The natural rate may still be edible

This summarises a Sunday afternoon conversation with Roger Farmer on Twitter. Apologies for multiple drafts and no links: this is one- fingered on an iPhone from hospital.

Roger has a new microfounded macroeconomic theory that has the prediction that the unemployment rate is a random walk, and cointegrated with the stock market.  He looks at the data and finds that the unemployment rate is a random walk and is cointegrated with the stock market.

Is the natural rate hypothesis, at the heart of mainstream modern macro dead, or, as Roger puts it, ‘well past its sell by date’? That’s the inference, at face value.

Another explanation, is that there is slow moving institutional change that drives both the stock market and the unemployment rate.  Institutions related to benefits, employment protection legislation, taxes that affect labour demand and supply, unions and collective bargaining have all been in slow motion change, which over small samples may look non-stationary (or even be thus), and may have affected the labour share and the value of a claim on the remainder. These changes one would have expected too to have pushed around the equilibrium unemployment rate.

On this view while naive manifestations of the natural rate that exclude institutional change may be past its sell by date, those that embrace it may still be edible.

Of course at this point I have done no more than raise a counter conjecture to compare with Roger’s econometrics but it is at least worth investigating.

Roger has been urging large scale intervention in the stock market to raise equilibrium employment. In fact dovish natural rate believers can find common cause with this and related policies right now, although the cost -benefit analysis will differ somewhat. So even though until entirely disproven I would urge we keep some eggs in thematically rate basket, at present the policy prescriptions from the two perspectives are not in direct opposition.

The hawk’s talk about Greece

Andrew Sentance tweeted: ‘If Greece now “insolvent” why was UK not “insolvent” in 1945? Public debt/GDP = 200%+ http://www.res.org.uk/view/article5jan12Correspondence.html … 25 yrs later was <70%!’

The answer is:  it was insolvent.  The Marshall Plan amounted to roughly £3.3bn pounds over just 3 post war years 48-51, which was about 30% of nominal GDP at the time.  I imagine that might have helped us somewhat.

And, there was what sovereign debt researchers have termed ‘financial repression’.  Liquidation of government debt via inflation, sub-market real interest rates, regulation.  Reinhardt and Sbrancia estimate that this liquidated about 3.3% of GDP’s worth of debt on average over 1945-1980 for the UK.  ie about 100% of GDP in total.  Measuring the contribution of these factors is not a precise science.  But still, you get a feel for the magnitudes involved.

So, it seems it wasn’t just ‘growth’.

Roughly 80% of the Greek sovereign debt is owed to the foreign official sector.  So the methods the UK used to steal from its mostly domestic bond holders aren’t so readily available.

Leaving all this aside, what does  Andrew Sentance think would happen to Greece if either the debt were not forgiven, or the generous terms to ‘repay it’ [in quotes because of course no one expects much of it to be repaid] were not extended?

Of course Greece [the murky combination of the public and banking sector] is insolvent.  The Greek banks would collapse instantaneously without the ECB’s ELA.  And that would bankrupt what, 5-10% of the private sector too, over the next 12 months?   More?

Did John Taylor get us stuck at the ZLB?

Paul Krugman picks up on my post about proposed legislation to get the Fed to pick a policy rule.  The legislation is being championed by John Taylor because he thinks that the reason we got into this mess was because we deviated from his rule.

It’s interesting to wonder whether in fact the truth is the reverse.

Was it the sticking to the rule, rather than deviating it, which got the Fed trapped at the zero bound?  That’s one way of reading PK’s post.

In the public exchange between JT and Bernanke, Bernanke argued that they didn’t really deviate from the rule, so that could not have been the problem.  However, PK – if he is suggesting this – has theory on his side in the shape of a paper by Schmitt-Grohe and Uribe called ‘The perils of Taylor Rules‘.  This paper shows that religious adherence to the Taylor Rule produces two ‘steady-states’ [jargon for where the economy settles when there is nothing buffeting it around], one of which involves interest rates trapped at the zero bound.

I don’t really think this can be the reason.  The theory offers a knife-edge result, a trap that would be avoided by a Fed with even a slight tendency for discretion.  And those who are briefing FOMC and even on it don’t use rules like this.  Though many of them produced the papers exploring the usefulness of these rules, their instinct is to respond as they sit to events as they arise.

In so far as monetary policy was at fault, the problem was that it was directed at a rate of inflation that with hindsight was just too low.  Hence why I and others, PK and Blanchard included, have argued for a higher inflation target in the future.  In the long run, higher inflation means higher central bank rates, one for one.  And this means fewer and less severe episodes at the zero bound.

