Expensive talk on inclusive capitalism

On 27 May, Mark Carney, Governor of the Bank of England, gave a speech on the topic of ‘inclusive capitalism’ at a conference carrying the same name.  I can understand why he made it.  Once invited, there are risks to turning the invitation down.  Since Mr Carney is shortly (in central bank time at least) off to Canada with the presumed intent of assuming high political office, he can be taken to be already in pre-campaign mode.  Such a conference is the perfect platform to stake out a cuddly but free market position, and to appear statesman like and escape the nerdiness that can hinder those who linger in finance too long.  There are more genuine reasons to give the speech.  The Bank of England looks to some like the friend of the City, and this is a chance to counter that.  Occupy – assisted by the BoE’s new Chief Economist Andrew Haldane – charged that the financial crisis was in part caused by inequality (=exclusive capitalism).  So this is a chance to answer that charge, or explain what can be done about it.

But there are costs too.  Central banks don’t have questions of redistribution in their mandates.  In that sense, it’s none of their business whether capitalism is ‘inclusive’ or not. When they speak on topics outside their mandate, they – to indulge in central bank speak that it is hard to shrug off – run three risks.  The first is that they  politicise their jobs.  By which I mean that future office-holders will be selected to make sure that when they go off brief they do it in support of the sponsoring political party.  The second risk is that their reputation for doing what they are mandated to do impartially is tarnished.  (How can we trust this lot when they are so overtly ideological?).  Risk number three is that the institution gets cut down to size in the future, in a backlash against central bank autonomy, stripping out jobs that would normally be better left inside it.

In my opinion, central bankers should stick rigidly to talking about issues that are confined to their mandate.  Even if such comments are solicited – as they were of the previous Governor by the Government on fiscal policy – these invitations should be turned down.

As a parting shot, there are pecuniary costs too.  I reckon it must have cost at least £50k for Mr Carney to make that speech.  [Calculations at the end of this post].  Was it really worth it?  In this particular case the outlay might be deemed ironic in the midst of a conference on inclusive capitalism:  tax taken mostly from the poor so that someone already rich can look good!  (Granted I am caricaturing here).

Anatomy of the guessed £50k spent on speaking about ‘inclusive capitalism’

Suppose annual junior staff cost, including pension, of 100k a year.  30 days holiday, leaving about 235 working days.  Daily staff cost of about £425.  Governor time rated at 6 times that.  MPC/FPC time rated at 4 times that.   Senior staff time rated at 2 times.  Typical speech of this length would take 2 weeks of the Governor’s speechwriter’s time.  This would include writing time, meetings with suppliers,  meetings to collect comments.  The Governor himself might work on it for 5 days, conservatively, including writing, commissioning, rehearsing and so on.  A typical speech will involve commissions from junior staff outside the Governor’s office, that I reckon might conservatively be costed at 5 days.  Such a request will cause a flurry in the local area, as this is the chance for that area to excel and draw attention to themselves.   I have added 3 days for press office time, spread from the most senior to the junior lot who person the phones.  And 2 days of MPC/FPC time.  Supposing it takes 1 member an hour to read and comment on it.  And that 8 from the two committees have a go.  That seemed a fair guess from my experience.  The cost includes 3 days senior staff time commenting.  It’s essential to read and comment on all the speeches by the Governors.  Heads of Division are fighting for promotion on a rapidly flattening hierarchy and have to make themselves visible by doing this.  So this assumes that 24 of them spend an hour each doing it.   Which gets us to about £25k.   The true cost is probably much larger, (at least double ?) since each of these staff imposes an overhead on the organisation in terms of HR, IT, office space, etc.  So that gets me to £50k.  There’s a lot of guesswork here, but I am happy to be corrected.  The true cost of more substantive speeches, like set piece lectures on monetary policy or financial stability would, I guess be vastly higher, by a factor of 5-10.  So in this sense this one might be regarded as cheap, I suppose.

Slow-moving changes in equilibrium real rates could be accommodated with periodic inflation target reviews by an independent 3rd party

Many, for different reasons, have suggested that the rate at which central bank policy rates might settle will be significantly lower than the rate that prevailed on average in the pre-financial crisis period. In his parting speech as Deputy Governor for Monetary Policy, Charles Bean suggested that rates might end up around 3 per cent, at least 2 percentage points lower than they were before.

Such a large change would warrant an upward revision of the inflation target.  Without it, there would be insufficient room to use central bank rates to control inflation and cushion the real side of the economy from the effect of shocks as they come along.   This is so because, in the absence of these shocks, the central bank rate will settle at a rate that is equal to the real compensation people demand for lending money and not consuming now [leaving risk out of it] plus the extra they need to protect their investment against the erosion in purchasing power caused by inflation. [In models the equation that delivers this is known as the Fisher equation].

There would have been a solid case for an upward revision in inflation targets even in the absence of lower long term real rates.  Before the recent financial crisis, the probability of hitting the zero bound to interest rates in developed economies was judged inside central banks to be extremely small, and the chance of experiencing a protracted period trapped there as vanishingly so.  (The view in officialdom was, so far as I could tell, that the travails of the Bank of Japan, trapped at the zero bound for more than 15 years before our crisis, was down to a special set of institutional failures and incompetence in the Ministry of Finance, the BoJ, and corporate governance.  How wrong that turned out to be!).   So, if we add in the central guess at the change in equilibrium real rates real rates, it could be argued that the inflation rate should rise by around 3 percentage points.

The forces that determine long-term real rates, and hence the amount of room above the zero lower bound for a given inflation target, are presumably likely to wax and wane. So in an ideal world one would have the inflation target moving all the time as a function of estimates of this equilibrium real interest rate.  Such a system would probably be chaotic and open to abuse.   A practical approximation to the ideal might be low-frequency reviews, say every five to ten years.

