Comments on retrospective guidance on forward guidance from the BoE

The Bank of England has been trying to clarify what it was doing when it launched its policy of forward guidance, committing not to think about tightening monetary policy until unemployment fell to 7% (provided….).  The fog is lifting somewhat, but lots of questions and puzzles remain.

Charles Bean spoke at Jackson Hole, saying pointedly that forward guidance in the UK was NOT about injecting more stimulus by holding rates lower for longer and causing an inflation overshoot.  He gave two reasons.  One referred to past, above target inflation, and translated as implying that more stimulus was not needed.  I agree with that.  But I find it hard to square that language with Carney’s at the Inflation Report press conference when the policy was first launched.

Also, one could nit-pick here.  Forward guidance was aimed at making sure that interest rates were forecast to be lower for longer than markets would have counterfactually forecast them to.  And one might presume that markets would forecast how and when MPC would raise rates based on how they have responded to movements in inflation and unemployment in the past.  That sounds pretty Woodfordian to me.  For Bean’s comment to be consistent, the MPC judgement must have been this:  once rates were freed from the zero bound, MPC would respond as they normally had.  For some reason markets were either i) forecasting that they would become more inflation-nutter-like than they had previously been (for no apparent reason) or ii) taking a more optimistic view of the conjuncture than they were.  ii) seems more plausible than i) to me.  Particularly if one recalls that the MPC were judging the pick up in the inference about demand to be reflected perfectly in an equal, and therefore inflation-neutral, pick up in supply.  Though Bean and his colleagues seem to feel the need to stress i) instead.  (There has not been an equivalent campaign to clarify that the MPC’s view of the conjuncture is less benign than the markets’).

A second reason Charles Bean gave as to why forward guidance was not of the Woodfordian type referred to the fact that the MPC could not bind its future members.  (So there was no point in trying).  I found this puzzling.  The commitment just made requires committing its future members.  John Cunliffe will take over from Paul Tucker.  Mr Bean himself will probably sign off in June 2014 when his current term expires, before MPC are forecasting that unemployment will hit 7%.  Ben Broadbent’s term is up in May 2014, and is Paul Fisher’s.  Potentially, there might be four new MPC members who didn’t vote for forward guidance who one would have to take as pre-committed.  (And of course there is nothing stopping an MPC member going back on the agreement, nothing except words).   So in fact MPC’s ‘inject no more stimulus’ forward guidance policy IS like Woodford’s in respect of requiring commitment from individuals who might not be able to offer it.

Spencer Dale and James Talbot [Head of the Bank’s Monetary Assessment and Strategy Division, instrumental in preparing the analysis of forward guidance for the MPC] write on behalf of the Bank in a VOXEU column.  In this piece, and in that by Charles Bean, mention is made that ‘more effective’ refers in part to reducing uncertainty.  This risks confusing the ‘no more stimulus’ message.  Indeed Mark Carney seems to have persuaded the entire media that forward guidance was about trying to kick start the recovery, a central plank of which was the extra spending that would come with being confident that interest rates were not going to rise.  To be consistent with the ‘no more stimulus’ message, MPC would have had to tighten somewhat to offset the stimulatory effects of reducing unemployment.  No mention is made of this.  Is the uncertainty effect calculated to be too small to warrant any compensating tightening? [More on this in another post.]

Also potentially confusing is the phrase in the Dale-Talbot piece that refers to forward guidance as enabling MPC to ‘explore the scope for economic expansion without putting price or financial stability at risk’.  This phrase is totally mysterious.  What does it mean to ‘explore the scope for economic expansion’?  Elsewhere in this text and Bean’s we are getting the new message that no more stimulus was intended.  But ‘explore the scope for economic expansion’ is easily read as ‘have a bit more of a go at further economic expansion, more confident now than before that we can do this without overdoing it, in particular that that’s   how others will see it since we have these knockout clauses’.  Whatever it means, why does forward guidance help them do it?  Suppose it simply means ‘continue with the already very stimulative monetary policy so that we stimulate demand as much as we can without generating too much inflation’.  Why does explaining what will happen to future rates, and the knockout, help?  Since policy is not meant to be any more expansionary, the help guidance gives must simply be in the knockout clauses.  Before, we can infer, there was a risk that the (similarly) stimulative policy plan would put price or financial stability at risk.  Now guidance enables the MPC to ‘explore the scope for economic expansion’ (translate do what it was doing before) more confident than before that the punch-bowl will be removed if things get out of hand.  This all seems to hang together too, but it doesn’t match the rest of the stories about forward guidance.

For me ‘explore the scope for economic expansion’ is confusing jargon.  It sounds like a text thrown in the direction of the doves (by a hawk), in particular at Mark Carney, that sounds a little stimulatory, but nevertheless stays within the ‘no more stimulus’ rubric set out by Charles Bean.

