The BoE and the Brexit debate

Written in haste during a visit to South Africa, talking about fixing monetary and fiscal policy after the crisis [slides here], and recapping on recent tweets for those who don’t do Twitter.

Yesterday, Carney appeared before Treasury Select Committee and was grilled about the risks posed by Brexit.  If we take it as a given that the questions had to happen, and that there was no alternative to answering them, a great job was done putting over the salient points of the BoE’s work on this.

However, the BoE’s prominent role in these discussions seems highly risky to me.  To recap on what one commenter on my blog dismissed as mere ‘concern trolling’, the problem is this:  if Carney or other senior officials talk on matters of political controversy, this increases the chance that the next appointment will be made partly on the grounds of political acceptability, and not wholly on the grounds of monetary and financial expertise and leadership skills, or even that there arises a perception that this is what will happen.  At that point, the delegation of monetary and financial policy, which is supposed to create the expectation that the BoE’s instruments will not be abused for electoral purposes, breaks down.

The meeting included harsh words exchanged between Rees-Mogg and Carney, concluding with the latter saying that Rees-Mogg was being ‘selective’ in picking out pro-Remain points in the BoE’s contributions.  Whatever the rights and wrongs of that exchange, the fact that it happened at all, and the motives and competence of a committee member is called into question, is not great.

Carney explained:  ‘We will not be making, and nothing we say should be interpreted as making, any recommendation with respect to that decision.’  This sentence was a good try.  But, unfortunately, in its excellent work sifting the economic facts of the Brexit decision, the BoE has made its own recommendation completely transparent.  You can tell because there are no politicians on the side of Remain scolding the BoE for risking its independence and acting in an impartial and political fashion.  On the other hand, one has Peter Bone, a Tory MP, saying:  ‘The Bank of England is notionally independent but does anyone really think it will produce figures the government doesn’t agree with?’

I’d offer the following thought too.  Treasury Select Committee might also be considered joint guardians of the quality of our central banking, which means being a guardian of central bank independence.  And in a context where there is a limit to how much one can engineer institutional detail of this sort that may mean restraining oneself from asking questions which risk the BoE harming its own independence.

Knowing what the BoE think about this, Remain is tempted to tease out more scary words from BoE officials about Brexit.  Just as the SNP responded to the MacPherson analysis of currency options for an independent Scotland, Leave are bound to respond by questioning the BoE’s impartiality.  The result is that the campaigning objectives of those immersed in the Brexit debate are put above the objectives of nurturing independent monetary and financial policy.

For me this limits the force of the defence that it’s ok for the BoE to speak on these matters ‘when asked’.  They should not be asked.  The Bank is not an expert think tank.  It may well have the best concentration of expertise on this subject.  But if that’s the case, there is another model to exploit it.  When the Treasury were writing the ‘5 tests’ paper on whether the UK should join the Euro, they took on secondment Peter Westaway, one of the Bank’s foremost experts on international macro and monetary policy at the time, and other junior staff too.  Senior management kept out of it.   Why could that model not have been deployed this time?

You might well argue that, strictly speaking, the questions and comments were on matters that are relevant for its mandate.  This is true enough.  But one has to weigh this against the damage done.  If it is so important to do scrutinise to ensure that the Bank is as on top of these issues as it needs to be, hold hearings in private session, to be broadcast once the referendum is done.  Or substitute them for a public report written by an outsider, who is inserted into the BoE in the run up to Brexit, and writes after the event about whether preparations were adequate, with a mandate to ring alarm bells somehow if things look like going greatly astray.

 

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Negative rates, abolishing cash, nominal illusion and neurosurgery

Miles Kimball’s preferred solution to the current predicament, in which the zero, or quite near zero bound to central bank interest rates constrains the amount of stimulus that can be imparted, is to reform monetary institutions so that negative rates can be applied, with no more limit to how low they can go than there is with positive rates.

One option to permit this is to abolish cash.  With this done, negative interest rates can be applied to digital deposits in banks, with no risk that they will be out-competed by cash, which earns a higher interest rate of zero.

However, it’s possible that banks are affected by nominal illusion on the part of some of their customers.   One reason put forward for the woes of bank shares has been that while the banks’ asset side has rates that are competed, or even indexed down as bank rate falls, bank deposit rates cannot fall so much, nor be replaced by charges.  A reason being some psychological reaction to negative nominal rates akin to the disproportionate response to nominal wage cuts versus nominal wage rises that is discussed by labour economists.

