SNP playing dirty over the currency question

This morning’s interview on UK’s Radio 4 ‘Today’ program with Deputy First Minister for Scotland, Nicola Sturgeon, of the Scottish National Party, had me shouting at the receiver.  I don’t know whether she and the SNP leadership understand the monetary economics lurking behind the costs and benefits of alternative currency options for Scotland and the rest of the UK (RUK) and are simply obscuring things to make them look rosier for the Yes campaign, or if they simply don’t get it.  They say such idiotic things on the subject that it’s hard to tell.  And it worries me that their interventions, both clumsy and poisonous, are debasing this debate, and economic discourse generally.

This morning, Nicola repeated the silly assertion that it would be in the RUK’s best interest [I think she actually used the word ‘overwhelmingly’] to retain a currency union with Scotland without any restrictions on Scottish fiscal policy.  Jim Naughtie deftly pointed out that the example of Europe was surely a pointer that it would not.   Nicola replied that unlike the Euro Area, the UK constituted an ‘optimal currency area’, so there would be no problem.  This is another silly falsehood.  I’d like to see what analysis she thinks backs up this claim, by the way?   She was making a very abbreviated (brevity not her fault) version of an argument that goes like this:  if two economies are hit by very similar shocks, that would warrant similar monetary policies, and so there would be no cost on this count to having the same monetary policy, i.e. the same currency.  Unfortunately, this argument ignores difficulties presented by economies either running different fiscal policies (which is after all what the SNP want ultimately) or facing different fiscal pressures.

Excellent work has been done on this by Angus Armstrong at NIESR, and I also posted on it briefly here. But to recap.  The RUK would be reckless to allow such a union.  As a baseline, the RUK would want to insist that Scottish debt to GDP levels were no different from its own over long periods.  And that the tendency for fiscal policy to try to counter booms and busts were also not much different from its own.  On top of that, the RUK would wish to insist that fiscal policy were more conservative, less stabilising, to guard against a market run on Scottish bonds that might result from large fluctuations in either its revenue (from oil) or its liabilities (from a possible failure of Scottish financial institutions, which weigh heavily relative to the size of the Scottish tax base).  And over and above this, the Scots would be required to run tighter fiscal policy to save for the costs of an ageing population and declining oil revenues, and to put money aside to fund a possible bail out of its relatively larger financial sector.

It’s not surprising that Sturgeon tries to put things differently.  The SNP (and newly independent Scots) would themselves want to have their cake and eat it.  It would be better for them to have a currency union, and try to free-ride on the RUK ‘s deeper fiscal pockets to bail them out of another financial crisis.  And, unfortunately, once a deal like this was done, it would be in the RUK’s interest to buckle under and fork out, because allowing Scottish banks to fail would likely cause knock on problems for our own banks and economy.  (That’s why we helped out Ireland).  For this reason it would be essential to have watertight controls over Scottish fiscal policy.  Unfortunately, without political union, no watertight controls exist.  Witness the fact that the austerian North Europe is powerless to stop Greece from backsliding on reform (put aside whether they are right to try to insist on it or not, the point is that they can’t) because they and the Greeks know the risk of a disorderly default is not confined to Greece.

In essence, the only currency union that would make sense would be one in which fiscal policy was pretty nearly identical to the fiscal policy that pervades under the political union.

Even sillier was Nicola’s claim that because Sterling was a ‘shared asset’ they had a right to continue in a currency union on their own terms.  ‘Shared asset’?  Which SNP advisor dreamed that one up?  This is silly on many levels.  First, somewhat pedantically, Sterling is not an ‘asset’, it’s a liability of the Bank of England.  Actually, it’s a liability that is a promise to pay nothing but itself.  (Thanks to a friend who can’t be named for making that point clear).  But still, it’s not a financial asset.  Perhaps I should be charitable: surely the SNP were not literally trying to claim that ‘Sterling’ was an asset?  Surely they simply meant to refer to the fact that our monetary book-keeping system was a public good that they had the right to enjoy too?    But I’m not sure about this.  In the same breath Nicola argued that if the Scots were to be deprived of this ‘asset’ then they could not take their share of the national ‘debt’.  This kind of language struck me as a politically sinister attempt to get the lay listener to think that the argument had some deeper financial common sense about it.  ‘Yeah, assets, and debt, it kind of evens out doesn’t it?  Well, that’s fair enough then, let’s give it to them.’

