Escaping the zero lower bound: electronic money, or higher inflation?

Ken Rogoff wrote recently extolling the virtues of abolishing cash in favour of electronic money in order to escape the zero lower bound, which he prefers to the alternative of raising the inflation target.  Targeting higher inflation would ‘baffle’ the public, he thinks, and would mean that the inflation targets were no longer the ‘moral equivalent of zero’.

To recap.  If everyone uses electronic money, then balances in this money can be ‘taxed’ so that the market generates negative nominal interest rates, and thus the constraint on the ability of monetary policy to respond to contractionary shocks posed by the zero bound is alleviated.  Cash has to be abolished because if the option to hold cash is there then people will simply switch to holding it at zero interest rather than keeping their liquid balances in electronic money at negative interest rates.  The option of targeting higher inflation achieves the same end since higher long-term inflation generates a higher long-term nominal rate from which central banks could start cutting in the event of a recession.

A few points.

First, I think abolishing cash and instituting electronic payments for all would be pretty hard to grasp for many.  Some of the people I hang out with have trouble operating their 10-year-old Nokia phones to send a text message, let alone doing smartphone payments.  Many are excluded from the digital payments and information network entirely, and not for nefarious reasons.  Would people embrace electronic money, when there have been so many large-scale and well-publicised IT failures in major banks, and security failures in companies involved in online payments, like eBay, PayPal and so on?

Granted, raising the inflation target would take some explaining.  I can see the twitter storm from Andrew Sentance and the hawks coming already ‘Aha, they are finally coming clean on the high inflation they have doing by subterfuge for years!’  But to argue that electronic money would be preferable on these grounds seems peculiar to me.  It would be an unprecedented leap at a time when many have not yet mastered paying for stuff with bank deposits.

On this point of low inflation being the moral equivalent of zero.  Rogoff touches on something important here, that policy objectives have to be morally justified.  But moral equivalence to zero inflation doesn’t seem to me a useful comparison.  The moral equivalence we are looking for with policy is between the practical and the best policies.  And, in order to create the necessary room to smooth business cycles with interest rates, (which we could agree is morally justifiable without needing to drink the strong waters of normative ethical philosophy), it may mean that we need more inflation.

What Rogoff thinks would particularly ‘baffle’ central bankers’ constituents was that they had changed their minds about the benefits of price stability.  There’s something in this.  But it should not be the overriding concern.    And:  the profession has done a lot of changing of minds recently!  We would hardly decide against tightening prudential supervisory standards on the grounds that we would baffle everyone that we had changed our minds on it.  On the contrary, it would be perplexing if the authorities had not changed their minds in the light of the evidence about what constituted good policy.  So too with inflation.  For generations, the authorities wrestled with different metallic standards for monetary policy.  Finally, we ‘changed our minds’ about this being the right thing to do.  It was probably baffling at the beginning.  But slowly people got used to the meaninglessness of the ‘promise to pay the bearer on demand the sum of’ text.

 

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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.