The UK election consensus that we are all ok with the new mighty BoE

One thing that’s interesting about the election is that no-one has seriously questioned the new settlement of powers within the Bank of England.  Perhaps there is discord, but it simply gets filed under ‘too hard to worry the voters’ pretty heads with so we’ll do what we want afterwards.’

This new settlement means a much larger and more powerful Bank than before the crisis.  It has had the supervisory functions re-incorporating into the Bank, following the dismantlement of the Financial Services Authority and the creation of the Prudential Regulatory Authority as part of the BoE.  And it has been given new powers and responsibilities for altering regulatory levers through the cycle under the Financial Policy Committee.  On top of that are more informal expansions of BoE power and reach through the agreements reached with HMT over unconventional monetary policy (QE), and other interventions like the Special Liquidity Scheme, the consultative role on Help to Buy, and Funding for Lending.

There have been spurts of scrutiny on the Bank.  Surrounding the conduct of some of its officials in the markets area, and of the Bank itself in managing its part in reviews of those misdemeanours.  And of the Governance of the Bank through the BoE’s court of directors.  And of the BoE’s transparency – or lack of it – in its old practice of destroying recordings made of MPC meetings.  But no broadside challenge to the new, larger and more powerful BoE.

This is pretty surprising.  Because the changes described above constitute a pretty sizeable and important redrawing of responsibilities in economic management.  And it is not as if the economy has not featured in the election battles.  It has.  It’s just that has not involved the BoE.  It’s been about the extent of job creation and whether the government was responsible for that.  And about the alternative trajectories for the deficit.  None of the parties are complaining about the Bank’s response to the crisis.

I don’t myself think there is a huge amount wrong with what they are doing, in the grand scheme of things.  But given the amount of imagination put into other aspects of government critique, it’s surprising that monetary and financial policy has escaped without a mention.   With a bit of effort, one could caricature QE as overreach that did for pensioners;  or as ineffectual;  or one could caricature macroprudential policy as meddling, or a flop;  and the FLS likewise [what has it done for SME lending?].

I can see why Labour are not gunning on this topic.  Although the Coalition politicised the settlement by dismantling the FSA that the 1997 Labour government created (in my view spuriously putting the global crisis and near universal failure of analysis down to the arrangement of chairs in the UK) there’s nothing to be gained by reopening these debates and reversing institutional reform.

But the rise of the more radical, fringe parties has also come without any of them questioning the new status quo.

Contrast with the US, where the Fed’s powers and responsibilities – as a result of its post-crisis conduct – are coming under the spotlight.

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Rosengren: A big day for the ‘raise the inflation target’ campaign

I just noticed this article by the FT’s Sam Fleming, in which he writes that Boston Fed President Eric Rosengren has pointed out the potential benefits of raising the US inflation target.  The implication being – as Blanchard, Krugman and others  have pointed out – that we now know booms and busts are big enough that the old one can send rates to the zero bound.  And aside from that, we suspect that the equilibrium real rate – also crucial in determining how far above zero the central bank rate lives – will be lower than before for the foreseeable future.

This is a big day for the raise the inflation target campaign because Rosengren is the first real life actual policymaker to express this view.  Granted, he doesn’t have a vote on FOMC this year.  But he will get one later.  This could say more about the latitude Fed members feel to express blue-sky views than the chance of it ever happening, but still.

It nevertheless seems unlikely from a realcentralbankpolitik perspective.  Bernanke’s quantification of the vague ‘price stability’ mandate as a target was a bold enough step.  Raising it might stretch the consistency of the target with the Fed’s mandate for ‘price stability’ too far in the eyes of Congress.  And trigger a ‘while we are at it’ fundamental review of their goals and perhaps even operations.  (Don’t forget the AudittheFed nonsense).

A target raise would not be entirely inconsistent with Fed goals.  The Fed has a dual mandate, the other item involving full employment.  Raising the target would lead to greater inflation stability (sounds a bit like price stability) but lead to smaller deviations from full employment, if that means fewer and less protracted periods spent at the zero bound.  And less recourse to unconventional monetary policy tools might appeal to economic conservatives in Congress, who view such things (falsely) as signs of meddling with capitalism, rather than (as they should) attempts to fix it.

Lurking here is who should have the right to set Fed targets.  I favour myself the UK system, in which the Government sets the target, and the central bank is delegated the task of pursuing it.  In the academic literature this is known as giving the central bank instrument independence but not goal independence.

