The lesson monetary policy needs to learn

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

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

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

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

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

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

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

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

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

How Neoliberals weaponise the concept of an ideal market

This new book by Colin Crouch will perplex many on the left who simply believe neoliberalism has to be overthrown. Indeed the author starts his book by talking about the Grenfell Tower disaster, which he along with many others believe epitomises the failings of neoliberalism. Yet he writes that the book

“is not a contribution to the demonology of neoliberalism, but an attempt at a nuanced account. Only in that way can we assess its capacity for reform.”

Such an account can of course also be justified on the basis of intellectual curiosity, but in addition the author sees some positive aspects of the ideology: He summarises these as

“the discipline of price and calculation [recognising efficiency and opportunity cost}; helping us appreciate the limitations of democratic government; facilitating trade and reducing barriers to it; and facilitating links among people [reducing national divisions].”

So what exactly is neoliberalism? He defines it as

“a political strategy that seeks to make as much of our lives as possible conform to the economist’s ideal of a free market”

The problems and deficiencies of this strategy come when the conditions required for the free market to be ideal do not hold, and the author’s long discussion of these problems would be useful for any economics undergraduate.

One of these conditions for an ideal market is competition: a free market is an ideal from a social point of view if (alongside many other conditions) each good is produced by a very large number of producers. The author recognises, for obvious reasons, that most neoliberals (as opposed, perhaps, to ordoliberals) tend not to go around wanting to break up monopolies and reduce monopoly power. As a result, he distinguishes between market-neoliberals who might, and corporate-neoliberals who would not. He talks about past competition (that may have resulted in monopoly) and current competition. As Luigi Zingales describes it rather well here, business tends to be in favour of a competitive market before it enters it, but once it has a dominant position in that market it is happy to put up barriers to further competition.

The author goes on to discuss conflicts between corporate and market neoliberalism, and much else besides. I think it is a great book, free from unnecessary jargon that you often find elsewhere. It got me thinking about the concept of neoliberalism again as you can see below. Whether that is a good thing or not, I would encourage you to read the book. The author also of course discusses whether he thinks neoliberalism can save itself. For his answer to that question you will have to read the book.

Now, for what it is worth, are some of the thoughts the book inspired. They go back to the distinction between market-neoliberals and corporate-neoliberals. It seems a little odd to define an ideology as the evangelisation of the free market, and then go on to say most neoliberals happen to exclude a crucial component of that free market (competition) when it suits them. I am quite prepared to believe that some of the people who first wrote about neoliberalism many years ago (and perhaps one or two today) could be described as what the author calls market-neoliberals, but as I have suggested in the past I think neoliberalism has evolved (or if you like been distorted) by ‘big money’ or capital to become a tool for self justification.

As a result, I would tend to suggest a slightly different definition that seems to work quite well today. The definition would be: 

neoliberalism is a political strategy promoting the interests of big money that utilises the economist’s ideal of a free market to promote and extend market activity and remove all ‘interference’ in the market that conflicts with these interests.

This replaces a definition based on following an idea (the author’s market neoliberalism), by one of interests promoting an idea so long as it suits those interests.

This alternative definition seems to fit two cases I have used in the past to question more conventional ideas. Large banks benefit hugely from an implicit subsidy provided by the state (being bailed out when things go wrong), but neoliberals do not worry too much about this form of state interference in the market (whereas economists do). Regulations on the other hand they do complain about. It is a very selective focus on market interference.

The second is executive pay. This is always justified by neoliberals as being something determined by the free market, when obviously it is not. Yet if you pretend that there is a market in executives and salaries etc are set by that market and not the remuneration committees of firms, then you are being a good neoliberal by defending these salaries. This example is interesting because it involves defending one part of ‘big money’ (CEOs or some workers in finance) at the expense of another (shareholders). It is why I do not talk about the interests of capital in my definition. 

Is this alternative definition simply negating the power of ideas and going back to good old interests? Only in part. Interests utilise an idea because the idea is a powerful persuasive tool. There is an obvious lesson for the left here. Because neoliberals promote the concept of an ideal market only when it suits them, so opposing neoliberalism does not necessarily mean opposing the concept of an ideal market. The left should utiliise the same concept to oppose monopoly power, for example. The idea of a free market is too powerful an idea to cede to the other side. 

The impact of austerity in the UK

When they do their forecast evaluation report, the OBR also look at the impact of fiscal policy on GDP. Here is the relevant chart from their report published yesterday.

There is a useful innovation compared to previous years, which comes close to an something I suggested a few months ago. The orange bar shows the impact of fiscal measures implemented in that year. The total effect of fiscal policy is this plus the impact of previous fiscal policy actions unwinding.