The common message from both the Bean and Dale texts is that no more stimulus was intended.  If that was the case, then presumably Bean and Dale must view the Carney press conference launch a total failure.  Carney was careful to use the ‘more effective’ language. But almost everything else he said subsequently was calculated to direct observers to the ‘more stimulus’ conclusion.

The Bank of England won’t and shouldn’t try to cap house price increases

A UK, housing-industry lobby group, the Royal Institution for Chartered Surveyors, recently called for the Bank of England to try to ‘cap’ annual house price increases at 5%.  This is in the context of evidence that house prices are accelerating again in the UK, despite measures of turnover remaining relatively subdued, and comments by Mark Carney, Bank of England Governor, that the Bank might contemplate interest rate rises if a housing boom got going.

‘Capping’ annual house price inflation would not be a good idea.  Houses perform several functions, and the demand and supply for these functions will likely vary from time to time, in ways that could mean that increases or decreases far greater than 5% in annual terms may be necessary and desirable from the point of view of society as a whole.

One obvious thing houses do is offer what economists would call ‘housing services’, what the average punter in the ‘Dog and Duck’ would call shelter.:  all that is nice about living under a roof.  (It’s dry, harder for people to steal your stuff, and you have more privacy than on the street).  Supposing the supply of shelter roughly fixed, the price of shelter services will rise and fall with demand.  Some factors determining the rise and fall in demand for shelter should play out slowly – like changes in the average size of households, or changes in net migration.  (In the UK the former has shrunk with single parentage and divorce, putting pressure on houses, and net migration has been strong for ten years or so).  But some such factors might move quite quickly, in line with changes in disposable income, or expected disposable income.  These dived at the start of the recession, for example.   If we could establish that even these fast-moving influences on the fundamental price of housing services would not change prices by more than 5% in a year, then perhaps there would be some sense in the cap the RICS were calling for.  But we can’t possibly claim this.

Houses don’t only offer shelter.  They are also an asset.  Since they usually last, if built well, and can be re-sold, they provide a way to store wealth.  One key factor determining asset prices is the price of consumption today relative tomorrow, or the real interest rate.   Once again, some of the factors determining the real rate move only slowly over time, but some of them moving very quickly.  Demographics affect the real rate, and, social catastrophes like wars or plagues aside, move slowly.  Young people are trying to bring forward consumption, spending out of income they don’t have.  The middle-aged are saving for when they can no longer work.  The old are running down their savings, unable to work or tired of it.  More young people puts upward pressure on real rates to encourage those that can to save and lend it to them. (Etc).   Another key factor determining real rates though is beliefs about the trajectory of income over the future.  If we all discovered that we were going to get some huge windfall in the future, we’d try to spend some of that now by borrowing, pushing up real rates.  When real rates go up the value of an assets falls.  News about the future, or changes in beliefs about the future, can materialise quickly and have very large effects on the ideal price for houses.   In the face of such changes, caps don’t make sense, no more so than capping the price of oranges relative to apples.  Of course, if the authorities had better insight into the trajectory of national incomes than those investing in houses, then there might be justification to try to limit house price movements accordingly, to bring about the price people would strike if they knew as much about their own futures as the Government, but even then the ideal price could move a lot more in a given year than 5%.  And after 20 years in the Bank of England, watching the last housing boom and bust play out alongside our forecasts, I see no reason why we should think that the authorities have this special insight.

Houses do other things too.  They hedge people against fluctuations in rents.  (If rents double shortly after I retire, but I own a house, what I can buy out of my pension is protected.  If I don’t own a house, I can afford much less food after paying for my housing).  And houses protect people against inflation risk. (For example,

 I doubt the component of house prices that is related to hedging fluctuations in rents varies that much.  But inflation (and deflation) risk could.

There is plenty of research showing that volatility in house prices may be bad.  One line of reasoning in particular is that house prices amplify booms and busts.  Housing serves as collateral for loans.  In a boom, the demand for borrowing may rise anyhow, but rise even more because a rise in house prices increases the amount of collateral households have, and this reduces the cost of borrowing because lenders are more confident of selling the security and recovering the loan if the household defaults.  But these models don’t give us enough to argue for a quantitative cap on house price changes from one year to the next.  I expect and hope that the Government and the Bank ignore the RICS’ suggestion.

Imagine a counterfactual world in which George Osborne understood the deep irony in his speech…

Notice two arguments in George Osborne’s ‘mission accomplished’ speech.

1.  After several years of declining or stagnant output, we at last have evidence of  moderate growth in official data and other positive, survey indicators.  This demonstrates that those that argued that the government’s ‘Plan A’ austerity deficit-reduction policies were wrong.

2.  We shouldn’t judge the Bank of England’s forward guidance policies a failure, because yields may have been even higher in a counterfactual world in which forward guidance hadn’t taken place.

Oh, the irony!  Surely he and his speechwriters must be aware of it!   Argument 2, of course, is watertight.  We might be sceptical of it, because yields did not really fall on the announcement of forward guidance, during which short period one might think that there was little else affecting them.  But it is still logically correct.  Argument 1, of course, as forcefully argued by Simon Wren-Lewis and Paul Krugman, is completely fallacious.  The argument that looser fiscal policy would have meant a shallower and shorter recession is not undermined by output eventually starting to grow.

