The BoE’s Warsh Report on transparency around monetary and financial policy

What a day for BoE watchers, and particularly for ex-BoE people like myself.  At Treasury Committee in March this year, perhaps prompted by media coverage [eg this and this by Mike Bird, and this by Chris Giles] of the revelation that MPC were routinely destroying tape recordings of their meetings, [and at least Granger caused by my blog here], Andrew Tyrie ambushed Mark Carney at the end of his hearing on the topic, and the Bank subsequently promised to review the way it operated.

That review, by Kevin Warsh, was published today, along with the BoE’s response.  The Bank is to publish transcripts of ‘Day 2′ MPC meetings, plus some staff briefing for MPC, after an 8 year lag.  Financial Policy Committee [FPC] and Prudential Regulatory Authority [PRA] Board meetings won’t be subject to the same degree of transparency, yet.

Some reactions.

My first reaction is:  blimey, how much things have changed since Carney took over.    Almost all the Executive Team and above during my 20 years there were vigorously and instinctively against further transparency.  Many of us who worked on transparency issues inside the BoE were subjected to a dispiriting ‘Commission, encourage, dilute, squash, sideline’ cycle during that time.  So changes like this, [and, the improved transparency over the forecast already introduced this year] are a startling break from the past.  So many of the reforms  that the wise birds of the Bank, availed of deeper insights into the political economy of monetary policy, deemed impossible, are now in place.

Digging into the detail a bit…

Transcripts [of Day 2] will be released with a reasonable lag of 8 years.  That sounds like a long time.  But many internal members arriving on the Committee as Executive Director might find themselves in gainful employment on MPC more than 8 years later.  So this is short enough for contributors to realise that they might be confronted with things they said and did while still on the job later.

A distinction is drawn between Day 1 and Day 2 of MPC meetings.  Day 1 is supposed to be when the thinking aloud happens, and MPC get to try out arguments without fear of being skewered either by their colleagues or history.  Not transcribing these discussions is an attempt to preserve that.  [Though the skewering by colleagues, in the constant low-level warfare that is MPC, will continue].

Day 2 is described as ‘decisional’ by Warsh, [an adjective unlikely to be in the Economist style guide].  The implication being that by then everyone will have made their mind up, and will probably be speaking from pre-prepared written statements.

In support of the recommendation not to record, transcribe and release Day 1 deliberations, Warsh makes reference to the academic research on the lower quality of more public deliberations.  This research is intriguing.  But dispiriting.  Monetary policymakers are middle-aged, high-IQ, highly confident, already successful individuals, not 25-year-old interns, who one could understand might need encouraging out of their shells.  But yet the suggestion is thta even those at the top of central banking are incapacitated by this human frailty.  Responding to that, Warsh suggests we should trade off transparency against functionality.

In other spheres, we don’t arrive at the same point in the trade-off.  Parliamentary transcripts are taken and released.  Court transcripts are produced and released.  The nation is in fact replete with important activities requiring debate and argument testing, yet which are transcribed and published.  The presumption is that the people selected for these important jobs have the capacity to debate and think on their feet, and are sufficiently self-confident and able to do it knowing that what they say will eventually be released, and must be released for the state’s legitimacy to be nurtured.  We would not often consider further constraints on publication on grounds that the top people of the state need their debating skills nurtured by privacy.  Why is the argument so much more compelling for  monetary policy?  I hope that in time this decision will be reconsidered.

Briefing related to the policy decisions is also to be released with an 8 year lag.  This is going to raise the stakes for MPC members seeking to go against staff advice;  and for staff members writing briefing that they know will contradict positions held by MPC.  It is going to strain the ‘constitutional’ position of the internal members who also are in the chain of command for staff working on MPC related briefing material.

Staff members will have to be braver, putting aside the worry about risking their careers with advice that goes against the views of their current or potential future employers.  And/or internal members are going to have to try to separate out their roles as performance managers in the Bank, and as individuals voting on the MPC.

Behaviour on both sides was routinely tainted when I was there, even without these new pressures. [I include myself as culpable too.]  Something concrete will have to change in internal processes to make sure that things change under the new regime.  From what I know of Carney, he is every bit as forceful in using what resources he can to get his way as his predecessors.  And a way will have to be found to prevent the interesting and contentious stuff being channelled out of the ‘official’ briefing to be published, and into the depths of the BoE’s email servers, leaving only the ex-post sanitized stuff for posterity to look at.