Right now, in the US, with the debate about economics – particularly fiscal policy – being so bonkers in Congress, one shudders at the thought of them having the freedom to write the Fed’s targets as the UK Government does here.  [The Chancellor – our finance minister – can simply change the target when it suits by writing a letter.] But then the long run legitimacy of delegating powers to the central bank – which is more in doubt in the US than it has been for some time – may be better served, eventually, by a UK-style split of responsibilities.

My past rants on raising the target can be found here and here

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John Taylor and the thesis that Taylor Rule deviations caused the global financial crisis

John Taylor [here/here] recently reiterated his views on what caused the global financial crisis.

He contends the following.  That the Great Moderation was due to adherence to the Taylor Rule [and to ‘rules-based’ fiscal policy].  That during the early 2000s, monetary policy was set looser than that prescribed by the Taylor Rule.  This caused the build up of debt and risk-taking, which ultimately led to the bust, and the end of the Great Moderation.  Weak activity following the crisis has been due to departures from rules based monetary policy, in the form of unconventional monetary policy.   And departure from rules based fiscal policy, in the form of the fiscal stimulus enacted by Obama in 2009.  These departures have created uncertainty that has weighed against activity.  Tighter policy on both counts would have led to more buoyant activity during the recovery on account of being more certain.

I think he’s wrong on every point.  And I doubt many at all in the mainstream macro profession, even the conservative strands of it, will agree with him.

1.  Research on the causes of the great moderation are split.  Those that take explicit macro models to the data tend to stress good policy.  (But sill leave a sizeable role for good luck).  Those that are more agnostic, and in the empirical macro tradition, stress good luck.  Even to the extent that good policy is stressed it does not follow necessarily that adherence to a Taylor rule was what delivered the goods.  John’s claim that macro performance during that era was due to adherence to his rule was highly dubious even before the Great Moderation’s end.

2.  John’s rule was shown to deliver pretty good results in variations on a narrow class of DSGE models.  The crisis has cast much doubt on whether this class is wide enough to embrace the truth.  In particular, it typically left out the financial sector.  Modifications of the rule such that central bank rates respond to spreads can be shown to deliver good results in prototype financial-inclusive DSGE models.  But these models are just a beginning, and certainly not the last word, on how to describe the financial sector.  In models in which the Taylor Rule was shown to be good, smallish deviations from it don’t cause financial crises, therefore, because almost none of these models articulate anything that causes a financial crisis.  How can you put a financial crisis in real life down to departures from a rule whose benefits were derived in a model that had no finance?  There is a story to be told.  But it requires much alteration of the original model.  Perhaps nominal illusion;  misapprehension of risk, learning, and runs.  And who knows what the best monetary policy would be in that model.

3.  In the models in which the TR is shown to be good, the effects of monetary policy are small and relatively short-lived.  To most in the macro profession, the financial crisis looks like a real phenomenon, building up over 2-2.5 decades, accompanying relative nominal stability.  Such phenomena don’t have monetary causes, at least not seen through the spectacles of models in which the TR does well.  Conversely, if monetary policy is deduced to have two decade long impulses, then we must revise our view about the efficacy of the Taylor Rule.

4.  John puts great store on the effect of uncertainty on weak-post-crisis activity.  But in the models in which the TR is shown to be good, the effects of changes in uncertainty are small.  Highly unlikely to be a major cause of a drop in activity in the region of 5-10%.  Of course, it’s possible that the effects of changes in policy uncertainty are large and the models are wrong.  But in which case, we need to revise the class of models we used to evaluate the TR in the first place.  A fair argument can also be made that QE and fiscal stimulus did not aggravate policy uncertainty.  It provided the stimulus that monetary policy was not able to, but would normally, absent the zero bound, have been expected to.  The coincidence of the Fed and Treasury’s actions with the elimination of elevated spreads on risky assets is at least good circumstantial evidence of this alternative view.  It is plausible that the fiscal stimulus helped aggravate the wars between the left and right in Congress over the debt ceiling, and that, other things equal, this depressed demand.  However, relative to a situation in which there had been no discretionary stimulus at all, the US economy was surely still better off [goal variables closer to target].  Of course, the ideal policy is one in which there is certainty over the fact that discretionary fiscal stabilisation steps in when conventional monetary policy has run out of room.  Freshwater macro people don’t agree with that;  but this is the conclusion in the family of models in which the Taylor rule is shown to do well.  Taylor can’t draw comfort from the freshwater rejection of the efficacy of fiscal policy, since that line of thought asserts that prices are flexible and active central bank policy of the kind JT wants is at best an irrelevance.