Can we rescue the Chancellor from this absurd boast?  Some were arguing that the austerity implemented will tip us into a vicious circle of ever larger deficits and ever-declining output.  The turnaround in the data makes that less likely to happen now.  Can we consider that particular argument won?  Not really, no.  First, since Plan A was embarked on, we have had two measurable relaxations in the deficit reduction targets.  Who knows, if Plan A had been stuck to (as the Government promised at the time) we might have experienced this vicious circle.  Second, even the reduced probability that something will happen does not make it wrong to have forecast that this would happen back in 2010 when Plan A was first embarked on.  Just as the fact that I roll a double six does not make my initial forecast that this was not very likely wrong.

Krugman pointed out that although this is bad economics, it is probably good politics.  I think he is sadly right.  But it is a shame that politicians get away with it.  Speeches like this debase economic discourse, and political discourse about economics.   Osborne would probably like to be remembered for his good work in setting up the Office for Budget Responsibility, and introducing apolitical oversight and restraint on fiscal policy.  But if this is the case, it is strange that he succumbed to the temptation to run these cynical, false arguments about his austerity plans, cynical because they count on the economic illiteracy of the listener, a cloak behind which you can do with fiscal tools what you feel like to make sure that you get elected.

(And I say this as someone who was arguing that looser fiscal policy was not necessary (eg on account of high and stable inflation) nor prudent (need to save for another rainy day in the financial system)).

Why hasn’t anyone called the ECB’s bluff over OMTs?

Last Summer, the ECB stemmed the panic in peripheral sovereign debt markets with a promise.  The promise was to undertake ‘Outright Market Transactions’;  purchases of short-term debt issued by troubled sovereigns, from secondary markets, in quantities not limited at the outset, provided the country in question submit itself to the discipline of seeking conditional assistance from the European Stability Fund.  It seems amazing to me that this has worked so well and that no-one has tried to call the ECB’s bluff.

Why do I think OMTs are a bluff?  If markets did not believe the promise, and continued to require such high premia from peripheral sovereigns that the sustainability of their finances, and their continued membership of the euro was in doubt, the ECB would be pouring good money after bad.  It would stand to lose a great deal on the bonds it bought, whose value would be very uncertain, clouded by a possible redenomination and/or default.  The protection of buying short-term bond would not be much protection, as their value could evaporate in minutes.  It is at least possible that there would not be the political support from the core, creditor countries, already on the hook to the tune of around 700 billion euros if there were a quick euro area break-up, to back unlimited ECB operations as this dynamic played out.  Even if it could be argued that such operations were in the core’s long-term interests, it is surely possible, if not highly likely, that voters in Germany (for example) would themselves panic as purchases began,  or that the German leadership would worry that they would.

If the view that this was how things would turn out were to take hold in markets at any point this would cause the premia that the OMTs had eliminated to re-emerge and force the ECB’s hand.  The ECB’s promise is bluff because they could not carry it out, nor would they wish to, in all possible circumstances.   The ECB’s discussion of multiple equilibria in speeches like this one by Coeure on the ECB board is highly pertinent. But its account of the phenomenon is misleading.  Since the ECB would clearly could not, nor would not want to carry out unlimited OMTs in all circumstances, it clearly is a valid candidate forecast that they would not, and that the events associated with them not doing it (sovereign default, euro exit) might take place.  Since it is a valid forecast that this would happen, it’s also valid to forecast that others will forecast that this will happen, and so on.  In order to stop a self-fulfilling prophecy, you have to make it irrational to forecast doom in the first place.

The OMT bluff is also not particularly well executed bluff, and there are several curious aspects to it.

One is the talk about redenomination risk.  The ECB wishes that we believe it can distinguish between redenomination risk and other premia priced into troubled sovereign bonds.  It’s important for the motivation for the policy that it argues it can, because addressing other premia (like those connected with troubled sovereign solvency) is the preserve of fiscal policy, which is the preserve of other bodies.  If the opposite view of OMTs were to prevail, that might risk the German constitutional court standing in the way of OMTs, or risk people believing that it might, which would trigger all the events described above.  Even if were possible, conceptually, to separate out this particular premia, it would be a stretch to believe that the ECB could measure it.  But in this case, it is surely not possible to distinguish ‘redenomination risk’ from risks connected with the solvency of a government and an exit from the euro.  The two are bound up with each other, because it is precisely that prospect of running out of money which would mean that governments would be forced to pay their bills by printing their own.

