Coping with segular stagnation by raising the inflation target. Respose to Kaminska and Delong

Brad Delong and Isabella Kaminska are against raising the inflation target as a response to secular stagnation.  To recap.  Larry Summers argued that currently the natural real rate is very low and may remain so for quite some time ahead.  Other things equal, this is going to generate a low value for the nominal central bank interest rate required to hit a given inflation target.  This leaves less room for rates to respond to further contractionary shocks, since starting out at this already low nominal interest rate ‘steady state’ [if that is the right word for it] means the ZLB is not far away.  To make more room, to raise the low-frequency nominal interest rate, central banks or their finance ministry bosses could temporarily – or, as Blanchard suggested before, permanently – raise inflation targets.  Delong emphasises the corrosion of credibility that would result.  Kaminska suggests that it could prompt a flight from state, fiat stores of value.

A few quick points in favour of increasing inflation targets.

First, fighting to preserve the credibility of a policy can be counter-productive.  If raising the inflation target is workable [suppose we put aside currency reform to eliminate the zero bound for a moment, something Miles Kimball has been pushing lately], the authorities will lose legitimacy if they don’t opt for it.  Sooner or later there will arise the view that a political consensus will form for raising the inflation target, and this will feed into expectations, come what may.  Failing to choose what’s sensible could also undermine the credibility of other policy tools too.  If you can’t trust the authorities to do the right thing with monetary policy, the punter on the street may muse, why should we continue to allow them independence to supervise banks [or do anything else]?  If you buy Martin Wolf’s view that the authorities’ legitimacy to govern is already strained, this is the kind of straw that could break the political economy camel’s back.  As an analogy, [and repeating points from earlier posts] I don’t think UK fiscal credibility would have been served by Osborne doing what he said he would do at the outset, sticking to the Coalition’s austerian Plan A consolidation.  Having made the initial error of making the unkeepable promise, he did the right thing and reneged, at least twice.  Had he not done so, he would have brought the Coalition’s legitimacy to govern into total disrepute.  Likewise, if raising the inflation target is the right thing to so, the long term reputation for competence will be best served by doing it.  If.

Second, Kaminska and Delong, in my view, over-play the worry about stores of value.  I would observe that past history suggests that it takes serious departures from price stability – hyperinflations, or sustained bouts of very high inflation – to dislodge an equilibrium where agents coordinate on using the state’s chosen fiat currency.  Examples:  the Jacobins’ debasement of the Assignat, vouchers presentable at auctions of confiscated church lands.  The adoption of the Undidad de Fomento in Chile after hyperinflation there, documented by Robert Shiller.  Dollarization elsewhere in Latin America.  A logical, pre-announced, moderate increase in the inflation target, unconnected with public finance needs [perhaps accompanied by a further switch into financing using indexed debt], need not undermine the collective choice to use state fiat currency.

Two parting side points.  First, note that Michael Woodford shows [in his textbook Interest and Prices for example] that you don’t need the fiat currency to be the chosen store of value for monetary policy to have traction.  What you need is that this currency still defines the unit of account.  Second, foregoing seigniorage by encouraging a further shift out of money would not be material for public finances, since it currently accounts for only a tiny fraction of revenues.

Advertisements

At the ZLB, reducing unemployment benefits increases total unemployment AND reduces frictional unemployment

Paul Krugman has been accused recently of being inconsistent with his own textbook on the issue of whether higher benefits for the unemployed raise or lower unemployment.  His textbook explained the consensus view that such benefits can increase ‘frictional’ unemployment – or the natural rate of unemployment, by reducing the pressure on the unemployed to find work.

Krugman’s reply was, paraphrasing:  there are no jobs for these people to find, so not paying them benefits is just a reduction in private demand, and that aggravates the situation in the US, which is to be characterised as one of deficient demand.  Those benefits, which may be wasteful at other times, are productive because they are a way of public spending filling in the gap that low private spending has left.