If such reviews were to happen, who would carry them out? In the UK, currently, the Finance Minister [aka Chancellor of the Exchequer] has the power to set this inflation target whenever he or she likes.   So in principle, incorporating that inflation targets are set as a function of real rates could be done without any institutional reform. However, the custom of such targets has been that they are set for good, bar on a trajectory for disinflation, or major redefinitions of the price index. My guess is that if the Government were to start changing the target to accommodate real rate changes the UK monetary framework would fall into disrepute, and that the view of those at the top of officialdom would be that any accommodation of this kind should be avoided for this reason. After all, there are many at the top who can still remember the bad old days of UK monetary policy and were presumably burned by the experience.

However, if no changes were made and we were in for a ten-year period of very low real interest rates, not adjusting the inflation target might be risky for the legitimacy and therefore the credibility of monetary policy too.   (Legitimacy:  why should we have an institution that doesn’t do what’s right for us?  Credibility:  why should we believe that an institution will follow through on something that isn’t in anyones’ interest?).  In the darkest days of the last recession, before the Bank of England persuaded everyone of its Panglossian view of the effectiveness of QE, it was easy to imagine that the political consensus for low inflation would evaporate, along with other components of current capitalist practice. Doing what was necessary to avoid another period trapped at the zero lower bound could actually be the best thing the authorities could do to nurture society’s confidence that monetary policy was in sound hands.

A solution might be that inflation target reviews were carried out by some 3rd party, call it an Inflation Remit Review Commission. Such a third party being not the Government, which might be suspected of engaging in financial repression under the guise of a benign response to secular stagnation. And also not the central bank which, at least in the UK,  already has an alarmingly large set of jobs to do, and should not be put in the awkward position of being seen to set the targets against which its monetary policy performance will be judged.

One objection to this proposal might be: haven’t we discovered that we can do quantitative and credit easing, and therefore freed ourselves of the constraints of the zero bound? If you believed all the Bank of England wrote (at least before the moratorium on QE that coincided with Mark Carney’s chairmanship of the UK’s monetary policy committee), this is what you might conclude. However, in reply to this many things can be said. First, many  don’t subscribe to the view that QE worked.  Summarising previous posts on this which outlined this view: i) it has not been proven that the effect of QE on yields was persistent or simply due to signalling about future rates; ii) whatever effect on yields was achieved does not necessarily translate into a benefit; iii) all the major central banks clearly felt there were political or other costs associated with QE at some point, in which case it cannot be considered to relax the constraints of the zero lower bound altogether.  Credit easing seems much more desirable and effective to me, but also hardly a perfect substitute for the much better understood tool of interest rates.

Another objection might be that we could hope for institutional reform to fiscal policy so that conventional spending and tax instruments could be brought into play to back up monetary policy, or even replace it, if a zero bound episode loomed. Simon Wren Lewis and Jonathan Portes argued recently for such reforms.  Such reforms would be desirable but there is no immediate prospect of them.  Delegating these tools might be thought one delegation too far, and never happen in our democracies. Moreover, the reasons why central banks assumed the job of macroeconomic stabilisation with the use of monetary policy still hold – that using discretionary fiscal tools is unwieldy and generates costs of its own.

Some might object that the experience of the financial crisis in giving birth to sounder regulation and macro-prudential tools should mean that we don’t again encounter the zero bound.  This objection is the weakest of all in my view.  Regulation is perceptibly more conservative, but still complicated, confusing, and unresolved.  Macroprudential tools and the institutions wielding them are untested.  The recent crisis underscores to me that the experience is to be repeated more often than we thought before it, not less.

The device of the 3rd party review would mean the Government foregoing its current perogative to change the target at will, a very British and anachronistic piece of institutional discretion.  And a Review could handle future redefinitions of the price index, allowing genuine changes on technical grounds to be seen as such, protecting the Government from accusations of financial or monetary policy engineering.  It might also tackle the issue of how the central bank should weigh the competing goals of inflation and real economy stabilisation, (and, in fact, also the meta-issue of whether this should be a matter for the central bank itself or not).

 

Raising the inflation target: great idea, but not now.

In a recent paper, Paul Krugman, echoing a suggestion made by Olivier Blanchard, makes a compelling case for raising the inflation target in the US and other Western economies, to avoid the difficulties that would come with another episode at the zero lower bound [ZLB] to interest rates.  I wholeheartedly agree, but now is not the time.

Why not?  Although core inflation in the US shows signs of rising, the Fed has not decisively won the battle to stave off risks of deflation.  And raising the target now would set them up to fail.  Right now the Fed needs a chance to regain its reputation for being able to deliver on-target positive inflation.

Moreover, a rise in the inflation target now would mean another further protracted period where interest rates were held at the zero lower bound in order to send inflation higher [before rates eventually settled at the higher level that the Fisher equation would suggest would be associated with the higher inflation target].   What worries me about this is that such an economy would begin to look to a sceptical econometrician like one in a permanent liquidity trap, risking a fall in inflation expectations that would make such a conclusion self-fulfilling.

Given the current balance of power in Congress, and the likely waning of the Obama Presidency as it heads into its final 18 months of office, raising the inflation target – if not achieving anything new of note in economic policy – would seem to be completely infeasible anyway.  And attempting it would risk reopening other discussions about the Fed’s monetary policy and other objectives that could end up leaving the Fed with a less well designed set of tools and objectives than currently.

In the UK, raising the inflation target can be achieved by George Osborne writing a short letter to Mark Carney.  (Another example of the curious tendency in UK constitutional life for important facets of the political economy to be sustained by durable but seemingly fragile convention.)  Should George write one now before the next Mansion House speech?

In the UK inflation never looked like falling below the inflation target, and instead was for many years greatly above it.  So risk of setting up the BoE for a failed attempt at creating more inflation is less.  However, interest rates have been pressed at the zero bound since December 2009 and are expected by most to remain so until at least the beginning of 2015.  A further protracted period of apparently constrained monetary policy may indeed wind up failing, or looking like failure.