Another curious aspect of the bluff is the talk of the conditionality of the OMTs.  This is needed to make OMTs as un-fiscal as possible.  If it can be argued that the fiscal problems are being addressed by an explicitly fiscal body or fund (the IMF, the EFSF or ESM), then there is no further fiscal problem to deal with, and the OMTs can be argued to be a measure aimed at monetary policy purposes.  But this is just talk.  One can almost argue the opposite.  That without the fast-moving, potentially unlimited capacity of the monetary authority to create money to plug the financing gap of troubled sovereigns, the slower-moving, clearly limited capacity of the ESF and its sponsors would not work.  And it is also stretching it to argue that this fiscal conditionality is watertight.  The ‘reforms’ spoken about as being required as part of an ESF loan are not specified.   As we have seen with Greece and Portugal, it is a subjective matter as to whether they have been carried out.  Once the loan in exchange for reform is agreed to, it is often, after the event, not in the interests of the lender to carry out the threat not to hand over the money when reforms don’t happen.

Yet another curious thing about the bluff is the behaviour of the political custodians of the ECB and the currency union.  One might guess from the fact that Draghi announced OMTs that Merkel and co supported them.    But that it is not an adequate rebuttal of the charge that OMTs are a bluff.  It simply says that the ECB got Merkel’s agreement to have a go at bluffing.  (After all, if you have run out of options, why not try it?)  What evidence have we got that the Germans would be willing to follow through?  Has there been any decisive change in the opinion polls indicating public support for extending much larger credit to troubled sovereigns in the euro area?  I’m not aware of any such shift.  More plausibly, the German political elite extend credit reluctantly because they know that this is the view of their voters;  that explains their tardiness before OMTs, and it must surely colour how they view OMTs themselves.

One can almost see these concerns and delicacies in the central texts outlining the bluff, the text that describes the limits or lack of them on OMTs.  ‘No ex ante quantitative limits are set on the size of Outright Monetary Transactions‘ is the phrased used.  The phrase is clearly aimed at making it clear that they don’t want to disclose a cap yet, because that would allow people to look at the cap and figure out whether they think it is large enough to do the job.  But then, the text does not have, yet could have, had a prhase that said ‘whatever quantities are deemed necessary to convince market participants that pricing in a risk of exit is not rational’.   So in the absence of such a text, should we interpret what has been written as ‘not yet limited, but if things start going badly, it soon will be, don’t worry, and we will pull out’?  It’s as if the ECB knows it can’t actually write ‘unlimited’, because they know that it would not be believed, nor judged consistent with their mandate.  There are no fiscal funds earmarked to recapitalise ECB losses associated with ‘ex post limited’ OMTs, and allowing these losses to be absorbed by money creation is not consistent with the mandate for price stability, nor would be judged so by the German constitutional court.  The phrase ‘no exante quantitative limits’ seems designed to impress a busy markets trader, but reassure a concerned German constitutional lawyer.  It might well reassure the lawyers, but I don’t understand why it should have impressed markets.

If you are persuaded that OMTs are just bluff, and a bluff not very well executed at that, it’s then a puzzle why the policy was so successful, and no-one has tried, seriously, to call the ECB (and the Germans) on it.

Scottish? Don’t let the SNP hoodwink you into thinking you can have a currency union without tight fiscal oversight

Back in April, the Treasury published a report explaining, in short, that an independent Scotland could not be a member of a currency union, managed by the Bank of England, without considerable fiscal oversight.  The Scottish National Party (SNP) dismissed this report as ‘scaremongering’.

In this post, I want to reiterate why the Treasury was right, and if anything understated the problem, (probably scared itself of being accused of scare-mongering).  The SNP’s failure to address this important issue of institutional design reveals either incompetence on their part, or, worse, indifference to the future macroeconomic stability of Scotland and a determination to make sure that the Scottish electorate don’t grasp the issue.  10 years ago, this debate would have been much less clear cut because we did not have the example of the euro area on our doorsteps.  Now, however, we can see clearly what happens when countries combine to form a currency union, but have independent fiscal and financial stability policies.

The short answer to this question is:   without intrusive fiscal oversight, the currency union of the Rest of the UK [or RUK] with Scotland would look like the currency union in the Euro Area.  Not good!  In fact, even worse, because the size of the balance sheet of the banking sector in Scotland relative to GDP is much higher than say, the typical basket case Mediterranean country.  And worse too because the exposures to Scottish banks of the UK probably exceed those of the European core to the periphery.  So, it seems pretty clear to me that the RUK would not want to sign up to a currency union on these terms, contrary to the SNP’s assertions.

To spell things out a little more:  the RUK would want to ensure two things. First, Scotland supervised its banks to the same standard as the RUK supervised its system.  Second, that Scottish fiscal policy was sufficiently conservative as to be able to cope with a failure of its banks.  Otherwise, in the event of a crisis, there would be irresistable pressure (just as for the European core now) to offer a bail-out to Scotland, so that it in turn could protect Scottish banks, and thereby protect RUK banks from a run as a result of worries about exposure to the affected Scottish institutions.  Without these two guarantees in place,  there would be every incentive for the Scots to free-ride on UK financial guarantees.  The Scots might be tempted to offer lax capital or oversight, in the hope of retaining or attracting further domiciled banks, and obtaining the tax revenues that come with it, while relying on the incentive of the RUK fiscal authority to bail it and its banks out in the event of a crisis.  [This is one way of reading Salmond’s response to the proposed acquisition by RBS of ABN Amro.  He welcomed it because it beefed up the profits that would be billed to Scotland, and the tax revenues that he could argue should be hypothecated for Scottish spending].