5.  John seeks tighter monetary policy in the form of no quantitative easing, and no fiscal stimulus.  In the models in which the TR was shown to be good [rational expectations models with sticky prices], doing this would have moderate, but damaging short run contractionary implications, taking goal variables further away from target than they were or are.

6.  John does not address worries about the fact, that, in models in which the TR was originally shown to be good, which ignored the zero bound to interest rates, it was also shown that adherence to the Taylor Rule could lead to the economy becoming perpetually trapped at the zero bound to nominal interest rates.  This is unfortunate, since we know now that this trap is a real possibility.

7.  It’s highly contestable that the Fed set too-loose monetary policy in the early 2000s.  Bernanke made a stern and convincing case in favour of what they did while still Fed chair.  He pointed out that if you substituted inflation for forecast inflation in the Taylor Rule, for which a convincing case can be made that one should, you find that Fed policy was not too loose.  Specifically, rates were so low because the Fed were worried about deflation, and the zero bound.  They had watched what they saw as slow and weak Bank of Japan monetary policy, and had seen its consequences, and were doing what they could to avoid that experience being repeated.

8.  Not only does John’s ‘monetary policy caused the financial crisis’ thesis go against the theoretical models [in which his rule was shown to be good].  It also goes against the consensus of evidence about the vector autoregression evidence of the effects of an identified monetary policy shock.  So far as I know, monetary policy shocks are not measured to have large, 1.5 decade-long [2000-2015], destabilising effects on the financial sector.

9.  When pressed about the meaning of the #audittheFed requirement for the Fed to declare a monetary policy rule, he responds that this rule is not meant for religious adherence, but to provide guidance.  Yet the research which he and others did studying central bank conduct has nothing to say about central banks that do and should depart in discretionary and judgemental ways from the rule.  If those departures happen and are thought necessary, then this has to be because we think the world works in ways different from the models in which the TR was observed to do well.  What are those differences?  How important are the discretionary departures from the rule in a model that articulates them?  This could be a detail, or it could be very important.  If it’s a detail, I’d like to have it explained to me why.

10.  JT’s thesis, that the TR is great in theory, and was responsible for the Great Moderation, expresses a confidence in this research that is not warranted.  Although I personally don’t subscribe to the freshwater view of macro that prices are flexible, I do have a lot of sympathy for their view that the modelling of sticky prices is often superficial and question-begging.  And certainly not sound enough on which to build a case for legislating to tie the hands of the Fed.  Moreover, JT ignores doubts cast on the framework by John Cochrane’s hard but profound papers on equilibrium selection in monetary policy rule modelling.  His view of the story that lies behind the equilbrium JT and others study so much is that it is a load of nonsense.  And he can’t be dismissed lightly.

11.  For reasons that escape me, John Taylor seems to relegate the misunderstanding of finance, and financial regulation, to the status of a detail in the list of likely causes of the financial crisis.  Yet there are so many reasons to believe that this was its primary causes.  Not least that in the models we know and love, real, low-frequency problems generally have real causes.  John also has to contend with the freshwater economists on this matter, since they – mostly believing in flexible prices – would view monetary policy as the detail.  To give a few examples, we are asked to believe that keeping interest rates a few tens of basis points below what JT argues – controversially – should have been the case, was responsible and not:  politically motivated subsidies for sub-prime lending;  failures in credit ratings of sub-prime securities; failures in the regulation of retail banks with new, aggressive wholesale funding models, and lax lending standards;  failures in the regulation of investment banking functions which had unappreciated and systemic importance; instability caused by the failure of institutions to internalise the effects of their fire sales on the system as a whole once the crisis had begun;  and by Knightian uncertainty over things like the value of asset backed securities and who was exposed to what.  The impact of the export of vast flows of savings ‘uphill’, from emerging market countries, on asset prices, asset pricing models, regulatory capacity and so on.   This is a short extract from a very long list of causal factors unrelated to monetary policy.  But the general idea should be plain.

For me, it’s ironic that John calls his talk ‘a monetary policy for the future’.   John does not seem to have absorbed the lessons of the recent past.  The crisis has reopened questions about the appropriate macro model and the macro policy conduct within it that were previously thought to be settled.  That there should be closer adherence to this old answer to monetary policy questions is a conclusion that I think very few indeed will draw.

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Who needs mainstream friends when you have enemies like these?

Steve Keen is on top form in his latest Forbes column.

He thinks that when it’s pointed out to Munchau who says ‘their [mainstream macro economists’] system of equations is linear’ that it is very often not, that this is a ‘smokescreen to justify a copout.’  Steve.  Read some of the few thousand papers now on nonlinear models in the mainstream.  What kind of ‘copout’ is that?

