The German court’s futile search for Platonic essences of ‘monetaryness’ and ‘fiscalness’

It’s fascinating when macroeconomics and finance becomes a matter of constitutional law, as is happening in Germany, where their constitutional court has ruled on the legality of outright monetary transactions, or OMTs.  Their justification for ruling is that the ECB’s activities might enter the fiscal sphere, and so undermine German fiscal sovereignty, which would be contrary to the German constitution.  That constitution was put in place to stop the German central banks buckling under pressure to finance German deficits, and so to avoid a repeat of the hyperinflation which undermined the Weimar Republic.  With monetary policy now delegated to the ECB, this constitution has the effect of limiting the ability of the ECB to debase the euro to finance another government’s deficit.  Somewhat perversely, given the original intention of the constitution’s drafters, these limits are having the effect of undermining the credibility of the (relatively young) Southern European democracies that are struggling most with fiscal problems.  [Update:  actually, if you think about it, the historical irony is even more unpleasant and apt, since it was the social chaos of hyperinflation in part that provided for the emergence of German National Socialism.  It’s now the chaos post-austerity in Greece, a direct consequence of the German anti-inflation bias, that is fuelling the support for the Golden Dawn].

The core issue is the distinction between policies that are deemed ‘monetary’ and policies that are deemed ‘fiscal’.  The court ruling has a good go at making this distinction.  But, perhaps unbeknownst to itself, it gets into very hot theoretical waters.  ‘Monetary’ things are things that central banks should do, and which the ECB was intended to do.  ‘Fiscal’ things are things that governments should do, which the ECB was set up to avoid doing.  And which in the case of Germany the constitution reserves for itself.

Monetary policy – the setting of interest rates or the decision about the speed with which central bank money is created – has fiscal consequences.  And the setting of what the court (and actually most of us) think of as fiscal policy – taxes and government spending – has monetary consequences.  Everywhere and always.

First, the fiscal consequences of monetary policy.  Positive inflation implies a certain amount of seigniorage, for one thing, which is money made by the central bank and usually repatriated (once a generous slice to pay for its own nice offices and pensions has been lopped off) to its Treasury owners.  That means less money to raise through other means.  [Not much less, mind, given the stately pace at which money is printed at 2 per cent inflation].  Despite the best intention of central banks, inflation targets are of course almost always missed.  Inflation varies, and the interest rate tool used to control it varies, all the time, and these variations, many unforeseen and unplanned, have small but definite fiscal consequences.  That same central bank interest rate ultimately determines the rate at which the government can finance itself.  And the fluctuations in interest rates affect spending and revenues through the effect that they have on the state of the economy and the automatic stabilisers.

Likewise, fiscal policy has monetary consequences.  Some are relatively mild and hard to detect.     How fiscal tools are set affects the supply side of the economy, and therefore the inflation/output trade-off that the central bank has to confront in designing monetary policy to best meet its own mandate [which typically involves it worrying not just about inflation, but also the real economy], and so fiscal policy will bear on the path for inflation chosen by the central bank.   Some effects of fiscal policy are typically latent, but can then manifest themselves in extreme ways.  For example, the credibility of fiscal policy affects government financing rates, and these ultimately affect the rate at which consumers and businesses can borrow.  If the government comes under extreme fiscal stress, it is possible that this spills over into monetary policy, either by causing the price level to jump to revalue outstanding nominal debt [the fiscal theory of the price level] or the government to lean on the central bank to print money so that it can repay the debt without legally defaulting.

The court ruling wants to make distinctions between monetary and fiscal policy based on the instruments used.  But as we have seen, the use of one instrument usually reserved for the central bank has consequences for the instrument and objectives of the government, and vice-versa.

The constitutional court also wants to make a judgement about the ‘fiscalness’ of the ECBs actions based on its objectives.  But we might presume that the objectives of the government and the central bank are highly overlapping.  They are in the UK.  If they are not overlapping we would judge them to be highly deficient.  Price stability, for example, is not an end in itself, but something to be pursued to the point where it raises overall well-being, and not, therefore, to the point where it leads to excessive output volatility. Hence the corresponding wording in the UKs mandate, persuasively reemphasised in HMT’s 2013 review of the Bank of England mandate.