This problem would be less severe if Scotland were forced to manage its own currency and exchange rate against the RUK, because Scotland would have the option of plugging the gap in its finances by printing that currency, and the fall in the currency that would be associated with a financial-sovereign crisis would stimulate export-led growth (just what the European periphery are lacking now).  The knowledge that such an option exists would put an (inflation risk) premium on Scottish government bonds, but it would also lessen the likelihood of a run on those bonds and the banks that held them.

This is why the RUK government would not be content to maintain a currency union with Scotland without tight fiscal and financial stability oversight, which, in effect, amounted to a fiscal union.  And the reasons, to repeat, are almost identical to those governing the struggle over how to work through the European crisis.  Scots voting for political independence in order to achieve fiscal independence should not count on remaining part of the Sterling currency union.

Even with a floating currency, there would still be some incentive for a RUK government to offer aid to a Scottish sovereign having difficulty financing a bail out, or guaranteeing Scottish deposits to prevent a run on Scottish banks, and an associated plunge in demand for RUK exports to Scotland.  (The funding for Ireland during the euro area crisis that the UK offered was not for altruistic purposes).  And knowing this, there may well be some incentive to free ride in advance (with lax regulation and higher tax revenues accruing).  So from this perspective only, namely, to ensure a watertight financial stability union, while Scottish and RUK banks are so intertwined, RUK voters should hope that the Scots vote no.

The analogy with Europe isn’t perfect.  One of the reasons why Germany has not yet pushed to cut Greece loose is because of the precedent that might be set for Portugal, Spain, even Italy, and the worry that default and exit by these countries might become a self-fulfilling prophecy.  There would not be the same problem for a RUK contemplating kicking out Scotland from a currency union in the event of a financial crisis.  There would be no further entity within the currency union that might have to break away.  For that reason it would be less traumatic for the RUK to force a Scottish exit in a crisis.

Another reason why the analogy isn’t perfect is that a currency union with an independent Scotland would happen with the experience of a Euro Area crisis fresh in everyone’s minds.  One would presume that the real possibility of a break-up of the Scotland/RUK union would make a break-up itself less traumatic.  For one thing, RUK banks would think carefully about the price they wanted to pay for Scottish bonds, and would not treat them as substitutes for RUK ones, as it appears that markets in general did when pricing euro area core and periphery bonds in the run up to the crisis.

Political economy of subsidies to bank borrowing

Not the modest interventions to try to stimulate lending, but the huge subsidies to bank borrowing implied by the state guarantee to prevent banks failing (discussed in various writings by Andrew Haldane), which allows them to borrow from private markets at low cost.  Simon Wren Lewis writes about how these came to pass in his blog ‘Mainly Macro’, speculating that it was about bankers lobbying politicians.

But why do politicians give in? Another speculation to add to Simon’s:  these subsidies translate into fat profits for banks, which translate into tax revenues now.  These revenues can be handed out to constituents now to buy votes now.  The liabilities taken on (the costs of a future bail-out) are not realised now.  They come as and when a financial crisis is realised.  Most likely, the taxes, and the constriction on pork-barrel spending plans, that come with a crisis, will hit some future government, a long way beyond the planning horizon of politicians focused on the next election.  That’s why governments are content with the subsidy, because they aren’t paying for it.  On the contrary, they share in the spoils.

Something aggravating the problem is the international competition between tax jurisdictions for banks’ profit (and tax revenue) cyphoning machines.  The Basel Accords were attempts to solve both problems:  regulating banks to make the realisation of crisis-related liabilities less likely, with the cost being lower profits (and tax revenues), and by agreement eliminating international competition.  However, some might see these Accords as highlighting that the problem is still there.  The fierceness of the competition between governments, and the difficulty for each of them in forgoing the goodies, makes it hard to strike an agreement that does any more than make a dent in the problem.

Why do markets not share MPC’s views about future interest rates?

Mark Carney, Governor of the Bank of England, spoke yesterday to try to convince markets that interest rates will stay lower for longer than they expect.  Assuming that was the intention, it wasn’t very succesful.

Why don’t markets share the expectations of Governor Carney and the MPC?  There are many possibilities.  Some possibilities Carney dealt with in his speech, but not all.