In the UK, reputational concerns work the other way, but would perhaps still mitigate for raising the target much further down the road.  Raising it now would look like consolidating into the objectives the above target inflation outcomes of the last seven years or so.  [‘Aha, this is what they were doing all along, and only now do they come clean about it’].  I take the view that the above target inflation was a brave, wise and deliberate overshoot, a price worth paying for temporarily higher output and lower unemployment [even if the BoE’s MPC did not always describe it in this way].  However, a sold period of being shown to achieve inflation around 2 per cent, instead of inflation around 5-6 per cent, would make a subsequent target hike look more like a considered policy change, and less Machiavellian.

If such a raise were contemplated, I would counsel that it should be accompanied by changes in the statutory framework for the BoE that would do away with the power to change the target by the mere writing of a letter, to allay suspicions that the political authorities would acquire a taste for writing more of them.  This surprising piece of discretion is anyway an anachronism, associated with the understandable trepidation that New Labour felt in 1997 at handing over responsibility for monetary policy to the Bank of England.  It hasn’t turned out so badly as Ed Balls, then Gordon Brown’s advisor, and presumed architect of the current system, must have feared.  And anyway, it is surely enough that the Treasury make most of the  appointments to the Monetary Policy Committee, and retain emergency powers to take back control over interest rates.

What about the Eurozone?  The ECB devised its own objectives and has the power to revise them.  Provided they can be interpreted as achieving the vague ‘price stability’ mandate that constrains it.  There the case for an inflation target rise to make more room above the ZLB is even more compelling, since the difficulties of coordinating substitute stimulus policies (conventional tax and spend policies, or quantitative easing) are, as we have been watching, much greater.  However, the timing would be even worse, with the ECB already struggling to get EZ inflation even close to its inflation target.

And the political chances of such a venture must be considered almost nil.  It would require persuading the Germans, whose cooperation is already stretched to its inadequate limits.  The Germans also operate under their own price stability constitution clause, actively policed by its judiciary.   It’s conceivable that a higher inflation target could be legally defended as, somewhat perversely, preserving ‘price stability’.  If the result of a higher target was to eliminate the chance of becoming trapped at the zero bound, inducing intractable deflation, or perhaps losing control of the price level altogether, then higher inflation might mean more stable prices.  It could certainly be interpreted to be a measure to generate more price controllability and predictability.  But though such a legal strategy seems conceivable, it seems highly unlikely to succeed.

Did economics fail? Reflecting on the Krugman and Wren-Lewis responses

Paul Krugman and Simon Wren Lewis give my post on the unresolved nature of state of the art macro a good kicking.

Paul characterises me as saying that macro has nothing useful to say, and that justifies doing nothing about anything.  This greatly misstates my meaning.  My post is about how reasonable people could cite differing theories and evidence to back prescriptions for the appropriate policy response to the crisis that embrace not only Paul and Simon’s own [UK and US should have stimulated even more than they did] but also what actually happened.  [Both countries engaged in huge fiscal stimuli anyway].

Modern macro offers lots of advice, but it doesn’t confer certainty on policymakers.  (Though it even offers lots of useful advice about what to do about that uncertainty).  The way to respond to that is, in my view to try to be Bayesian about it.  Put weights on the competing explanations of what you see, and the corresponding policy prescriptions, and what you do will be, crudely, a weighted sum of what you would have done in each of the competing world-views.   Paul and Simon put all their probability mass on the IS/LM/New Keynesian explanation that there was far more demand deficiency than was responded to by the increase in the deficit.  I don’t.  In fact, I think it’s perverse to put all your weight on an explanation that has no role for the financial sector;  that ignores the rough constancy of inflation, or at least explanations that include the stimulus having been large enough, roughly;  that sweeps aside important questions about the value of money (surely a big no-no at the zero bound), and many more (see my long paragraph, third from bottom, in the original post, for all the questions up for grabs, none of which are dealt with by either Paul or Simon).

Paul concludes with a worry about my motives.  Is my reluctance to come down on his side ‘distaste’ that economics should ever have to confront the messy task of doing something useful?  Not at all.  It’s part of a debate about how to translate what we know into sound advice.  Sound advice being advice that communicates a fair sense of the range of plausible competing views and corresponding prescriptions.  If we don’t do that, the policymaking clients may listen for a while, but they may conclude at some point that the other views are being left out of the picture for political reasons.

David Andolfatto defends me, spotting that Paul and Simon incorrectly translate my post into a message of ‘do nothing because it’s all very uncertain’.  Simon responded to this with his post ‘humility and chameleons’.  The nub of that seemed to be that we should be wary of letting politicians do what they want just because we have a few thought-provoking but whacky models on the table that give opposite prescriptions to those we feel are right.

On its own that’s a fair point.  But hang on.  You don’t have to put chameleon models on the table to overturn Paul and Simon’s view that fiscal policy was drastically too tight in the US and the UK.  You could, for example (though I don’t) put all your weight on the unadulterated New Keynesian model that Paul and Simon use to justify even more stimulus.  That model, to repeat, says:  if inflation is roughly on target, you are done.  On-target inflation means that whatever other reduction in activity you are observing and feel you should be correcting you should be doing with some other policy (like – if you modify the model to attempt to explain the key thing that happened in the crisis, namely the contraction in credit – intervening to expand credit (presumably more aggressively than either the Fed or the BoE did with its credit easing policies)).

Simon points out that you don’t have to take the models instructions lock stock and barrel.  In particular, you could question whether it’s instruction that inflation fluctuations are an order of magnitude more concerning than fluctuations in real activity is valid.  True.  (Although Simon’s reference to the heterogeneous agent literature won’t work, I suspect, for reasons that would require another post to explain).  However, your Bayesian policy maker could reserve SOME weight for taking the model as it comes.

Digging into the particular issue Simon raises about the concern for inflation helps to make my main point that this sticky price model can’t be the be all and end all policy model.  So…  Dispense with that relative weight on inflation versus output, and you are querying whether you have got agents’ utility functions messed up.  Or whether indeed they are utility maximising at all.  You are also implicitly worried that the assumption that firms and workers would have to respond to the volatility in relative prices caused by inflation by meeting all the attendant fluctuations in demand is not right.  (And rightly so).  And you are saying to yourself:  hang on, should we really think of firms as worrying that there is some chance they will NEVER EVER change their prices?  All these things would be legitimate concerns.  Responding to them would probably not get rid of the desirability of counter-cyclical fiscal policy but it could easily lead to arguing for less stimulus than we saw, or more.  When you look at this family of models closely, it’s pretty whacky itself isn’t it?