Dig into the academic literature, and you will find that ‘monetary policy’ is taken to refer to policy that has to do with the price and quantity of central bank issued liabilities;  ‘fiscal policy’, by contrast, is taken to refer to policies that have to do with the price and quantity of government issued debt.  Both are, in a sense, debts.  One is a perpetuity not redeemable for anything other than itself.  The other may or may not be a perpetuity, redeemed by a combination of real taxes and seigniorage.  But usefulness of these definitions depends on behavior and is not absolute.  If people chose not to use euros, the price and quantity of euros would no longer be of any consequence.  It’s conceivable that people could switch to making transactions using government-issued debt, or IOUs written on such debt.  [I say that, but of course many financial market based transactions are effectively done in just such a way].  In which case, both ‘monetary’ and ‘fiscal’ actions would happen inside the debt management office.

Perhaps the German constitutional court understands this, because their ruling states that if the OMT policy were interpreted ‘restrictively’, in particular, if it were made clear that the ECB would not engage in unlimited purchases of troubled sovereign bonds, the policy would not be in breach of the ECBs mandate.  This comment reveals that the important thing is not whether OMTs are monetary or fiscal, but how fiscal they are.  Actions by the ECB that involve small fiscal risks are ok.  [After all, there are many other open-market-operation-related fiscal risks run in the normal course of business].  But any actions that involve large fiscal risks should be okayed by member state parliaments first.  Such a distinction would be perfectly sensible.  Though not consistent with the earlier text in the ruling that insists on trying to make an in-principle distinction.

One response to the ruling about the limited or otherwise nature of OMTs has been to say:  the ECB already have limited purchases by saying that they will only buy existing short-term bonds [a fraction of total debt].  However, if there were a genuine limit on OMTs, the policy could not guarantee to defend the sovereign from fiscal implosion and thus stave off an exit from the euro.  Markets would be free to rally behind some George Soros like figure just as they did when the UK were forced out of EMU in 1992.  Or could rationally forecast that such a run might happen, in which case the ‘redenomination risk’ in troubled sovereign bonds would persist.  And the limit itself is quite ambiguous.  A sovereign headed down the road to fiscal ruin would find itself rolling all its long-term debt steadily into more and more short-term debt.  So the quantity of ‘existing’ short term debt would increase exponentially, thus making room for and probably necessitating larger purchases.  And finally, this is only what the ECB have said.  They can say something else later, when circumstances demand it, and the German court process may be too slow to prevent them acting on any new form of words.

The same problematic distinctions in the German court ruling of course crop up in the ECBs own language, no doubt because such distinctions were forecast to carry legal force.  Hence OMTs are directed at solving ‘liquidity’ problems of a troubled sovereign, facing speculative activity based on an irrational forecasts of a euro exit.  As I wrote before, and others have no doubt too, the distinction between liquidity and solvency (which is fiscal, and to be avoided by the ECB) is impossible to make in practice, and controversial in theory.  But ‘liquidity’ problems sound like something that should be the concern of the central bank, and that would not carry a fiscal risk once everyone catches up with the wise view of the ECB that there is no chance of a break-up.

This is not to say that legal restrictions on all the relevant parties are not important.  On the contrary.  It’s important that the ECB, which is not staffed by elected politicians, does a well-defined job that those who are elected have decided they are happy to delegate.  However, rather than looking for Platonic pure essences of monetaryness or fiscalness to decide what the ECB can or cannot do, it would have been better to ground such legislation in specifics, based on what the best thing to do would be when certain problems arise, and who would be best-placed to do it.

Right now, ideally, it would be best to have a transparent agreement from the euro area polities that they want to save the euro no matter what, that the governments with deep pockets are prepared to back actions to save it as much as necessary, and that the ECB is the organisation best placed to do the saving, and that creating central bank money to buy troubled-sovereign bonds is a policy worth gambling on.

Instead we have the ECB bluffing to markets, with no explicit political backing for the potentially unlimited quantities of purchases of bonds that an attempt to call that bluff would imply.  And the bluff is laced in language straining under contradictory forces:  the need to sound audacious to markets, and the need to sound conservative to the German constitutional court and, ultimately, the German electorate.