This is standard fare from Steve.  He makes his living out of ‘debunking’ a discipline he doesn’t read or know much about.  Either that, or, if he does read it, he calculates that no-one will call him out.  We know this must be true because, at various points, he has said that modern macro ignores money, ignores banks;  that you can’t publish in top journals unless you use rational expectations.  [See my post on his ridiculous contribution to a recent radio program in the UK].

I also don’t get why you have to read anything into the different messages coming from Blanchard, DeLong, Krugman or myself.  The mainstream does not speak with one voice.  Why should it?  There are fights all the time.

DeLong and Krugman think you can and should get along fine without nonlinearities. Krugman’s latest offers an argument that is a version of occam’s razor.

I don’t agree, but, since I know that they are extremely clever, and both have lots of prior experience, I’m inclined to lodge their advice somewhere on a post it in case one day I find myself completely lost in nonlinear Matlab code.

Blanchard makes the following point.  We should aspire to stabilising the economy.  [Surely one can’t argue with that.]  And if we succeed [we might not, but if], and assuming it’s not done perfectly, but just quite well, then the small movements left over will be described well enough with a linear model.  He’s not saying we definitely will be able to bring this about.  Just that we might be able to.  And, if we can, he states a result in words from function approximation, which again is unarguable.  [With the caveat that this small range should not cross over some crucial point of inflection/attraction/repulsion… ]

My advice to Steve is to stop writing, and start reading.  It’s never too late.

 

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There’s something Wolfgang on the internet

I like Wolfgang Munchau’s columns on the Eurozone crisis a lot.  But this one on claiming that macroeconomists need new tools is serious overreach.  Anyone actually building, solving or just reading others’ models, will see that it isn’t right, not even a little bit, on a single point it makes.  This is not to say macro doesn’t have challenges to answer, or may indeed need ‘new tools’.  But these are not for any of the reasons given in Wolfgang’s columns.

Error one.  That ‘their system of equations is linear’.  Well, this is true, except for the thousands that are not.  And those that are linear are approximated as such.  I dare say some don’t do this as advisedly as they should.  But most will know what they are doing, and when it works and when it does not.    But the importance of not making them linear is THE WHOLE POINT of many papers, in fact of many macroeconomists WHOLE LIVES.

I’m not at the forefront of this research, but I did teach a 5 hour workshop of various different methods for solving these models.  Check it out.  And in that time I could barely skim the surface of what’s been done. Or take a look at this textbook by Ken Judd.  It contains lots of ‘new tools’.  In a 1992 book!  And tools that were around for a lot longer before that in paper form before they became lecture notes and then his textbook.  Popular topics now are the macroeconomics of borrowing constraints and the zero lower bound.  Both of which require non-linear methods, which are embraced, in fact positively revelled in by the practitioners.

Error two.  Macro restricts itself to single equilibria.  Or ignores ‘chronic instability’.  Nope.  Multiplicity is everywhere.  Some, admittedly, get embarrassed about it, and hide it away.  There’s an amusing interview with William Brock where he explains how some liked to conceal multiple equilibria in footnotes.  [Can’t find it now, but I’ll update with a link when I do].  But I think most either address this head on and demand a lot of explanation from authors that seek to sidestep it.  Roger Farmer made much of his career out of multiplicity.  The New Keynesians – often bearing the brunt of this ‘failure of macro’ waffle – have spilled lots and lots of ink over the issue of what kinds of policies and environments generate multiplicity of equilibria and what don’t.  [Anyone who doubts this can try a quick google.  I’d suggest terms like ‘multiple equilibria, multiplicity, equilibrium, macroeconomy, monetary, stability’.]

One example [but there are hundreds] of a paper that embraces both issues, nonlinearity and multiplicity.  Benhabib and Schmitt-Grohe on the ‘perils of Taylor rules’.  This is solved non-linearly, in the presence of the zero bound.  And it explains how there are 2 steady states.  One with inflation at target.  And one with nominal interest rates perpetually trapped at the zero bound.