These changes edge us a tiny bit closer towards having a staff forecast.  Although we will only see the MPC members’ Inflation Forecast, we will eventually get to see what the staff were advising about aspects of it, and therefore be able to infer something about what they would have forecast.  All analysts working on monetary policy in the BoE have their views about policy solicited and discussed in working-level meetings.  The closer people are to the forecast, the more those people have fully articulated alternative forecasts of their own.

Should the BoE go all the way and pull what lies there already into a staff view?  I’m not sure.  On the one hand, there is expertise there that is not being exploited, or, if it is, revealed.  On the other, we have to remember the ultimate objective here, which is to get MPC members themselves to inform their policy vote.  In an economy where it takes time for policy to have its full effect, one has to act ahead of time, so this necessarily means MPC members forming their own forecast.  Question is, is that better done as currently, or via, or in addition to, a staff forecast?

A staff forecast might act as a disciplining device.  It would be harder for the great tradition of forecast reverse-engineering to survive.  (That’s where MPC members used to decide on economic judgements [eg participation, productivity] based on whether it would tweak the forecast towards the policy vote they had already decided on).  But it might also force the staff in on itself, in an attempt to maintain the robustness and coherence of its view, and leave the MPC feeling that it wanted more of its ‘own’ resources, to construct its own forecast.

The Bank chose the 8 year publication delay itself, a fact noted neutrally by Kevin Warsh in his report ‘Ultimately the Bank will choose the delay’.   Well, yes, it will, in the absence of its boss, the Treasury doing that job for it.  I don’t think it’s for the Bank to choose how it itself is held to account.  The Bank chose to employ Kevin Warsh to conduct this review, but that doesn’t seem appropriate either.  The Bank might have expert insight to comment on a decision made by others, but shouldn’t be taking this decision itself.  We are fortunate that the BoE is under such enlightened leadership in these (governance) respects.  And mostly seems to have taken the decisions an impartial observer would have taken.  But the current Governor will be back in Canada in 3.5 years.

The Bank has chosen to continue to make use of a blanket Freedom of Information exemption on monetary policy matters, which I infer from Chris Giles’ FT story  on the release of the Warsh Report.  This is wholly inappropriate in my view.  Old papers on monetary policy are not matters of national security or institutional integrity.  (Though I am glad that my 10 pager from circa 2005 on how the miracle of better risk-management will affect the equilibrium risk free rate is safe).  The Bank can surely come up with a more nuanced use of the FOI Act than it has at present, and perhaps should be forced to.  That catch-all device does not now sit well with the new transparency measures giving further access to specific kinds of material around the forecast and monetary policy process.  I suggest that Treasury Committee looks into find a way to circumscribe the BoE’s use of this FOI exemption.

Warsh excuses FPC from the same transparency reform recommendations as MPC on the grounds that it doesn’t yet know how to use its tools or precisely what it is doing!  Quite extraordinary to read that.  I don’t disagree with his assessment.  (Though I am not sure it’s consistent with how the FPC describes its own progress).   But I think one could argue that this makes scrutiny all the more valuable.  Mere handle-turning in a settled regime involves lower stakes.  But foundational decisions about what the FPC should be doing and what they expect their instruments to be used for are more important.  All the more crucial that we can see, later, that these tasks were being performed well.  Or, if not, that FPC’s successors can use transcripts to figure out why not.

The Warsh Review also excuses the Prudential Regulatory Authority Board meetings from the same transparency standards [as MPC].  One argument, perfectly reasonable, is that those meetings are about individual institutions, and cover information of such commercial import that even an 8 year lag might be insufficient.  Another argument given is that the PRA board operates by ‘consensus’.  What does that mean exactly?  It could mean ‘this committee chooses to debate things to such a degree that eventually all but the single, indisputably correct view falls away and everyone agrees with it’ [unlike with MPC].  Not a very plausible description is it?  What’s so different about the matters that the PRA board deliberates on that unanimity can be reached?  Another interpretation leaves the argument a tautology:  ‘For reasons not specified, the Board chooses not to register dissenting views.  Therefore, dissenting views in the form of votes should not be registered.’

However, these points should not detract from the fact that today is a triumph for the BoE.   Lacking someone to tell it precisely what to do, the BoE decided for itself – albeit under a little pressure from the media and Treasury Committee – to introduce greater scrutiny into the operation of monetary policy.   Good for them.  Even if Carney achieves nothing else, these transparency reforms, and those already introduced around the forecast, will be a commendable legacy.

