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.
Here are some grumbles about the current econ election debate.
1. That the Coalition claim credit for the extraordinary job-creation. This almost certainly had nothing whatsoever to do with Government policy. Except by comparison to some counterfactual Government that would instead have greatly increased regulation. In fact, the most pertinent thing to say about the surprisingly high employment is that it would have been even higher were it not for the Coalition having over-egged ‘austerity’.
2. That this credit can be claimed in the teeth of very weak productivity, which has, of course, arithmetically, been one of the drivers of high employment.
3. That the Opposition parties blame the Coalition for weak productivity, or the ‘cost of living crisis’. Once again, except relative to some counterfactual, transformational government, incumbent governments can’t do much about real earnings per head, except over very long horizons. And even then there is much controversy about how they could go about that.
4. That key elements of the debate about the best fiscal policy going forwards are not being recognised. In particular, that the plan for reducing the deficit over the next few years has to be contingent on the economy evolving so that interest rates can be lifted sufficiently clear of their zero lower bound.
5. That the Opposition feel they have to apologise continuously for their management of the economy. The typical punter forgets several pertinent facts about that guardianship.
-First, it was Labour who took the plunge in making the Bank of England independent, the Tories too wedded to the idea that monetary policy setting should be available for manipulating the business cycle.
-Second, the financial crisis cannot be laid at Labour’s door. It was a global crisis, caused by almost total negligence and misapprehension of the risks accumulating in a fast-innovating financial system. I don’t doubt that that aspect of our history would have played out identically had the Tories instead been in office. Light touch regulation was part of a cross-party political consensus.
-Third, there was not, as is commonly thought, gross mismanagement of public finances. With the benefit of hindsight, we can see that pre-crisis tax revenues from the financial sector, and the trajectory of productivity driving taxes from income, were not sustainable. But those key aspects of current fiscal challenges could not have been so easily foreseen.
6. That the Coalition make capital out of the creation of the new BoE/PRA/FPC architecture as the solution to the financial crisis, which is in turn pinned on Labour having created the FSA out of the Bank of England. This seems to be taken as read, even by Labour. In my view, the shuffling of chairs did not cause the crisis, and the reshuffling will not prevent another one. The real failure was one of substance, and we don’t yet know whether we have addressed that….
6. That there is almost no debate about whether we have an adequate monetary-financial-fiscal framework that will serve us well over the future, and in the even that we have another crisis. I’m not so sure that we do. For example, as I’ve mentioned many times, a good argument can be made for increasing the inflation target to leave more room for interest rate cuts next time. I think more work could be done to institutionalise the use of strongly activist, discretionary fiscal policy in the event that the zero bound limits future monetary responses to the next crisis. The lack of this is what caused the Coalition problems last time. It felt boxed into making promises to be tough that it could not and thankfully did not keep, and then into concealing that it had not kept them: all this the worst kind of expectations management. Third, more work needs to be done to formalise the use of unconventional monetary policies next time. Too much last time was left to the discretion of the internal executive of the BoE. Fourth, there seems to be no taking stock of whether we have the right financial policy framework now.
More of a question than a post.
A while ago, after reading another interesting take on Italian politics describing the many failures of that state, which ascribed the 20 year-long stagnation in GDP/head to these, I wondered: hasn’t it always been thus in Italy? And in which case, why did Italy prosper so well before 1990?
Today, over lunch at the LSE, I got an interesting answer from a local. The argument was that state failures got much worse from the 1980s onwards. Left-wing terrorism prompted a political call to arms from a right-wing coalition in politics, which needed to orchestrate funding from business to buy votes to secure office to take action against the Red Brigade and similar. This flow of funds set off a weakening in control over how public funds were spent, and all the things we associate with the Berlusconi era.
This argument is to be contrasted with another which puts the stagnation down to the emerging economies, which stole markets from the previously successful niche manufacturing sectors in Italy.
Any views?
Ben Bernanke’s new blog has gripped the Econternet.
Bernanke has argued that the US economy is not experiencing secular stagnation. Sooner or later, warranted real interest rates will rise above -2 per cent, and the Fed will be free to achieve its inflation target and full employment. The pathology of the last several years will prove temporary.
