Saving the euro with second order Ricardian non-equivalence

This post picks up on Draghis’ comments that buying riskier assets can be better for the stabilising properties of the ECB’s forthcoming credit easing.  The title looks like it’s calculated to put readers off.  But 1) it’s Friday, 2) I’m tired after spending the afternoon re-learning how to derive the Kalman Filter for students and 3) it’s factually correct.

What you might call first order Ricardian equivalence is the claim that giving consumers a tax cut won’t increase spending, because they correctly foresee that in the future, taxes will have to rise again to repay the debt that was incurred financing the tax cut in the first place.  It fails for many reasons, not least that consumers don’t forecast as well or behave as optimally as we macroeconomists take them to in our models.  And also that the timing of taxes matters.  If I am pressed up against my borrowing constraint and struggling to feed my family on a measly academic salary (purely hypothetical, you’ll understand) I will be glad of extra disposable income now, and knowing that in a few years time taxes will be a bit higher, and the income will be clawed back, won’t negate the benefit.  The fallacious Ricardian Equivalence argument is not just academic, as it got a run around in the debates about the usefulness of the fiscal stimulus in the early part of the crisis.

Hard-line second order Ricardian Equivalence people would say that whether the ECB takes risky assets onto its balance sheet or not shouldn’t affect spending in the private sector in the eurozone.  Banks get relieved of the risk, which is great.  But the risk is now borne by the ECB, and ultimately by the ECB’s owners – eurozone governments – and that risk means more variance in (or larger second moments of) taxes and spending to make up for it.  So the private sector’s risk doesn’t change, though the routes through which the risk impacts its income does.  You could call this second order Ricardian Equivalence, because it’s about how the variance (second moment) of returns of the private sector’s cash-flows is not changed by undertaking asset purchases (or whatever).

Which brings us to why purchasing more risky assets from the private sector will be more stimulative.  Although at some point in the future, taxes and spending will have to be adjusted by governments to recapitalise the ECB if things go badly with the assets purchased, the future is some time down the road, when consumers and firms and banks will be all lifted further from their borrowing constraints (Panglossian view for simplicity here) and happy to fork out.  Right now, with deflation a real prospect, bad debts, high cost of finance, the private sector appetite for risk in the eurozone is low, and the ECB taking it off them will be welcome.

Hence the title.  Second order Ricardian non Equivalence refers to the fact that even though the variance of after-tax cashflows at some imaginary end point once purchases have been unwound does not change, the private sector feels better off, because riskiness in the near term, under stress, is more costly to it.

One caveat.  All this works fine for a monetary union where there is no possibility whatsoever of dissolution.  But where there is – eg in the eurozone – there will be some uncertainty about who will make good, or benefit, when the private sector assets come to be sold.  And that will depend on who exits and who is left standing backing the ECB, and on the outcome of any subsequent negotiations with the new ‘outs’ to compensate the ‘ins’.  It seems at least possible that that uncertainty could, in extreme circumstances, weigh as heavily as the risk-relief of the asset purchases themselves.  That might be an argument for these purchases being done directly by the eurozone fiscal agents, with liabilities spelled out up front.   But good luck getting them to agree on anything.

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Short term separation risk: a confidence run at the zero bound with fiscal policy incapacitated

A long-time risk of simply the possibility of a Yes vote for Scottish independence, let alone the actuality, is that investment would dry up in Scotland, and perhaps in the rest of the UK;  deposits and wholesale funding for Scottish banks and other non bank financials would also get re-routed, most likely to the South, but perhaps out of the country altogether.  This conraction in funding liquidity would cause lending to fall, certainly in Scotland, but possibly in the South too, and that would compound the confidence-induced fall in demand.  As polls narrowed, different versions of this story have popped up in financial research notes, and economic commentary.  And the tremors of a confidence shock have started to be felt.  A fall in Sterling and the market capitalisation of firms exposed to Scotland, commercial property deals falling through or being made contingent on a No vote, and so on.

If these trends worsen, we are in trouble.  Monetary policy is, to a first approximation, now powerless to stimulate further.  Rates are stuck at the zero bound, where they have been since 2009.  Long rates don’t leave much room for loosening via forward guidance.  For reasons best known to itself, the Bank of England’s Monetary Policy Committee decided against further asset purchases:  plausibly, the MPC is doubtful as to whether further QE is desirable.  (Some of us never thought it did much good anyway.)