But, even if you ignored all of this, what if you said to yourself: ok, I’m taking the model lock stock and barrel, except the bit about how important inflation fluctuations are, and I’m going to estimate it, and see what those estimates imply for explanations of the crisis, and policy prescriptions.  An unfortunate fact of life is that this model, and most others like it are, in the jargon, badly identified.  Macro data are going to leave you with a lot of uncertainty about all the parameters in the model, and the model’s explanations of which shock caused what, and that is going to translate into a LOT of uncertainty about policy, easily enough to embrace the competing calls for looser or tighter policy in the UK.  Not enough to embrace the ‘get rid of the state altogether’ view of the Tea Party.  But still.

Did economics fail?

Paul Krugman says that economics had the answer to how to respond to the crisis.  It’s just that policy failed to follow the prescription.  The textbook said that private demand was deficient, and that what we needed was more public spending to fill the gap.

I don’t think this tells even nearly all the story.  The ‘textbook’ just isn’t as unambiguous as PK would have you think.  The reasonable and non-partisan economist could take widely differing views on what should be done.  And many of these are built on models which are silent about the mechanisms that gave rise to the crisis in the first place.  Economics hasn’t properly resolved what caused the crisis nor how best to respond to it.  All the big questions are still up for grabs.  Into this gap plunged policymakers who had to do something about it without a clear prescription, and were given the opportunity to fashion a response that pandered to their own political instincts (UK Tory desire for a small state).  In the case of the US, the up-for-grabness of the economics leant strength to the Tea Party Republicans pushing the argument that failed state policy could only be cured by less state, not more.

The old (but, historically, still ‘post’) Keynesian, IS/LM account of deficient demand, pretty much resembles the more modern account embedded in the rational expectations, sticky price models, dubbed ‘new’ Keynesian.  But using these models to prescribe drastic fiscal expansions that greatly exceeded what we saw is problematic.  In the UK, inflation exceeded target substantially.  In the US, it has not fallen all that much below it.  Modifications of the New Keynesian model that have a financial sector explain the recession as a dramatic constriction in credit supply that both strangles output, and creates inflationary pressure (offsetting the depressing effect on inflation coming from the fall in demand).

Following this line of argument, conventional demand-side fiscal policy was roughly on track.   You might argue that we ought to have had very great deviations of above target inflation, and much looser conventional fiscal policy.  But to do this you would have to ditch what those models say about the costs of inflation.  They contain the view that inflation fluctuations are an order of magnitude more costly than fluctuations in real activity.   So much the worse for them, you might say.  And policy makers frequently have said this.  But, with the models thus binned, you are in the dark about what should be done.  And there’s no way you can then argue that economics gives a clear answer, since you have discarded the one bottom-to-top [microfounded] answer it does give.  Granted, not everyone goes in for bottom-to-topness.  But that just reinforces my point that there is no sound economic answer.

Things are obviously worse than this, because the models that Paul Krugman is using to reason his way to arguing for a drastic further fiscal stimulus don’t contain financial sectors.  And the ones that get bolted onto the New Keynesian models to argue that policy was about right contain financial sectors that aren’t subject to systemic runs;  don’t malfunction therefore in the way that the real one did.

One of the themes of the early post crisis debate was the controversy between those like the Tory-led Coalition in the UK who warned about the possibility of a run on UK sovereign bonds, and those like PK who dismissed these concerns as opportunistic invoking of the ‘bond market fairy’.

PK would have history judge that he made the right call on this.  Certainly there were no runs on UK or US bonds.  But economics itself could not have given such an unambiguous a steer as PK claims.  The literature on optimal fiscal policy is riddled with ambiguity.  How to view what government does:  wasteful, substituting, complementing private expenditure?  How to model the possibility of runs, and on what they might depend?  Whether to accept the possibility of the fiscal theory of the price level.  [And whether this should be viewed as a difficulty or, as Sims sometimes suggested, an opportunity].   How to account for why people hold money.  [Without a good account of that, we can’t confidently say how they will price nominal bonds].  Whether the government can be viewed as being able to commit;  if not, whether it can acquire a reputation for good behaviour.  [If they can commit, then borrow now pay later strategies will work better].  Whether prices are sticky or not.  [This affects how much work fiscal policy should do to stabilise].  How to assess the tensions in the intergenerational conflicts over fiscal policy.  [Another take on the commitment problem].  How to produce normative guidelines for good fiscal policy that weighs concerns of competing generations.  The imponderable questions regarding how policy should deal with uncertainty, applied to the task of designing fiscal policy.  [How to weigh the unknown risks of a sovereign run, versus a deflationary spiral, for example].

I don’t know what economics PK has read.  But the miserably small quantity of serious reading I have managed on the above issues leaves me thinking that economics does not offer the clear advice PK claims.   PK seems to be backing away from all these intractable debates about the detail, and saying that we can ignore it.  Big picture, demand was weak, public demand had to be stronger.  Politicians did not get this message clearly enough, and were able to ignore it.  End of story.  Well, maybe.  Maybe not.  Perhaps only great minds can see the wood for all these unfinished modelling trees.  But to me it looks like a mess that many decades of future research may not sort out.

I think a plausible account of public policy failure is  that our economics profession had not yet come up with clear answers.  And in the absence of this politicians were free (or perhaps had no choice but) to be guided by their baser political imperatives.

 

The Bank of England isn’t institutionally doveish

Chris Giles wrote that the Bank of England was ‘institutionally doveish’, recalling when the London Metropolitan Police was labelled as ‘institutionally racist’.  I don’t agree, despite that Chris’ article pre-empted the Bank of England’s Monetary Policy Committee leaving interest rates on hold on 8 May.