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George Osborne lashes out at the BBC

This morning [4/12] on BBC Radio 4’s Today program, George Osborne lashed out at the BBC’s coverage of the budget labelling it ‘hyperbolic’.

This is a pretty low tactic, and also substantively wrong.  All the BBC were doing is pointing out what Osborne’s budget ombudsman the Office for Budget Responsiblity had said, which was that planned [but as yet unspecified] spending cuts would reduce the size of the state [government spending as  a share of GDP] to levels around those last seen in the 1930s.

As Chris Cook pointed out on Newsnight last night, this is amazing in the history of modern capitalism.  That history charts a steady rise in the size of the state, either as it gains new competencies and enlightened insight into its proper role (my view), or interest groups hijack it to nefarious ends (Tea Party view).

The comparisons the BBC and OBR made highlight very well how incredible Osborne’s plans are, because there is surely not any support for such a shrinkage, even in the bulk of Tory voters.  On my view, you have to persuade people they don’t want something they should be getting.  Even on the Tea Party view, you have to wage war against so far entrenched interest groups to cut spending.

That fact no doubt explains why so little of the spending cuts needed to deliver the Autumn Statement forecast have actually been specified, because doing so would immediately lose them the election.

Osborne’s next ploy, to say ‘all the disaster that was forecast last time just did not happen, so why hasn’t the BBC learned this time around’ is also equally off the mark.  Last time, disaster was averted – for the economy and for his Party – because deficit reduction was postponed.  Wise, as I have frequently pointed out, when the Bank of England is unable to inject more stimulus at the floor to interest rates.  Moreover, as others have made clear, electoral disaster – or further obfuscation – is more likely next time because the next round of cuts will be harder.  Why?  Because they will fall on spending by definition identified as higher priorities (hence not cut) in the last spending review.

Even with a good case, Osborne should refrain from hacking at the BBC in this way, outside of all due process.  That tactic takes us further down the US road where discussing government policy becomes entirely a matter of competing fictional narratives, and detached from fact.  But he didn’t have a good case.

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Aditya Chakrabortty’s one sided Radio 4 polemic on economics

Last night I caught AC’s Radio 4 program on teaching economics after the financial crisis.  It’s a great story, well told.  But, it is just that.  In its totality, a distorting dramatisation, on account of allowing multiple silly, uninformed critiques to go unchallenged in the program.  Yet presented as a reasonable, impartial take on what is going on in economics.  If this were an op-ed in a newspaper, it would be forgivable.  Most people know that when they read comment that they are getting selective advocacy.  But I think a lot of listeners think of Radio 4 as a station they can trust to explain things how they really are.  This program reveals that sometimes the editors slip up.

Here are some examples the one-sidedness that undermines AC’s attempt to portray himself as your friendly, impartial, interlocutor.

1.  The tale of the panics and bubbles course that Manchester University refused to incorporate into their module.  The story told is of a rare piece of enlightened teaching, done voluntarily, leading to the termination of the contract of the dissenting teacher.  I blogged before on what I thought of this course [AC was sent this blog, but either chose not to read it, or ignored it].  From the reading list the students were given, I guessed that the lecturer either knew very little about what was going on in the literature on panics and bubbles, or deliberately set out to give them a haphazard pot-pourri of his favourite tracts.  I won’t claim to be the final arbiter on this [though I do think my views are representative of those working in the intersection between macro and finance].  So presenting only my view, or something like it, would have been just as bad.  But that view did not get heard.  Also, AC plants the inference that the teacher’s contract was terminated solely because of his giving up his own time to offer a dissenting course, and to propose a regular one.  But we don’t get to hear what Manchester University think happened.  Did AC try to speak with them and they declined?

2.  AC caricatures mainstream economics as blindly applying rational choice, pitting a 20 second soundbite from Danny Quah explaining the idea, against a catch-all alternative from Ha-Joon Chang.  The other side of the story about the mainstream is this.  First, there are now hundreds of papers in top journals using what you might call crudely ‘behavioural’ alternatives to rational choices.  Robert Shiller just won the Nobel prize for pointing out the failures of rational choice to explain finance.  Second, most of those I read and know who use rational choice use it in a more nuanced way than you would guess from ACs program. A philosophy I’d characterise like this:  we know people don’t behave literally like this in all its minutiae, but maybe the rational model captures enough of what’s going on to make progress explaining what we see.  Plus, there is the practice of using the contrast of rational choice models with the data to point the way to better models.  [Example:  Shiller again].  Any hint of this in AC’s narrative?  No.