Leaving this aside, do the Scots have a ‘right’ to continue to be part of the currency union without fiscal controls?  Morally, no.  Because the services conferred by the monetary system for everyone else would be deteriorated by Scotland so doing.  Once agreed to, the RUK would have no choice but to make fiscal provision themselves to insure against Scottish oil and financial risks, and to save for Scotland’s old age, bearing a disproportionate burden for doing so, and risking a run on its own bonds without it.  Of course, rights may not come into it.  What will emerge will depend on what the Scots could force in a negotiation.  That’s a trickier question to work through, and beyond the scope of this blog.  The ‘right’ thing to do would be for the Scots to take more of the national debt in recompense for the burden they would impose on the rest of us by insisting on their fiscal freedom and their own fiscal risks they would transfer to us.

What is most depressing about all of this is the attempt to debase important economic debate because of essentially political wishes.  The SNP wants independence for Scotland for political reasons, and it seeks to distort, subvert and wilfully misunderstand the economics of independence in service of that (who knows, maybe laudable) political aim.  When the UK Government seeks to explain things differently, the SNP went to battle, arguing ‘well they would say that wouldn’t they, for political reasons THEY seek to debase the economics’, a particularly poisonous intervention, I thought, as an outsider, since exactly the opposite was going on.  When independent bodies like the OBR make the same arguments, the SNP try to cloud the issue.  ‘The OBR are simply saying there is a lot of uncertainty’ was one response I read.  This kind of behaviour by the SNP has costs outside the arena of the debate over Scottish independence.  It prevents the lay population at large from understanding the economics of issues they have to decide on.   And at a time when the crisis has put these economic issues at centre stage.  It also taints the reputation of politics for plain speaking.  ‘If I can’t trust political leaders to talk straight about the economics, who can I trust?’, thinks the median voter.   There are plenty of non-affiliated bodies and academics commenting, but people don’t encounter them directly.  There are also journalists in the print and broadcast media to explain things plainly.  But these are difficult topics for them to grasp too, sometimes, and the attention span of the hypothetical customer is deemed too short to be lectured to at length.

It’s perhaps not surprising that the debate gets contaminated so much at times like these;  by holding a referendum for independence, the SNP stakes almost all its political credibility and identity on success, so the payoff for some future era, on other topics, of an enlightened and informed economic debate, is too etherial for them to worry about.  The restraint by the Government is convenient, but probably also not to be applauded too much.  My surmise is that’s a calculation that it would backfire politically to weigh in more heavily, stoking up anti-Westminster feeling, not a view that citizens should have informed economic discussion.  When it suits them, eg in the debate with Labour over austerity, the Westminster Government are perfectly capable of playing dirty:  witness the claim by George Osborne that the fact that the UK is finally growing proves that tight fiscal policy was what was needed.  [Which is obviously false:  counterfactual GDP under looser fiscal policy would have been higher].

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John Taylor not applying the Taylor Rule?

Well, not quite, but it was worth it for the headline.  In this post, John Taylor cites recent work by Erceg and Levin at the Board of Governors, pointing out that headine unemployment rates are a bad indicator of true labour market slack in the US, because the contraction has discouraged a large share of the labour force from even trying to look for work.  So true unemployment (or under-employment) is much worse than headline unemployment.  [One reason why it’s helpful to use the property of sticky price models, if you believe in them, that the inflation rate can also tell you about the amount of slack in the economy].   John Taylor does not, however, draw the conclusion that, after all, the loose monetary policy he has been criticising is warranted.  Why not, I cannot fathom.  The output gap is the unobserveable variable he told central banks to feed into their interest rate rules in 1993.  Surely any sensible model of that unobserveable would conclude that the output gap was greater, having formally digested the result that participation was highly cyclical?  In which case policy should be looser than previously thought?  (If not, what procedure should we be using to estimate the output gap?)   Instead JT alludes to why activity is weaker.  I am putting words in his mouth here, but reconstructing from other things he has written, he thinks that activity is weak because of corrosive fiscal policy wars, caused ultimately by the Democrats breaking with what he (incorrectly in my view) sees as a tradition of not doing fiscal stimulus.  And to be corrected by tighter fiscal policy.  Something I noted before to be counter-intuitive.

Post script on the campaign to reform the economics curriculum

I enjoyed Simon Wren Lewis’ excellent post on this on MainlyMacro.   A few points by way of a post-script.

