The Office for Budget Responsibility’s Fiscal Risks Report

This is a new product.  It’s a tour de force, ranging from obscure line items on government finances, to some philosophising about the nature of uncertainty.

But it is not beyond criticism.  This post pulls together tweets I sent last night [Sat 11 July].

First, I was hoping to read something explaining how indefinitely low equilibrium real interest rates, and therefore central bank rates, would translate into greater fiscal risk for a given recession risk, on account of there being a greater call on fiscal stimulus – automatic, or discretionary, or both – at the zero bound.  This extra fiscal risk comes about on account of monetary policy being more constrained than it was during the past recessionary episodes that the OBR’sreport discussed.

Even if you thought that quantitative easing was a perfect substitute for interest rate policy – a position that would be rather extreme – this itself would translate extra risks in the balance sheet of the consolidated government/Bank of England, as assets were bought and sold in the busts and booms.

Second, it is curious that the risks relating to our current >8 year spell at the zero bound are not spelled out.  It may be that the UK economy cruises back to a resting point for interest rates at say 2%, permitting a slow further consolidation of fiscal policy.  Or it may not.  It may instead prove to be the case that we are trapped indefinitely at the zero bound for the need of a very large fiscal stimulus to achieve lift off.

The silence on this risk mirrors the need that the Bank of England itself feels not to comment directly on current fiscal policy.  The BoE’s silence is more understandable.  But despite the existence of 2 independent bodies commenting on or implementing macro policy, there seems to be a missing mandate or preparedness to point to the major macro-fiscal risk of the day.

There is some interesting text about the Treasury’s risk management structures.  We are told of the existence of a dedicated ‘Fiscal Risks Group’ which writes reports regularly to the ‘Executive Management Board’, from which advice emerges.  We are told of activities like ‘horizon scanning’.  Well, we are clearly in safe hands then!  An analogy is writing a report in 2007 that observes with approval that the Bank of England writes a ‘Financial Stability Report’ and expecting us to draw comfort from this.  Merely alerting us to the existence of committees and meetings and reports cannot be at all reassuring.  Such things may not amount to a hill of beans in the face of a choppy world economy and a struggling polity.  Writing about them so uncritically, the OBR’s report dilutes its normally severe and disapproving tone of independence.

A curious thing about the report is that it does not draw out that in many ways the whole point of government is to assume risk, not to avoid it.  Many government policies fill in for missing, or poorly or inequitably functioning markets for risk [unemployment insurance, health insurance, pensions].  Government is the means by which many of the risks we face are pooled.  Since it has the deepest pockets of all, the largest risks naturally lie with it.  Its power to borrow allows us to spread risks across cohorts through time.  A government balance sheet which was managed to continually avoid risk would be one that was wasted.  Of course, the capacity of the government to absorb risk is limited and so attention must be devoted to ensuring that scarce fiscal space is used for the most worthy causes.  But nevertheless it must be used.

Finally, the Report seems to abstract from risks emanating from government policy itself.  Recent UK history has been characterised by the repeated adoption, fudging and then dumping of fiscal rules. This itself has probably impaired the credibility of policy and the capacity of the government to bear risk.  And that this behaviour may be repeated is itself a source of risk to the trajectory of fiscal balances going forward.  The practice of the OBR – just like the BoE – of conditioning its analysis taking stated policy as a given precludes commenting on this problem, ultimately reducing the chance that the problem is ever fixed.

 

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More crypto monetary dystopia: political fall-out of a partial take-over

Writing a serialised monetary policy dystopia seems to be a good way to thin out your readership, but I am going to plough on regardless.

In the event of a partial take-over of a cryptocurrency, politics in the state may become strained.

The currency fissure creates a new cleavage of monetary and fiscal interests that did not exist before.

Most obviously, those who have adopted the cryptocurrency have an interest in using whatever power their state has to preserve or improve the protocols underpinning that currency, to nurture its integrity and ensure that it offers the most enlightened monetary and payments security policy possible.  This is less of a priority for the vestigial fiat currency users.

As discussed in the last post, the introduction of a new exchange rate into the economy warps ideal monetary and fiscal policy towards managing fluctuations in the nominal exchange rate between the vestigial fiat and the new cryptocurrency.

A channel for this to happen is the price stickiness in home units of account that typifies economies today.  Which means fluctuations in the nominal exchange rate translate to fluctuations in the real exchange rate.  Those fluctuations – caused by this price rigidity – are damaging.  But from the perspective of those who live only in the vestigial economy, policy could be improved upon, freed from the compromises enforced by a multi-currency area.

Moreover, for  similar set of reasons the new currency cleavage will induce a commonality of interests in fiscal flows amongst those on either side of the divide that did not exist before.

If the cleavage were to produce two economies that were in other respsects identical, these problems would not arise.  But such a cleavage is highly unlikely.  More likely, it would arise because cryptocurrencies worked well for some activities or some people and not others, or in some places and not others.