3.  AC, as if to explain what’s wrong with mainstream academic macro, puts the ridiculous question to Steve Keen as to whether Keynes would get published in a top journal now.  This is just such a daft hypothetical.  Things have moved on so much since then.  Who knows what Keynes would write now.  Would you ask whether 75 year old physics papers would get published now?  And:  papers in top journals are literally drenched in Keynes.  It’s probably Keynes’ influence that’s pretty much why the dominant model in central banks has sticky prices, and many have unemployment.  Keynes is everywhere in the modern debate about the power and usefulness of government spending increases in recessions.  [Added 4/12:  AC repeats this silly tactic, asking about Minsky’s chances of getting published.  And a moments’ sensible thought would give the same answer.  PS here’s what I think about Minsky].

4.  In the same breath, Keen states baldly that you can’t publish in top journals if you don’t use the assumption of rational expectations.  False.  I know many dozens of examples.  But here’s Nobel laureate Tom Sargent this time using models with learning, a framework he pioneered.  [That’s funny, two Nobel laureates flouting the AC stereotype of economics.]  If AC had wanted more, he could have googled ‘expectations, learning, business cycles, adaptive’ or something like that.  Perhaps throwing in ‘heuristics, self-confirming’ for good measure.

5.  We’re told that the other thing you can’t write about now in the mainstream is animal spirits.  False.  Try reading Roger Farmer, who climbed to the top of the US university system publishing papers on just that.  Or, try googling ‘animal spirits, business cycles, recession’.

6.  George Soros is quoted telling us that mainstream economics is wrong because it’s based on ‘General equilibrium theory’ which gives you the answer that markets always work perfectly, and their outcomes cannot be improved.  False.  Some such theory does, but there are thousands that don’t.  [eg, any model with sticky prices, or unemployment, or credit frictions, like this one, or……].

7.  Soros again telling us that finance assumes always that risk can be quantified.  False.  Sure, a lot of it does, but, now, there’s lots that explores Knightian uncertainty.  [Oh – is that more Keynes again?  Surely not!]  Try looking at the collected works of Cogley, Sargent, Hansen [Nobel Prize winner again?], who model the effect of agents’ doubt about their models of risk – and the caution that injects into their investment strategies – on asset prices.   Or, google ‘asset prices Knightian uncertainty dividends business cycle’.

8.  Steve Keen is allowed to assert that mainstream macro ignores money, lending and banks.  False.  Take a look at some of the papers on my putative panics and bubbles course.  Or have a read at the mainstream ‘Journal of Money, Credit and Banking‘, or ‘Journal of Monetary Economics‘, or ‘Journal of Banking and Finance‘.  The titles are a bit of a give away.  I’m not sure what Gertler, Rajan, Gale, Brunnermeir, Kiyotaki, Diamond, Keister and others who devoted their lives to modelling banks in macro would make of Steve Keen’s claim or AC’s unsceptical playing of it.  They might say ‘try googling “banks, credit, business cycles, friction, spread” ‘.

9.  Keen makes the subtler accusation – still false! – that where mainstream macro does include money, it’s simply ‘a veil over barter’.  Well, a lot could be described like this. But a lot is not at all like this.  For example the overlapping generations models of money in the Karecken and Wallace volume;  or the ‘new monetarist‘ models of Kiyotaki, Wright, Williamson, Lagos and others.  But even where money is a kind of veil, things are not so silly as Keen makes out.  Those models embody the view that inflation is costly – for which there is some empirical evidence.  They explain the phenomenon at the zero bound that increases in money don’t lead to increase in prices – contrary to the inflation hawks’ worries.  And anyway, not all questions need a model of money to answer them.

10.  AC interviews Andrew Haldane at the Bank of England.  He says ‘it turns out that the model we had was false’.  Which model was that?  I thought all models were false?  And that that was the point of them?  I think Andy is referring to the New Keynesian model of monetary policy and business cycles, varieties of which leave out banking and finance, used across central banks [and still, incidentally, in the banking and finance-less version, at the Bank of England].  But, you know what? I don’t think any of the monetary policymakers I worked for or read believed much of that model.  They worked off hunches, gut instinct, practical experience.  And the judgement that i) finance would not go wrong and ii) monetary policy should and could not try to sort it out if it did.  i) was clearly wrong.  But I think ii) is still a respectable position to take.  So Andy’s quote doesn’t really do justice to what was in the minds of influential people in the profession.