The hawks/doves label gets used a lot, but it’s worth digging to recap on what it might sensibly mean.  In the context of monetary policy, it could mean either:  i) having the view that the inflation target should be higher than the one given to the BoE by the Treasury.  Or ii) leaning towards more tolerance of deviations of inflation from target, as against fluctuations in real activity, compared to the mandate (if the mandate implies anything clear at all) or (if not) compared to your typical monetary policymaker.  Perhaps we could also think of iii) a dove who considers an undershoot of the inflation target more costly than an overshoot [which would lead, if this person held sway, to guesses at the average inflation outcome to being higher].  A fourth kind of doveishness would be more innocent. Simply viewing the conjuncture right now as implying the need for more stimulus than others, or as requiring that it is not monetary policy, but, say macro prudential policy that would be needed.

Pursuing a higher than mandated inflation target would be hazardous for the career of a monetary policymaker.  The MPC are individually accountable for their votes.  And all recent incumbents have hoped to move on to further rewarding jobs in their careers, if not even promotion within the monetary policymaking profession.  There’s a lot to risk by engaging in average inflation deceit.  Pursuing it as a committee would require a great deal of private coordination and enforcement, across a shifting committee full of outspoken personalities, who would recognise that there would be benefits to being seen as the one to rescue the monetary framework from such abuse.  Not impossible, but highly unlikely.  Hard to pull off for a new Governor.

Being doveish on deviations of inflation from target is much more plausible.  But it’s also entirely reasonable.  There is no cast iron message from experience or from the academic literature to draw on regarding how such deviations should be weighed relative to fluctuations in real activity.  The models that the MPC use to set policy embody the message that fluctuations in price and wage inflation from target together should be weighed an order of magnitude greater than fluctuations in real activity.  But this result relies on taking the models literally.  Which the MPC often don’t, overlaying their forecasts with heavy doses of judgement (no doubt wisely), and occasionally hinting that they weigh inflation versus real fluctuations roughly equally [for example, Charlie Bean’s comment that his ‘lamda’ was 1].  Contrast this with the observation Danny Blanchflower (former MPC member himself) often reminds me of on Twitter, that survey measures of respondents contentment record that inflation fluctuations cause only 1/5 the misery of unemployment fluctuations.

Based on this, you would have to say that reasonable people can disagree a lot about the relative costs of deviations of inflation from target, and deviations of activity from its natural rate.  And you would therefore be hard-pressed to pronounce that a policymaker or a policy is doveish.  Unfortunately, commentaries such as Chris Giles’ flourish in the silence the MPC (and other policymakers) maintain about just how they weigh their competing goals, and how they see their ‘reaction functions’ [their plans of how to respond to events as they unfold].  More constructively, the response to comments like Chris’ should be to provide enough clarity to rule out charges of doveish subersion of the mandate.

What about doveishness on undershoots relative to overshoots?  Well, in my view this would be entirely justified.  Overshoots can be quashed with tried and tested and relatively riskless methods for tightening:  raising rates, hiking taxes or cutting government spending.  Undershoots when the interest rate is trapped at the zero bound are to be avoided more energetically, because we have much more dubious tools to fight them.  QE is more controversial.  Even some QE believers view it as ineffectual in well-functioning markets.  And some view it as effective but costly.  Add to that, the current Government has been politically unable to stand by to follow a clear, discretionary policy of loosening in the face of worsening conditions.  (Though, as I and others wrote before, it did loosen quietly, while insisting it hadn’t).  The cost would have been to concede victory to the opposition.  Also, much economic theory points to undershoots containing the danger of being forever trapped at the zero bound, enduring deflation.  Even if you don’t put much weight on such evidence, the experience of Japan is enough to justify guarding against inflation target undershoots more energetically, when the zero bound is in play, than overshoots.

What about ‘conjunctural doveishness’?  This is a possibility.  Over time, if the apparent doveishness of the MPC were to derive from this source, we should see it reverse itself, or at least disappear, as the business cycle moves into another phase, and shocks of a different sign are experienced.  Right now, it’s an open question.  But once again, empirical and theoretical models could give plausible but widely disagreeing signals on the best policy right now.  And reasonable people just arguing from charts and hunches could also disagree.  So this is not enough to convict.

The label ‘institutionally’ doveish raises the additional possibility that the Bank’s monetary policymakers are advised by staff that fall prey to one of the intellectual flaws identified above (supposing we accept that they are flaws for the moment).   Two points.  First, in my experience, there was little or no staff-MPC interaction on the question of the MPC’s goals (and little discussion of which I was aware of goals, period).  Second, if there were an institutional view amongst staff, it would be one that i) bought the basic idea that it is futile to try to get unemployment permanently lower by choosing higher inflation, [a piece of wisdom absorbed from their orthodox macroeconomics teaching!] and ii) that it was vital to execute the Bank’s mandates faithfully to safeguard the BoE’s reputation for not abusing its independence, ie that the mandate was sacrosanct.

You might worry that perhaps Carney, with doveishness of whatever sort, had subdued the staff with his views, and stifled challenge to them, or somehow therefore tainted the advice staff gave to other members.  Who knows.  But this would be a difficult task for a new Governor and one here for only 1 term.  Surely a 1-term Governor does not an institutionally doveish staff make.

Don’t underestimate the pivotal and persistent role of the banking crisis

Paul Krugman responds to Martin Wolf and John Cochrane arguing for narrow banking [allowing banks simply to take our cash and invest in risk free securities] in part by commenting that the banking crisis came and went quickly, and that the real problem lay elsewhere, in the debt overhang and deficient demand.  Therefore, the banking crisis was not decisive in bringing about the recession.  For that reason, don’t get so excited about the need to outlaw traditional banking.

Leaving aside the debate about how to regulate banks, this description of the crisis, although it’s an intriguing idea [if it’s just a matter of the occasional spike in spreads, why not run things as they are?] caused me some trouble.  Some reactions below.

1.  Although many spreads have normalised [accounting, I guess, for that normalisation of the St Louis Fed stress index Paul Krugman points to], I conjecture that the harm to banks is more persistent.  They have found themselves, in part pressured by their shareholder valuations, to delever.  This has constrained net lending, and aggravated the depth and length of the recession.

