Ruling out ruling out [changes in taxes and spending]

Karl Whelan commented on Twitter, after the ‘ruling out’ tax change competition was replayed on Newsnight, that this might be the worst general election campaign ever.  I think he and I are too young to comment on that authoritatively, but it captures the mood.

Hear this!

The deficit, taxes and spending should all be set as a function of the state of the economy.  Automatic stabilisers – the tendency for the deficit to rise in recessions even as tax rates and welfare policies don’t change – are likely not enough to achieve the government’s macroeconomic aims.  Most certainly in the near future, as the economy is still trapped at the zero bound.  Monetary policy would struggle to loosen, so the deficit may need to rise by more than these stabilisers imply.  And if the MPC were to realise belatedly that they had overcooked loose policy, and the Sentance club were proved right, a fiscal tightening might be needed too.

Ruling out changes in some important tax rates [like VAT and national insurance contributions] places all the burden of macroeconomic stabilising actions on those instruments that remain.  And this probably means more pain for most people.

And this is the part that the parties are not saying.  The ruling out arms race is a cynical one conducted with the view that people won’t realise what the consequences are.  If the ruling out is stuck to – another moot point – revenues will have to be raised from somewhere [unless deficit rules are broken, entirely possible], and, in aggregate, that somewhere is the same pocket supposedly protected by the ruling out.  What a mess.

Right now, the guardians of our fiscal framework – which includes the opposition and the incumbent Coalition Government – should be taking great pains to nurture credibility and transparency.  We are still stuck at the zero bound.  We may yet require many more years of chunky deficits to help clear it, or to respond to another, perhaps Eurozone-induced, banking crisis.  This ruling out trickery does the opposite, and is a way to harvest votes based on not being frank with the voters.  It corrodes the credibility which preserves the room for manoeuvre should more fiscal activism be required.

A tolerable form of ruling out would be to write down a coherent framework for monetary and fiscal policy, including highly activist discretionary fiscal policy when we are at the zero bound, and to rule out messing with this.

Otherwise, ruling out should be ruled out.

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Peston graded a zero on non-zero zero bound.

Despite the evident contradiction in further blogging, given my ‘why bother?’ post, I thought I would explain why I tweeted ‘er, no’ in response to a blog by Robert Peston [UK BBC Economics Editor] on issue of whether the zero bound to interest rates was really zero or not.  The title is actually far too harsh, for Peston gets some way to the point, but not all of it.

So here’s why the BoE’s Monetary Policy Committee first decided that the bound would be 0.5%.  A simplified bank makes a turn by offering a low deposit rate to get money off savers, and lending it out at a higher rate to borrowers.  After the crisis broke, post Lehman’s, and central bank rates started to head South, the MPC figured that at some point cutting rates would eat into bank profits.  That would happen because many loans were on tracker rates, meaning there was a pre-existing contract with the borrower to cut rates in line with Bank Rate.  However, there was no pre-existing contract with depositors.  And in fact as spreads [gap between deposit rate and lending rate] rose, there was nowhere for this rate to go.  Given that storing large amounts of cash is costly, there would have been scope to charge depositors for their account holding services in the form of slightly negative rates, but this was calculated to be likely to be politically unpopular for the banks.  So, with lending rates forced down by tracker contracts, and deposit rates unable to fall, bank profits would fall.

Robert Peston’s account has it differently, that ‘competition’ drives lending rates down, and deposit rates can’t fall.  But the way the MPC saw it – and the way I see it too – was that ‘competition’ would, normally, demand a relatively stable risk-adjusted spread between lending and borrowing.  It was just that pre-existing promises, combined with the floor to deposit rates, meant the spread would fall, shrank.

The reason the MPC have reassessed this risk is that bank balance sheets are much healthier than they were.  Banks have rebuilt capital through retained profits, made by charging through the roof for new lending, despite the fines for bad behaviour.  And their loan book now looks much more healthy as asset prices and therefore collateral values have recovered, and borrowers sources of repayment [jobs for household borrowers, customers for corporate borrowers] look more secure.  Although I’m not sure of the facts on this, one might also hope that the proportions of borrowers on tracker loans had fallen, and so a further cut in rates would be less profit-eroding.  And given rates have been low for so long, the heat on bank reputations has subsided a little, and the fact that some interest rates have gone negative, perhaps the floor for deposit rates has fallen a little too.