11.  We don’t really get the other side of the story from student’s point of view.  There are interviews with some contrarian Manchester students who are happy with the department.  But what about other universities?  Manchester’s National Student Survey scores plummeted because of the Post-Crash-Economics campaign, but how about talking to the universities that did best?  In fact, Steve Keen’s Kingston Universty aside, try talking to any other university.  Were those students happy because their curriculum was supplying them with lots of heterodox economics?  I don’t think so.  But that is the inference you will draw from AC’s program.

12.  AC voices the complaint that Ha-Joon Chang’s career has suffered solely because of tribal discrimination.  He doesn’t get promoted simply because he fails to publish in top journals, and is not properly compensated for his successful book-writing career.  What about the other side of that story?  Perhaps publishing in peer-reviewed journals does a fair job at quality assuring someone’s grasp of, perseverance and creativity in pushing the frontier?  Perhaps Steve Keen’s assertion that he can’t publish in top journals is not because they are run by religious cabals, but they are all clever and reasonable people?  That the profession has, over a long time, settled on ways of formulating economic ideas and seeing how well they fit the data?  That’s pretty much my view.  I accept that there might be something to the fads and cabals critique on occasion.   But as an explanation for the entire published canon?  Come off it.  Do we get these views in AC’s program?  Nope.  We get Steve Keen’s revelations as unchallenged fact.

The program does have some mainstream voices, so the piece is not 100% propaganda.    Danny Quah is allowed a few seconds on rational choice.  And there is Diane Coyle [not sure what she must have felt about being the token mainstreamer] and Wendy Carlin [who’s excellent new textbook is now out] both making great points.  But they are deliberately drowned out by AC pushing his own distorted story.  The effect conveyed is:  ‘there are one or two who disagree, but, hey, common sense tells you that these students have got it exactly right’.

When I tweeted about this last night, AC’s response was to say ‘merely shouting false…is a better way to draw attention to yourself than actually making an argument’.  This motive-questioning escallation was ironic.  I think you could make a case that AC’s program is  ‘shouting’ to get ‘attention’.  At most turns in the narrative, he fails to maintain journalistic scepticism and balance, and reveals that he didn’t even fancy a quick google, which most of the time would have contradicted things that were put to him.  To speculate about his own motives:  I’d say that a more balanced narrative just wouldn’t be as engaging.  ‘Fair-minded, hard-headed mainstreamers engage in many flowers bloom approach following crisis, having made as good a fist of it as fallible human beings usually do’ [Hold the front page!]

 

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Dear Ed and George

Dear Ed and George.

Today, on the Andrew Marr show, the debate between you on public finances and macroeconomic policy seemed to reach new lows.

1.  The focal point of today was the part-leak-part-preannouncement of policy.  Surely better for all to wait until the Autumn Statement itself?  Instead, George succumbs to the temptation to try to extract more good news and a weekend political victory, hoping to catch Ed out on the sofa.

2.  For your part, Ed,  it was mystifying to hear you say simply that your NHS funding plans would be on top of whatever the Tories were announcing or meaning.  Presumably there would be some extra amount of money that would mean the Mansion-Tax-funded £2.5bn a year would not be needed?

3.  Both of you are stuck unable to describe fiscal policy in macroeconomically literate terms [insult borrowed from Simon Wren Lewis].  Why don’t you face up to the fact that, right now, with interest rates pressed against the zero bound, and QE of uncertain impact, large deficit funding is needed to support monetary policy?  We can be fiscally virtuous, but not now.

4.  Ed, you are onto something when you curse Coalition fiscal policy for being too tight, and deepening the recession.  But that criticism, which you repeated today, is out of date.  What you should be pointing out is that the Coalition did relax fiscal policy, pretty much as you would have recommended, and it was because of that that growth resumed.

5.  George, your describing the government’s conduct as following through on plan A doesn’t help the quality of debate either.  Much better to say that initially caution was needed, until it was clear that we were not going to be viewed in the same light as the Southern European sovereigns, and only then was it possible to turn on the taps again.  If you had set out a contingent plan in the first place, you would not have needed to confess to a change of direction.  As it is you place the need to look like a government of resolve  above the need to look like a government of rationality.  And you seemed to reveal that the future consolidation would be of the same ‘come what may’ variety as the last one that you (thankfully) didn’t follow through on.  I guess that you therefore calculate you weren’t caught out last time.  You might be right, which is a depressing thought.