1.  Simon comes close to giving the impression that the only conclusion you can reach from ‘mainstream’ textbook models is that ‘austerity’ was a public policy disaster.  I don’t agree.  At the time the Coalition took over, there was a genuine risk of us being dubbed ‘like Greece’.  Recapping briefly [more here].  Although we can print our own currency, and, if we chose to, use that printing to finance budget deficits instead of defaulting, I don’t consider that much of an alternative.  It would be hard to control, damage monetary and fiscal policy for at least a generation (perhaps, like in Germany leading to overly restrictive institutions and attitudes about these policies in the future), and would expropriate plenty.  As the crisis wore on, it became clearer that we were unlikely to be dubbed ‘like Greece’.  But at the same time, inflation was high and stable, which, using the same mainstream models that Simon uses, can be interpreted as telling you that there is no weakness in output that it is appropriate for monetary or conventional demand-boosting fiscal policy to stimulate.  On this view, chronically weak output has some other cause – likely the sclerosis in the financial system.  So, to recap, I think these same mainstream models do make a case for fiscal policy roughly along the lines of what we saw.  [Of course, that doesn’t make them worse models, simply because it happens they can be used to explain an unpopular policy].

2.  One of the complaints by the campaign for a new curriculum is for a shift in emphasis away from ‘neoliberal’ market economics.  It is fair enough to take the position that more intervention in markets would be the thing to stop a crisis of this sort repeating itself (though there are plenty who would disagree).  Perhaps even the subversion of the entire market system.  But it seems to me that such an analysis has to proceed first by studying the system as it was, an imperfectly functioning market system.  Those who go on to do graduate studies learn about the ‘social planner’s problem, and the circumstances under which the solution to this problem does or does not get reproduced by markets.  I don’t know if this features in any undergraduate programs.  It didn’t in mine, but that might be because that was too long ago.  This intertwining of the analysis of the social planner and the competitive market equilibrium expresses the unity in a formal way between the thing the curriculum critics want to subvert and what they want to replace it with.

3.  What is most galling about the whole debate is the deluge of ‘expert’ opinion from commentators and writers loosely connected with the economics and policy profession, but who are not practising economists.  Not either responsible for implementing policies, nor in any recent period, or perhaps ever, producing research at the frontier, or, seemingly, not even reading it.  (Actually, if you aren’t producing it, it’s hard to read it, as most is not very user-friendly).  I read a lot of popular physics books, and have a tendency to follow tweet or other internet links on physics (greatly detrimental to my own productivity).  But I wouldn’t dream to pronounce on how physics funding should be reformed, or how the physics curriculum should be changed.  But this is exactly what economics journalists and other commentators are doing.  Economics has a flavour of common sense about it.  It’s about buying and selling isn’t it?  Demand and supply?  I know that, because I want stuff, and people give it to me.  The price of fish?  I’m an expert because I buy it all the time. They feel like they already are economists and that their daily life tells them all there is to know about it.  And when they hear whiffs (for example from Paul Krugman) that it’s not like that sometimes, they conclude quickly that it should be.  One retort might be:  but why do I have to read all that stuff ? It’s exactly that ugly tricky mathsy stuff about markets that has gotten us into this mess in the first place isn’t it?  I don’t believe it is, actually, but, even if you are more sceptical, you can’t judge what has to be thrown away if you have never grasped what it has to contribute.

4.  Simon comes close to making the comment that most economists did not make the mistake of failing to forecast the crisis.  From where I stood, it seemed that most people did make this mistake.  And many of those that did not were forecasting the same crisis for most of their lives, over and over, for reasons that often were internally inconsistent, garbled, and seemed to reveal that they hadn’t absorbed any recent economic thinking.  [Some of those populating the senior ranks of the BIS I would put in this category].  So I think most have undergone a re-evaluation of their position on what questions are really solved and what are open.  Caballero has a paper in which he refers to a ‘pretence of knowledge syndrome‘, which captures the problem.  There were long strands of thought on proper monetary and financial economics in macro, but these were minority activities.  Not any more.  Everyone is at it now.  And citations of those who got in early (Gertler, Bernanke, Kiyotaki, Moore, Williamson, Wright, Lagos, Gilchrist, Carlstrom, Fuerst) have gone through the roof.

5.  To re-iterate Simon’s point about forecasting not being a good way to judge economics.  Read Nate Silver’s book.   Some things may be inherently unforecastable.  At risk of irking the anti-economics reader, we know that in theory there are inherently unforecastable things, so it shouldn’t surprise us to find them in the real world!