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Steve Williamson and the sign of the effect of interest rates on inflation

This is prompted by the latest post by Steve Williamson, where he reiterates a view he’s expressed a few times, that the Fed’s [and other central banks’] efforts to keep interest rates pinned at the zero bound, in an effort to push inflation back up to its presumed target, is self-defeating, since low interest rates are typically associated with low inflation.  If they want inflation to rise, he argues, the Fed should tighten policy.  To illustrate his point, he imagines a hypothetical alien econometrician trying to figure out what happened when Volcker tamed inflation in the early 1980s in the US.  Interest rates fell.  Ergo, lower interest rates caused lower inflation.

What central banks are doing is very well explained by modern New Keynesian theory.  In that theory, the nominal rate that the central bank controls has to fall if the natural real rate – the rate associated with stable prices – falls.  A central bank that sees inflation falling below its desired target would need to lower interest rates to correct the problem, or see inflation fall further below the target.  Lower rates would lower real rates, which would increase demand relative to potential supply, putting upward pressure on prices, bringing about the desired correction in inflation.

Through the lens of this New Keynesian theory, the fact that lower nominal rates are happening at the same time as low inflation does not mean that low nominal rates are causing low inflation.  On the contrary, higher rates would imply still lower inflation.  If the central bank wanted lower inflation in the long run, nominal rates would initially be raised, contracting the economy, putting downward pressure on prices, and soon after rates would be lowered in line with the new lower inflation target.

Now Steve might well say that the fact that low nominal rates are happening at the same time is circumstantial evidence that the NK model is wrong, and that on the contrary, the relationship is causal.  That’s true.  But this circumstantial evidence is a very loose test of the theory.  A sterner test might be how well the theory does at matching the response of the economy to  a surprise increase in nominal rates as identified in VARs.  Such surprises are widely taken to induce falls in inflation (and falls in output).  Sims got his Nobel partly for helping us see this.  This stock-taking survey by Christiano, Eichenbaum and Evans explains ‘what we have learned and to what end’ [sic – I rejigged the title].  The NK model matches this empirical regularity quite well.  And, with some effort, building in mechanisms to slow the response of consumption and investment in the model, it can match the fact that these responses tend to be hump-shaped too.  Steve’s alien econometrician, confronted with just interest rate and inflation data, is going to have a tough time distinguishing between the ‘mistakenly chose lower inflation by keeping rates low’ theory from the sticky price theory.  But if we gave her a computer, taught her the method of undetermined coefficients, and data on the output gap, I think she would reject Steve’s theory.  (Because she would see the negative output gap, and be able to compute the low natural real rate warranting low nominal rates).

With flexible prices, the need for interest rates to fall to combat a fall in inflation vanishes.  The inflation-control problem becomes one simply of adjusting the money supply to offset changes in velocity.  Steve’s fretting in such a world about central bank choices would be highly germane.  So this could boil down to whether you are happy to believe that prices are sticky.  And if you aren’t you had better explain to us why VARs imply real effects from monetary policy shocks.

Later in his post, Steve criticises central banks for worrying about deflation.  He says:  “As far as I know, there is no sound theory that actually delivers such a phenomenon. We certainly have multiple equilibrium models in which the economy can be stuck forever in a Pareto-dominated equilibrium, but I don’t know of a model like that in which a bad equilibrium is associated with deflation (maybe you do?). Indeed, in a wide class of models, deflation can be associated with Pareto optima – that’s the logic of the Friedman rule (not that I’m endorsing that).”

Well, this same New Keynesian theory delivers this phenomenon exactly.  The model was shown by Benhabib, Schmitt-Grohe and Uribe to have two steady states.  One involves inflation fluctuating around the central bank’s inflation target.  The other is a liquidity trap with nominal interest rates trapped at zero.  In this model, if prices are sticky, the Friedman Rule is not optimal.   Falling prices generates deviations of actual prices from desired prices which hurts firms.  In this steady-state, further contractionary shocks cannot be responded to and the lack of response (again, because of sticky prices) would generate welfare costs.  Moreover, the inability of central banks to move interest rates around allows new sources of fluctuations arising from self-fulfilling changes in views about the future.  In a model of flexible prices, where there is no motive for central bank stabilisation policy, the unattractive features of this steady state would disappear.