As I recall it was the smaller building societies that were most hampered by loan trackers.  And I never accepted that the floor should have been there in the first place.  These banks should have been kept afloat by other means if that was necessary, so that monetary and fiscal/financial policy were more clearly separate.  [More of a question than a statement, but, couldn’t regulatory intervention have stopped the banks offering trackers to the extent that they did, so that this concern could have been removed, or made their supply contingent on Bank Rate being amply above the zero bound?]  Plenty of finance is routed around the banking system, and the price of this, which also works off central bank rates, was kept unduly high.  I also found it odd that the floor was only revisited last month.  The situation of the banks improved dramatically from the depths of the crisis, especially over 2010-2012, and that would have been the time to acknowledge that this ‘plank’ of the 0.5% floor to rates had been removed.

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Discord about econ discourse

Danny Blanchflower remarked on Twitter that UK economic discourse lacked much engagement from academics. This was a follow-up to a Paul Krugman post where he disparaged UK economic discourse, and used as his metric the fact that there was a lot of focus on the deficit.  And that in turn derives from Simon Wren Lewis’ developing caricature of UK’s ‘mediamacro’.

Well, this blog is about why – supposing the assessment of our discourse to be true, which I don’t really accept in the way it was put – you shouldn’t blame the academics. Or perhaps anyone, except the market.

The first reason why is that there is little or no financial incentive to take part.

UK economics departments are partly assessed on ‘impact’. But there is almost no link to that and me, for example, piling into a debate about whether inflation 2pp below the BoE’s target is, as George Osborne’s office seemed to be claiming, was a good thing.

The ‘impact’ criterion is, mostly, about the impact of a particular piece of research [produced while at the institution being evaluated].

I could, for example, write a new paper examining the costs of inflation target misses, and succeed in persuading either the BoE or HMT to take notice, cite my work. My department might then choose to use me as one of a small number of impact ‘case studies’. Or they might not.

Notably, me piling into a conversation over Twitter on the train to Bristol, synthesising what most macroeconomists would already believe into a few tweets and persuading those who listened of the correctness of my case, would not carry any weight whatsoever.

You might well say ‘Good!’ Do something more useful on the train! Write that new paper on the costs of target misses! But, actually, that wasn’t necessary to point out the dangers of bragging about too-low inflation. We don’t need a new paper to do that.

What dominates the financial calculus for those on either side of the academic hire is publications.

Some small weight would be put on other aspects of an academic’s profile, but not much. I’m soon off to Birmingham. They might have been happy to see that there is someone with experience of how the UK monetary and fiscal regime works. But I am sure they were much more vexed about how their 2020 Research Excellence Framework results would come out, and for that they need publications. And trying to predict what a bunch of impact case studies might look like, and who would be used to make them, is much less certain than adding up the number of 4-star publications now, or forecasting those in the pipeline.

A second point to make is that engagement often isn’t wanted, really.

Engagement sometimes presents itself as criticism of those in the media who are currently paid to try to keep eyeballs focused on them. I don’t expect any pieces reporting ‘Selflessly engaged academic Tony Yates explained how all our pieces extolling the bottom-up theory of inflation fallacy were, in fact, wrong, for which we are eternally grateful. How much clearer the world looks to us now the fog has been lifted.’ Silence is much more likely, even on uncontentious points, and understandable.

Those controlling access know what their consumers want better than people like me. They probably don’t want mini-literature surveys that are faithful to the small economic print and convey all the shades of opinion and controversies about some issue. Consumers don’t have time or inclination for that.  They want a way into a topic.  And that way in might be an opinion.  A crude version of one of the many possible arguments.  Something that people like me don’t offer.

A great example is Robert Peston’s old blog on QE. With my academic/central bankers macro hat on, this was full of stuff that was wrong and confusing, and I explained why.  But in retrospect, what was the point?  Those who were likely to read my response didn’t need persuading.  And those that did need persuading were, thanks to Robert’s wise guardianship of his own access point, not going to hear about it, and probably would not want to anyway.

Peston’s blog would be an unreadable mess if it was full of stuff responding to pedantic academics no-one had heard of. And the point of some of these journalism brands is that they are themselves the founts of their chosen specialist wisdom, not that they humbly intermediate from academics who know better. You can see the business case for keeping academic minnows out of ‘engagement’ because it changes the brand.

I exaggerate the extent and scope of these problems – if they are problems – to make a point.  There are lots of examples of successful conversations emerging too.  Although I think most of those are between the discourse producers, and not about academic stuff being put in front of the ultimate consumers (the readers/watchers).

I also don’t want to claim that this is a case of the media selling a dud and concealing from the information-hungry public the holy truths that noble academics are dying to tell them.

I already conceded we were selfish, and looked to our incentives.