6.  Ed, the Mansion-Tax for NHS top up proposal is gimmicky.  Hypothecating tax revenues might be arguable in a state that was failing, illegitimate and unable to collect taxes.  But not in ours.  Where would such a process end?  [Before you answer that, could you just tell me who is paying for the replacement of Trident?  Is it me?]  The gesture seems a perversely reactionary one.  Why offer an explicit financing plan for this tiny part of the NHS budget, before you customarily knuckle down to costing the entire budget?  This is a case of presentational imperatives trumping all.  You are reluctant to maintain explicit, all-encompassing fiscal plans, preferring instead to keep as much time for vague ‘oppose everything’ strategies, but in order to look serious, you pick out micro-policy-costings like this.  But following this strategy, you risk it being judged that the case for taxing high value houses stands or falls on the existence or otherwise of an NHS funding problem.  Which is not the case.  You don’t help the debate about social justice and redistribution – surely exactly what your party is for – by tying the two together like this.

7.  George revealed that the next come-what-may consolidation would be achieved entirely through spending cuts.   To me and others this looks like an opportunistic shrinking of the state, right when it’s most hazardous to attempt it [when monetary policy cannot or will not compensate].  You must know that people judge such an extreme tactic as undeliverable, not just practically, but politically?  Yet you risk uncertainty festering about just what you will do by taking up this position.  I find it hard to believe that your median Tory target voter really wants it either.

8.  Oh, and there was the confusion about how much new money was really being announced.  It was trailed as £2bn extra money.  But this wasn’t quite true, was it?  Actually 0.7bn was a reallocation within the existing NHS budget.  That was a particularly petty piece of media warfare.  Catch Ed out on the sofa, then leave the less important facts to work themselves out in the chattersphere.

9.  The two of you make an excellent case for delegating more control over fiscal policy to technocrats.  [You might think:  he would say that wouldn’t he?].  I don’t know how such delegation, over levers of iconic democratic importance, could be made politically acceptable.  Especially when our economics profession is licking its wounds after largely failing to realise that the financial system was going to explode.  But some way has to be found so that your successors can have a better conversation.  A debate about the average size of the state, the strength of the automatic stabilisers, whether discretionary fiscal policy is needed on top of that (eg at the zero bound), and, if so, on menus of latent measures that could be triggered as such stimulus or tightening was needed.  Such a conversation would involve you setting out explicit and different positions on how much risk sharing the state should be doing across regions, income groups and generations, which spring out of your different political philosophies.  I hope at least that Ed’s proposal that the OBR should be tasked with vetting your manifestos will prove hard to resist, and that this might be a first step along the way to the utopia I and other economists are seeking.

 

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Oil prices and monetary policy

In 2002 I was seconded at the ECB, and tasked – with another, from the research department – with writing a note to the Governing Council on oil prices and monetary policy.  If I remember correctly, in the 3 months up to the time we were writing the note, oil prices had risen in euro terms by 1/3.  Consequently, my coworker and I hit on the idea of beginning the note with the phrase ‘In the last 3 months, oil prices have risen by a 1/3 in euro terms’.  This sentence got purged on the grounds that it was ‘too alarming’, and replaced with ‘From time to time the oil price changes’.   I hope that material flowing to the ECB policymakers is written more directly now, or, if not, that the custom widespread at the time – according to my contacts in member state central banks – of disregarding entirely briefing emanating from the centre, is still prevalent.

Right now, arguments could be made for doing nothing, cutting, or even tightening in response to the oil price fall.  But I hope that in so far as this is possible, they loosen, since this would be the policy that minimises the risk of making the worst mistakes.  In the jargon, this would be the robust thing to do.

The argument for doing nothing is that oil-intensive-final good prices like refined petroleum are highly flexible, and can therefore be ignored.  (Modern orthodoxy says just stabilise sticky prices).  Or that the effects on inflation will be so temporary that they will be gone before anything can be done about it.

The argument for loosening is that on account of oil being a major input, it will raise potential output relative to actual output.  Which in models like those central banks uses is deflationary.  Also, if inflation expectations are extrapolative, ie they look at changes in total inflation and project those forwards, a temporary oil price fall would lower inflation expectations, transmitting into core inflation.  (Inflation itself being lower on account of the fall in expected inflation).

It’s conceivable there’s an argument for tightening.  If the demand/confidence effects of the improvement in the terms of trade for a net oil importer come through before the boost to potential output.

By far the largest risk to me is the risk of setting too-tight policy, since there is no proven or politically feasible instrument to use to loosen further in the ECB, and, to a lesser extent, in the US or the UK.    So if possible, better to loosen now rather than face the possibility of needing to, but being unable to loosen by a great deal more later.

