BoE: not court napping IMO

What should people make of the Minutes of the Bank of England’s ‘Court’ of Directors dating back to the early phases of the financial crisis?  Was the BoE and ‘Court’ caught napping?  Not in my opinion.

A few points.

The financial crisis was a global professional oversight, and there is nothing special about the apparent confidence the BoE had in dealing with its earliest tremors.  You could, I am sure, find similar conversations going on at all the central banks, finance ministries, and macro-finance groups in the leading universities.

It’s been suggested – eg by Danny Blanchflower on Twitter – that the minutes show evidence of ‘Groupthink’.   I don’t agree.  Groupthink suggests almost wilful bending of one’s views to the collective.  As I said above, Court and the BoE exec were no different from the rest of the Profession.  I don’t think the world missed the financial crisis because of Groupthink.  They missed it because it was genuinely hard to foresee, and because they misapprehended risks in the system.  Plus, from what I remember, there was vigorous and sometimes acrimonious disagreement amongst the Governors about how to approach the early phases of the financial crisis.  There was definitely no shortage of debate and challenge at that level.

Early media coverage is taking the lack of involvement of Court in the BoE’s decisions during the early phase of the crisis as dysfunction on both sides.  And the lack of challenge from Court on policy and analysis as dysfunction on its side.  But I don’t subscribe to this view.  At some point, the infinite regress of overseers, as far as operational and policy decisions goes, has to stop.  So why not stop it with the Governors and the BoE’s policy committees.   Accountability, to preserve effective delegation and policymaking, has to be done ex-post, and at low-frequency.  If it’s done well, with those in charge wielding a credible threat to commission regular reviews by respected experts, the policymakers will feel the appropriate pressure to do their jobs well.   If the Court had been challenging and second-guessing policy all the way through the crisis, this could well have made things worse, more chaotic, and decision-making less decisive.  More recently, Court has been commissioning reviews, on all kinds of things.  We’ve had the Stockton Report, the Warsh Report, the Winters Report, the Plenderleith Report.   One could point a finger and say why weren’t there more reviews earlier on?  But one could just as well blame Treasury Committee for that.

So, before you get too outraged at these minutes, ask yourself if things would really have been any different with a different set of personalities in those roles, with different reporting lines, making their challenges over lunch.  I doubt it.  And then ask yourself what the right model for oversight should be at the Bank.  Is it so obvious?  The outrage suggests it is, but I’m not so sure.  Andrew Tyrie has piled in, castigating Court at the time, as though the Treasury and Treasury Committee somehow had nothing to do with its design, mandate and make-up, nor any role themselves in having failed to provide effective challenge, an activity they certainly see as their function too.

 

 

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‘Shorthand’ for Steve Keen’s contribution to R4 econ program=’made up’?

I had an interesting exchange with Steve Keen last night on Twitter, about things he said on Aditya Chakrabortty’s program on the state of economics and economics teaching.

On the program, Steve Keen said a number of things I contest are false.  He said that mainstream economics ignores banks;  ignores money, or when it doesn’t, simply treats money as a veil.  He said that you can’t publish in top journals without the assumption of rational expectations.  All of these things are false, as a quick Google with some names I suggested in an earlier post will reveal.

The exchange got to the heart of why Steve said these things.

He had two somewhat different answers.

One was that his contribution was ‘edited down’.  Implying that there was a fuller, qualified set of statements not all of which were broadcast, but whose totality could be said to be fair comments.

A second, however, was that his words were ‘shorthand’.  Specifically, when he said ‘you can’t publish papers in top journals without rational expectations’ he didn’t mean that.  He meant ‘you can’t publish papers in top journals without the whole neoclassical edifice.’ This response was to cover my comment that top journals are full of papers that don’t have rational expectations [by Sargent, Marcet, Nicolini, Ellison, Williams, Evans, Honkapohja, McGough, Mitra, Bullard, Brock, Hommes….].

However, these journals are also brimming with empirical finance papers trashing modern finance theory;  of empirical macro papers trashing RBC and New Keynesian theory.  And they are full of behavioural economics and behavioural finance theory papers.  Are those papers that are counted as having ‘the whole neoclassical edifice’?  If we get rid of rational choice, do we still have ‘the whole neoclassical edifice?’  If we dump entirely the project of erecting a theory and have an econometrician demolish one, do we still have ‘the whole neoclassical edifice?’

And when he said ‘mainstream economics ignores money’ [which would be somewhat mysterious for Messrs Kiyotaki, Wallace, Wright, Lagos, Moore, Karecken, Williamson to grasp] he meant ‘mainstream economics has models of money that I think are incorrect’.  [I guess this because he cited my own blog posts questioning whether we yet had a proper model of money].  Presumably the same goes for the claim that ‘mainstream economics ignores banks’ [which Bernanke, Gertler, Gilchrist, Brunnermeir, Carlstrom, Fuerst, Diamond, Dybvig, Keister, Gale, Allen…. would also find peculiar].