Recall that Steve says he knows of no ‘sound’ theory which has the property described above (and which would therefore cause central banks to worry so much).  So Steve may be omitting to mention this sticky price theory because he doesn’t think that theory is ‘sound’.  In fairness, there are lots of ways to shoot the theory down.  Even without letting the anti-macro blog-trollers in on this act, there are plenty of criticisms of the sticky price model from within macro.  Steve and his collaborators in the New Monetarist school don’t like that people just assume prices are sticky because they see that they move infrequently.   They want people to try to figure out why they are sticky.  And many, like Lucas, Golosov, Midrigan, Karadi, Gertler, Leahy and others are doing just this, digging deeper.  The models they come up with are, currently, too tricky to handle to do the equivalent of the monetary policy analysis so far done in the ‘let’s just assume prices are sticky and be done with it’ models.  [More importantly for their focus, they are also – think justifiably – pissed at the superficial way in which money is dealt with, if it is at all.  But no time to go into that here.]

However, for me, if this is what Steve is doing, he is raising the bar for ‘sound’ very high.  I know of no ‘sound’ theory that can explain the response of economies to identified monetary policy shocks, in that case, or, if such a test should not be met, contains within it an explanation of why.  And in the absence of it, if I were a policymaker, I would be happy to follow the lead of Blanchard and Kiyotaki who told us we should assume prices are sticky and be done with it (for now).  And, to recap, if you do, you will find that deviations of inflation below your intended target warrant temporarily lower interest rates;  and that if you wind up with interest rates stuck at the zero bound, and prices falling, the electorate in your economy will not thank you for it.

[Updates:  This version includes two corrections:  a link to the right Benhabib et al paper;  and revisions to clarify that the second liquidity trap steady state exists even with flexible prices.  Though I think it’s correct that the costs of negative inflation in this steady state disappear with flexible prices.

Note also Steve Williamson’s reply in the comments section, clarifying where he thought the gap in the theory was.  Ie not just liquidity trap steady states, but ever declining output and inflation dynamics, which he dubs the ‘black hole theory’.]

The lucky car-crash of UK fiscal policy

A link to my post on the Guardian blog site, which is a compact version of my rant about fiscal policy a few posts ago.

http://bit.ly/1e0GPJG

Why money targeting would not be a good way to implement forward guidance

As the ECB slides inexorably towards a liquidity trap, debate focuses on whether it might be prepared to engage in a forward guidance policy that implied a Woodford-style inflation target overshoot.  Simon Wren Lewis suggests that a more palatable way for the ECB to implement forward guidance for its hyper-inflation scared Bundesbank veto-wielders [my qualification of the proper noun Bundesbank, not his] would be for them to make promises about the path of money.  If I recall correctly, Michael Woodford argues that money quantities could serve as a way to monitor a commitment to lower future interest rates, and correspondingly higher inflation and output.  So Simon’s proposal is not without precedent.

However, I don’t think it would be such a good idea, because all the old reasons why money targets were dropped apply with even more force at or in the proximity of the zero bound.

These reasons centre on the uncertainty about the quantity of money consistent with the desired inflation rate – or velocity shocks.  In the past, velocity – here another word for money demand – varied so much that it was deemed undesirable, perhaps even infeasible to meet the previously announced target, on account of the consequences for the real economy, or even for inflation.  I’m not old enough to have worked under the UK monetary targets, but those I worked for were, and they never tired of explaining that painful era.  Even the Bundesbank themselves, who Simon hopes his proposal will appeal to, amassed some pretty impressive cumulative misses of their own money targets through the 1970s.  [I recall a number like 50%?]

At the zero bound, our monetary models tell us that almost any quantity of real balances (money divided by the price level) would be consistent with the prevailing interest rates.  That’s why Woodford explains that monetary injections at the zero bound (in the form of quantitative easing) would themselves have no effect at all.  And why the Bank of England erred in its early communication about quantitative easing when it sought to stress that the transmission mechanism was all about injecting money, and no different from before.  So in the zero bound period, a commitment to a particular level of money will not be very informative.  And would be completely harmless for a central bank that didn’t want to change anything, provided it was reversed as the zero bound period ended.  Then looking forward, although the quantity of real balances consistent with nominal rates becomes determinable again, practically speaking velocity will be extremely uncertain.  And we need to add to this that – not articulated in the plain vanilla New Keynesian account of money and the zero bound – there will be a recovery in financial intermediation that will mean that the velocity of all broader monetary aggregates will be increasing, and by ex ante unknown amounts.  So there would be no telling what the level of any money stock consistent with the desired inflation overshoot would be.