Events might prove a loosening wrong, of course.  But in that case the ECB can simply raise rates, or the Germans can gallop to the rescue and tighten fiscal policy.  And anyway, an inflation target overshoot would be welcome for most.

So, ECB policymakers, recall those wise words [inserted by my superior] ‘from time to time the oil price changes.’  Most often, the risks are balanced, and it might be safe to ignore those changes.  But not now!

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Buiter’s reassurances about the value of government currency

A quick and incomplete response to Buiter’s note for Citi [which is a great read], quoted extensively in FTAlphaville today.

Buiter compares the properties and usefulness of government fiat currency, and other intrinsically worthless assets like Gold and Bitcoin.

He reports that only in models with flexible prices can an economy suddenly spit out a zero value of a fiat currency.  Noting that in the real world, the prices of goods in terms of government currency are sticky, yet the relative price of goods and gold or Bitcoin are flexible, he offers this as evidence supporting that the value of fiat currency is more assured than that of the others.

Two notes of caution.  First, although he doesn’t say precisely what results he’s referring to, I am sure he is talking about models that invoke rational expectations.  So in that respect they are not to be taken as comprehensive ways to adjudicate on the relative properties of these different currencies.  [Buiter himself notes that sticky prices are sometimes justified on the grounds that agents are less than ‘rational’ in the (confusing) sense typically meant in this literature].

Second, I don’t think Buiter’s observation that the ‘world is Keynesian’ – relative price of government fiat money and goods is sticky – can be taken to be the final word.  It may well be, but we don’t really understand why if it is, and don’t know what models that encoded a better understanding would tell us about this.   For example, it also seems to be that prices are sticky until they aren’t!  Extreme monetary events have greatly increased price flexibility.  [witness the unidad de fomento in Chile, with prices indexed, or most hyperinflations or instances of dollarization].

So, if that government-printed note is burning a hole in your pocket, spend it, and don’t miss out on a Black Friday bargain just because a few sticky price monetary models make you think you are safe.

 

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Inflation truthing, asset prices, discount rates, QE

A thought-provoking post from Toby Nangle on this topic raises some difficult questions that go to the heart of monetary economics and policy, and take in important practical questions like what are official statistics for.

In his post, Toby recaps on the arguments of those who have become known as ‘inflation-truthers’.  These are commentators, who, reasoning from versions of the quantity theory of money, [pq=mv], predicted that money expansions associated with quantitative easing might generate runaway inflation.  When they didn’t see this inflation, they speculated that it was there, just that the authorities had conspired to manipulate public statistics so that it could not be seen.

Toby doesn’t try to rescue this conspiracy theory.  It’s hard to disprove it, although you will find that almost every practising economist who has ever interacted with government or the ONS will dismiss it as absurd.  Unfortunately, the experience of Argentina, where this does seem to be happening, gives this dark view life it does not deserve.

Instead what Toby does is to get at something that did happen, and might be the source of what is itching inflation truthers.  And that is that quantiative easing lowered yields and thereby raised the cost of providing for a given lifestyle in the future by saving.   In so far as it raised this cost, the argument is put that this is a kind of inflation, so perhaps this is the inflation that the inflation truthers were thinking would happen all along as a result of the money expansions.   And, extrapolating the logic, perhaps, if it is a kind of cost, we should include it in a proper definition of inflation.  Such a suggestion harks back to debates at the end of the 1990s and early 2000s when inflation targeters’ inflation was low and on target, but asset prices were booming.  Proponents then wanted tighter monetary policy to curb the boom they thought would lead to a crash (and which eventually did, of course) and some thought that the way to do that was to redefine inflation so that it included the asset price inflation [short hop from implicit yield] that would make the target index overshoot.

The more I think about this, the more I conclude that there are not any definitive answers to the questions raised here.  There are some points we can make about monetary theory, which the inflation truthers get wrong, but the theory is just that, and all the more a work in progress since we had to think about QE.  And there are some practical and historical points to be made about inflation indices, but about which different people could reach different conclusions.

The first question raised is whether the fact that QE lowered yields proves the inflation truthers right all along about the fact that MV=PT would assert itself somehow. From theory, the answer is no. PT=MV is not so much a theory as a piece of book-keeping. Standard monetary theory that accounts for the existence of an effect of QE on yields tells us that the monetary expansion bit was of no consequence, except in so far as it might have signalled something about lower future interest rates. The bit that lowered yields was the bit that involved a twist of the maturity structure of government assets out there, replacing long dated securities with short-dated equivalents. The thought experiment of two ‘bits’ of QE is just that, but recognise that buying long dated securities with reserves – what the Bank of England actually did – is the same as doing a conventional open market operation, (reserves for bills), and then a twist (bills for long dated gilts). MPC emphasised the importance of the expansion of money in the early days of QE. And some of their educational literature still does. But this was just hopeful bluster, at least as far as the theory we have tells us.