But I should also concede that we often don’t know the answer either. Many of us are drawn into specialisms that would look frighteningly narrow to an outsider (in pursuit of publications). And we are sometimes therefore just as bad at digesting literatures outside that specialism as your average journalist. (Extreme but common example being the number of Nobel laureates recruited to talk off topics they excelled at, and getting it wrong).

Even when we do know the answer, we don’t have the skills to put it into words intelligible to even a well-meaning journalist quickly enough to be useful. The few conversations I’ve had have often conjured up my fond memory of former BoE Deputy Governor John Gieve asking ‘ah, so what does this answer depend on this time, Tony?’  In fact, I’d say I was treated rather charitably, given my tendency to insist on the ‘on the one hand, on the other’ format.

So, in short, engagement by academics is unpaid, is sometimes experienced as unwelcome [either because it undermines the business model of the expert journalist, or because consumers wouldn’t want it] and we are often not very good at it anyway.

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Eurozone QE: features and bugs

Daniela Gabor at UWE tweeted an interesting article on Reuters describing troubles in money markets due to a ‘shortage’ of high quality sovereign bonds in the Eurozone.  The proximate cause is the launch of the ECB’s quantitative easing program.  The cause of that being the persistent below target inflation and depressed real activity.  And the cause of that being a GLUT of sovereign bonds.  A shortage ultimately caused by a glut?!  This it not necessarily a contradiction,  since the glut would correspond to lower quality bonds issued in desperation.

A few observations.

1.  Depending on how you view the transmission of QE, it’s partly a feature and not a bug to create such shortages, so that market participants switch to using private sector assets as a substitute, bidding up the price of those assets, lowering the cost of funding for and stimulating spending by the issuer.

2.  But for activities involving private sector market players only, there could be painful, perhaps insurmountable obstacles to switching from an equilibrium in which everyone uses sovereigns as collateral for everything, to one in which private sector assets do the job.  There have been glimmers of this before, in econometric evidence showing that QE lowers government yields, but leaves private yields less affected.

4.  For transactions involving the central banks themselves, the obvious solution is to combine QE with a relaxation of collateral requirements to embrace riskier private sector assets on less disadvantageous terms.  The ECB was anyway inclined towards credit easing [taking private sector assets onto its balance sheet].  Here’s an excuse to do more of it.

5.  Oh, one might wish, for the existence of a combined Treasury/Debt Management Office in Euroland, who would issue new debt into the market, spending the proceeds in the South, where aggregate demand more obviously falls short of supply.

6.  Yet the benefits of 4 and 5 depend, to repeat, on how you view QE working.  If QE is predominantly about signalling lower future central bank policy rates, then these correctives to QE might not undermine that signal.  On the other hand, if QE is about changing the mix of public and private sector assets in the hands of private investors, then corrective policies have to be careful not to correct this aggregate!  They would have to be about redistributing between private participants;  or ensuring that supply was even across sovereign maturities and bond types.

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Price level shocks and bottom up theories of inflation

I think the ‘price level shock’ fallacy is related to another fallacy that we can divine the causes and future of inflation by adding up individual price series.

The price/level/inflation shock categorizer like Ian McCafferty thinks to himself: ‘oil prices won’t keep going up and up.  This a one-off.  Inflation is caused by the sum of the individual sectoral inflation rates.  So when this one-off oil price change is done, the oil sector will be back to contributing zero to the inflation rate.  Since we are inflation targeters, we can ignore the oil price rise.’

But this is all wrong.  What’s happened is that there has been a change in lots of relative prices [brought about by a complex mix of demand and supply factors].

Notably, there has been a change in the price of oil as a final good relative to the other final goods;  and a change in the price of oil relative to other inputs;  and a change in the price of labour relative to what a given bundle of labour can produce.

When prices in the oil/petrol sector fall, we can’t simply project forwards the other sectoral inflation rates as before to work out what will happen.

What happens to these other sectors depends on what the central bank chooses to do with its policy instrument.  If it wanted, it could make sure that the sum of these sectoral inflation indices added up to zero.  Or whatever.  And what it was appropriate to do depends on a whole host of things, as I went through in the previous post.

This inflation is caused by the sum of its parts problem rears its head every time new inflation data gets released.  Where we can read that inflation was ’caused’ by the prices that went up, and inhibited by the prices that went down.  A classic example of this being this piece in the Guardian.  (Though this problem is ubiquitous).

Sometimes this is harmless semantics.  Often it can badly mislead.  Next time you read ‘inflation soars as clothing retailers jack up prices’ pause a moment to say a prayer that the writer has not fallen foul of the bottom-up theory of inflation fallacy.