Steve calls this ‘shorthand’.  I don’t think this is respectable intellectual discourse on his part.  In my own ‘shorthand’, I’d say that Steve’s characterisation of mainstream economics is ‘made up’ to wage war.  But it’s a desperate tactic.  There are lots of good points to debate about the state of economics and economics teaching, [many made by Karl Whelan, and by Diane Coyle and Andy Haldane, for example, in January’s Prospect] but, by association, Steve weakens the movement he hopes to lead.

 

 

 

Higher inflation target is preventative, not a cure

I had 3 comments on recent posts taking me as having recommended a higher inflation target now as a cure for the current zero bound episode.  That’s not my position.  A higher inflation target would help avoid the next episode, but probably not help this one.  The Fed, despite the options of talking down future rates and undertaking QE are still struggling to achieve their current mandate.  (And the same goes for the BoE, the ECB and other central banks too).  Raising the target now, without a means to exert the concerted stimulus to achieve it, may simply set the Fed up to fail.  One might speculate ‘off model’ that a higher target now would raise expected inflation all by itself, but, equally, if the Fed simply undershot this higher target for longer than it would undershoot the current target, that could undermine confidence in the Fed’s competence, or its honesty.  These views were made clear in a post back in May last year.

Simon Wren Lewis defends NGDP targeting

Simon’s defence of NGDP targeting makes many good points – in contrast to what he calls the ‘faith-based’ argumentation of the market monetarists – and this blog responds to some of them.

He rightly challenges the emphasis I place on the extremely stark result in the modern sticky price macro model that optimal policy involves stabilising a weighted sum of inflation and output (and other things in more complex models) with a weight an order of magnitude greater attached to inflation than other things.

That is fair.  This weight is controversial.  Many participants in the literature I have spoken to privately would say that they doubt its literal truth.    I would make a few points by way of a reply.

First, the same models would also put very high weights on nominal wage inflation.  And zero weight on sectors with flexible prices.   The main point is that this weight has to come from a grasp of the frictions in the model. And, repeating the old Neil Wallace dictum:  it takes a model to beat a model.

Second, whilst the survey results asking people what concerns them (inflation, unemployment, the weather?) are interesting, I don’t think they are that informative about the underlying frictions that characterise the macro economy and therefore which should guide macro policy.  People may not have a clue what is good for the macro economy, and, therefore, for them.  Ultimately, I would only be convinced by a competing model that does a more convincing job of accounting for price-stickiness (taking that to be a macroeconomic fact, controversial for some, I know) and casts a different light on optimal policy.  There are one or two already, but it is early days for that literature.

To dig into the intuition of what leads to the high weight on inflation.  It’s not any distaste for inflation on the part of firms or consumers, or that it makes it hard for them to tell what’s what in the prices that confront them.  It’s that unplanned inflation erodes their real wage or relative price that they would ideally prefer, and, as a result, firms and consumers end up experiencing volatility in the hours that they work, or the amount they have to produce, and therefore volatility in the wages/ profits that they recoup and the amount they can consume.   In fact, if you were to tell me that people don’t like the idea that unemployment might vary a lot from one period to the next, throwing them out of their jobs, I’d say:  well, the corollary of such fluctuations is unplanned inflation in the model, so though they are telling you that they dislike unemployment changes, part of the solution to tackling those, is curiously, to eliminate inflation changes.

I don’t want to pin myself to that mechanism so literally.  These conclusions drop out of microeconomic evidence on the elasticity of demand with respect to changes in relative price, and also the particular resting point of the literature regarding what to do about how or if to clear markets when desired prices don’t prevail.  Neither of these foundations are particularly strong and may not last.  But the main take-away is the difficulty of inferring anything from what people tell you they don’t like in a macro economy.

That said, in a democracy, one can only give so much weight to opinion of a bunch of math-loving technocrats, and, ultimately, policy choices of all kinds, central bank mandates included, have to be anchored to what people want.

A final point on the high weight on inflation in optimal policy in these models:   note that the models I referred to before leave out things we suspect may be costly about inflation.  Its corrosion of liquid stores of value, its confusion of the process of determining real prices, and, typically, the costs associated with resetting prices.

Moving on:  in my last post, I made the point, based on my joint work with Blake and Kirsanova, that delegating levels (NGDP, price level, or whatever in between) targets to central banks that can’t commit isn’t as likely to generate benefits as we thought.  SWL worries that this is not relevant.  I think it is.  In the context of debating the commitment-mimicry benefits to come from NGDP targeting we are asking the following question:

‘Suppose we have a central bank that can’t commit and instead does discretionary policy each period.  Will we get better outcomes if we give it the socially optimal policy mandate, or one modified so that it follows a levels target?’  Some, Woodford included, have suggested that perhaps we might.