But actually there’s another reason that PK is not, actually, being inconsistent, that is worth teasing out.  If you buy the modern sticky price model of the liquidity trap, as exposited in papers by PK himself with Eggertson, or Woodford, and others, what the expiry of benefits for the unemployed does [on top of reducing aggregate demand] is to act like an increase in aggregate supply, by pumping up the numbers looking for work [unless all the said unemployed are completely discouraged now anyway, which one infers that they are not, not only from survey evidence, but from the fact that otherwise inflationary pressure would be much higher that it is currently].  This effect is entirely consistent with textbook PK.  We are encoding that the natural rate of unemployment falls, in line with the 1990s/2000s micro-econometric evidence on ‘active labour market policies’.  But it’s also consistent with blogging-PK, in the sense that it’s bad.  It increases the gap between actual demand and potential output, reducing inflationary pressure further, requiring more monetary or fiscal easing to counteract.  Eggertson called things like this ‘paradoxes’.  They are paradoxes because they are things that we commonly think of as good.  But actually turn out to be bad for the whole economy, and most people in it, in general equilibrium.

Chris Dillow defends PK by arguing that the effect of unemployment benefit expiry might be different in different states of the world, and that such states of the world naturally requires different models.  PK seems to accept this ‘different models’ defence, adding that economics is no different from, and not inferior to natural sciences in resorting to it.  But actually I think the defence is sounder than both or Krugman or Dillow make out.  The Eggertson-Krugman-Woodford, sticky-price account of the world is a single model, just one that recognises that sometimes shocks are large enough to drive the economy to the zero lower bound [which is always there, not sometimes] and sometimes they are not.

So, in brief, cutting unemployment benefits reduces aggregate demand [bad in a liquidity trap] and increases aggregate supply [also bad in a liquidity trap].

There are thought-provoking challenges to the whole sticky price macro toolkit.  [I for one read and re-read Cochrane’s regular attacks, particularly those on equilibrium selection.  And I recall the Grandfather of these models, Kiyotaki, calling them ‘at best, fairy stories’].  But you can’t accuse them of not providing a single , perfectly consistent account of current circumstances, and of why Congress should not be cutting off benefits for the unemployed.

This time only the names are different

Roger Farmer tweeted this quote from a Martin Wolf article today:  ‘in essence, today’s financial system is the same as before’.  Without checking, I am guessing that ‘before’ means before the latest crisis.  But perhaps ‘before’ might not be so specific.  I was reminded of the great Forrest Capie, financial historian.  The Bank of England held a celebration of his career, with a few invited speakers.  The best speaker was of course Forrest himself.  Without notes, he delivered a nail-biting narrative of what could have been this crisis, with all the names removed.  The irrational exuberance.  The panic.  The hurried chaotic meetings of officials. Desperate measures.  Some lessons learned, most not.  With a terrific theatrical flourish, Forrest’s closing words revealed that he was actually talking about the banking panics of the 1800s.  Sending the message:  this time only the names are different.

Fiscal policy: as if Carney had said ‘we won’t stick to this forward guidance’ and then stuck to it anyway

Another thought on the Coalition’s attempt to manage expectations about fiscal policy.

My last post on the Coalition’s fiscal policy, in a nutshell, said that although the eventual path of the deficit, ex post, turned out not too far wrong, (in that, in combination with monetary policy, we ended up with at least as much inflation as we wanted, and perhaps even then some), there were politically calculated mis-steps along the way.  In particular, the failure to set out a policy that could i) promise fiscal responsibility, but ii) allow for changes of plan if fiscal risks turned out to be less than at first thought, or the recovery weaker (exactly what happened, of course).

My conjecture is that if instead they had promised a loosening if conditions allowed, at the outset, expectations of the future would have been brighter, and the recovery sooner to take hold.  Modern macro stresses a great deal the management of expectations.  One of the phrases in Michael Woodford’s tome Interest and Prices that sticks in my mind is that ‘very little else [apart from expectations] matters’.  In this respect, the Coalition failed miserably in expectations management.  Of course, they did so in pursuit of generating expectations that the UK would be fiscally solvent.  It was right that they viewed these two kinds of expectations management as competing.  But they went after fiscal soundness expectations in a mistaken way.  Ex ante, no-one should have believed them when they said that they would stick to their ‘Plan A’ come what may.  Ex post, they didn’t stick to them anyway.  So if anyone was fooled, they would have been disappointed.  So the Coalition ended up with depressing expectations of future demand [bad for current demand, ie bad for demand back in May/June 2010], without enhancing expectations of fiscal soundness.

