Douglas Carswell, Brexit, and the BoE’s independence

I saw on Twitter today that Douglas Carswell responded to the March MPC minutes, which revealed that the Committee thought that uncertainty about the outcome of the referendum on EU membership had caused Sterling to fall, and may be depressing demand.  He Tweeted:  ‘Chancellor’s appointees agree with Chancellor:  shock.’

I have absolutely no beef whatsoever with the minutes opining like this.  But I do wonder whether the BoE’s previous interventions [the published report on EU membership, and Carney’s exchanges at TSC] have contributed to comments like this.

It’s pretty depressing to read that a prominent politician concludes that there is a conspiracy to subvert Bank of England independence, based on almost no evidence, and on a point that ought to be entirely uncontroversial.

Whatever one thinks about the long-term consequences of exiting the EU or not, the short-term effects of the uncertainty about our EU membership are not at all difficult to fathom, and the MPC reached exactly the right conclusion [as I wrote here for the Independent].

Carswell’s response to me was to urge that the views of economists be discounted, on the grounds, I think, that we are prisoners of our vested interests and predetermined ‘function’ in the political/bureaucratic process in which we operate.

Well, maybe.  But down that road leads to utter nihilism, including the observation that politicians themselves issuing that advice should be ignored.  Economists come in many varieties, academic or not, public or private sector, independent or corporately affiliated.  I’m sure the overwhelming majority would agree on what uncertainty about our future EU status would do to Sterling, and demand, and the MPC view reflects this.

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The golden rule of borrowing to invest

John McDonnell has committed his party to a version of the ‘golden rule’ for public finances.  A government in which he was Chancellor would only borrow to invest.  Except when monetary policy was hampered by the zero lower bound.

The reasoning behind the Gold Rule is that borrowing for investment  is judged less likely to scare the bond markets because that investment promises to yield returns that ultimately generate tax revenue to pay back the debt issued.

However, put like this, the Golden Rule is somewhat problematic.

Some things that would constitute ‘investment’, like building better facilities for caring for people at the end of their lives, would probably not generate any more tax revenues in the future – even if it would make all of us happier when we reach the point where we can use them.

Other kinds of investment, like in road infrastructure, would have a tenuous connection with future revenues without introducing tolls.

And other things that would not be thought of as ‘investment’, but would instead count as current spending, might well raise tax revenues.  [A point that Ethan Ilzetzki at the LSE beat me to on Twitter].

For example, money spent on better teachers might improve the capacities of pupils as they entered the labour market, expanding output, perhaps even raising growth, and for a given tax rate, the government would take more taxes to service the expenditure on salaries.   Similarly, spending money on salaries for health professionals on ‘public health’ – health education to change lifestyles so that disease is prevented – may generate very high returns at the current margin.  [A smaller long-run health budget for the same outputs].

So, to repeat, there are things that we might define as ‘investment’ that don’t generate future tax returns;  and things that we would label current spending that do.  Both rather undermine the thinking behind the golden rule.

Moreover, if the pivotal feature of the deficit-inducing policy is that it generates future revenues, then any counter-cyclical fiscal change that lessens the risk of hysteresis, or helps reduce the risk of a deflationary spiral, ought to be as exempt as ‘investment.’

As Simon Wren Lewis writes, there is another issue with the conventional interpretation of the golden rule.  There not being tax returns accruing to a public investment good does not mean there is no case for borrowing to finance them.  Depending on your political standpoint, there may be perfectly sound ethical reasons to back such borrowing.  (For example, spreading the tax burden across all those to benefit from a welfare improving investment means financing most of it now via debt).

But the point of the golden rule was not to deal with ethical or distributional considerations.  Rightly or wrongly, it is to try to discipline debt issuance.

How good it is at doing that is moot.  Even if there are tax revenues to be harvested in future as a result of borrowing to finance some fiscal action, there remains the issue of ensuring that the revenues that start accruing at that point are not matched with higher current spending.  This involves a promise about some future action.  Not much different from simply borrowing to finance current spending now, [eg to combat the zero bound], and promising to levy taxes that are higher than current spending in the future [once you have escaped it, and monetary policy can compensate].

 

Instrument forecasts for the Fed, HMT but not the BoE

A quick post on a hobby-horse of mine.

Today, the Fed released its economic projections, including the famous ‘dot charts’ where FOMC members project what they think should happen to the Fed Funds Rates.

By contrast, the Bank of England’s Monetary Policy Committee, in its wisdom, feels that it cannot tell us what it forecasts will happen to Bank Rate or Gilts held in the Asset Purchase facility.

Instead, we have to infer what it might do by scrutinising forecasts conditioned on other peoples’ forecasts of what the Bank will do.  [Actually a 15 day moving average of those other people’s forecasts].  Where, inevitably, those other people’s forecasts will be conditioned on a different view of the state of the economy from the Bank’s own view, and, more confusingly still, a different view of what the Bank sees as its reaction function from the Bank’s own view of its own reaction function.

These confusions, and the Bank’s lack of transparency about precisely what its reaction function is, or, similarly, just how it weighs competing inflation and resource utilisation goals at different points in time, make it impossible to reverse engineer what the Bank’s MPC do intend to do with interest rates.

Perhaps because of this, since Mark Carney’s arrival, he has engaged in much verbal communication about the likely timing of the next interest rate change, its sign, and the eventual resting place for interest rates.  From the perspective of outsiders, this communication has been notoriously hard to read;  from Mr Carney’s perspective, that misreading has looked wilful.  Really, such communication problems are inevitable when the forecast is communicated so vaguely in words only.