I dislike strategies like this for other reasons.  The main being that the tactic of deploying an intermediate target again is confusing, even for the supposedly well-informed financial journalist community.  For example, Michael Woodford’s suggestion at Jackson Hole that optimal monetary policy might be approximated by a nominal GDP target prompted a tirade of material by commentators who were for targeting nominal GDP for its own sake, (ie not for the sake of targeting inflation), and by some who didn’t seem to get the distinction at all between intermediate or final targets.  This kind of commentary unhinges consensus around what it is the central bank should be doing and erodes the legitimacy of the current mandate.  In the UK, the papers were full of stuff suggesting that the inflation target should be set aside, which HMT thankfully, and elegantly, cut through in its review of the Bank’s mandate back in March 2013.

Why Kydland, Prescott and Sims got the Nobel and why it isn’t weird

This is really just a comment on Noah Smith’s blog post about the oddity of the Nobel Committee awarding the Economics prize to Kydland and Prescott for finding that the business cycle was caused by technology shocks, and then later to Sims for finding that it was caused by monetary policy shocks.  I tried to post the comment a couple of times, but was obviously fended off by some clever algorithm that filters microfounded macro fans, but poses as a device to stop spamming. [:)]

One reply to this is just to note that the KP prize came first and the Sims prize came second.  By the time Sims’ prize came along, the Committee had seen the light, and, had they known what they knew later, they would not have given the prize to KP.  However, this isn’t the case.  We knew most of what Sims had told us that got him the prize by about 1995, by which time he’d explained how he would identify monetary policy [and some other] shocks.  Moreover, we knew that the KP claim was literally spurious long before that.  For example, a nice paper by Ingram, Kocherlakota [recent freshwater-basher] and Savin made the point that an economy that produces multiple time series with independent random components cannot be explained by one shock, technology or otherwise.

In his post Noah highlights the KP citation as focusing on ‘the driving forces of business cycles’ to suggest that the prize wasn’t awarded just for methodology, which would rescue the Nobel committee from incoherence.  Reading back those lines, I think that the language leaves enough room for us to translate along the following lines ‘KP showed us how to articulate a claim about the dominant causes of business cycles conditional on an entire laboratory economy, something that had not been done before and itself is deserving of the prize;  the substantive part of their claim, that the dominant driver of those cycles was technology shocks, has since been refined, overturned, restored and overturned many times, but it nevertheless now has to be seen as kicking off an ever sharpening conversation about those causes, where echoes of the original claim still bounce around even the very latest papers.  [If you will excuse the outrageous presumption of mentioning my own work in this conversation, see the exchange of papers between Christiano and coauthors and myself and coauthors on ‘risk shocks’].  This itself is also deserving of recognition in the Nobel.’  I conjecture that 90 per cent of those in the RBC/DSGE microfounded macro literature would agree with this view of their contribution.  Since the Nobel Committee take extensive soundings – for example they even ask around the central banks who should get it and why – I am sure that they would have heard this view made many times over.

Final point.  Part of Sims’ Nobel was no doubt the contribution towards identifying monetary policy shocks, and measuring their impact on real variables, and, therefore, their potential role as drivers of the business cycle.  But although his own substantive work measured significant effects of monetary policy on real variables, this did not mean on its own that they were a significant driver of business cycles.  In fact it’s common to find that the contribution of monetary policy shocks themselves is quite small.  One of the bugbears of central bank policymakers [and I remember that Charlie Bean used to make this point whenever such VARs came up in conversation] is that they don’t inject monetary policy shocks.  Why should they?  They should be doing good systematic policy.  If they were, Sims and his acolytes would be searching for something that wasn’t there.  There is a perfectly reasonable defence of this search:  monetary policymakers get imprecise information;  personnel at the top change for reasons unconnected with the business cycle…  But nevertheless the point remains that although we might measure that monetary policy is not neutral on the real economy, nevertheless it may still not be even a major cause of business cycle movements.  So in principle, awarding Sims the prize in part for measuring those non-neutralities in a rigorous way was not in contradiction with KP’s original claim.