To make an analogy with central bank ‘forward guidance’.  It would be like Carney saying:  “there’s no way we can keep interest rates this low for this long” [ie deliberately stoking up expectations of a rate rise] and then confounding expectations by keeping them low for that long.

Why the lack of private sector DSGE models is weak evidence of the worth of DSGE models

For some Friday night fun, and, caution, after a day grinding through DSGE models of credit frictions, preparing for an MSc Masters module at Bristol later this year, I thought I would comment on Noah Smith’s typically entertaining macro-smackdown.

For the uninitiated, a ‘smackdown‘ is an American wrestling term for, I guess, a decisive point score by getting your opponent on his or her back on the floor of the ring.  It should be part of a US blog reading glossary for consuming the Smith, DeLong and other fare.  Steve Williamson chided Noah once, indirectly, for using terms like this.  But for me in conjures up the era of wrestling on Saturday afternoon TV in the UK in the 1970s, pure choreographed theatre;  on the surface, violent, but actually perfectly friendly.  So ‘smackdown’ seems fine to me.  It’s especially appropriate for this post.

Noah’s smackdown for DSGE models is to observe that no-one uses them in the private sector.  Evidence he takes for their lack of worth in society.  OK, how do we go about throwing that one onto its back?

Well, one tactic is to point out that there are quite a few private sector people doing DSGE modelling.  I used to work with some of them.  I’m not going to name them, in case they feel shamed by being outed as DSGE-ers.  But you know who you are.  However, this is a pretty sterile tactic.  Because the reason these people are doing it, and I speculate many are, is because they know central banks are doing it.  And if everybody in the central banking community is doing it, you can see why it might pay the private sector economist to be doing it.  If they think that central banks are actually using those critters to set policy, they might be able to get their clients an edge by figuring out what those DSGE models will be telling central banks.  Why does that make this tactic for refuting Noah sterile?

1.  Central banks could be mistaken in using these models.  Though it pays the private sector to use them to try to shadow them, it doesn’t prove their worth.  Tony Blair denied that he and George Bush used to pray together.  But, even supposing they did, and we decided to check out the Bible for a clue as to what they were thinking, that wouldn’t prove the social utility of the Holy Book.

2.  Central banks could be hoodwinking everyone into thinking they are using these models.  [My comment on the BoE:  they have much less of an influence than you might think.  So little influence that they can ship out one model, and ship a whole new one in without anyone really noticing it in the inflation forecast profile.  In fact, they can perform this feat twice in a decade].  Why would they do that?  Well, many reasons.  Here’s one:  there is an arms race between policy institutions to try to hire smart people who like thinking about the economy.  To get them, you have to tell them that these models are very important to you.  Once they are in the door, you let them write a few working papers, and pay a few flights for conferences.  Of course, all you want to do is ask whether real yields went up or down last month, but to get someone able to pick up the phone, open a spreadsheet, and subtract one line from another, you have to go through the whole charade.

OK, so we are done with trying to refute Noah’s thesis by pointing out that private sector people do use these models.

Well, not quite.   A lot of people who wind up in the private sector have studied DSGE models.  Are there any macro Masters or PhD courses that don’t cover them now?  [I mean DSGE in the term I think Noah meant it, ie microfounded macro, not just direct descendents of Blanchard-Kiyotaki].  If these models are worthless, why are the private sector still hiring a disproportionate number of people who have wasted their lives committing these fairy-stories to memory, and cluttering up their computers with them?  [My microfounded model Noah Smith replies:  they are trapped by the same network externality.  The market coordinated on this being the way to test whether someone can endure the tedium of early mornings, business casual, and Powerpoint over lunch.]

Onto other tactics.