My paper (BKY) says:  not necessarily.  You can end up making things no better, and, potentially even worse.  Worse or no better, that is, than giving the original optimal policy mandate [a flexible inflation target] to the central bank and telling them to get on with it.   Why worse or no better?  Because there are at least two equilibria under every scheme, including the original optimal policy mandate, and all possible levels targets one might think of.  So, in order to figure out if you are going to make life better by delegating, you need to know where you are starting from, and where you will jump to.  (Unless all the start points are worse than all the end points).

Without an argument that can knock out the inconvenient equilibria – and one that leaves the rest of the model intact – we can’t put much faith in the benefits of delegation.  If you believe BKY, then you would put more weight on leaving central banks doing what they are doing (inflation targeting under discretion) than trying to squeeze out potentially non-existent benefits from levels targets.

Simon disputes my argument that supporting a levels target – PL or NGDP – requires believing in rational expectations.  He notes that RE is a routine assumption in central bank models and argumentation.  This is partly true, but caricatures.  Note that the Fed’s FRB/US model had the facility to be run under less-than-rational-expectations.  Policymakers at the BoE used an RE model, but when they thought it was relevant, would often adjust forecast profiles by hand afterwards to try to offset what they thought were the effects of rational expectations.  (Highly unscientific and hopelessly imprecise in doing it this way, but well-intended).  However, whether central banks assume RE or not,  it’s not a good defence of a regime that it works well in a false world that central banks happen to believe in.

SWL also makes the point that ‘a key argue for inflation targets is that agents are forward-looking’.   From what I recall, flexible inflation targeting would be appropriate for most commonly used non-rational expectations assumptions, like adaptive learning, sticky-information, rational inattention [mentions that hesitantly], heuristic-based inflation expectations.   Levels targets would not:  since there is no point in using the expectation of correcting to a level to stabilise the impact of an initial shock, since there is no such widely held expectation.

It’s true that the forward-lookingness of expectations is often used in discussion of the merits of inflation targeting.  But I think that is only done in good faith in the context of arguing against the existence of a long-run trade-off between inflation and unemployment, say in countering the idea that the effects of the financial crisis could be permanently ameliorated by a permanently higher inflation rate.  It’s not an argument that should be made to defend inflation targeting against alternatives like price level targeting.  The Bank of Canada’s research into this issue, and their deliberations on it, I would take as a good example of the state of the art.

 

The silliness of NGDP targeting – again.

And a post post post script.

The case against NGDP targeting is actually even stronger theoretically than I let on in that post.  I organised the last post around the simplest possible sticky price model, with no saving, capital, only one type of consumer, no sticky nominal wages, no credit frictions, a closed economy, so no trade…

If we relax these restrictions, optimal policy becomes a much more complicated beast.  It involves [actually this is an informed conjecture not an assertion of analytical fact] a weighted sum of deviations of inflation, nominal wages, consumption by borrowers and lenders (entering separately), interest rate spreads, the capital stock, the real exchange rate…  and with weights on inflation of prices and nominal wages an order of magnitude greater than the rest.

It would be reasonable to scoff at this and argue for nominal GDP targeting on grounds of simplicity.  But then, as I said in the last post, on grounds of simplicity I’d argue for sticking with the status quo, with plenty of communication about how the central bank also cares about nominal wage growth, the real exchange rate, spreads and unemployment.

Escaping the zero bound. NGDP, PLT vs raising the inflation target.

Post Post Script on the zero bound and raising the inflation target.

It’s put to me that NGDP targeting is a better way to avoid the zero bound than raising the inflation target.

This question can’t be answered definitively without reference to a model, or class of models.  So, as ever, let’s take the standard monetary, sticky price model, of which there are several variants, used in central banks to simulate the effects of monetary policy.  It may not be right, but it is beholden on market monetarist NGDP fanatics to write down a different and better one if they don’t like it, or its conclusions.

This model’s steady-state obeys the Fisher relation.  [Steady state singluar there for simplicity].  Which is to say that investors in nominal assets will require compensation for inflation.  Namely, interest rates in the long run will rise one for one with a rise in the average inflation rate.  For a given variance of shocks to the economy requiring offsetting action by the central bank [at this point sticky price assumption invoked], the higher the rate of inflation associated with the monetary regime, the lower the frequency of zero bound episodes, and the less missing stimulus.

