing this. First, the price cut might raise demand by much less than expected, with the consequence that profits fall further still. Once the firm realises this it can always put prices back up again, but in the short run profits will decline. Second, it may take time for the price cut to feed through into higher demand: those buying competing products may not immediately realise that they should switch. So although profits might rise eventually, they could fall in the short run.

So in both cases, there is a risk that profits in the short run might suffer as a result of the price cut. In normal times firms would be prepared to take those risks, either because the risks are symmetric (maybe demand will increase by more than expected), or because they represent an investment with a positive eventual payoff (as customers switch products). Critically, even if the short run might actually bring losses rather than profits, the firm’s bank will cover the losses because it is taking a long term view.

However, since the financial crisis, the firm may have noticed that the behaviour of its bank has changed. It refused the business down the road any credit, even though by all accounts its difficulties were clearly temporary. Although the firm would like to cut prices in the expectation that this will eventually raise profits, if the price cutting idea does not work out and the bank plays tough that could mean bankruptcy.

The idea is that the aftermath of the financial crisis, by raising the risk of bankruptcy associated with short term losses, has lead to greater price rigidity. In addition, there are two related effects that could actually lead to higher inflation in the short run. First, the firm does not like the fact that it can no longer depend on the bank to cover any short term losses. Who knows what might happen. So although a price increase might reduce profits if sustained (as customers gradually switch), in the short run profits will rise, and that allows the firm to pay off those debts which would otherwise keep its owners awake at night. This is the firm as a precautionary saver. Second, firms might be keeping prices low not because of existing competition, but because of the threat that a new start-up might emerge and steal some of its business. The one silver lining of the financial crisis for existing firms is that new start-ups are much less likely to get any money from the bank, so this diminished threat of new entry allows the firm to safely increase its profit margins.

I have absolutely no evidence that any of this has been happening, or indeed whether these ideas stand up to serious analysis. I don’t know of any papers that have explored the impact of financial frictions of this kind on prices, but that may well be my fault, so please point me to any you know. If there is anything in these ideas, then they caution against interpreting any current rigidity in inflation as evidence against demand deficiency.