Perhaps the worth of DSGE models is a public good.  Perhaps they cement certain externalities to do with the good design of monetary and fiscal policy.  The Germans managed to cement their own distaste for inflation with a hyperinflation, so they did it without the benefit of DSGE models, which were at that point only twinkles in the eye of the people who would beget the people who would eventually beget them.  However, perhaps DSGE models offer another, less socially catastrophic form of institutional glue.  In which case, they might not be all that useful for the private sector.  Especially if they are only good for figuring out the headlines.  Like:  high inflation doesn’t pay in the end.  Or:  you should use monetary and fiscal policy actively to stabilise the business cycle.  [This is what they do say, by the way, in case you are a general reader and you have, by some miracle, not clicked away in irritation by this point].

Another tactic.

Noah argues that according to DSGE creed, you can’t do conditional projections with anything but a Lucas-Critique proof model.  Because if you do, when you project conditional on a policy that looks a lot different from the one that went before, you’ll invalidate the statistical correlations encoded in your non-Lucas-Critique proof model, and the effects you hoped for won’t materialise.  However, it was widely recognised that how much those coefficient changes would depend on how much the contemplated conditional projection differs from what went before.  Leeper and Zha explore his in their paper on ‘modest policy interventions’.  ‘Modest’ means modest enough to make it ok to use a VAR, estimated on a particular policy history, to do a conditional projection.  So, perhaps the private sector nerds Noah knows never need DSGE models because they find their modest policy interventions don’t undermine their empirical model coefficients.

Next tactic.

Aren’t unconditional distributions ok for many purposes?  Here I court disaster in the form of a finance smackdown.  But, don’t I sometimes just want to know the joint unconditional density of outturns for everything relevant for pricing all assets?  In which case, isn’t an infinite dimensional nonlinear empirical time series representation adequate for such a piece-of-cake task?  Or, failing that, say a VAR with a few choice macro finance variables and a few lags of each?  If I want to price a ten year government security, perhaps I would be happy just to know what the central bank rate will be over the next ten years.  In which case the details of policy, provided they don’t change, can be mashed up with the details of everything else in the VAR.  This is what some of the other people I used to work with do now for a living.

WHUMPH.  [Sound of 120kg wrestler thrown on ring].

The UK Coalition’s fiscal ‘mission accomplished’ twaddle

George Osborne and fellow Conservatives are attempting – seemingly with success – to run the argument that the fact that the economy is now growing quickly proves that their austerity policy was the right one.  The message gets pumped out by the Tory Party, and everyone that wishes them well.  For example, I subscribe to tweets from an old Bank of England colleague Tim Montgomerie, now Times columnist and influential thinker on the right, and this is one of his staple retweets.  Although the silliness has been countered already by others, it seems appropriate to fight repetitive twaddle with repetition.  And while I’m at it, it’s worth recapping on the multiple mistakes made since the Coalition took over.

Modern macro theory suggests that economies will eventually return to growth unless governments kept contracting fiscal policy.  The Coalition’s plan involved a slow reduction in fiscal drag.  This reduction in drag has contributed to the return to growth.  That growth proves nothing about what the ideal path of fiscal policy was beforehand.  It does disprove any claim that austerity would lead with certainty to a vicious cycle of ever higher deficits and ever greater recession.  But no-one ever made such a claim.  Some of Ed Balls’ interventions alluded to there being a risk of such a vicious cycle.  This was understandable, because arguably that’s what the Euro peripheral countries are going through.  But that this was a risk then is not disproved by it not materializing later.  Even my six year old boy understands that just because he threw a double six in a game of Snakes and Ladders doesn’t disprove that there was a risk he could have got a double one.  By taking this tactic, Osborne presumes and then exploits the public’s lack of understanding about risk and uncertainty.  It’s highly undignified for an incumbent Government that they choose to debase current economic debate with their rhetoric on the recovery, though rather standard practice in UK and seemingly US politics [the Scottish Independence question, and the debt-ceiling fights being two cases in point].