2.  Some markets remain closed, even now.  I guess these prices must be excluded from such a stress index.

3.  Weighing on banks’ behaviour has been the uncertainty about the long run regulatory regime.  And, in the UK, surrounding the regulators’ preferred path of getting the banks to that [uncertain] point.

4.  Also weighing is the desire not to crystallise losses, given current accounting and regulatory practices.  This has been talked about as an acute problem in Japan.  It’s an emerging one in the UK, with the FPC spending much effort pondering how much forbearance there is.

5.  Part of the normalisation of some prices is perhaps the expectation that the authorities will not allow a repeat of Lehmans’.  This is must surely be why peripheral EZ spreads have normalised:  banks are not really solvent, but with the ECB bluffing that it will buy whatever quantity of sovereign debt necessary, the sovereigns are solvent, and therefore they can credibly stand behind the peripheral banks.  It is probably also why similar measures are normalised for the UK.  This is less satisfactory as a description of the US, where it seems the Fed would be unable to repeat the bail out of Bear Sterns.  Unless we are to fathom that, in another crisis, the executive would find away to change course again, and Republican insistence on non-intervention could be won over.  Anyway, the point of this is to argue that the crisis hasn’t gone away, it’s just that the risk has been socialised.  And that socialisation of the risk is constraining fiscal policy to some degree, and that is contributing to a more protracted recession than we would otherwise have had;  and/or spending is weak because private agents worry about the long term health of their sovereigns, whom, ultimately, they stand behind.

6.  Although it may be true that the proximate cause of the protracted recession is household and corporate debt, the real reason may lie in the crisis in banking and intermediation.  Borrowers were offered debt at unsustainably low prices by a financial sector mis-pricing, over-optimistic about the future, or leaning on the state’s future support, or all three.  Now, with either normal or still abnormally high spreads, debt has to fall and demand is therefore weak.  If [excuse mixed metaphor] there was a magic wand to iron out surges and troughs in intermediation, we would not have had the debt build up, and would not be suffering a period of protracted weak demand as it was paid down.

Following this reasoning, it’s vital to sort out whether something can be done to get banks and other intermediaries to behave better.  And it may well be that their behaviour even now, with the immediate threat of deposit or market runs receded, is dragging on activity.

If the central bank rate falls, does inflation rise or fall? The limits of verbal reasoning.

Noah Smith and Ryan Avent got his debate going again, a conversation whose last incarnation was an exchange between Steve Williamson and Paul Krugman, essentially, sparked by Steve asserting that inflation was too low because Fed rates were too low.  Chris Dillow has offered his own contribution.

The latest exchange, for my money, shows the limit of verbal reasoning about questions in monetary economics, and lack of prior exposure to the long past literature on this.  This literature isn’t necessarily right (about what would happen in the real world).  But it offers a menu of what ifs, a menu to which these blog posts are essentially trying to add.  Noah and Ryan wrestle with the impact of expectations on current prices.  Chris wrestles with different ‘mechanisms’.  All of them seem to me to get trapped by the pitfalls of the initial thought experiment.

First thing to say.  If expectations are rational – in the jargon this means if agents know how the model works, what the central bank is doing – then under either sticky prices, or flexible prices, a wide class of models gives the answer that if the central bank holds the interest rate down at a fixed level for ever (even for a long time) ANYTHING can happen to inflation.  You have what is known as ‘indeterminacy’.   There are infinitely many values for inflation expectations and thus inflation consistent with any given value for the shocks hitting the economy.    This has been known since Sargent and Wallace.  And was later studied by McCallum, Woodford, Evans and Honkapohja, Bullard and many others.

It may well be unrealistic to suppose rational expectations for an experiment like this.  If expectations follow processes generated by least squares learning, or similar, then holding the interest rates down for a long period, or forever, is highly likely to generate violent instability in inflation.  So, in a slightly different way, if we were to ask what inflation might turn out to be some time down the road, we would have to say : who knows, anything could happen.

Holding inflation constant, we can then only really ask questions about what would happen if interest rates were held temporarily lower than were dictated by a monetary rule that, once followed subsequently, were sufficient to guarantee determinacy or stability.  The answer to that question we know in a wide class of models.  Inflation rises if interest rates fall.  Temporarily.  Thereafter, interest rates rise to combat the unwanted loosening, and the rise in inflation, and eventually all settles back to steady state.  So far as I know, none of this depends on whether expectations are rational, or prices are sticky.

We can ask questions about what would happen if the inflation target were to change permanently.  If it were to fall, then in the long run, so would nominal interest rates, by the same amount [leaving aside, as most of the models I am subblogging [term coined to mean blogging without referencing properly, derived from subtweeting] do, the costs of inflation].  In the mean time, what happens to nominal rates depends on whether prices are sticky or not.  If they are flexible, then nominal interest rates would fall immediately, and correspondingly.  If sticky, then initially nominal rates would have to rise before settling back to a lower steady state.   I don’t think this result would depend on expectations.

I recall being mystified by Steve Williamson’s cryptic suggestion that the Fed is causing low inflation with low interest rates.  Because presumably he meant ‘despite telling everyone that their inflation target was 2 per cent, roughly’.   I was mystified because I know he understands the models I have just cantered through better than I do, where this isn’t true.  These models exclude models in which money is modelled in a way that would satisfy Steve and the other ‘new monetarists’.   I don’t know what happens in these models.  Or if versions of them have been developed that are sufficiently realistic in other respects to allow us to compare.

A final nihilistic contribution was made by Cochrane, in his JPE paper of a few years ago.  If I can offer the most ridiculously short summary of a long and hard paper ever attempted, I’d say that this paper says ‘even when modellers using the rational expectations sticky price model say that things are determinate, they may not be, though they are certainly not when they say they aren’t.’  Which means that you have to go back over what I said, and note that where I said we might get a definite answer, instead of ‘anything’, we might actually just get ‘anything’.