Suppose for example that fiscal policy reduced GDP by 1% in year 1, but its impact on the level of GDP was expected to decay by half in year 2. If no fiscal policy was enacted in year 2, then fiscal policy in year 1 would increase growth in year 2 by 0.5%. Why might the impact of fiscal policy on the level of GDP decay over time? The obvious explanation is that monetary policy ensures that it does by stabilising the level of GDP. This assumption is problematic when interest rates are stuck at their lower bound, which is why it is useful to publish the within year estimates as well as the total estimates,

You can see when this matters from 2012 onwards. We have a run of years where the total impact of austerity on growth is zero or positive, but only because of the unwinding of previous austerity. If monetary policy, or anything else, had not been able to offset earlier fiscal tightening, then instead the impact of austerity would be to reduce growth in all those years. In that (extreme) case the level of GDP in 2016/17 would be over 4% below what it would otherwise have been without any fiscal tightening from 2010/11.

As the OBR’s assessment of fiscal impact is in their publication on forecast errors, they naturally talk about whether there is any relationship between the two. This year they included this chart.

It is important to understand what we are looking at here. It is not whether there is a correlation between fiscal consolidation and GDP. As we have seen the OBR assumes there is, and indeed their calculations were the source of my estimate that the average household had by 2013 lost a total of £4,000 worth of resources as a result of austerity. The foolishness of austerity in 2010 was not that the OBR underestimated its impact, but that it left us vulnerable to negative shocks because interest rates were at their lower bound. The shock that hit in 2012 was the Euro crisis and the impact of austerity there.

What the chart above might tell us is whether the OBR have in fact underestimated the impact of austerity i.e the numbers in Chart E are too small. Each year there are hundreds of potential reasons for forecast errors, of which underestimating the impact of austerity is just one. So the best we can expect, if the OBR are underestimating the impact of fiscal policy, is a negative relationship going through zero between the two variables in Chart D but with lots of random variation on top. That is what we see in Chart D.

The myth of No Deal

It suits the government to keep talking about the possibility of No Deal for as long as the first stage negotiations continue, for three reasons. First, there is of course the remote possibility that the other side will believe it and make some concessions to avoid it. Second, as concessions are made on the UK side, it becomes a palliative to Brexiteers: maybe the Lion will roar in the end. Third, when the deal is finally done, the collective response might be relief that No Deal has been avoided rather than indignation at the terms.

But how can I be confident that No Deal will not actually happen? First, there has as yet been nothing done to prepare for that consequence, as Chris Cook outlines. Now you could rightly respond that this government is not known for its rational planning so this means little. But the lack of planning means that No Deal will bring UK chaos: not just firms leaving or going bust but highly visual dislocations like lorries clogging up ports and motorways. It would look like total economic incompetence, like Black Wednesday on steroids. It might mean the Conservatives lose not one but two or three general elections.

That is not the legacy that May wants. The second reason No Deal will not happen is that she wants to be remembered, despite everything else, as the Prime Minister that got the deal done without destroying her party. The only way I can see of that not happening, given the pro-Brexit nature of Conservative Party members, is if she is unseated by Brexiteers. 

The chaos argument still applies. So those who try to remove May before a deal is done will be putting the terms of Brexit above party loyalty: not something you normally associate with Conservatives, but as Raphael Behr argues that is just what many Brexiteers might do. (An exception is surely Boris Johnson, who sees Brexit as his route to power and would prefer the safer route of the inevitable leadership election after the deal is done.) But they would need good cause, and the details of citizens rights, the divorce bill or even the terms of transition seem unlikely to be enough. What could trigger a revolt is if the EU presses the border issue at the first stage as I outlined here, forcing May to agree to stay in the customs union permanently or more likely abandon the DUP. Even then, there may be enough Remain MPs to block the challenge or enough members may choose to compromise rather than risk electoral oblivion.      

Yet although No Deal is very unlikely to happen, it will remain a myth long after the deal is done. It will become the excuse used by Brexiteers for why the post-EU period turns out to be no better and perhaps worse than its predecessor. If only we had ‘true Brexit’, they will say, things would have been different. Ironically a deal is useful to Brexiteers in that it gives them a story for why the sunlit uplands that they described during the referendum campaign did not come to pass.

However we should still be concerned about No Deal rhetoric for the following reason. If you were the head of a firm having to decide to make an investment which would lose money if there was No Deal, would you have the confidence based on the analysis above to go ahead with that investment right now? I think you would be far more likely to postpone until you saw what happened. In addition there are all the EU nationals in the UK who continue to face a horrible uncertainty about their status under No Deal, as well as the prospective EU immigrants who will not come for that reason. Talk of No Deal, even if it is cheap talk, has real economic and social costs.    

Economists: too much ideology, too little craft

Paul Krugman argued yesterday that the belief in the need for new economic thinking after the financial crisis was incorrect, but led to some crazy but influential ideas that suited big money and the political right. While I agree with a lot of what Paul says, I would want to add something. These thoughts are strongly influenced by the fact that I’m in the middle of reading Dani Rodrik’s new book, called ‘Straight Talk on Trade’ (of which hopefully more in a later post).