Contrary to what the Government has been saying, the overwhelming evidence is that fiscal contractions reduce growth, at least temporarily.  This is true in the workhorse model of monetary and fiscal policy (The sticky price New Keynesian model). And it’s true in various empirical studies, where care is taken to identify autonomous shocks to fiscal policy.  The effect is presumed to be more marked when interest rates are at their zero bound, so long as you think that unconventional monetary policy instruments either cannot, will not, or should not be loosened to compensate for the conjectured fiscal tightening.  The overdue return to growth of the UK economy is entirely consistent with this evidence.

The Coalition went wrong at the outset.    They started out by declaring their Plan A and stating that they would commit to it come what may.  This was silly and incredible.  Obviously there were some circumstances that would prompt a shift to a plan B.  It’s just that the Coalition would not tell us.  It was macho bluster, aimed at sharpening the political difference between themselves and an irresponsible Labour (according to their caricature, anyway) and at the markets, who they feared might run from UK government banks and bonds.  And so circumstances proved:  as the Institute for Fiscal Studies have pointed out, and Simon Wren Lewis has highlighted in his blog, the Coalition did switch to a plan B, and then some, in fact adjusting its deficit targets at least twice.

This fake certainty was a second blow to the cause of promoting good understanding of risk and uncertainty in economics and policymaking.  It plays to a view amongst some policymakers and the media that any sign that you don’t know precisely what the right thing to do is indicates weakness or incompetence.  The reality was that there was a genuine debate about the fiscal risks at that time, and about the consequences for the economy of the austerity plan.  Contrast the bluster surrounding the bogus ‘Plan A’ no turning back stuff with the much more rational, if occasionally maddening, continual hedging by the Bank of England.

The Coalition hoped to paint itsef as the new party of fiscal responsibility (eg by setting up the new Office for Budget Responsibility).  But instead history seems to be repeating itself.  Initially irrationally straitjacketed fiscal policy when there is no need to worry about the polls with a view to saving money for a pre-election splurge.  And in the process cementing the reputation of the UK for fiscal obsfucation.

Personally, I took seriously the worries that markets may have dubbed us a Greece or an Ireland in May 2010.  It was possible that the combination of political uncertainty and the uncertainty about the fiscal strain caused by a possible need for a second capital injection into UK banks could have provoked a run on UK bonds.  Others seemed not to worry about this, on the grounds that we had our own currency.  My position was that being able to print our currency at will to plug a fiscal hole caused by our failing banks did not constitute an insurance that we or markets would feel solves the problem, or provides a sufficiently comfortable route out.  Money printing in those circumstances would be default through more gradual means and lead to great economic costs itself.  However, once the risk of such a meltdown abated, much looser fiscal policy could have been contemplated, and indeed such a contingent loosening could have been promised at the outset by government.  This might have lifted confidence without frightening financial markets.  As it turned out, inflation ended up high and stable.  And I judged that to be a sign that loosening beyond the Plan B/C Osborne chose was not necessary.  (It would have boosted output, but probably just at the expense of higher inflation, and arguably inflation was high enough above target).  However, it would have been better to build the Plan B/C that was followed into the original, contingent on markets deciding that the Coalition was stable, and that either no further bail-out was needed or we could afford it anyway.  So, although I don’t think there was that much wrong about the initial and eventual paths for the deficit, I think these fiscal choices were executed in a highly damaging and dishonest way, one that will cast a shadow over future fiscal policies.  (What is the point of ‘austerity’ if you don’t buy credibility with it?)