What about fiscal policy?  Surely that could come to the rescue?  Well, this is problematic, for two reasons.

First, with the Coalition’s staying, if not halting of the deficit-reduction plan, the scope for further fiscal expansion on top of what is already being injected, is somewhat limited.

Second, the unravelling of the union makes it much harder to pull off a loosening of discretionary fiscal spending.  How would the soon-to-be-unravelled polity agree to any such program?  Where would money be spent and on what?  Who would be voting on it?   Who would own what the money was spent on, if it went towards infrastructure or some other durable?  How would the crumbling UK governmental infrastructure, with so much to resolve about its own future, and the division of spoils, spare any high quality decision-making time for a fiscal stimulus package?  Would the debt incurred by a stimus package after a Yes vote be treated differently from debt incurred before?  Would there be differently stamped debt to finance spending in Scotland?  Could the stimulus in different regions therefore be different on that account?

A contraction in liquidity and credit, causing, or accompanying a reduction in spending because of shaken confidence about the institutional framework for the UK, would be a great misfortune in normal times.  Trapped at the zero bound with no obvious means of injecting stimulus, it would be a disaster now.  And it seems to me that the very impotence of monetary and fiscal policy would be something that would make such a confidence drop more likely to happen.  Imagine Japan convulsing over how to split in two right now.  Or, er, the Eurozone….

Why ECB purchases could be more stimulative, euro for euro, than UK or US QE.

A short post substantiating my tweet yesterday asserting this, which was picked up by the Guardian, but, all on its own, to those not swimming in this stuff, might look rather odd.

We could think of an ECB purchase of a package of bank loans (an ABS) in two steps. First, it agrees to buy a government security from the bank. Then, in step 2, it agrees to swap this for an ABS issued/held by the bank. In reality, of course, the purchase involves a single step, a straight swap of electronic reserves for the ABS.

However, thinking of the purchases in two synthetic steps highlights why these purchases might be more stimulative than the Fed/BoE asset purchases, which involved straight swaps of reserves for gilts. [Leave aside the earlier Fed purchases of agency debt, and the tiny amounts of corporate paper the BoE bought]. Unless you think the swap stage would have no stimulating effect on the bank, or a negative effect, the ABS purchase must be more stimulative. If one supposes that the value of the government securities is effectively underpinned by Draghi’s earlier promise to invoke ‘Outright Monetary Transactions’ (OMTs), then we presume that the private bank and its funders feel its balance sheet to be less risky if it dispenses with an ABS than a government security. (In the past I blogged that I thought that OMTs were an almighty bluff and was puzzled that markets had not called it. They don’t look like calling it any time soon, so this presumption seems fine.) Wholesale debt funding can now be sourced more cheaply, its equity price will rise, and it will feel able to extend new loans at lower cost, stimulating spending by households and companies dependent on that funding.

Actions like this were urged on the Bank in the early days of the crisis, both publicly, by former MPC member Adam Posen, for example, but also privately, by myself and others on the staff, precisely on the grounds that one would presume them to have a larger bank for buck using this logic. In that case there was less of a question surrounding the credit-worthiness of gilts either, so the conclusion that private asset purchases would be more stimulative was on firmer ground.

This said, as I tweeted, though more stimulative euro for euro, one would presume that the purchases will be on a significantly smaller scale than US/UK QE.  [At least, assuming that there is no subsequent round of straight purchases of government securities].

Draghi post mortem

Draghi’s press conference today left many questions hanging in my mind. Here are a bunch of disjointed responses, recapping on tweets earlier today.

Why didn’t he mention an amount in announcing the start of purchases of private sector assets? Is this because, actually, and as Frances Coppola has intimated, there won’t be a large enough quantity of eligible assets to make it sound like a policy that will really work?

It seems likely this announcement is coloured by what the German constitutional court would view as the ‘fiscalness’ of ECB policies. Buying private sector assets is ‘monetary policy’, in this topsy-turvy world. Doing familiar QE – buying government securities – is fiscal policy, and to be avoided. Note that in the UK, former Governor Mervyn King and others rejected buying private sector assets precisely because this would be seen as fiscal policy, which is properly the concern of the UK Treasury. In the end, these distinctions, as I have blogged in the past, are hard to make concrete.