There are a whole set of regimes that would deliver higher long run inflation.  Regimes that target a weighted average of deviations of inflation from a target, and deviations of real activity from potential.  Or regimes that target a weighted average of deviations of the price level from a rising trend and deviations of activity from potential.  If you choose equal weights in the former, you get an NGDP growth target.  If you choose this weight in the latter, you get an NGDP level target.  These are optimal in some special cases, but generally not optimal.

That doesn’t mean NGDP targeting is out.  It could be rescued by arguments that it is easy to communicate, defend, and likely to endure.  But then you can’t really argue with any conviction that inflation targeting is inferior on these grounds.

Once you have chosen how much you want to increase the long run average inflation rate to escape the zero bound – using one of the infinite variety of regimes to deliver it, including NGDP targeting if you like – there’s then the issue of whether your target should be specified as a rising levels target or a growth target.

The objective that it is optimal to assign to the central bank, assuming it can commit to it, is clear in the models.  It’s a growth rates target, with a very high weight on inflation.  [About 20:1].  Curiously, and somewhat confusingly, in many varieties of this model, if you assign this growth rates target to the central bank, and it can commit to pursuing it, and, of course, there are rational expectations, then the path for the price level delivered is often, but not always, stationary.  And so it will resemble what much of the informal discussion about central bank targets means when it refers rather vaguely to a ‘price level target’.  Inhabiting this model world, we can observe that if we drop the assumption of commitment, and presume instead (more realistically), that central banks can’t tie their hands each period, they will suffer more frequent and or larger episodes at the zero bound, for a given long run average inflation rate, on account of not being able to stabilise the economy with the ‘extra’ instrument of future expectations of current interest rates.

If you are still with me, we then get to the literature that says that when central banks can’t commit, you can, somewhat paradoxically, get them to deliver the best outcomes according to the original, optimal, growth rates target [‘inflation targeting’] by assigning them variants of a levels target [eg a ‘price level target’].  So, applied to the current question, we could, having chosen the long run average inflation rate, squeeze a bit more by way of zero bound avoidance by assigning a levels target of sorts to a central bank condemned to act discretionarily.

That said, my own work with Blake and Kirsanova points out that this is not nearly as reliable a result as once was thought.  For those interested:  rational expectations models under discretion typically generate multiple equilibria if there are state variables like debt or capital.  And then it becomes ambiguous what the welfare benefits are to assigning a discretionary central bank a levels target [of whatever variety] since one doesn’t know immediately which equilibrium one is jumping from and to.

Analytical drawbacks like this aside, readers should imagine the communication somersaults required to get over to the general public that, in order to get over the fact that policy suffers from [dynamic] lack of commitment, the government, which would ideally like a growth rates based target to be pursued, is actually going to assign a levels-based target to its central bank.

And we have yet to deal with the fact that the benefits presume that agents have forward-looking rational expectations, an assumption that is highly unrealistic.

Taken together, the case for levels based targets – including NGDP levels targets – is, both practically and analytically, extremely weak.  This was why the Bank of Canada rejected moving to a PLT.

So, based on this, I don’t see that following a levels target of any variety, NGDP or otherwise, is an alternative to raising the long run average inflation rate, however implemented.  There’s no choice [reform to negative rates aside] but to bite the bullet and figure out a different trade-off, between the costs of long run higher inflation, and the costs of higher volatility [imposed by missing stimulus at the zero bound].

In so far as we choose to go for higher average inflation, the choice of whether this should be delivered by a regime that weights equally inflation and real growth [NGDP growth] or  something else, like ‘inflation targeting’, resolves in favour of the status quo on practical [it’s a version of status quo] and theoretical grounds [models point to IT].

 

Rather than sweating over complex institutional reform to break ZLB, raise inflation target

Postscript to the previous post on the ZLB.

The practical challenges of devising watertight legal reform to eliminate cash and its near substitutes, both currently invented and yet to be, or to reform them so that a variable negative interest rate can be set, seem like a tall order.

Much easier is simply to raise the inflation target, as suggested previously by Olivier Blanchard, Krugman and others.  Perhaps by 2 percentage points.  To be done when interest rates would otherwise – under the old target – lifted clear enough of the zero bound that the new target can be achieved within a realistic time frame.  And perhaps reviewed at low frequency as evidence on changes in the natural rate accumulates.

Higher inflation imposes extra costs on the economy as the private sector struggles to insulate themselves from it.  And hits the poor hardest, since they are typically less adept at indexing themselves.

But then part of this cost – erosion of the value of money – is imposed by negative rates anyway.

And to conclude with a rather woolly argument, though felt keenly myself, higher inflation would be a much easier thing to explain and communicate than innovative, invasive reform of monetary institutions that not all on the econosphere grasp readily.   And being more easily communicable, I conjecture that it would be easier to build a lasting constituency for higher but stable inflation.