RIP the primary surplus

Any negotiations over debt relief between Greece and the Troika can no longer focus on the primary surplus.  There is clearly a sharp contraction under way, amplified by a decline in funding for Greek banks.  Whatever primary surplus there was has surely disappeared right now.  And how the current events will play out into future values of that surplus – even on unchanged policies – is highly uncertain.  Bargains over Greek policy can’t be expresed in terms of a fuzzy forecast future primary surplus that some civil servant economist somewhere thinks those policies will generate.

The probable disappearance of that surplus weakens the Greek hand somewhat.  But not that much more.  It was already pretty weak, since the financial convulsions associated with a default would have swallowed the surplus anyway.  There has been no sign of contagion into private or sovereign spreads outside Greece, and that will also make the Troika more confident of holding its line.

The Greek behaviour post-election makes me marginally more pessimistic about a deal being reached.  Partly because there is a sense of there being a lack of coordination between Tsipras and Varoufakis, who are saying things that imply different notions of what would be an acceptable deal with the Troika.  Can they get their acts together, agree a common line, and deliver any agreement to their party?

The sense of chaos is amplified by the (to me) surprising foreign policy ploys of blocking further sanctions against Russia, irritating China, a potential lender of last resort, by cancelling the port privatisation;  and even annoying Turkey over a visit to disputed Island territories.  Perhaps these are viewed as relatively costless acts to please their followers, sweetening them before a compromise on what really matters, finance.  But they could also add to the arguments rehearsed in Northern political dinner parties that Greece can leave the euro, since it would not play a constructive role in the Eurozone political union anyway.

 

No legislation on the Taylor Rule please

John Taylor and Alan Blinder have been exchanging op-eds in the US press on a bill before Congress now that, if passed, will force the Fed to ‘describe’ its preferred rule for monetary policy.

I posted before here on why I thought this was a bad idea.

The recent exchanges are about whether the legislation would tie the hands of the Fed or not.  Blinder argues that it will, Taylor argues that it won’t, since all the Fed have to do is disclose the rule they will follow.

John Cochrane blogged some time ago sounding supportive of the idea.  Which I found puzzling, since he has written a few fascinating papers tearing apart the framework that produced central bank received wisdom that these monetary policy rules were a good idea.  For example, he questioned the notion of equilibrium that most people sweep aside along the way to admiring the stabilisation properties of Taylor Rules, and the stories people tell about why the rules do well.  And he even queried  whether people have the sign right in New Keynesian models when they think about the effect of monetary policy on inflation].

To recap earlier arguments, there are many reasons this is a terrible idea.

1.  Supposing the Taylor Rule was genuinely thought to be a great guide to policy.  In a few years, we might realise it isn’t.  And legislation is hard to change.

2.  The legislation sets a terrible precedent for interfering in the operational independence of the Fed.  The right way to delegate monetary policy is to be clear about what goal they are set.  [A little unfortunate that the Fed have been left to define their own goals, quantifying the previously unquantified definition of price stability].  And then the Fed ought to be left to decide itself how to achieve those goals, and be held to account based on performance.  Even if this were a well-designed interference, (it isn’t), the next one might be for nefarious political ends.

3.  The US Congress is not to be expected to reach fair-minded conclusions on anything these days.  The effort to tame the Fed is probably entirely a political thing stemming from the visceral libertarian feeling that the Fed’s activism – admirable in my view – is part of the problem in the US, rather than the solution.

4.  The Taylor Rule or any particular rule like it only ever performed well in a very narrow class of DSGE models.  That class of models now looks much less reliable after the crisis as a testing ground for monetary policy design.  In some senses, the crisis shows why it was a great idea not to have legislated in the days of the Great Moderation, when rules like this reigned supreme as explanations for why macroeconomic performance looked so good.

5.  John Taylor’s argument that the act of describing the rule won’t constrain the Fed must be incorrect.  If this were not the aim, or the likely outcome, there would be no point.  JT wants description to bring about more rule-following.

6.  The Fed do enough describing without legislation.  Continual reference to rules is made in their research outputs, the staff forecasts, research based work in the speeches of the PhD FOMC members, even the FOMC minutes themselves.  Why is legislation need to force this process of ‘describing’?

7.  JT’s support for the legislation is based on his view that deviating from the Taylor Rule was a major factor in causing the financial crisis.  This is a really weak argument.  In the models JT developed himself and in which the TR is a good policy, monetary policy just does not have such powerful and long-lasting real effects.  As I said above, we might argue that there’s good reason to ditch this model.  But if we do, we can’t keep the Taylor Rule or anything like it as the prescribed policy.  There’s a long learning process to go through that legislation won’t help.  Moreover, Bernanke pretty conclusively refuted the idea that monetary policy was anyhow loose relative to a sensible rule in the early 2000s.  JT’s own rule remember is not actually operational (point made by McCallum long ago) since it includes contemporaneous inflation and GDP, not available in real time.  If forecasts are inserted instead, policy looks fine.  And, there are some pretty strong pieces of circumstantial evidence that other policy failures were the cause!  This thesis is to be twinned with his comment on fiscal policy.  He sees the fiscal stimulus agreed at the beginning of Obama’s first term as a deviation from rule-based behaviour.  Despite the fact that in the same model that is the testing ground for the Taylor Rule, which JT built himself, a fiscal stimulus is an optimal response to a recession.