Empirical evidence on the effectiveness of QE doesn’t refute this basic notion.  Though it shows that money expansions lowered yields, it also shows that twists lowered them.  And the fact that money expansions did lower them might have nothing to do with the ‘money leg’ of the transaction.

Note that the inflation-truthers’ contention, that PT=MV asserts itself somehow, wasn’t anyway true at the zero bound. As the economy approaches the zero bound, velocity [jargon for how much real balances people want] falls [real balance demand rises] which is not surprising, since economics 101 tells us that as the price of something falls we want more of it [the price being the nominal interest rate in this case].

The second question raised is whether the fall in yields constitutes a cost for those trying to provide for their savings. This is certainly true, other things equal. Lowering yields means that yields on savings are lower! Implying that you need more of them to leave you with the same sized pot as you had thought. But, as the BoE explained pretty well in its evidence to the House of Lords, other things are not equal. Absent QE and the lowering of yields, it’s plausible that real activity and the value of funds invested in private assets, would have been much lower. So the reduction in the yield does not tell the whole story for savers.

Even if we had established that the ‘cost of saving’ had risen, this would not mean that QE was a bad idea either. If it had the effect of redistributing funds from savers to borrowers, then one might have anticipated that this would raise aggregate demand, since the latter we think have a higher propensity to consume out of income than the former.

This then leads us to the question of whether this ‘cost’, if it was a cost, should be included in the inflation index.  This is impossible to answer definitively.  In a free country, anyone can construct whatever weighted averages of things they want!  So whether adding other things to what one conventionally thinks of as inflation is worthwhile depends on why we are doing it.

Conventional practice is to define inflation to mean the change in the amount of money needed to buy the same basket of consumption goods: or, if this basket changes, and, to dig down to the theoretical fundamentals, to generate the same amount of utility that such goods provide.

This definition has certain theoretical purposes. For example, in macroeconomic models with flexible prices, it is this definition that provides the instantaneous link between the level of the money supply [requiring its own definition!] and the level of prices, referred to  by the P in PT=MV.  And it is the definition which allows us to connect the rate of growth of money and the rate of growth of prices.  Using this definition, we can also develop reasoning about long run optimal monetary policy [the optimal rate of growth of money, or level of nominal interest rates].   In this flexible price world, that policy is to  induce negative inflation equal to the real rate, so that the return on holding money is the same as holding other risk free assets.  Thus maximising the social benefits to holding money.  You could still figure out optimal monetary policy if you added to this definition a weighted sum of the real rate embedded in a long security and Brazilian rainfall, but it would make life slightly harder.  A more economical way to put this is that we define inflation to be the thing that monetary policy can choose, and the thing that can only be determined by monetary policy, in the long run.

In models of macroeconomies with sticky prices – like those used by all the major central banks – the same concept of inflation produces a refined steer about the appropriate long run monetary policy, and also a guide to short run, cyclical monetary policy.  The refined steer about long-term average levels of interest rates is that they need to be a bit higher than in worlds without sticky prices.  The same force in flexible price models works to pull optimal policy to try to equalise the return on monetary and other assets by generating deflation.  But this force is offset somewhat by the fact that changing prices invalidates the price choices of those who can’t readjust, so the optimal rate of inflation becomes a weighted sum of the Friedman Rule and zero.  And thus average nominal interest rates are higher.  The steer from these models about short run monetary policy is that we should try to keep inflation – conventionally defined – as close as possible to this long run level, traded off against other short run objectives too, like controlling real activity.   Once again, there could be no particular theoretical objection to defining ‘inflation’ to include Brazilian rainfall.  It wouldn’t affect the setting of interest rates in this model world.  But it would make communication of policy tricky in the real one.

That said, if you wanted to record the cost of those trying to provide for a certain level of utility in the future in terms of resources set aside today, you could adjust the inflation rate for a change in real returns.  But those returns are not something that conventional monetary policy can do much about in the long run [except via reducing nominal uncertainty in the economy].   This ‘cost’ is something that the ‘fiscal’ bit of monetary policy [the twist bit of QE] should pay attention to.  But, weighed against the other effects of QE, it might well still prove to be the right thing to do.

 

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