One presumes that the inflation forecast was not conditioned on any asset purchase program. At a time like this, it would have been great to have one to compare including such a purchase program, so we would know not only it’s size, but the anticipated effects on the ECB’s goal variables. Then we could monitor what the ECB intended to do, and what it intended to do if the economy did not develop, or the purchases did not have the same effect, as anticipated.

It’s a real shame that Draghi feels forced to mention ‘structural reform’ at every turn. At one point he commented that monetary and fiscal policy alone cannot fix Europe. On the contrary, monetary and fiscal policy can fix what the ECB is mandated to care about, namely the possibility that inflation will stray forever below target (and, at a generous interpretation, that the output gap will be negative for a long time). Potential output is the concern of member states and the EU, not the central bank. In fact, as I and others have commented, seen through the model that the ECB itself uses to forecast, structural reform may be deflationary, since it increases output relative to potential, making the output gap more negative. Really all this does – aside from keeping the German ECB board members and politicians onside – is to inject negative noise that reduces confidence in future inflation and real activity in the Euro Area. Imagine the response if Mark Carney said ‘We can’t fix UK secondary education with monetary and fiscal policy alone: we need educational reform.’ Or ‘we can’t fix crime with monetary and fiscal policy alone: we need criminal justice reform.’ How silly it would sound. But this is not really much different from what Draghi said.

It’s frustrating that he and other central bankers fling the word ‘anchored’ around when discussion inflation expectations. What does it mean? If expectations were always equal to target, would that be such a good thing? What if the economy suffered persistent under and overshoots of the target, through no fault of the central bank. Would we wish that private agents nevertheless assumed inflation expectations would always be at target, and suffer the forecast errors? Is this meant to refer only to the fact that longer term expectations are not at target, when the ECB itself expects inflation at that horizon to be at target? If so, then one needs a clearer discussion. We need to understand what the ECB is assuming about why private participants don’t share their own view. Is it that they use a primitive method of extrapolating past inflation to forecast the future? Or do the ECB think that private participants are guessing the economy is in a worse state than the ECB itself think? Or that policy instruments will not be used as has been promised, or will not have the effects the ECB are assuming? And how are the ECB assuming that this world view different from theirs will develop such that the ECB itself can still forecast inflation to be on target eventually?  Is the ECB assuming that everyone comes to share their own world view?  If so, how and why?  Or is the forecast projected on a policy loose enough to compensate for the fact that private expectations stay ‘too low’ and to bring inflation back to target nonetheless?

Draghi mentions that there was not unanimity on the Governing Council regarding this announcement [whatever this announcement amounts to]. Some wanted more stimulus, some less. But if so, what did they want? By how much did it differ in size and nature? How were these minorities outvoted? 1 person 1 vote, or was it weighted by GDP? Are any members allowed a veto on any issue? Do Executive Board members count the same as Governors of member state central banks?

That the ECB cut rates again caused me to reflect on the fact that the UK’s MPC had chosen back in 2008 that the floor of rates would be 0.5%, higher than both the Fed and the ECB. I wonder: does the fact that these other central banks have gone lower without disaster cause the MPC to reflect on whether, if they needed more stimulus from some source, they could cut rates themselves?

A mauling Minsky moment: comment on Martin Wolf

Martin Wolf’s call to arms is a stirring read, and I agree with much of its conclusions on the need for simple and very much tighter regulations on bank leverage.  However, I don’t agree with how they are reached.  Somewhat caricatured, the logic is:  1) as Minsky said, stability and financial systems breeds instability, which explains why our global financial system collapsed.  2)  It follows that we need drastically tighter regulations on bank leverage.