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I’ve accepted a post as Prof of Economics at Birmingham, where I’ll join in the Summer.

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Carney and McCafferty on oil and monetary policy

Carney and McCafferty delivered a one-two on monetary policy and oil prices.  Both get it wrong in my opinion, but, in diffent ways.  [Remember Tolstoy’s Ana Karenina:  ‘all good economic arguments are alike.  Each bad one is bad in a different way…’]

McCafferty first.

The basic approach he takes is:  we need to decide what caused the oil price to change, because that determines how we respond to it.  That much he has right.  But there are two big problems with how he sets about deciding [and, I infer, in his vote, which we must presume is based on this logic].

First.  What caused oil prices to change.  He rightly sets out on a hunt for oil demand and oil supply shocks.  But in my view he wrongly thinks you can diagnose the oil supply schedule from the quantity of oil produced by the oil-producing countries.  Identification is harder work than this!

I’d suggest three ways of doing it, that parallel those in the academic literature on, for example, identifying shocks to monetary or fiscal policy.  1:  study the motives of those controlling oil production and what they say about what they are doing.  2:  estimate a Vector Autoregression and identify oil supply and demand shocks from the correlations between oil output and oil prices [and other things, perhaps].  3.  Formulate a structural model of the world economy split into oil-producing and oil consuming sectors, and recover the shocks by estimating this model directly.

Second, McCafferty engages in the ‘price level shock fallacy’.  As I have ranted before there is no such thing as a price level shock in the sense meant here.

The logic in McCafferty’s mind goes:  oil causes the price level to fall, and the inflation rate to fall only temporarily.  Therefore there is no need to respond.

However, in fact, ultimately, it’s up to the central bank to decide whether or not even the price level falls in the long run.  Anecdote:  in the simplest versions of the BoE’s New Keynesian model, if inflation targeting is done optimally, [under commitment], NOTHING affects the price level permanently.  So in that world McCafferty’s category of ‘price level shocks’ would be an empty set.  A hypothetical MPC colleague inside that model would retort reading Ian’s speech: ‘oil only affects the price level so we don’t need to respond?  what are you talking about?  nothing affects the price level because we respond in just the right way.’

A related assertion to the one IM makes in his speech might be:  ‘given our planned policy rule, if we don’t deviate from it, that will, by choice, generate a lower price level in the long run than if the oil shock hadn’t happened, but the inflation rate will be no different, so we won’t deviate from the rule.’

But there’s nothing axiomatic about whether this will or won’t be true.  Whether it is  depends on how large the shock is, how activist the planned policy rule is in responding to variables in the economy, and the process driving expectations.  And the proximity to the zero bound.  And the efficacy of alternatives to interest rate policy.  And…

You can’t deduce the optimal response from categorising something as a ‘price level shock’.  That description includes a policy response already [the decision to make sure there is no effect on the inflation rate] .  You have to take a stance on all these other things.

Note too that ‘not responding’ to oil would not mean ‘leaving interest rates unchanged’.  It would not even mean ‘not altering the previously agreed trajectory for rates’. It would mean ‘not altering the previously determined recipe for arriving at the interest rate trajectory’.

But McCafferty has not explained what the [or his] recipe is, or what trajectory it gives you.

In fact, the whole problem here, [to repeat] is that he’s trying to decide something about the recipe [whether or not to respond to a certain kind of oil price movement] based on already presuming a recipe [which leads to that shock changing the price level].

So, away with those ‘price level shocks’.  The term should set of a mental hooter that goes off when you see it.

Onto Carney’s speech.

As was widely reported today, he said that it would be “foolish” to loosen in response to the fall in oil prices, which had led to the chunky drop in headline CPI inflation.

Well, I don’t think it would be foolish.  The motivation for cutting is twofold.

First, a case could be mounted that the oil price fall boosts potential output relative to demand.  In the Bank of England’s own model this puts downward pressure on deflation and would warrant a cut.

Second, to the extent that there is a risk of inflation expectations responding to the fall in headline CPI inflation that we have seen, and of the economy becoming more permanently entrenched at the zero bound, a cut would be warranted on precautionary grounds.  On that logic one would not wait until wage growth or inflation expectations fell.  By that time it might be too late.  So Carney’s qualification that loosening would be foolish “unless” wage growth weakened does not cover this concern.  As Carney stresses in his own text, monetary policy takes time to work.  Hence one has to act on the basis of a probabalistic forecast, always.


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