George Osborne presented the Budget for 2016 today, including projections that embrace forecasts for umpteen of its own fiscal instruments.  It is rather tolerant of the Bank’s bosses at the Treasury, and its overseers on Treasury Select Committee to give the Bank a pass on telling us what it plans to do.  Perhaps someone on TSC might ask at some point what the special advantages of not telling us what MPC will do with interest rates are, and why they outweigh the gains that other bodies think are telling.

We should long for fiscal policy, and budgets, to be boring

The UK financial press is full of pent up excitement about the budget.  Including talk of money ‘behind the sofa’ being replaced with the metaphorically transposed ‘black hole’, and how George Osborne will respond.

We should all long for fiscal policy to get as boring as Mervyn King, former Bank of England Governor, used to say monetary policy had become.

The ideal budget would confirm what we should already know.  Major welfare state reform would be finished with.  There would be no cosmetic tinkering with customs, excise and duties for the tabloid press.   And the macroeconomic aspect of fiscal policy would be a simple following through of a pre-announced plan of how to respond as economic news came in.  Since we would already have the economic news, and the forecast that went with it, we’d know just what they were going to do anyway.

Imagine if the same attention to headline grabbing and strategic change were visited on monetary and financial stability policy?!  More credit easing;  less.  Interest rates up;  down.  QE asset purchases;  sales.  Capital requirements up;  down.  We’d rightly think the Bank of England had gone crazy.

For this reason, although I have my own views about what constitutes good macroeconomic fiscal policy, half of me is praying for a tedious, damp squib budget.

 

How to minimise the credibility damage of a rise in the inflation target

I had an interesting exchange with Malcolm Barr at JP Morgan via email.  He made two points that were food for thought.

Both are aimed at finding ways to minimise the risk that a rise in the inflation target was interpreted as an old-fashioned fiscal measure, or a losing of heart to control inflation as against other things that those pressuring policymakers are concerned about.

Recall that the real motive for raising the target is to improve macroeconomic stabilisation – including inflation control – by making sure the interest rate hits the zero bound less often.

The first comment was that ideally the inflation target rise would be done in a coordinated fashion, internationally.  Most developed countries settled on 2% before the crisis.  If all moved to 4%, say, at the same time, this would increase the chance of observers buying the economics behind it, and not concluding that the UK was just a basket case country.  It would also minimise the chance of an exchange rate adjustment when the inflation target was announced.

A second point Malcolm made was about whether compensation might be devised for holders of gilts who had bought expecting only 2% inflation.   So that there was no chance of inferring there was a direct fiscal benefit from an inflation surprise.

Thinking this through would be tricky.

There are also benefits to gilt holders to consider, like the reduction in inflation uncertainty coming from making room at the zero bound.  [Although from the perspective of investors the inflation target rise might increase uncertainty].  One option – appropriate if the bond market delivered faithful judgements – would be to let the price reaction to the news determine the net cost/benefit.  But that assumption is obviously somewhat heroic.

 

Making ECB corporate bond buying ‘fairer’ and better targeted

The ECB announced this week that it was going to start buying investment grade corporate bonds.  Several people in my Twitter feed pointed out that there was a problem with this.  This chart posted on marginal revolution by Tyler Cowen makes the point.  There are practically no eligible corporate bonds in Eurozone peripheral countries.  Unless the bond buying program was miniscule, there would be no chance of mimicking the kind of geographical ‘neutrality’ you get with changing the ECB policy rate.  And, bearing in mind that the need for stimulus differs greatly by country, it is perverse that the stimulus imparted by this bond-buying will be weakest, or even absent, where it is needed most.

This could be fixed with fiscal policy.  Imagine the following.  The ECB buys a ton of bonds issued by large French and German corporates.  This raises those bond prices.  A Eurozone fiscal agent computes the stimulus effect for France and Germany, including, amongst other things : the direct subsidy for the corporates, the consequences for public finances in France and Germany of more spending, via the automatic stabilisers.  Taxes are raised in those countries to offset some of that stimulus, and this is used to finance temporary tax cuts in  the periphery, equalising the stimulus across the Eurozone.  To make this fair the ECB would have to drop the requirement that the bulk of the risk of bond-buyng was born by the national member central bank whose bonds were bought.  If the benefits were to be distributed equally, then so should the costs.

Of course, thinking through this reveals a rather obvious point.  That a much simpler policy would be to implement a fiscal transfer from North to South [roughly] in the Eurozone, calling the analysts at the ECB to tell them that they can have their weekends off after all.   My rather convoluted fiscal policy would only be appropriate if fiscal policy was ‘maxed out’ in the North, which is nowhere near being the case, and the bond buying there was a way to squeeze out more tax revenues.

Sadly, the simple transfer is not going to happen.  [Nor the complex one].

This doesn’t mean that the ECB are doing the wrong thing.  Some inappropriately distributed stimulus is better than none.  The periphery trade with the core.  And avoiding a recurrence of the sovereign-bank doom loop in the cost of finance in the periphery depends on avoiding it entirely in France, Italy and Germany, which policies like this will help.

But the ‘unfairness’, or peverse targeting of the ECB’s credit easing does raise the issue of whether eligibility might be extended.  Whether some framework could be devised that buys sub-investment-grade at an acceptable level of risk, and an acceptable level of risk of being gamed by the sellers of those bonds.

Prospect article on the budget

I wrote this article as a preview to the budget for the Prospect website today.