Minsky’s reading of economic systems was a stroke of creative, imaginative but informal genius.  But it’s highly conjectural.  It may be part of the story of the financial collapse that financial system stability is inherently destabilising, or it may not.  Just because intermediation was cheap and plentiful before it became expensive and scarce does not validate Minsky.  There are plenty of other preceding and coincident events which don’t fit.  To go through a few examples:  Technological advancement in intermediation and financial transactions, accompanied by deregulation:  innovation (the destabiliser) did not advance because over some prior (stable) period it hadn’t. (The regulatory story fits, which I’ll return to later).  Calomiris-like tales of political interference in the financial sector:  banks didn’t lobby Governments (destabilising) because previously they hadn’t.  According to that story, they always have and always will.  The export of savings ‘uphill’ from emerging Asia, (destabilising) looking and hoping for safe haven:  this happened because barriers to that capital export were lifted, not because for no other reason capital had been invested locally.  None of these competing narratives of the crisis have anything to do with Minsky’s hypothesis that stability breeds instability. The simplest model of bank runs, which many use as a metaphor for the closure of wholesale funding markets, Diamong and Dybvig, simply says:  runs can happen on healthy banks which borrow short to lend long.  It doesn’t say ‘runs happen because they didn’t happen previously’.

Besides, as a theoretical conjecture, it needs working through.  Before we accept Minsky’s verbal conjecture, what would an artificial economy do if you peopled it with agents with imperfect apprehensions of risk?  Would such artificial systems be characterised by a ‘stability is destabilising’ dynamic?  There are lots of counter-examples in models of less-than-rational expectations.  For example, heuristic models of inflation-forecasting, a field I know more about, often have multiple rest points.  These rest points are not necessarily inherently destabilising.  If shocks are small, they attract the system back.  If shocks are large, the economy might be sent off to another attracting rest point.  There is nothing inevitably cyclical about the volatility of systems like these.  If you hit these systems with shocks so that every now and then a large one arrives, then you will see repeated movements between the rest points.  But you would not describe such models as exhibiting a stability-is-destabilising dynamic.  You would describe them as exhibiting a ‘large shocks cause the economy to move from one rest point to another’ dynamic.  Models of learning would go by the opposite description.   In such models, stability is stabilising;  instability is destabilising.  What causes agents’ forecasting models and the system at large to explode is large shocks:  instability.  There are probably hundreds and hundreds of mathematical systems with potential lessons for economics that don’t fit with Minsky’s hypothesis.   If you follow Paul Krugman’s reasoning, the financial crisis, at least as manifest in spreads, is over and done with.  And it’s lasting consequences for demand and inflation are down to insufficiently stabilising fiscal policy.  There’s no room for a ‘stability is destabilising’ dynamic here.  The future would be bright if Governments simply spent more money raising the natural rate.

But suppose we accept the idea at face value.  One reading of it suggests that we restricting bank leverage as Martin Wolf urges won’t work by itself.  A long period of stability breeding complacency would presumably erode the support for these restrictions.  In a democracy like the UK’s, where by convention no Parliament can bind any of its successors, there would be nothing to stop this complacency leading to future regulatory relaxation.  Is this an argument for something that does bind future Parliaments?  It would be, if we found solid theoretical and empirical support for the stability breeds instability idea as the dominant cause of the crisis.  But we haven’t yet.

 

 

 

Blame the EZ crisis on Woodrow Wilson, not Germany

Paul Krugman and Simon Wren-Lewis characterise the Eurozone crisis as partly or wholly caused by German intransigence, the outcome of which is monetary and fiscal policy that is too tight, forcing an unnecessarily harsh fiscal and competitiveness adjustment on the Southern European countries. Taking the premise of this as true:

If we focus on monetary policy, one could just as well blame it on the Allied powers who enforced the Versailles Treaty on the defeated German nation at the end of World War 1. Indulging in some rather crude history: it was the impossibility of financing reparations that led to Weimar hyperinflation, and then Hitler’s take-over and subsequent determination to reverse German humiliation. And it was the experience of that hyperinflation that led Allied Powers to – with the presumed support of the German elite at the time – enshrine price stability in the constitutionally mandated framework governing the Bundesbank.  That same hyperinflation coloured the Bundesbank’s conservative post World War 2 monetary policy, and the coincidence of the apparent success of that, coupled with the years of monetary-anchor-wilderness faced by the other major economies, as they worked their way through various ways of operating fiat money systems, that meant that this same constitutional price stability provision was to be hard-wired into the EU Treaty.