If there is this kind of nominal illusion, abolishing cash isn’t going to allow seamless transmission of negative nominal rates that matches those nominal interest rate rises the older generation remember fondly.  In fact, nothing will do it, short of some not yet thought of neurosurgery, except perhaps a rather painful learning process where circumstances slowly accustom depositors to the new reality.

In the meantime, however, negative rates would not guarantee regaining control of inflation.

 

Smartphones, bitcoin and the unit of account

I listened to BoE Deputy Governor Ben Broadbent’s speech on digital currencies today.  It’s a tour de force.

One line of thought that one might be tempted into is the following.  Because Bitcoin is not widely used as a unit of account, it won’t grow as a medium of exchange.  And, completing the self-reinforcing feedback loop that favours the status quo, if it does not grow as a medium of exchange, there is no chance it will become a unit of account.

However, the ubiquity of smartphones, and information about exchange rates between digital currency, goods and other currencies, might obviate the need for a conventional, common unit of account.

Smartphones plus free, high frequency, exchange rate data, enable me and those I trade with to check what I could get for my Bitcoin [or similar].

There have been many instances in the past when there were multiple units in which prices were posted.  In gold, silver, and private banknotes.  Coping with that then was no doubt a headache.  But in the near future, perhaps less so.  The smartphone does the mental arithmetic, and avoids the need to remember anything.

Following this logic, smartphone technology plus information may make the fact that Bitcoin is not a unit of account less of an issue in its growth as a medium of exchange.

We have observed that central banks have lost control over what is used as money in some economies.  But typically only when the currency was spectacularly abused for seigniorage purposes, as in Zimbabwe.  However smartphone and related technology might make the threshold for misbehaviour at which these dynamics begin lower.

All this puts to one side the current problems actual digital curency communities like Bitcoin are experiencing, of course.  Which seem to be many and serious right now.

Helicopter money blog tennis

Simon Wren Lewis pitches in to an exchange involving Adair Turner, myself and most recently Paul Krugman.

Adair wrote to make the argument that helicopter money was an alternative to lowering interest rates.  My blog pointed out that it wasn’t.   Absent the Fisher effect of helicopter money kicking in instantaneously, lower interest rates would be experienced in the interim, because of the liquidity effect of the extra money, just as in the case of the lower policy rate alternative [which would be implemented by….  creating extra money!].

Simon’s contribution says,  in so far as it bears on my post, in short:  if we are already at the limit below which the policy rate cannot be lowered, then interest rates can’t fall.  Of course that is true.  But the thought experiment that started the conversation clearly presupposes that interest rates are not already at this level.  Otherwise it would not make sense to claim in the first place, as Adair did, that HM was an alternative to lower rates.

Simon also writes:

“anything that raises demand (as a fiscal expansion will) will tend to raise inflation, and so the monetary authorities will tend to raise nominal interest rates. Any temptation to say ‘yes but in the short run’ becomes dubious because of expectations effects.”

A few points here.

First, with sticky prices – and especially with other forms of persistence in the economy on the demand side – the change in inflation will be gradual.  Just as with a conventional fiscal expansion.

Second, it’s perplexing to me for Simon to note ‘the authorities will tend to raise nominal interest rates’.  HM involves moving to a conscious plan for the trajectory of money quantities.  In order not to undo HM either wholly or partially, interest rates are left to clear the market.  The debate here is whether that market clearing rate will, for a while, and for the duration of the preference by policymakers for money quantities, be temporarily lower than in a counterfactual world in which the authorities instead forgo HM and opt simply to lower interest rates from their starting value.

Third, the importance of expectations is no doubt crucial.  We can say that under rational expectations the Fisher effect might work faster than under adaptive expectations or learning.  We don’t know for sure how expectations would work in this novel policy experiment of HM.  But it doesn’t follow from this uncertainty that one should simply conclude that the Fisher effect of higher rates dominates in the short run too.

 

Constraints on monetary and fiscal policy will reduce the number of Samuelson false positives from the stock market

Suppose you had a vote on an interest-rate committee at a central bank.  And you were wondering how to figure out what the falls in global stock prices in 2016 meant for your vote.

You might try to reassure yourself by looking at historical correlations between fluctuations in the stock market and variables you were employed to care about, like inflation and resource utilization.

These would be of some use because, although you would be fully conversant with the mantra that the effect of asset prices depends on the ultimate cause of their movements, you may well find yourself, given the imponderables in modern macro and finance, and having invested much energy in trying to decide, little the wiser in determining what exactly caused the global sell off.

And when you spoke to economists and traders close to the market, you’d find that the cacophony was not resolved, but got louder and more confusing still.

Well, here is a reason to be less reassured by those historical correlations than otherwise.