A weightier issue to raise might be the fact that the econometric toolkit Sims devised gave rise to ways to agnostically identify technology shocks in VARs.  First came Blanchard and Quah (1989), and then Gali (1999) with ‘long run restrictions’ [ways of identifying technology shocks that rely on asserting things like ‘in the long run, monetary factors should not affect real factors’], and later Faust (1998), Uhlig (1998), Canova and de Nicolo (2002) and Uhlig (2005) with ‘sign restrictions’ [that rely on asserting things like ‘technology shocks that increase output should reduce prices at the same time’].   Depending on your perspective, this collective body of work [all springing from Sims’ own] must be read as dramatically narrowing the apparent contribution of technology shocks relative to the original KP claim.  However, I rest on my earlier point, that this conversation would not be going on if it weren’t for KP.  Indeed, most of the restrictions in these VAR models appeal to properties of the original KP model or its direct descendants.

There are plenty of reasons to think that Nobel prizes are not going to be perfect.  But I think that giving it to both KP and Sims isn’t one of them.

What is Buiter writing for his clients about the current ECB shenanigans?

Reading about Draghi’s comments that the ECB would not be engaging in quantitative easing (QE) because this would amount to ‘monetary financing’ prompted a burst of nostalgia for the time when Willem Buiter was writing his ‘Maverecon’ for public consumption, and not selling his wares privately for Citi’s clients.  There was no more entertaining way to begin the day at the BoE than by reading his central bank tongue-lashing.  And surely he would be moved to fury or sarcasm now [since, in general, it did not take much].

So, to recap.  The ECB will expose itself to unlimited capital losses, potentially, by buying short-term bonds from troubled sovereigns, but won’t buy bonds of undetermined maturity from any old well-behaved sovereign – for example the one that hosts its headquarters.  Yet, if some way can be found to securitise ‘bank loans’ [those wouldn’t be the same bank loans that are troubling the sovereigns whose bonds might be bought under OMTs would they?] the ECB would buy those as a measure to fight deflation.

First, it’s pretty shocking that the ECB are simply musing about this, rather than explaining an already worked-up contingency plan.  If they are worried about deflation, I don’t see how there is going to be time to devise a continent-wide bank-loan securitisation program of sufficient magnitude for the ECB to make any difference.

Second, why is it ok to buy potentially worthless short-term bonds of troubled sovereigns, but not probably reliable bonds of any maturity from other sovereigns?  The mention of the Treaty [of Rome] ban on ‘monetary financing’ doesn’t seem like an adequate answer to that.  The Bank of England’s legal team – the Bank also being bound, despite not participating in the euro, by that same treaty – concluded that provided those purchases were from the secondary market, QE would not leave it falling foul of the Treaty ban on monetary financing.

Ah, you might say, the fact that the troubled sovereign has sought fiscal help from the European Stability Mechanism (ESM), thus supposedly extinguishing any potential fiscal gap, makes it ok for the ECB then to buy its bonds, safe in the knowledge that it won’t be left on the hook.  However, as I’ve pointed out before, the fact that the threat of OMTs are needed at all is testament to the worry that markets might not believe that the fiscal support offered by the stability fund would be adequate.  What distinguishes the ECBs OMTs from the stability fund is the speed with which a potentially unlimited balance sheet protection can be offered to a troubled sovereign.  OMTs may be dubbed not to be ‘monetary financing’, but they certainly are the use of an institution that prints an accepted means of settlement and exchange [a ‘monetary institution’ no less] to convince markets that there will be no trouble ‘financing’ the sovereign.

The other side of the implicit contention about QE euro style is also intriguing.  They can’t by any old bond from any old sovereign, because of the chance that the ECB itself won’t reverse the transaction, and will, under its own definition, have financed that sovereign with money.  Eh?  Why won’t this transaction be reversed?  Will the ECB not be able to resist the temptation to lock the money financing in once the bonds are on its balance sheet?  Perhaps because of the votes wielded by Governors from potentially troubled sovereigns?  Or is that not the problem, in which case, are we being reminded that the bonds it buys might not be worth anything when it comes to reselling them and unwinding QE?