The unit of account and medium of exchange cleavage will give rise to a correlation in outcomes for employment and output and all the things we care about, even if there is no change in the fundamental disturbances hitting either economy.  And that will mean there are now times when there are fiscal transfers needing to go one way across the currency cleavage, and times when they go the other way.  In a situation where these flows reverse quickly, it might be relatively easy to sustain support for the fiscal union.  But as we see from the Eurozone and, in fact, the history of the US, differences in ‘business cycle’ conditions can persist for very long periods – decades.  During such time, voters in one region see their taxes [or their fiscal space] used for spending in the other economy, and may resent it, having short enough memories that they don’t recall times when things were in reverse, and short enough horizons not to care about a reversal in the future.

Aside from this stress, and supposing that the monetary policy in the cryptocurrency area is rubbish – as it seems to be in the protocols for those currencies currently operating that I know about – voters in the vestigial fiat area will grumble at the volatility in fiscal settings in their region caused by the need to compensate for the gold-standard like monetary inflexibility in the neighbouring crypto-economy.

It might not be too implausible to think that the new currency cleavage could cause functions of the old state – like risk sharing – to wither, and even, if the currency cleavage operated also as a geographical cleavage, for the state to split eventually.

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Central bank policy in the face of a crypto take-over

Continuing the dystopian theme – at least dystopian from the perspective of the fiat currency issuer – a partial take-over by a borderless cryptocurrency will pose interesting questions for central bank monetary policy.

For starters, it will introduce a motive to care about fluctuations in the real exchange rate – and thus fluctuations in the nominal exchange rate – between the vestigial zone covered by the old fiat currency and the new crypto-region.  This must surely mean worse macroeconomic performance overall for both regions.

Another way of interpreting this is that it will lead to pressure for the protocol governing the issuance of central bank currency to move closer to the – probably inferior – protocol governing the issuance of the cryptocurrency.

Past decades have seen much hope for, and occasional outbreaks of, enlightened cross-currency monetary policy coordination.  But just as there would be nobody for a centralised polity to negotiate with in the face of a partial anarchist takeover, so there would be no-one with whom to discuss modifying a decentralized, hard-coded and damaging cryptocurrency issue-protocol.

In this way, the reach of the apparently partially victorious cryptocurrency would have extended further than is at first apparent, much like in the case of the reach of the old Deutschemark in the former Eurozone, or of the dollar with the countries who adopt currency boards, fixed or managed exchange rates.

 

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Crypto-currencies and the vestigial states they plunder

That headline was a bit strong.

But a thought.  In a previous post on Alphaville I wrote about how the currency area that a private sector cryptocurrency created would be undesirable.  That was because it would likely straddle national borders, and therefore there would not exist institutions to funnel fiscal resources around it to perform the functions that we hope for in an optimal currency area, and have been tragically absent in currencies like the Eurozone.

Rather obviously, the vestigial states carved up by this hypothetical crypto currency would face new problems and constraints.

In a conventional currency area, where the state has a monopoly on supplying the currency, to some extent the central bank can stand behind its government, which may need to borrow large sums to tackle fiscal or financial crises.  I say ‘to some extent’ because the costs of high inflation, and the inefficiency of money-financing when inflation is expected, limit the ability of the money printers to stand behind fiscal policy.  [One reason why I think those who dismiss concerns that the UK could ever have faced a run on its own sovereign bonds as unfounded are wrong].

If part of the economy now functions using a cryptocurrency, this financer of last resort function does not work so well for the affected region.  [I say ‘region’, though the cryptocurrency takeover need not be of any contiguous geographical area].  Resources to be funnelled to that part of the economy have to be in Cryptos, which means either issuing bonds directly to the quasi ‘foreign’ Crypto economy, or milking the vestigial fiat currency holders, and then going to the market to buy Cryptos.

If the former, then the central bank does not stand behind those fiscal actions.  And if the latter, this highlights how the vestigial state constitutes a shrinking of the inflation-tax-base for the ‘standing behind’.

The central bank could try forcing those in the Crypto part of its economy to accept its own currency in any emergency operations – like paying local government civil servants, or suppliers – but it would face subjecting the economy to the same trauma as Tsipras contemplated would happen if Greece had exited the Euro and began issuing new Drachmas.

In view of this, we might expect the authorities not to be particularly relaxed about a significant invasion of private sector crypto-currrencies.  That is, unless they happen to be presiding in states which cannot discipline themselves to use the financer-of-last- resort function sparingly enough, and have the wisdom to forego it.

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Accounts at the central bank: technical policy choice, or a right?

A simple point made to me recently at a talk on digital currencies is this.  There will come a point when comprehension that offering digital accounts with the central bank is possible becomes widespread.  Then, the discussion about whether it should do so may change gear somewhat.

As of now, the proposal that central banks offer digital accounts to its population is couched in purely technocratic terms, as a device to i) circumvent the zero bound to interest rates, enforced by zero interest bearing cash;  ii) head off the threat from private sector crypto-currencies;  iii) implement narrow banking;  iv) combat illicit economic activities (as part of an elimination of cash).