In the preface to that book he tells the story of how 20 odd years ago he asked an economist to endorse a previous book of his called ‘Has Globalisation Gone Too Far?’. The economist said he couldn’t, not because he disagreed with anything in the book, but because he thought the book would “provide ammunition to the barbarians”. Dani Rodrik argues that this attitude is still commonplace. That attitude is, of course, both very political and very unscientific.

I suspect that something similar might have been going on before the financial crisis among economists working in finance. Paul Krugman is certainly correct that mainstream economics contained models that could explain much of why the GFC happened, so little new thinking was required in that sense. But one reason why so few mainstream economists used those models before the event owed at least something to an ideological aversion to regulation, and perhaps also not wanting to bite the hand that feeds you.

One of the features of mainstream economics today is the huge diversity of models that are around. Academic prestige tends to come to those who add to that number. But how do you decide which model to use when investigating a particular problem? The answer is by looking at evidence about applicability. That is not a trivial task because of the probabilistic and diverse nature of economic evidence, and Dani Rodrik describes that process as more of a craft than a science.

So, in the case of the GFC, good craft was in seeing that new methods of spreading risk were vulnerable to system wide events. Good craft was to see, if you had access to the data, that rapid increases in bank leverage should always be a concern. And more generally that arguments that ‘this time was different’ do not generally end well.

In my own discipline, I can think at least one area that should not have got off the ground if the craft of model selection had been applied well. RBC models were never going to describe business cycles because we know increases in unemployment in a downturn are involuntary. If you do not apply the craft well, then what can replace it is ideology, politics or simple groupthink. This is not just an issue for some individual economists, but can sometimes be a concern for the majority.

The OBR, productivity and policy failures

Chris Giles had an article in the FT yesterday about the UK’s continuing dreadful productivity performance, and the implications this might have for forecasts of the public finances. It has the following chart comparing successive OBR forecasts and actual data.

I want to make two points about this. The first is about the OBR’s forecast. [1] It is easy to say looking at this chart that the OBR has for a long time been foolishly optimistic about UK productivity growth. Too often growth was expected to return to its long run trend shortly after the forecast was published but it failed to do so. Expect lots of articles about how hopeless macro forecasts are in general, or perhaps how hopeless OBR forecasts are in particular. It was obvious, these articles might say, that trend productivity growth in the UK has taken a permanent hit following the financial crisis.

Anyone saying this is ignoring the history of the UK economy for the 50 years before the GFC. After each downturn or recession, labour productivity growth has initially fallen, but it has within a few years recovered to return to its underlying trend of around 2.25% per annum. This means not just returning to growth of 2.25%, but initially exceeding it as productivity caught up with the ground lost in the recession. In a boom sometimes growth exceeded this trend line, but it soon fell back towards it.

This made sense. Productivity growth reflects technical progress and innovation, and they tend to continue despite recessions. A firm may not be able to implement innovations during a recession, but once the recession is over experience suggests they make up for lost ground in terms of putting innovations into practice.

Given this experience, OBR forecasts have always been pretty pessimistic. They have assumed a return to trend growth, but no catch up to make up for lost ground. If they had also forecast, in 2014 say, that given recent experience they expected productivity growth to be almost flat for the next five years that would have been regarded as extreme at the time. Why would UK firms continue to ignore productivity enhancing innovations when the macroeconomic outlook looked reasonable?

And of course in 2014 UK productivity growth was positive. This brings me to my second point, which follows from this quote from the FT article:

“In the Budget, both the OBR and Mr Hammond are likely to stress that the downgraded forecasts do not reflect a new assessment of the damage to the UK economy from Brexit, but a reassessment of likely productivity growth after so many recent disappointments.”

Chris may be right that they will say this, but is it remotely plausible? As my recent post tried to suggest, UK productivity growth can be seen as suffering from three large shocks: the recession following the GFC, the absence of a normal recovery as a result of austerity, and then Brexit. The first two of those shocks led to a period of intense uncertainty, causing UK firms to put on hold any plans to innovate. Just as they thought things had returned to a subdued version of normal they were hit by the third, Brexit. During periods of intense uncertainty, productivity stalls or may even decline a little, as firms meet any increase in demand by increasing employment but not investing in new techniques. [2]

This story involving uncertainty seems to fit the data. Once the recovery (of sorts) finally began in 2013, productivity growth picked up. That sustained growth came to a halt when the Conservatives won the 2015 election, and the possibility of Brexit began to be an important factor for firms. [3]

These two points are related in the following way. The experience of the 50 years before the GFC suggested that you could hit the economy with pretty large hammers, but it would eventually bounce back. However that may have been contingent on a belief by firms that if policymakers were wielding the hammer (using high interest rates for example) they would take it away fairly soon, and replace it by stimulus. That belief was shattered in the UK by the GFC and austerity, where policymakers decided to keep using the hammer. What little confidence remained was destroyed by Brexit.