These weren’t the only mistakes made on fiscal policy.  One impropriety we should not forget was the act of soliciting of comments on the soundness of the Coalition’s fiscal plans from the Governor of the Bank of England, then Meryvn King.  This was highly risky and ill-advised.  I think it was a shame that the Governor agreed to cooperate.  The risk was that it politicises the office of Governor, corroding the apparent independence of monetary and other policies.  The risk was aggravated in this instance by it being widely assumed that Lord King had acted in an advisory capacity for the Conservatives before his time at the Bank.  (If I recollect correctly, this is hinted at in Nigel Lawson’s biography).  In my view, Bank of England Governors should not comment on policy choices not directly within their own remit, to avoid the risk of being seen as a political appointee, and their bosses, the Chancellor, should not solicit such comments.  If the appointment looks political, then this may create an incentive for the next aspirant Governor to say things that sound supportive of Government policy, and the corrosion accelerates.  At a time when the Bank was taking on more powers on the financial stability side, it seems especially unwise to try to include Bank officials in the debate about optimal fiscal policy.  (Why?  Well, it could incite widespread discontent with an over-mighty Bank of England, and a movement to clip the wings of the Bank.  This wouldn’t itself be a bad thing, but if that led to markets thinking that the independence of monetary policy would be compromised as a result, then inflation expectations could rise, and the output cost of hitting the inflation target would be temporarily higher).

Comments by the Governor that seem permissible to me would be comments that explain how (eg) fiscal policy bears on the best choices for the central bank instruments, and the likely performance of monetary policy.  An example of a permissible comment might have been the following:   ‘Frankly, there is a lot of controversy about the ideal fiscal policy at the moment [I’m taking you back to May 2010 right now], and this is anyway a political choice.  However, tight fiscal policy is going to mean, other things equal, that monetary policy would ideally like to be looser.  We have unconventional instruments to try to execute that, but their effectiveness is uncertain [this bit obviously far-fetched, as the BoE engaged in its own QE certainty nonsense at this point], so we can’t be sure of being able to generate the looseness needed to compensate for fiscal austerity, and this creates a risk that inflation and possibly real activity would be below target.  That itself doesn’t mean that austerity is the wrong choice, just that there are likely consequences for the ability of the MPC to meet its target at the zero bound to interest rates.  Ultimately this is the Government’s mandate at all times, so it’s perfectly natural that it makes these choices.  However, I’m explaining the consequences to you so that you don’t inadvertently judge the MPC to have fallen down in its duties when in fact fiscal policy was changing what was possible or likely.’

So, supposing the recovery is now secure, we can’t declare ‘mission accomplished’ on fiscal policy.  The Coalition fortunately chose to ditch it’s own unbelievable fiscal straitjacket, fearful of the economic consequences of not following a Plan B.  Sadly, they chose to promise falsely that they would not deviate, and then tried to pretend that they hadn’t afterward, perhaps correctly calcluating that they would get away with it.  Having indulged in the usual crass ‘certainty politics’, they concluded by trying to fatally undermine our grasp in the notion of the counter-factual, by pointing to the recovery as evidence that they were right all along.  If instead of fiscal probity the mission was to spread economic illiteracy for political gain, then I think we can say that it was ‘mission accomplished’.

More on Draghi’s almighty OMT bluff

A while ago I posted this, explaining how I thought that OMTs were an almighty – if so far successful – bluff.  The reasoning being that the promise is to buy whatever quantity it takes to eliminate a gap between actual and ‘fundamental’ prices (whatever that means) of troubled sovereign bonds.   That promise exposes the ECB to unlimited capital losses for which there was and is no political support, and possibly no legal support either.

At  a recent lunch this subject came up, and the following line of thought was pursued.  Since at any point in time there is a known and finite quantity of eligible short-maturity bonds, does that cap the fiscal liability of the ECB, and therefore render OMTs not a bluff but a credible promise?

I don’t think so, for two reasons.  First, there is probably not even the political support to sustain losses equivalent to the outstanding stock of short-maturity troubled sovereign bonds.  Second, the thought experiment we need to carry it is to ask how the stock of eligible bonds would evolve in a hypothetical ‘speculative’ attack on a troubled sovereign.  (Speculative in quotes, as such a run would involve calculations no less rational or probabalistic than in any other outcome).  That attack would involve rising yields, and an increasing requirement to issue more bonds, probably tilted ever more towards short maturities, in theory without limit.  So although the current stock of eligible bonds is limited, in the status quo equilibrium where the ECB bluff is believed, the hypothetical stock in the event that there were a run would not be.  And hence the promise is still a bluff.  A remarkably and fortuitously successful bluff.