Recall [and thanks to unnamed friend in the City for pointing this out to me] that the ECB is using proxies to buy these same bonds.  The ECB is lending to counterparty retail banks who are buying the self-same bonds which the ECB says it will not buy itself.   And exposing itself in the process.  That’s not ‘monetary financing, though’.  Of course not.  That’s just monetary financing of a private institution that is ‘financing’ [governments].  And partly under the resultant coercion of new banking regulations regarding the need for those institutions to hold adequate liquidity.

Another thing. If it’s not ok to buy bonds from sovereigns not sufficiently troubled to seek help from a potentially inadequate stability fund, why is it ok to by securitised bank loans?  Where is the balance sheet protection for the ECB to undertake that policy?  The second phase of the financial crisis has essentially blurred the distinction between the large troubled banks and the sovereigns that are forced to stand behind them.  The ECB’s policy toolkit does not seem to make sense in this new world.

The ECB might wish that it could construct an indemnity in the same way that the Bank of England did before it embarked on QE.  QE is not actually carried out on the Bank’s balance sheet, but on the balance sheet of a company, the ‘Bank of England Asset Purchase Facility Fund’, against whose losses the Bank is indemnified.  If the Government chooses to default on gilts that the Bank has bought, it gains nothing.   And with its own balance sheet intact, the Bank won’t be suspected of being tempted to engage in extra inflation busting seigniorage.  Constructing such an agreement right now would be a nightmare in the euro area.  Even if agreement could be found, could signatory sovereigns make credible promises that would leave the ECB in the same position as the Bank of England?  I doubt it.  Another example of the general problem with having monetary unions in the absence of a fiscal union.

Come back, Maverecon.   Its absence deprives us of the European nominal and fiscal anchor.

What they talk about when they talk about taxes

The last few days have seen the UK Chancellor George Osborne and Ed Balls try to out-do each other in promising a fiscal surplus.  Labour have also put on the table the proposal to bring back the 50% income tax rate which has sparked the usual shallow exchanges about fairness and enterprise.

I find this unedifying.  What I would like is that the two of them try to out-do each other with the extent to which they promise to think hard about the optimality of fiscal policy, and for promises about things to spring from that analysis, not from political imperatives.  It might sound hopelessly naive to wish for this.  But you might have condemned people wishing for something as anodyne and gentle as the Office For Budget Responsibility as hopelessly naive a few years ago.

By ‘the optimality of fiscal policy’ I mean things like:  what is the ideal target long run debt to GDP ratio?  How high could we safely allow it to go without threatening fiscal solvency, and therefore how generous and counter-cyclical can the response to recessions be?  What institutional provision might we need to make sure that fiscal policy can max out when interest rates hit the zero bound?  (For example, could some commitment be made for fiscal stabilisers to be designed in concert with the MPC in such circumstances?)  How frequently should the fiscal pocket be able to fork out for a banking sector recapitalisation?  What is the evidence on the effect of high marginal tax rates on high earners’ incentives?  How much inter-generational risk-sharing can our democracy sustain, and how much is appropriate?  There are lively debates going on in all these literatures, but the national conversation here never seems to make reference to any of them.  Who are the parties consulting about these proposals?  Certainly [and perhaps advisedly!] not me.  Why aren’t there policy documents making contact with the bodies of academic research on these questions?  One might observe that it is early in the electoral cycle to have fully fledged and academically sounded fiscal frameworks.  But, really, we have had decades for the parties to get serious about this.

The now discredited Alan Greenspan coined a definition of price stability that involved people no longer talking about inflation.  I yearn for a more settled fiscal regime, an analogous fiscal stability, when people no longer talk about tax changes.  I guess that is a long way off.  But at least one might strive for a world where such changes spring from new insights into the feasibility of stabilisation and redistribution policies, rather than what goes down well with the local party activists.

Update:  My one time colleague at the BoE Malcolm Barr, now at JP Morgan, cautions me to be sceptical about the FT story that prompted this blog.