So, for all those reasons, legislation on monetary policy rules is a terrible idea.  My main hope is that this issue just sounds too technical for your average Republican mischief-maker looking to make some headlines.

 

Post-Syriza post

There are many positives and negatives in the Syriza victory.

The most obvious positive in the Syriza result is that especially in a young and fragile democracy, it’s good for the established politicians to be kicked out once in a while, without prompting a military coup, just to show the next lot that it can happen.

It’s also compelling that the Troika struck the wrong deal, and Syriza’s craziness, if it is real, might give them the credibility to extract one that is better for Greece and the Eurozone as a whole.

But there are some negatives.

First is the demonstration that promising the Moon works.  Syriza’s promises, so far as they are intelligible, are not affordable.  But no-one cared about that, or no-one understood.

This strategy was adopted by the SNP.  And it worked for them too.  They didn’t win the independence referendum itself.  But they decisively changed their own political power, the constitution, and may yet win independence in the longer term.  What lesson does that teach future politicians who contemplate explaining things as they really are and really could be?

Another negative is the industry of drawing false lessons from Greece.

George Osborne draws the lesson:  we need more austerity ourselves, or we will end up like Greece too.  For a month or two after the May 2010 election, there was some justification for thinking this.  But never since.

The left draws the lesson:  Syriza have rejected austerity, we need to do it too, and can.  Well, there’s austerity and austerity.  The electorate was choosing back in 2010 between two plans that were pretty similar relative to the sharp contraction enforced on Greece by the Troika and their financial crisis.  In the end, the Coalition reneged on its deficit reduction plan and, with the assistance of the BoE, inflation was allowed to cruise more than 3 percentage points above target.  Rejecting austerity and an associated 25% cut in GDP doesn’t contribute much to forming an opinion about what the UK government should have done.  That’s like using an argument against famine to lobby against a slight trimming of one’s calorie intake.

The left also draws the lesson:  you see what capitalism and neoliberals do?  Let’s dump the lot.  But Greece represents not a failure of market economics, but instead a failure to construct a market economy, and a failure to construct a functioning public or ‘socialist’ sector alongside it.  And it’s almost utopian to hope that the state failure that poisoned markets and allowed the public sector to deliver so little for what taxes were collected, is going to be fixed by that same state.

Another negative:  the suggestion in some press commentary, that Syriza’s victory is one for democracy [fine thus far] and that if they don’t get what they want, that is democracy being thwarted.  Well, no.  If they don’t get what they want, it’s because leaders of other democracies calculate that giving more money to Greece would not be popular with their own electorates.

And one more:  Syriza’s harking back to reparations for World War 2.  This is bound up with an attempt to make a case that debt relief is moral.  I believe it is, on the grounds that the debt was in part the fault of reckless Northern bank lending.   But going back to past grievances.  Where does that end?  This is is a nationalist ploy that stirs up separatism that makes fiscal union (of the kind that would have avoided this mess) impossible.

 

 

Greece’s fragile primary budget surplus is not much of a bargaining chip

One reason cited [1] for why Syriza will be able to talk tough with the Troika, presuming it wins today, and can form a government, is that it has a healthy [circa 5%] primary budget surplus.  That’s the difference between revenues and spending, once we ignore the cost of servicing debt.  The hypothesised threat is that the new Greek government renounces the debt and has no more need to borrow from capital markets, taking more in taxes than it spends.

However, this is not the whole story.

Cut adrift from the Troika, the Greek government does not have the funds to stand behind its own banks.  They would be left insolvent by a Greek default [economically, they are already, really].  A run on Greek banks, either prompted by default or the threat of it, could not be stemmed by a credible guarantee of deposits.

The primary surplus would fast disappear as the contraction in money, credit and economic activity played out.

It’s these events that would precipitate the Greeks ejecting themselves from the euro – there being no legal mechanism currently for the EZ to do that itself – as they scramble to print Drachmas to pay their ongoing liabilities like pensions, government salaries, and social security.

And the prospect of self-ejection, done messily and slowly, since the Greeks have none of the requisite infrastructure to pull it off, will reinforce the likelihood of a bank run and capital flight, even if, as JP Koning rightly suggests, the Drachmasation may ultimately fail.

Quite apart from this, are two factors.

First, there’s the matter of new and unfunded government expenditure in the Syriza manifesto.  Who knows what would eventuate in the coalition-formation process, but they are not currently affordable [ie they would bust the primary surplus on their own].