His argument is pretty persuasive. But it all depends on how temporary is temporary. If temporary is as temporary as the experience of Japan, where rates have been trapped at zero for >15 years, then the practical distinction between the Bernanke and Summers versions of this hypothesis is somewhat academic. Under such circumstances, raising the inflation target would still be sound, precautionary policy.
After all, as Pascal would have had us reason, what would be the costs of raising the inflation target, only to find out 20 years down the line that the global savings market and demographic trends had gone into reverse? Very little. For the first 2 decades, higher inflation is helpful, and provides room for larger cuts to nominal interest rates. After that, it’s excessive, but the costs of moderately higher inflation are probably not noticeable. (At least not empirically, anyway).
And, as I’ve argued in the past, it might be perfectly reasonable to change the inflation target at low frequencies, as new evidence about the medium run equilibrium real rate came in. If Bernanke is proven right, we can lower again in the 2030s.
So, Bernanke might be right, but that may not change the policy prescription enough to matter. And it could be worth proceeding as though he were wrong anyway, in the absence of knowing for certain, on the grounds that the costs of doing the opposite – for example leaving the inflation target at 2 – are greater.
Mark Thoma sent round this interesting post from Cecchetti and Schoenholtz’s blog, [CS] asking whether 2% inflation targets were still appropriate. In a nutshell, they argue that if central banks were starting over, they should pick a higher number. But that the credibility risks of moving now are too great to make it worth it.
On this central point, I don’t think we can know. This is the sort of thing central bankers and ex-central bankers [Steve being one!] say a lot. But there isn’t any good theory or empirics of reputation formation and dissolution, so we are in the dark. I remember thinking it rather wishful thinking that inflation targeting – simply promising to create the amount of inflation you wanted – would be believed, especially after a few decades of failed proper [read ‘intermediate’, ie exchange rate/monetary] targeting.
I would also like to re-emphasize a point I made in my earlier post, that worrying about credibility is the right thing to do, but might cause us to be concerned about the status quo. If unconventional monetary policies are not as effective, or more costly to wield than interest rate policy, and if there are insurmountable political obstacles to using discretionary fiscal policy, then too-low inflation means more busts than we thought. And a higher risk of being trapped forever at the zero bound.
If this is right, then it’s possible to imagine the legitimacy of the objectives of central banks being slowly questioned, and, once the consensus is eroded, central bank policy itself no longer being credible. In the sense that no-one believes promises made for the future, because everyone can see that a switch in political government could easily lead to a switch in the central bank mandate.
Put more starkly, it may not even be sustainable to insist that inflation targets won’t be raised. In the face of mounting evidence that this would be a way to avoid business cycle volatility and allow central banks to do their job with interest rates, a promise to keep inflation at 2 may not be believed. It would become like the repeated promise of exchange rate targeters to kill off their traded sectors by sticking to an incredible nominal exchange rate target.
CS make an interesting point about the fact that the Reserve Bank of India has just chosen to target 4%. This looks about right to them because of the fact that Balassa-Samuelson effects mean that as India catches up with the West, it will be on a transition path of naturally higher price level growth. This coming about because faster manufacturing productivity growth leads to faster growth in the price of non-traded goods.
I thought I would tease this out a bit more. In fact, this Indian catch up means there is nothing inevitable about faster growth of the overall price level. It’s perfectly possible for India to choose 2% if it wanted. Faster growth in non-traded goods prices would then simply be reflected in (probably) falling manufacturing prices. The reason 4% is better for India is to avoid falling traded-goods prices there, on account of the inefficiencies that are aggravated if there is downward nominal rigidity in either goods prices or wages. (I’m pretty sure Cecchetti appreciates this, recalling conversations with him a long time ago, but it’s not explicitly in the CS text.)
But, if you were persuaded by my arguments for why 2 per cent was too low for Western countries after the lessons learned from the crisis, you might be driven to thinking that 4% is too low for India. Thinking rather roughly, one might add 2pp to a UK target to account for Balassa-Samuelson effects. But a further increment to account for new knowledge about the size of potential financial-crisis-induced shocks, and the incompleteness with which other instruments can step in.
CS also point to another argument, that higher inflation tends to be more volatile. I personally find that unpersuasive, at least as a decisive argument. It’s circumstancial evidence against raising the target, but no more. If the theory we have that tells us that inflation stability is a good thing is right, then actually, on account of the zero bound problem, slightly higher inflation should be more, not less stable.
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.
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.