1) Markets don’t believe that the economy will pan out the way the MPC think it will.  For example, they may not buy the analysis in the Inflation Report that the heating up of demand indicators over the last 3 months or so was precisely matched by an expansion of supply capacity, and therefore won’t affect the outlook for inflation.  Or perhaps they don’t believe that the natural rate of unemployment is as low as the MPC thinks it is, and so they guess that the ‘inflation knockout’ will ‘knockout’ the commitment.  Some participants in the market might (like me) put weight on the event that the stability of inflation itself over the last several years is evidence that the unemployment rate is closer to its natural rate than MPC appear to believe.  Or, perhaps markets are unnerved by MPC’s silence on the topic of how they have grappled with issue of how to estimate the impact of a very prolonged period of fixed interest rates?  As pointed out in previous posts (and before that by other writers) the MPC’s model (like all those it descended from) is extremely unreliable in this regard, and so the MPC is forced more than usual to rely on guesswork.

Unfortunately, Carney didn’t do much to try to address this problem.  He did re-emphasise that 7% was a ‘staging post’ not a trigger, in case that was the source of the disagreement.  He also noted that pre-crisis unemployment rates fell to 5%, hinting that the natural rate may be much lower than the staging post of 7%.  But that period may have simply been an unustainable low;  and post crisis, after long-term unemployment has entrenched itself, the natural rate could be much higher.  If you think markets are overestimating the natural rate, it is pretty unpersuasive simply to point to these pre-crisis rates.  MPC could start by telling us what they think the natural rate is, or will be, rather than keeping us guessing.   And in general they could be greatly more transparent about the model and judgements that construct the forecast, so that participants can take it to pieces and reassemble, getting a better sense of where MPC are coming from.  The August Inflation Report took steps in that regard (a fan chart for unemployment, for example), but only baby steps.  There are some reasons to keep back information.  MPC might worry that in the hands of mischievous or ignorant outsiders (like me) this information would be put to nefarious or damaging uses.  But the cost is that some suspect that the reason for not being clearer is to create wiggle room for future changes of policy:  wiggle-room that can be used to disguise a change of mind as consistent with the commitment already made.

2) A second reason why markets don’t share MPC’s forecast for future rates is that they don’t believe that the MPC believes its own forecast.  (Governor Carney didn’t cover this reason in his speech!)  What do I mean by that?  Surely the MPC wouldn’t publish a forecast it didn’t believe in?  What I mean is that the MPC is a heterogenous committee of 9 persons, and the mapping from the views of those 9 persons and the one published forecast is completely opaque.  (And has been since the Halcyon days of ‘Table 6b’, where the separate forecasts of Wadwhani/Julius/Allsopp were recorded).  Up to the point where the forward guidance was announced, there was a clear division of views between those who wanted to inject more stimulus, and those who did not.  This was reflected in some difference of view about how variables the MPC cared about would evolve under different paths for interest rates and asset purchases.  It’s not clear how those two (if it is only two) sets of forecasts have changed since Carney’s arrival, and therefore not clear what to make of the collective forecast published in August.  Perhaps markets put some weight on this disagreement persisting, hidden from view in the collective, ambiguously weighted Inflation Report projection, but likely to resurface and make itself felt later.

Carney didn’t do much to illuminate us on this, and neither did the minutes of the August MPC meeting.  Before the agreement on forward guidance was struck, the first forecast round for the MPC was looking from the outside like a car-crash.  Carney had made public remarks before taking office that he believed in FG, because it provided a way of injecting extra stimulus, yet the majority of the MPC not only presumably did not support FG (otherwise why their silence or disapproval on the subject up to that point) but didn’t want more stimulus.  Magically, agreement was struck.  Carney described FG as making monetary policy ‘more effective’ at the Inflation Report press conference, careful not to say ‘more stimulatory’, but actually drawing a distinction without a difference.  The hawks so far register no protest, so perhaps for them it is a distinction with a difference.

What are markets to make of this?  The magic that might unite the MPC behind the need for more stimulus could be the unwanted tightening of the yield curve around the time the first talk of ‘tapering’ emerged from the Fed, combined with the view that the distinct warming of the data at the same time was inflation-neutral (as remarked above, conveniently accompanied by an exactly matching improvement in supply).  But this stretches credulity for me, and perhaps for markets too.  For one thing, there have been many wiggles in the yield curve in the life of MPC, but none seem to have so decisively altered the consensus on MPC about the stance of current policy as this one.  For another, if this was what swung the hawks into line, why has there not been a clear focus on explaining and articulating it?  This is surely THE key conundrum about recent MPC behaviour, but it scarcely receives a mention.  It’s as if MPC wiped the slate clean and started over, pretending that all differences in view had evaporated.  Hence I called it Fudged Guidance.  For some, a plausible interpretation is that the hawks simply decided to set aside their independent vote for a while, as a kind of golden hello to the new Governor.  Many in the media write as if the Governor is the Committee (just as he was in Canada), ignoring the painstaking attention to individual accountability that MPC members give.  By not paying more attention to the task of articulating whether the course has changed, and, if so, why, MPC are naively running the risk of fuelling this lay view of a committee dominated by its charismatic new chair.

Not adequately explaining past changes of course is particularly hazardous in the new game MPC is playing.  The whole point of forward guidance is to convince observers that there will be no such changes of course in the future, thus influencing expectations now, thus generating more stimulus now.  So to start out on forward guidance by appearing to change course inexplicably is not only ironic but potentially self-defeating.