Discoveries are still be being made in universities around the world, and we know innovations are still being implemented by leading UK firms. It seems completely far fetched to imagine the GFC is still having some mysterious impact on the remainder of UK firms such that they refuse to adopt these innovations. A much more plausible story is that we are seeing what happens when most firms lose confidence in the ability of policymakers to manage the economy.

[1] I am on the OBR’s advisory panel, but as our job when we meet once a year is to be critical of OBR assumptions, and as we have no role in producing their forecasts, I think what I say here can be completely objective.

[2] Productivity can initially fall because new employees are not as productive as those who have been working in the firms for some time, for example.
Postscript (7/10/17) For evidence on the impact of Brexit on productivity, see work by Bloom and Mizen here.

[3] An alternative story is that the UK has settled into a new slow growth ‘equilibrium’, where the majority of firms are so pessimistic they hardly innovate at all.      

Why is MMT so popular?

I think, as a result of earlier posts, that I can be pretty confident that I can answer this question. But first some background. Although MMT has been around for some time, it recently held its first international conference and has in the last few years attracted a devoted band of followers online. According to this article, it has ‘rock star appeal’. In this post I just want to concentrate on the core of MMT which involves fiscal policy, and not talk about other ideas like job guarantees.

There are short and simple explainers around (e.g. here), but what these and MMT followers are typically not so good at is in explaining exactly why and how they differ from mainstream macroeconomics. To understand this, we need to go back to the 1960s and 70s. Then there was a debate between two groups in macro over whether it was better to use monetary policy or fiscal policy as an instrument for stabilising the economy. I prefer to call these two groups Monetarists and Fiscalists, because both sides used the same theoretical framework, which was Keynesian.

To cut a long story short the monetarist won that argument, although not quite in the way they intended. Instead of central banks controlling the economy in a hands off way using the money supply, they instead actively used interest rate changes to control output and inflation. Fiscal policy was increasingly seen as about controlling the level of government debt. I have called this the Consensus Assignment, because it became a consensus and because I don’t think there is another name for it.

The one or two decades before the financial crisis were the golden years for the Consensus Assignment, in the sense that monetary policy did seem to be relatively successful at controlling inflation and dampening the business cycle. However many governments were less successful at controlling government debt, and this failure was termed ‘deficit bias’.

MMT is essentially different because it rejects the Consensus Assignment. It regards monetary policy as an unreliable instrument for controlling the economy, and MMT prefers to use fiscal policy instead. They are, to use my previous terminology, fiscalists.

If you are always using government spending or taxes to control the economy, you are right not to worry about the budget deficit: it is whatever it needs to be to get inflation to target. Whether you finance those deficits by creating money or selling bonds is also a secondary concern - it just influences what the interest rate is, which has an uncertain impact on activity. For this reason you do not need to worry about who will buy your debt, because you can create money instead.

The GFC exposed the Achilles Heel in the Consensus Assignment, because interest rates hit their lower bound and could no longer be moved to stimulate demand. Alternative measures like QE really were as unreliable as MMT thinks all monetary policy is. What governments started to do was use fiscal policy instead of monetary policy to support the economy, but then austerity happened in 2010 for all the reasons I explore at length here.

Now we can see why MMT is so popular. Austerity is about governments pretending the Consensus Assignment still works when it does not, because interest rates are at their lower bound. We are in an MMT world, where we should be using fiscal policy and not worrying about the deficit, but policymakers don’t understand that. I think most mainstream macroeconomists do understand this, but we are not often heard. The ground was therefore ripe for MMT.

Policymakers following austerity when they clearly should not annoys me a great deal, and I am very happy to join common cause with MMT on this. By comparison, the things that annoy me about MMT are trivial, like a failure to use equations and their wordplay. You will hear from MMTers that taxes do not finance government spending, or that spending comes first, but you will hardly ever see the government’s budget constraint which makes all such semantics seem silly.

MMT is particularly attractive because it does away with the perennial ‘where is the money going to come from’ question. Instead it replaces this question with another: ‘will this extra spending raise inflation above target’. As long as inflation is below target that does not appear to be a constraint. In the US right now interest rates are no longer at their lower bound, but inflation is below target, so it appears to MMTers that the government should not worry about how extra spending is paid for.

Of course having a fiscal authority following MMT and a central bank following the Consensus Assignment once rates are above their lower bound could be a recipe for confusion, unless you believe what happens to interest rates is unimportant. I personally think we have strong econometric evidence that changes in interest rates do matter, so once we are off the lower bound should we be fiscalists like MMT or should we return to the Consensus Assignment? That is a question for another day.