Second, as the FT reports, tax collection is plummeting right now as Greeks forecast that unpopular property and other taxes will be ended, and perhaps also that there will be less appetite to collect on legacy obligations that the new political leaders discredited.  Ironically, this drop in tax collection reduces Syriza’s ability to deliver on the promised goodies which will win them the election.

It’s interesting that as the election has approached, there has been no precipitous rise in other spreads that might signal that markets were worried about contagion from events surrounding Greece.  That could indicate blind faith that a Syriza-led government and the Eurozone would see sense and find a sensible deal [which, to be clear, for me would involve drastic debt forgiveness in exchange for…].  But it could also indicate that they have judged a disorderly workout of the problem as largely a problem for Greece and no-one else.  If the latter were the case, this too limits Syriza’s leverage at the bargaining table.

[1] See, for exmple, Simon Wren Lewis.

On the lack of equity purchases in the ECB QE plan

There’s disappointment from some that the new ECB QE plan won’t incorporate the purchase of equities.  A few points.

1.  Equities are issued by companies that can!  [Don’t ever criticise this blog for lack of depth on finance matters].  And which don’t need to go via banks.  So, if there are finite funds/risks to take on the public sector balance sheet, one could argue they should be concentrated on segments of the financial system that are most dysfunctional.

2.  On the other hand, even if there were no financial friction in the equity issuing sector, on second best grounds, it would be justifiable to buy them to offset a distortion somewhere else, especially if the purpose was to boost overall spending on the grounds that this were inefficiently low.

3.  Purchasing equities might stimulate firms at the margin who wouldn’t normally issue, or not as much, to tap this source of finance.

4.  A question:  what’s to stop member state governments tapping the extra demand for their bonds by ‘over-funding’, issuing more bonds than they need to cover a gap between G and T, and spending the proceeds on equities?  This would have a similar effect as the ECB doing it itself.  There would be no explicit risk sharing.  But maybe plenty of implicit risk sharing.  Some of the most strapped states would not be able to bear much more risk and such bond-financed purchases would be counter-productive for them. But some might.

 

 

QE as debt management means ECB vs 19 DMOs

Larry Summers and others have wondered how much the US Treasury’s tilt towards easing undid the Fed’s program of quantitative easing, pointing out that the central bank stimulus was hampered by an uncoordinated and opportunistic change in issuance as longer yields fell.

If you are in the camp that QE only works through altering the relative demand and supplies of debt of different maturities – for example, that, hypothetically, QE could be replicated by the issuance of very short duration debt for the purchase of longer duration debt – then this is a big deal.

We might wonder if a single central bank/government can’t coordinate a combined reduction in the amount of long duration debt held in the private sector, what hope is there for the Eurozone?  There, we have a single 19 member ECB policymaking committee, but 19 debt management functions, many acting on behalf of governments sorely short of funds.

How will the ECB stop member state debt management undoing QE?

 

ECB QE: get rid of ‘but below’ to sharpen open ended promise

So, ECB QE surprised a little.  60bn per month, not 50.  A re-emphasis of the determination to buy private sector assets too.  Most importantly, stressing that the purchases were open-ended, to be continued until there was a sustained improvement in the inflation outlook, and ‘at least’ until September 2016.  So no preliminary cap on QE as previously guessed.

This open-ended nature of the program, which mirrors QE3 in the US, would, however, be more compelling if the Governing Council did not have the fuzzy asymmetric target it ‘clarified’ for itself from the Treaty-given price stability mandate.  That stipulates that the ECB shall aim for inflation ‘close to, but below’ 2 per cent.

This has always been a problem with the ECB monetary framework.  Unjustified in theory:  if anything, because of the zero bound, undershoots to be avoided more strenuously than overshoots.  And injects a lack of clarity in practice that has no obvious benefit.  Other than it being something the previous German GC incumbents could agree on, that sounded tough, and somehow differentiated themselves from weak-kneed inflation targeters around the world.

I had guessed optimistically that with new leadership, and inflation being anyway not even ‘close to’ target, the asymmetric words did not make much difference to anything.

But now I think it could be important.  Because the ambiguity in ‘close to but below’ makes it unclear just when otherwise open-ended QE purchases would be stopped.  Is 1 per cent ‘close to but below’?  If it is, headline inflation could justify enough members on the GC mounting an argument for curtailment much sooner than if ‘close to’ means ‘within 0.3 percentage points’.

To increase the force of the promise for open-ended purchases, therefore, and to help ex-post accountability, it would be better to get rid of the ‘close to but below’ and simply re-‘clarify’ to make the target 2 per cent.  (Of course, preferably, at some point this would be raised further, to something like 4, to avoid another quick revisit of the zero bound, but there is no hope of that.)