Error 3.  Secular stagnation is hard to capture in modern macro models.  A little more debatable.  For a start, this started out life as a bit of verbal reasoning by one of the great minds in our profession no longer building models.  It’s a conjecture, not a fact.  So even if it was hard to build into a model, that would not necessarily be a bad thing.  But, in fact it is.  Eggertson and Mehrotra have done it, for one.  Whether they have done it convincingly is up for debate.  But it is done.  And so has Greg Thwaites.  I would not like to trivialise what they did by calling it ‘easy’.  But I think it’s fair to say of both pieces of work that they are not pieces of technical virtuoso.  They use bread and butter tools, and the contribution is in the insight and the economics.  The difficulties they had don’t speak to some problem in macro.  They may well speak to a problem with the hypothesis, conjured creatively but speculatively out of a few charts.

Error 4. Well, I’m not actually sure what is meant here.  But Munchau starts out saying that there is ‘an assumption of limitless space.  That wherever you stand, you can go further.’  This is so vague, it’s not easy to know if it’s wrong or not.  But, some examples:  microfounded models assume budget and economy wide resource constraints.  So, in that sense, the ‘space’ is extremely limited.  And usually there is the invocation that the space that variables live in is bounded.  Munchau writes ‘No go zones like a zero bound are technical minefields in a model.’  Well, not really.  I teach my MSc students how to deal with it in 2 hours.  They are a clever lot, for sure.  But they are also busy and exhausted and have 25 other things to revise.  Yet they still get it.

The implication is ‘ooh, look at this really obvious real world thingy that economists just can’t deal with’.  But actually, they can and do, and it’s embraced by 100s of papers now, since Krugman wrote the first modern one in 1998.

Munchau identifies, therefore a false ‘consensus’.  And hopes that ‘new tools’ will come along to help people challenge it.  Not realising that these tools have been in use by mainstream macro people since the mid 1980s.  I hope that Munchau’s penetrating writing on other topics don’t lead peope to take him seriously on this one.

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The Tea Party won’t purify the market by tying the Fed’s hands

Matt O’Brien has a thought-provoking piece on Wonkblog at the Washington Post.

It’s about the curious business of the modern Republicans turning their back on what most mainstream economists would now view as ‘sound money’.  Namely the active use of the Fed Funds Rate in pursuit of stabilising some weighted sum of inflation and real activity.

The movement has sufficient weight behind it that it leaves its imprint in Bernanke’s opening blogs, where he feels obliged to explain how you can’t simply set the interest rate and take your hands off the wheel, allowing markets to sort the rest out;  and that the Fed is not setting interest rates ‘artificially low’ right now, but is instead accommodating weak demand/strong savings in pursuit of the goals Congress mandated it.

What the Republicans of this ilk are not aware of is that in so far as the theory informs policy, the Fed is actually trying to do its best to recreate conditions that would obtain in an idealised, undistorted market.  When people talk about the natural interest rate, and the Fed chasing it with the Fed Funds Rate, they are referring to this idealised real rate that would clear the market for savings in a perfect market economy.  Far from distorting the market economy, the Fed is trying to purify its outcomes.

But there is a lot that branch of the US political system does not get.

As I wrote a while ago, it has an equally puzzling approach to fiscal policy.  Concerned that the Federal government won’t pursue sound fiscal policy, that debt will get out of hand, perhaps be defaulted on or inflated away, it launches repeated attacks on the Federal government budget threatening to prevent it from making good on its existing debt.  The effect being to risk raising the cost of finance for governments, which makes debt management harder, not easier, and reduces, rather than increases private investment [the cost of funding for which is always priced off government debt].  And as collateral damage, it creates corresponding fluctuations in the liquidity of Treasuries, which is the equivalent of the Fed yanking around interest rates for the fun of it.  Something that adds to the chaos in markets, rather than purifying them.

This is no doubt bound up with the Tea Party’s distaste for all the manifestations of Federal government.

The founders debated long and hard whether to allow the Federal government to issue its own debt.  And perhaps the Tea Party still think they were onto something.  They and the other Republicans who pay heed to them might not have realised that we have 250 years of monetary and public choice economics to tell us that debt financed Federal spending, and active fiscal policy is a good thing.

The Federal Reserve was likewise a manifestation of evil for the states-rightsers (mostly Democrats then, before the two main parties switched scripts) and was created and abolished once before its current incarnation was set up in 1914.

Modern states-rightsers – the Tea Party – perhaps consider abolition too ambitious, but think that fixing the Fed’s instruments, or narrowing its objectives, will take the actual economy closer to a Founder’s vision of an unfettered one.  We have to hope that most people continue to think this view misguided.

 

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Sorry, but financial freedom for pensioners was a bad idea

Ben Chu kindly hosted and edited this version of an old blog post of mine on the Independent’s ‘Chunomics’ blog, explaining why think it was a bad idea for the Chancellor to let pensioners take their pensions as lump sums.

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