In the future, the discussion may revolve around whether or not such accounts, if they can be provided at relatively low cost, should not be a right of citizens.

Our social security and Tax IT systems demonstrate that the public sector can provide digital accounts [with a few glitches].  Central bank digital accounts could look very similar, but with the functionality of individuals being able to authorise transfers from one account holder to another.

Since this can be done, people may come to what justifies excluding all but the large elite financial institutions – those who happened to have caused society so much bother recently – from enjoyng the privilege of central bank accounts.

If public debate invaded this far into the privacy of central bank technicalities, it would be then but a short step to debating whether [like banks] individuals or non bank firms should be allowed to go overdrawn, drawing the state decisively into the business of retail credit allocation.

 

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The flaw in the argument central banks have used to justify the rates first, QE later exit plan

Two posts ago, I mentioned that the basic plan central banks had for withdrawing stimulus was to go first with rates, and then scale back QE.

That plan was based on wanting to avoid the risk that, if another recession came along, QE balance sheet shrinkage would have to be reversed to respond [interest rates being still trapped at the floor].  And that was motivated by central banks wanting to avoid relying on QE to be the marginal tool of stimulus that rises or falls with the progress of the economy.  Which in turn relied on the worry that this instrument was least well understood.

That logic goes back to an old paper from 1967 by Brainard [Bill, a different Brainard from the Lael currently on the FOMC].  In that paper, he showed that in a simple example with one instrument, one goal variable, and one shock, the more uncertain was the multiplier that connected the instrument to the goal variable, the less the instrument should be used to respond to the shock, for fear of injecting more variance into the goal than was saved by responding.

The intuition extends to multiple instruments.  If you have several instruments to counter a shock, respond most with the one whose effect is most certain.  If you are baffled, but happen to know the algebra of filters or forecasting or portfolio choice, there is a read across.  The more uncertain the link between the indicator and the variable to be forecast, the less weight you should put on it.

The evidence thus far is that what matters above all [if anything] is the stock of QE.  Applying the Brainard logic leads us to the conclusion that in the face of more multiplier uncertainty about QE, central banks should adjust the stock away from its base or rest point by less.

You can think of central bank behaviour before the crisis as a way of paying heed to this advice in an extreme way:  they used rates only, and left QE well alone, and only deviated from this when there was no way of lowering rates further.

On the way out of the crisis, and the period during which interest rates are constrained, the priority – from a perspective of eliminating the effects of multiplier uncertainty – should be to get the level of QE back to base as quickly as possible.  That means winding down QE first, and worrying about rate increases later.   The rest point for QE after the crisis – as Bernanke and others have written – may well be higher than before.  But we can be confident that it lies below current stocks.  And that therefore the Brainard logic would mean withdrawing QE-imparted stimulus first.

An important detail overlooked here is that the original Brainard logic did not cater for a situation where one instrument was constrained [as interest rates are by their effective lower bound].  I doubt this would overturn the basic point.  Even if it did, central bank rationale would not be rescued, since they were building from the floor-free intuition too, only incorrectly.

Could the central bank plan be rationalised by believing that the dominant effect of QE was via flows only?  No.  Suppose that there is some reputational cost to QE, and that balance sheets have to be scaled back so that they can subsequently be rebuilt again in a future crisis.  The optimal thing to do would be to very slowly shrink the balance sheet just as soon as the economy was buoyant enough such that the effect of keeping rates at their floor imparted a small stimulus to offset the shrinkage flows.  So, once again, we don’t get to anything that looks like the Fed or other central bank plans for exit.

The only way to rationalise what the Fed is doing and what the BoE said they would do is to assume that they believe that the costs of reversing interest rate moves are less than the costs of reversing a QE balance sheet shrinkage.  But there is no real evidence to back up such a belief, and I don’t recall a policymaker having asserted it.

 

 

 

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Published instrument plans: the Financial Policy Committee do what the MPC dare not

The Bank of England published its Financial Stability Report, and, along with it the decision of its Financial Policy Committee to raise the counter-cyclical capital buffer from 0 to 0.5%.  Interestingly, there is also an announced plan to raise this further in November to 1%, on the presumption that the economy, and along with it financial stability risks, evolve as FPC expect them to.  So the FPC has agreed and disclosed an instrument plan for its macro-prudential instrument.

This seems to be beyond the Bank’s Monetary Policy Committee.  For monetary policy, we have decisions about today’s instrument settings [interest rates and QE] and a published forecast conditioned on an estimate of what markets are guessing for those settings over the future.  And we have speeches, which make references to the chance of a hike in the near term and the likely destination of rates in the longer run, that are coded to differing degrees.

Two arguments made against interest rate and QE plans were these.

‘How could a committee of 9 people, who find it hard enough to agree decisions for today’s instruments, possibly have a manageable discussion about a whole sequence?’

And:  ‘If we publish plans, they will be misunderstood as promises for instruments to do this come what may, and when actual settings deviate, people will think we have cheated and our credibility will suffer.’

These objections, in principle, would seem to hold also for FPC, but they have found a way.

 

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