Anyway, that was a rather hurried post, offered really as an elaboration on a few tweets I have sent out.  I don’t pretend that they describe the real world, but I hope that they ring some alarm bells about the care that bloggers need to take when they pose and try to answer the question ‘what happens to inflation if the central bank cuts rates?’  You need to say:  for how long, and why exactly is it cutting rates?  Is that part of a revision of the monetary rule?  And you may have to ask yourself whether you can decide on whether prices are sticky or not, and on whether the change is comprehended or believed by the private sector.

Update.  [This is why I should stick to the Simon Wren Lewis rule of only posting what you wrote yesterday].

This discussion is not of purely academic interest, though it sounds nerdy and pointless.  Recall where it started.  Core inflation is sliding in the US and the ECB [and possibly in the UK too].  Does this mean that central banks should double down and keep rates lower for longer [this is how central bankers would see it, and this is how monetary econ as summarised above would have it], or is low inflation, by contrast, caused by the low rates?  It’s pretty crucial to settle this.

Relatedly, the discussion connects with recent efforts by the Bank of Canada, Fed and the BoE to stimulate the economy by announcing that rates will be held low, and fixed, at their natural floors, for long periods of time, before eventually rising, a policy they have dubbed ‘Forward Guidance’.  We know that the rational expectations, sticky price models used by central banks behave VERY weirdly indeed as we vary the number of quarters for which interest rates are held fixed.  Work by my former colleague Matthias Paustian and coauthors shows, for example, that you can get that a loosening implemented this way can generate a massive inflation, or, if the number of quarters is changed just a little, a massive deflation.  One presumes that central bank modellers have found some kind of fix for this [or have decided to just ignore it].  But these results must leave us with some disquiet about i) whether the models are the final word on the matter and ii) whether the central bank policymakers really can say that they have a clue what will happen to the economy under Forward Guidance.

I will revise this post with links later tonight.

If I was devising a panics and bubbles course…

In a recent FT article, Claire Jones reported on the decision by Manchester University to reject a proposal for a course on ‘Panics and bubbles’, the initiative of the Manchester students’ pressure group ‘Post Crash Economics‘ and sympathetic academics.

On the limited evidence of the course reading list, I thought that the course missed a great deal.  I also thought that Claire’s article was a bit one-sided, implying that the decision to ditch the course illustrated the continued, ostrich-like stupidity of the economics profession.

Claire’s article invoked two wise spirits in favour of the Manchester course.  One was Wendy Carlin, who has led an Economic and Social Research Council-funded effort to overhaul the teaching of macroeconomics.  But Wendy’s (excellent effort) doesn’t urge binning the macroeconomics canon in favour of Austrian or informal analysis [as the PCE lot seem to advocate].  It’s centrepiece is to try to get the New Keynesian model used by central banks to be the focus of the undergraduate macro canon, rather than the older IS/LM model, harder to relate to contemporary debates (without the obduracy and genius of Paul Krugman).  This is decidedly mainstream (and welcome).

The other spirit invoked by Claire was Andy Haldane, outgoing Executive Director for financial stability at the Bank of England.  Claire quotes Andy as saying, in support of the PCE’s manifesto:  “The economy in crisis behaved more like slime descending a warehouse wall than Newton’s pendulum, its motion more organic than harmonic.”  Two points.  Take a look at Andy’s cv of papers and speeches, and you find them peppered with formal, mathematical, decidedly mainstream work, or references to them [more on this later].  Second, this metaphor from Andy could rather be taken to be a call to get more mathematical (and therefore ‘mainstream’), not less.  The inference is that the crisis is like a fluid dynamics problem [comment stolen from friend who has to remain nameless].  The study of fluid dynamics  is built from heavy-duty applied mathematics [more so than frontier economics, perhaps].  Students wanting to draw the analogy between the financial crash and organic processes had better stop chatting about Austrian economics and start crunching exotic nonlinear ordinary differential equations [or rather, starting the slow and painful process of learning how to do it].  Even if heterodoxy is to be the new orthodoxy, students are going to need suffer the trials of dynamic mathematics.

Looking through the reading list for the PCE Manchester course, and presuming that this list sketches its scope, it seemed to miss the grand flowering of mainstream financial macro and microeconomics.  If I were teaching a course on panics and bubbles, I would try to give a guided tour of it.  For example…

– I would take them through Diamond and Dybvig’s classic model of banks runs, how redeeming deposits on a first come first served basis causes runs on even healthy banks.  And I would take them through the analyses of moral hazard in the provision of public deposit insurance to stop these runs [for example, see the references in Sargent’s LSE lecture, or indeed Andy Haldane’s speeches].

– I would discuss with them Geanakoplos’ work on how leverage and bouts of optimism creates booms and busts in asset prices.

– I would devote time to discussing rational expectations, monetary, overlapping generations models of fiat money, in which one can see that money acts like a ‘bubble’, and which serve to explain in the purest sense what a bubble can mean, of the kind recounted in the famous conference volume edited by Karaken and Wallace.

– I would try to give a taste of the work of Angelotos and co-authors, Morris and Shin and Shleifer and Vishny who have sought to model how beliefs (eg about the value of an asset, or the likelihood of a future event) can spread and become self-fulfilling.  And I would talk about the foundational work too of Roger Farmer and co-authors establishing the macroeconomics of self-fulfilling prophecies in rational expectations models;  these insights showed how pure shocks to expectations [like waking up and feeling pessimistic for no reason] can cause business cycles.

– I would give some time over to explaining the work of Hansen, Sargent, Cogley, Colacito, Ellison and other collaborators who have shown how asset prices can rise and fall as investors, doubtful of their own models of the dividends from holding an asset, revise their forecasts, and adjust their portfolios to prepare themselves for the worst.  [And, using similar techniques, how monetary policymakers may have aggravated booms and bust, weighing up the signals from competing models of the economy].

– I would make students read the literature on learning in macroeconomics, from its origins in Bray and Savin [and earlier], Marcet and Sargent, through to more recent applications by Adam and Marcet, who showed how cycles in share or house prices can be induced by learning agents revising forecasts of the value of the assets they hold.