3) This leads me to mention (again) the third obvious possibility.  Even if markets believed that the MPC were united in their views about the economy, they don’t believe that MPC will necessarily follow through with forward guidance.  I and many others have written about this before, but forward guidance is bluff, inherently non-credible.  Once the stimulus from lower expected future rates is pocketed, there is every incentive to renege and tighten.  The MPC turns over slowly, after all, so the agreement struck now could easily be set aside if newer members don’t concur.  The cost is that MPC has egg on its face.  But the benefit might be preventing another asset price bubble and ensuing bust.  This would come back to haunt MPC if there were another zero bound episode, but, what the hell, perhaps the calculation is that there won’t be another one until everyone has forgotten?

Paul Krugman vs Roger Farmer

Recently Roger Farmer published an open letter criticising Krugman’s commentary on modern macro.  He points out that Krugman frequently alludes to the fact that the Great Recession is due to self-fulfilling prophecies, without citing Roger’s prior work.  Krugman replied, explaining that he hadn’t read Farmer.  He’d tried, but found it too difficult to understand.  Steve Williamson characterised this as ‘show me your trailer or I won’t watch your movie’.  [And then proceeds to write a good trailer for Roger’s movie himself].

To all this, I add a few remarks.

1.  It’s not necessarily the job of scholars to perfect the marketing of their own work for the busy reader.  The incentives for many are simply to get it to the point where journal referees understand what’s been done and why.  Don’t blame scholars for not doing this, blame the market for their talents in which they are selling them.  Many lay readers will side with Krugman for not reading stuff that seems difficult, thinking it perverse or incompetent of an academic not to write things that are easy.  But those readers won’t appreciate that everyone has their own specialism, and scholars have their work cut out just formulating coherent macro models and testing them, pretty much the sole thing their academic market value will rest.

2.  It’s not good enough to plead that you haven’t read Roger (or anyone like him) IF you set yourself up as an authoritative mouthpiece on macro developments, and on developments in macro research (exactly what Krugman does).  Consequently, if you don’t read him, don’t write as though you are sure you have something original or watertight to say, because the implication is that you haven’t been keeping up.  It’s ok to drop Pynchon’s Gravity’s Rainbow, if you are an economics writer, [I confess I did], but not if you are an oracle on American Literature.

3.  It’s striking that PK says he tried and gave up.  It’s not that hard to grasp the basic points, even for those on the lower ranks of the academic food chain [eg me].  And it must have been clear to PK that Roger was writing about exactly what PK was thinking about.  So surely his curiosity was piqued?  Surely an alarm bell must have gone off that this was exactly the kind of macro work he should get to the bottom of?  After all it sought to bring the same house down that he had been trying to bring down latterly with his journalism?  Why didn’t PK drop Roger an email if he got stuck?  If he is stopped by such modest obstacles as these, even with his own evidently prodigious talents, on a topic squarely at the focus of his own writing, how much effort does he put into reading further away from his concerns?  What else hasn’t he read that’s hard?

Why it’s harder to build new houses in the UK than France

This is a brief response to Allister Heath, of CityAM, who has been writing and tweeting about how desirable it would be to build more new houses in the UK, and how meagre new building is in the UK compared to new building in France.

My response (tweeted here) was to note that population density is much higher in the UK than France.  We have roughly the same population as France, but 1/5 of the land mass.  Allister’s reply was to note (amongst other points) that actually an incredibly small amount of land is ‘concreted over’ (around 2 per cent) and that on the face of it a great deal more could be built on.  On this view, population density should not be a barrier to more new building.

I think the two of us are talking at cross purposes.  Allister makes a normative point, that more houses would be desirable, despite the larger population density.  He sees the planning restrictions as welfare-reducing.   My reply is a positive one;  I speculate that the tighter planning restrictions have at their root the higher population density, whether they are or are not socially desirable.

If Allister is right, that more building would make us all better off, then there are two positive explanations for the status quo.  One is that people simply don’t know what’s good for them.  For these people, it’s almost tautological to observe that density is the route of their objections to new building.   They don’t want new building because it increases the number of buildings near them!  Density comes into it in other ways too.  The planning restrictions that society (on this view, irrationally) dislikes need enforcing.  And enforcement is easier when density is higher:  ultimately it boils down to the number of cops you have per field!

A second explanation for the status quo in planning is that there is a small, influential group of people powerful enough to enforce it, even though on balance most people would prefer new building.  Enforcing ones will over the majority would also seem to me to be harder in less densely populated areas.  If the majority are spread out over a large territory, it will be more expensive for the minority to try to thwart their desire to build and enforce planning regulations they don’t like.