No doubt this history also coloured other facts, like the location of the ECB within a 5 mins Chauffeur of the Bundesbank, (something that would rebound on the Bundesbank itself, as it struggled to staff junior posts in an institution so close to its more important protoge institution);  the predominance of German appointments in senior positions in the monetary policy functions of the new ECB;  the early emphasis on the ‘monetary pillar’;  the aversion to characterising monetary policy as being about stabilising not just inflation but real activity (which, although the rhetoric has softened, may still be colouring actual policy);  the asymmetry of the inflation target [and its reluctance to call it such] which specifies that inflation shall be ‘close to but below’ 2 per cent;  the fact that the ECB got to define its own objective, safely away from its coalition of political masters, an unusual example in public economics, where principals usually set their agents target, not the agent itself.

So, conjecture: don’t blame the Germans for the ECB’s conservatism. Blame Woodrow Wilson for acceding to the daft Versailles Treaty under pressure from the French premier Clemenceau. [If Keynes’ account in the ‘Consequences…’ is to be believed].  Since the EZ crisis blows back on the UK, US and of course French economies, this is a kind of karmic revenge for the overreaction of the drafters of the German ‘Basic Law’ from which the price stability clause derives.

In Mervyn King’s Ely lecture, he wrote that institutions – like independent central banks, and constitutional provisions for price stability – are a kind of social memory of past learning through experience.  Let’s hope that this is right, and that future monetary and fiscal institutions governing the Eurozone correct for some of the features above which we are learning have contributed to overly conservative monetary policy.

Cue angry comments from proper financial and monetary historians…

Core blimey, Governor

This post recaps on today’s tweetstorm about core inflation, which follows Paul Krugman’s blog on the topic.  It’s late on Friday, productivity levels are falling, and I can defend not doing my bit for my co-authors on my revise and resubmit.

1.  In sticky price models, theory tells us that the optimal inflation rate is one weighted by the stickiness of prices.  So if it could be proven that food and energy are more flexible than other prices, that would legitimate the Fed dropping these prices from the core rate.

2.  By the same token, equal prominence should be given to nominal wages in formulating policy.  If prices were entirely flexible, and  nominal wages sticky, the central bank should be given a nominal wage inflation, not a price inflation target.

3.  Another defensible argument is that some shocks to inflation may come and go more quickly than monetary policy can respond, given, ahem, the long and variable lags between interest rate changes and changes in inflation.   Looking through such shocks may often wind up looking like excluding some prices from the headline index.

4.  It’s also defensible to formulate a core index on grounds of measurement error.  There are two kinds we can envisage.  One is that our statistics agency has the correct concept of price, but simply measures it with random noise induced by sampling.  It has long been known [see for example work by Svensson and Woodford] that optimal policy indicators should weight component variables by how well they are measured.  A similar argument was made by Bryan and Cecchetti in the early 1990s when they argued for the ‘trimmed mean’ inflation rate.  A second kind of measurement error is that the statistics agency simply has a concept of price that is not appropriate for monetary policy purposes.  (This doesn’t mean that the price is necessarily ‘wrong’, since it may do perfectly well for achieving some other policy goal.)  Responding to this kind of measurement error would hopefully amount to surgically removing the offending component index, and replacing with one more in conformity with what theory or common sense tells you should go in.  And this process might resemble constructing a core inflation index.  A classic example of this genre is that the theory consistent measure looks for an aggregate of nondurable goods.  Yet CPI weights the prices of many goods which provide services over a long period.  Ideally we would figure out the service flow and substitute this in place of the price of the computer, or car, or whatever.  [Although my Windows 8 computers struggle to provide a service flow over multiple periods].

5.  These arguments have to be weighed against the costs of the central bank, or authority which defines the mandate, appearing to choose and change the goalposts to suit itself.  If there is a strong feeling that something is inflation in the populace, it may be costly for the authorities to entirely disregard controlling that, since it may undermine the credibility of their actions in this and other spheres of public policy, and may unhinge expectations of the true measure of inflation, aggravating the problem of controlling it.  Lorcan Roche Kelly responded to my tweetstorm by pointing to ‘CPI flat‘, a joke index of the prices which, when aggregated, amount to the same number each month.  This is not such a joke.  It reminds me of a long period in the early 2000s when the ECB were continually pointing to above target inflation as being due to ‘price level shocks’, as though these were mysterious things that had nothing to do with the ECBs own actions.  ‘Price level shock’ madness haunted the corridors of the BoE too, in the early days of post-crisis high inflation, before the MPC made more conscious and honest reference to an explicit choice to tolerate higher inflation on account of moderating the recession.