– I would try to introduce the economics of networks;  related modern models of money whose value comes about as a way to economise on search for exchange partners, and which give one clear insight into the meaning of ‘liquidity’, (and thus into how liquidity can appear and disappear).

And having done all that, I would regret that there wasn’t time to devote a whole degree to the topic, and I would stuff the reading list with reams of papers I hadn’t even properly read myself, perhaps sentimentally hoping to entice a student to come back for more in postgraduate study.  I’d list Brunnermeir and Sannikov’s work [A survey by the former did make the reading list, as Claire Jones pointed out to me]; I’d tantalise them with the Clarendon lectures of Shin, and John Moore.  I’d offer the collected works of the Kiyotaki-Moore collaboration.  I’d retrospectively regret that I hadn’t had time to lay out standard models of macro-finance and their failures, set out in the sequence of papers by Lucas, Svensson, Mehra and Prescott, Campbell and Cochrane, Epstein and Zin, Fama, Shiller and many more, and, not knowing what to do about it, I’d slap them down in the reading list to perplex the students further.  And, in the same vein, I’d regret that I hadn’t yet set out the standard ways of including banking and finance in macro [due to Bernanke, Gertler, Gilchrist, Carlsrom, Fuerst, and others], where no bubbles and panics prevail, but one gets insight into how to formalise what finance does, and how it can amplify business cycles.  So I would shove all of those into the reading list too, wishing instead that another module could be taught on that.  And then, right before signing off and sending it out to the Faculty Committee responsible for approving the course, I’d fret that there was nothing on empirical macro.  After all, we might talk about panics and bubbles causing booms and busts, but how have people rolled up their sleeves to figure out what did cause business cycles?  And then another alarm bell would go off, worrying that students could hardly be expected to make sense of this without a proper introduction to game theory.  And then another, warning that we had not touched on the economics of financial regulation, or its political economy…

I don’t really know why the proposal for the Manchester course on panics and bubbles was rejected.  But, if it were me, I would have ditched it too, in favour of a course that looked more like the above.

 

The flaws in Osborne’s ‘I told you so’ speech in Washington

UK Finance Minister George Osborne’s Washington ‘I told you so’ speech  has prompted a thorough going over of the issue of what the recovery in the UK does or does not prove regarding the Coalition’s ‘austerity’ fiscal policy, by Chris Giles, Jonathan Portes, and Simon Wren-Lewis.

I want to add one point to this.  One of the challenges for what Osborne calls the ‘fiscalist’ position [the position that it was tight fiscal policy that aggravated the recession, and that it was its gradual loosening that caused the recession to wane] is that they purportedly need to show that the pace of consolidation slackened, causing the subsequent pick up in growth.

Jonathan Portes’ patient review of the facts showed that indeed the pace of consolidation, measured by the speed at which the cyclically-adjusted, structural deficit falls, did indeed drop off, a bit.  So, if this were a correct challenge, Portes shows that it was met.

However, seen through the lens of a modern macro model, Osborne’s challenge to the ‘fiscalist’ position may be false.   We might guess that what happened in May 2010 was a switch between two fiscal rules, towards one that entailed a less generous use of deficits to counter recessions, and a lower average debt to GDP ratio.  When people in the economy realised that this switch was going to happen, and what it entailed [a process that probably began some time before the election, as it was clear that Labour were not going to hold on to power, but was not complete until well after it, when the fog cleared on Treasury plans], they cut back their own spending, say, anticipating higher taxes and lower disposable income.  However, as the rule was followed through, no further belt-tightening by the private-sector was needed.  Although taxes and spending were doing what they needed to do to bring about the lower [relative to Labour plans] final debt to GDP ratio, private sector spending did not need to adjust further on account of these plans being followed through.

Actually, in the language of these rules, one might argue that fiscal policy loosened relative to the first post-2010-election plans, as the time over which the deficit was to be closed was lengthened.  [A rules-based echo of the ‘ever smaller fiscal shocks’ hypothesis that Osborne puts in the mouth of the ‘fiscalists’].  This actually works in favour of what Osborne called the ‘fiscalist’ position.  On account of this  loosening (relaxation of the pace of structural deficit elimination) one might expect some stimulus to private spending:  belts did not need to be as tight as consumers and firms had chosen to fasten them.  So consumers could treat themselves.

The key point here is that changes in the structural deficit may be anticipated to some extent, since they are pre-announced and part of an overall design [=’rule’] so these changes don’t measure fiscal impulses or shocks whose effect we then go looking for in private sector spending.

The argument above has been drastically simplified [believe it or not] to make a point.

For instance, you might wonder at the notion that we should assume that the private sector understands government plans.  [Osborne has repeatedly tried to confuse and disempower his audience, not least in this latest speech, with his claims for austerity’s supposed stimulus, or by denying that there was any change in plans].  Perhaps it took time to sink in, so each change in the structural deficit was felt like a new disruption to their own private plans.  If this were the case, then the Osborne challenge is less incorrect.  [But recall that Jonathan Portes answered it.]

Or, by contrast, perhaps we should think of the private sector as rational and sceptical;  never in the first place believing that Osborne would have the stomach to see such plans through to the extent announced.  In this case, the logic I sketched is still right, and the Osborne challenge is false.  So long as the private sector’s guess at the final path for fiscal outcomes [strictly speaking fiscal intentions] doesn’t change, no further readjustments in private spending plans would be needed.

The other big simplification is that there were lots of other things going on at the time.  Confidence in the UK [and around the world] was rescued by apprehending that the US fiscal stimulus was working, and that, bit by bit, the Eurozone authorities were getting to grips with their sovereign debt crisis, and that steps by the UK authorities to shore up the financial sector had worked and would hold.  It is possible [indeed surely most likely] that this is the dominant reason why growth recovered in the UK.  Even if the Osborne challenge to fiscalists were sound [that you can measure the extent of fiscal shocks by the profile of the structural deficit] their impact could easily be swamped by changes in demand induced by the private sector response to these global events.  This final appeal to the notion of the counterfactual might seem repetitive, but it seems appropriately repetitive, since George Osborne has so frequently try to abuse it.