Although I think we were talking at cross purposes, I could take Allister on and question whether more building would be socially desirable.  How would we figure this out anyway?  New building is surely not going to make everyone happier (see above).  At least not the people living next door.  And those who have their own house [either by owning one, or having enough income to guarantee to be able to rent one] are probably in the majority.  So to conclude that more building is socially beneficial means we depart from majoritarian schemes for deciding and to something like a utilitarian one.  Perhaps the unhappiness of the few without a house more than outweighs the mild displeasure those with one would experience if another house was built in front of their thus far unrestricted view of arable farmland.  Perhaps.

There must also be some socially optimal level of population density.  (Allister concedes this, he just thinks we have not yet reached it).  Noting, as Allister does, that only a small percentage of land is ‘concreted over’ is, however, not necessarily conclusive proof that we have not yet got to that optimal level of density.  For example, it would be easy to destroy all the remaining open wilderness in the world by adding only fractionally to that ‘concreted over’ percentage, ensuring that wherever you looked there was at least some man-made structure.  The proportion of land that is concreted over is not that informative about where we are relative to the optimum.

Moreover, there is some good in having a system that makes it hard to take steps to increase the density of buildings.  The optimal density of buildings is probably slowly time-varying, as demographics, and the economics of production and social interaction evolve over time.  [It’s entirely conceivable that the population will fall at some point.  Or the desire to get away from it all will rise.]  Since land once built on is harder to restore to its ‘original’ state, being cautious about new building is a crude way of protecting the interests of those that will follow us and want to make their own choices about the same question.

[PS a quick glance at Wikipedia showed me that I was way off with my guess at relative densities in the UK and France.  Population density seems to be about 2.5 times greater in the UK than France, not 5 times greater, as I asserted in my tweet.]

Krugman on history of recent macro thought

Increasingly, I find Paul Krugman’s [PK] forays into macroeconomics (or rather, the history and sociology of macroeonomic thought) bizarre, highly selective (selected in order to back his own view that unlimited stimulus obtained anyhow is great) and ridiculous.  This post responds to this article by PK, but there are many more in the last few years that I could pick.

Steve Williamson wrote at length rebutting previous claims by PK that debate at the forefront of macroeconomics was ideological, and not scientific.  This claim is repeated implicitly in the post I am responding to, but Steve’s rebuttal can’t be bettered or added to greatly.  I think it would be fair to point out that most economists, being human, find themselves prey to the weakness of trying once in a while to focus on the plus points of a piece of research, (if you don’t join the others in this, they will beat you), or to defend a previously held position for too long.  But I don’t think that ideology has played a part in any seminar I have attended.  (Unless you want to call a basic acceptance of the capitalist system with quantitative analysis of government intervention ‘ideological’.)

On to two specific points in PK’s column.

1  ‘The original idea that money had real effects because people were surprised by monetary shocks fell apart in the face of evidence of business cycle persistence’.

Where does this come from?  Here is what I would recognise:  when researchers took simple real business cycle models and made prices sticky, they found that monetary shocks had real effects.  However, because these effects were not persistent enough on their own to generate long-lasting effects that were computed for (what was hoped were) comparable effects (of identified monetary shocks) in the data, it was recognised that something else had to be added to the model to account for it.  The profession converged on adding various other frictions, like slowly moving consumption, investment, price and wage ‘indexation’.  These additions don’t mean the original observation that it is monetary shocks causing business cycles (at least in part) ‘falls apart’;  it is intact, it’s just that one needs a model with richer propagation.

2 ‘the real business cycle view that nominal shocks didn’t actually matter after all was refuted by decisive evidence (pdf) that, in fact, it did. Yet there was no backing off on this approach. On the contrary, it actually increased its hold on the profession.’

It’s selective to view this notion as ‘decisively rejected’.  The sharp way to test it is to try to find monetary shocks in the data and compute their effects.  There is a huge volume of papers trying various methods to do this.  On the assumption that these shocks exist and on the assumption that the methods accurately recover what we are trying to find, then it’s fair to say that the weight of evidence favours the view that monetary (policy) shocks have real effects.  However, both assumptions are questionable.  Policymakers don’t accept that they are injecting significant monetary shocks (after all, why would they).  And all methods for recovering these shocks (even if they are there to be found) have their problems.  Rejecting the notion of monetary policy neutrality on the basis of these two problematic assumptions hardly qualifies as ‘decisive’ in my view.

I also don’t get the comment that ‘there was no backing off on this approach’.  Actually, I think the view that monetary policy shocks have real effects was ‘decisively’ accepted by central bank economists,  [eg, it’s embodied in the Fed’s model, and models at the BoC, ECB, BoE, BoJ, RBA, RBNZ, and many more], and accepted by at least half of the macroeconomists working with real business cycle models or those descended from them.

The point of successful economics scholars migrating to journalism ought to be to bridge the divide between research and non economists who want to decide what to think about what their governments are doing or not doing.  But PK’s columns don’t do that any more.   They don’t even reinforce the divide, which would be less harmful.  They are filling non economists’ heads with stories of a cult of crazed mathematician-politicians that have lost their way, but could solve all problems if they simply thought through the old AS/AD/IS/LM diagrams in his macro textbooks.