Those correlations will embrace a period in which both monetary and fiscal policy were more free to move to counter the effects of a crash.  Now, fiscal policy in the major currency blocs – Japan, ECB, US, UK – is constrained, either by politics, or having tried hard already, or both.  And conventional monetary policy is also constrained by the current proximity of the zero [or near to zero] bound.  In history, on the assumption that monetary and fiscal policy were counter-cyclical, those correlations between asset prices, inflation and the real economy should have been muted.  Going forward, that dampening won’t be there, or at least not to the same extent.

So, although during your deliberations, you might have recounted to fellow committee members the old Samuelson joke that the stock market had forecast 9 out of the last 5 recessions, there is reason, looking ahead, to be more concerned, and expect a smaller fraction of false positives.

Liquidity and Fisher effects of a helicopter drop. Reply to Paul Krugman’s comment on my comment on Adair Turner

Adair Turner wrote arguing for helicopter money, as an alternative to lower, or negative interest rates, to stimulate the economy.  Paul Krugman comes down on the side of Adair, concluding that I have got confused about what effect a helicopter loosening would have on nominal interest rates by staying in the confines of a static IS/LM-type model.

I repeatedly get confused about lots of things, but not on this occasion.  Although, who knows, I might just be plain wrong.

I think what Paul is drawing attention to is the difference between what’s often termed ‘the liquidity effect’, of a monetary expansion, [which is captured in IS/LM] and the ‘Fisher effect’ [which is not].

To explain.  Suppose the hawks on the FOMC fall terribly ill before the next meeting, and the doves get to decide what to do next.  They conclude that they need a massive monetary stimulus.  They could either do it by a helicopter drop, or by setting out a declared plan for lower – potentially negative – interest rates, following the prescription of Eggertson and Woodford.

The first, instantaneous effect of either policy is the liquidity effect.  More liquidity lowers its price.  The second effect, if either policy is ultimately successful in raising expected and actual inflation, is the ‘Fisher effect’.  This will, when the economy returns back to the inflation target which otherwise would have been missed, lead to higher nominal interest rates than if the Fed had settled for lower inflation.

One case where the Fisher effect dominates right away anyway is in a land of flexible prices.  Suppose the Fed thought that, if it followed its current reaction function, inflation would settle below target.  And they simply announced an increase in the rate of money expansion.  This would raise inflation and expected inflation immediately.  However, in the more realistic case of sticky prices, it takes time for the Fisher effect to override the liquidity effect.  [This statement is a bit more contentious than it used to be, as the debate over ‘neo-Fisherian’ effects between Cochrane, Woodford and Williamson testifies.  These authors isolate sticky-price cases where Fisherian effects kick in right away, and debate whether they are realistic or not.]

My comment on Adair is about his contention that if the Fed chose helicopter drops it could somehow avoid the initial, instantaneous liquidity effect that pushes down on interest rates [and which Adair thinks has damaging effects on leverage].

Contrary to what Paul says, I don’t think Adair is making a case that the Fisher effect kicks in earlier than with a conventional interest rate policy loosening.

We could have a discussion about whether it would or not.  It’s arguable.  Perhaps the ‘shock and awe’ element of the helicopters would be so powerful that the Fisher effect dominates right away.  In Adair’s paper he doesn’t stress this.  In fact, he’s at pains to discuss ways of reducing unpleasant expectational dynamics of helicopter money;  and he queries whether expectational effects of forward guidance would work [see, eg page 15] since perhaps agents are not so forward-looking as supposed.  And part of his case for HM is that – so he argues – it works more effectively in the case that expectations are not as forward-looking.  But it is these same expectational effects that determine the speed with which the Fisher magic works on the nominal interest rate.  If we downplay them, then we slow down the point at which the Fisher effect outweighs the liquidity effect.

Also, note that Adair tweets ‘central bank can pay different rate on different reserve tiers‘.  He is countering my argument about the force of the liquidity effect not by invoking the Fisher effect, but by talking of some central bank intervention.

So, to restate, helicopter money involves taking your hands off interest rates for a while.  It might be more stimulative than lowering rates from their current level, or it might not, but it works partly through exactly the same interest rate channel as lowering interest rates directly.

We could overlay either policy with peculiar taxes or subsidies on banking, but this would not obscure the fundamental effects of money/liquidity demand in the short run, and the Fisher effect in the longer run.

Ultimately, if either policy – lowering rates, even below zero, or helicopters – work, then they will raise nominal rates and inflation.

The zero bound and the next currency system

Exchanging tweets with Steve Williamson and JP Konig prompted the following set of thoughts.  Though they cannot be blamed for any silliness or errors below.

The basic theme is that if currency arrangements are sufficiently messed up by the public authorities, society may coordinate on better ones.  We’ve seen this with basket-case countries in Latin America, or like Zimbabwe, which abuse the printing presses to pay for government outlays, and suffer hyperinflation, leading to the populace, or those that are able, resorting to using US dollars instead.  But perhaps the new world of negative rates, deflation and unconventional monetary improvisation [read floundering] is another example.

Suppose that the authorities set significantly negative rates, and this prompts people to withdraw their money from their deposit accounts as cash.  Initially, these get stored in safe-deposit boxes individuals buy for themselves.  As time goes on, the private sector starts to consolidate these cash holdings in larger vaults where economies in the scale of protection can be realised.

These institutions develop a reputation for being sufficiently reliable that people stop exchanging for things with cash, and instead use IOUs, which are claims on their small piles of cash.  The switch involves a leap of faith, because there is always a risk that the IOU won’t deliver what they promise the bearer on demand.   But the occasional disappointment is more than compensated for by the convenience of not having to pay someone to take cash out of one box, and move it or truck it to another.  And the centralised cash-vault management means that the trucking is kept to a minimum, and, eventually, when the vault managers work perfectly in concert and merge, eliminated entirely.

Over time, the convenience of the IOUs leads the cash-owners to wonder if they shouldn’t agree that their delegated vault manager should have the power to issue the IOUs itself.  Why not?  Much time passed with hardly any break-ins, and few notes lost to fire or flooding.  Once that step is made, it’s a short time before an agreement is struck that the central cash vault manager is allowed to relax the promise to exchange the IOUs for cash on demand.

Although this seems like a dangerous and revolutionary development, one that will over decades generate a vibrant subculture of resentful ‘cashbugs’, the cash-vault customers realise, collectively, that it has the advantage of allowing the delegated cash-vault manager to regulate the inflation rate  of the value of IOUs in terms of the goods and services they are used to buy, at the expense of fluctuations in the inflation of the value of IOUs in terms of cash and goods.  But, with prices increasingly posted in terms of IOUs, what does that matter?  And, after all, the former cash-vault customers conclude, since the authorities were floundering at the zero bound, this inflation rate had anyway become too low and unpredictable.

A bright spark at the central IOU-issuer realises that with prices initially pretty flexible in terms of IOUs, it can issue them at a pace that produces, straight away, an interest rate on securities promising IOUs that is well above the zero bound.  Over time, the sacrifice in terms of anxiety in allowing the unpredictability in the cash-goods inflation rate starts to seem insignificant, since most, if not all, of the functions of cash have been subverted by the new IOUs.  Soon, all that matters is the inflation rate between IOUs and goods.

In the early days of the new system, there are times of panic, when demand for the old ‘cash’ surges.  But mostly, time passes such that the notion that these old pounds, in cash form or otherwise, were necessary for the monetary system is as quaint as the notion that a household or government needed gold.  This quaintness advances to the point where some find the cash attractive, and are drawn, perceptibly, to the complex art work and richly manufactured substance of the notes, such that in some circles, cash becomes a medium for decorative jewelry and ornaments.  The IOU issuer cottons on to this, and, as a public relations effort, to try to encourage interest in its almost unfathomable acts of monetary and technical magic, holds open days where it takes schoolchildren down into its vaults to look at rooms staked high with the old cash.

In this fable, the currency shift comes about because the authorities force society to manage their own hoards of cash, rather than doing it themselves.  You might well complain that no such switch would ever happen.  Hyperinflation caused the value of cash to collapse, and people naturally flew from that.  The current problems amount to the authorities failing to erode the value of cash, and, in fact, in the case of Japan and Switzerland, unavoidably increasing its value.  Why would anyone run from that?  Well, perhaps they wouldn’t.  But the usefulness of something as money isn’t just about its use as a store of value, and the expected capital gain or loss.

You might well point out that the authorities could – indeed are typically instructed to – prevent this transition from coming about.  After consulting histories of the Jacobin government’s attempt to enforce the use of the increasingly worthless Assignats in after the French Revolution, they might be encouraged to employ heavies to sieze IOUs issued by the delegated central cash-vault-protector-cum-IOU issuer.  Or they could instruct the courts to refuse to recognise debts as settled in terms of IOUs.  Or ban individuals from posting prices in terms of IOUs.

But then, why should the authorities act like this, really?  If the new IOU authority can be regulated to operate along the lines of the old central bank, and obviate the zero bound, why not let it happen?