Goldman Sachs’ HQ and UK exit from the EU

Last night, watching Goldmans’ explain carefully that a UK exit from the EU would be one of the things they would consider in locating their HQ, it struck me that we have seen many such interviews, and all of them seem to miss the obvious point.  That being:  the biggest factor weighing on where to locate such an HQ (or on related decisions) is where other similar firms are going to locate theirs.  Being near others has many advantages.  You can steal their staff more easily because they don’t have to worry about relocating.  You can bank on a parrallel network of suppliers coordinating on being in the same place.  If you are a top executive you can more credibly threaten to leave yourself if you happen to be located close to a competitor, etc.  Once you see this, then the biggest factor in how to respond to an exit from the EU is how you think others will respond.  And once you recognise that, then it’s clear that that means that the key factor is how you think others will think you will think they will respond.  And so on.  Ad infinitum.  In situations like this, it could be quite possible for everyone to up and leave even if there were a whiff of an exit, even if the ‘fundamentals’ of location [business rates, schooling, regulation, etc] were not much different from one place to another.  For a similar reason depositors can run on a healthy bank, financial firms could pull out of London, simply because they think others will too.

Debt-ceiling fights destroy many kinds of money, and money in many countries.

I wrote before about how worries about a possible default or interruption in payments on US debt, resulting from Congress failing to agree a rise in the debt-ceiling, destroy money and liquidity.  Just to tease two things out of the analysis that need emphasising, even if they were already there….

First, fights over the debt-ceiling don’t just destroy the money-ness of US Treasuries.  Though they certainly threaten to do that.  They destroy other kinds of money.  In modern financial systems, many other institutions’ liabilities become money.  The most familiar being deposits in a retail bank, of course.  [This is partly why we don’t want them to fail, because their failing would amount to a devastating monetary contraction].  But short-term paper issued by retail and other banks into wholesale financing markets also serve similar kinds of functions.  When these markets are working well, those liabilities are convenient and predictable places to park your wealth and redeem it for something else you want by trading later, in the knowledge that the price at which you can trade will be fair and predictable, because there will always be plenty of people to make the trade with.

Those institutions who have parked their money in Treasuries, and are threatened with a shock to their cashflow by a default (or more realistically an interruption or deferral in payment) by the Congressional fights, may also have issued liabilities into the market that other people use as money.  Because people may worry about whether they can really pay up on those liabilities, or worry that others will worry (and so on, ad infinitum), those liabilities can quickly become much less money-like.  I wonder if there are any Wall St CEOs funding Tea Party Republicans?  I will wager that there aren’t.  Because those institutions earn a lot from the fact that their liabilities function as money.  [Just like the US Treasury].  If you happen to mix in those circles and read this blog [very small joint probability] and you know a Wall St CEO who is funding a Tea Party Republican, set them straight.

The second thing to tease out of this is that those institutions may be domiciled abroad.  The Tea Party Republican threats destroy money created by and that provides services in other countries.  Those people in the other countries affected by those Republicans’ threats don’t have any say in what is going on.  They can’t currently turn up to the primaries in which those extreme candidates are elected and register their protest.  Though I guess the TPR’s could not care less about that.

Won’t the Tea Party have to call everyone’s bluff to retain credibility?

Thinking ahead to the next round of the debt-ceiling talks in February.  Republican negotiators may be worrying that they are losing credibility.  The first time they extracted real concessions from Democrats.  This time they got nothing of note and appeared to come off worse in polling and in the chat-osphere.

I worry that going in to the next round of negotiations they may calculate that they have to actually trigger a default to be taken seriously in the future.  Otherwise, the whole thing looks like posturing.  What’s worse: being ridiculed for being prepared to trigger a default by refusing to agree a rise in the debt-ceiling, or for pretending to be prepared to do it?

The Republican idea that somehow a default would be purifying and beneficial is pretty crazy.  But at least it sounds like a principle, part of the wider view of the benefits of a small state. And risking all for your principles can look like an admirable thing to do.  But risking all by faking crazy principles sounds to me like a thing that would be seen to be dispreputable.  If you turn out not to be telling the truth about being prepared to risk a default, what else are you not telling the truth about?  How are you going to be treated in any other negotiation you participate in, either with the Democrats, or with other Republicans, carving up the spoils of Congressional Office?

Actually, for bad things to happen, you don’t have to worry that Tea-Party Republicans will try this.  You just have to worry that financial market participants will worry that Republicans will try something.  Or that markets will worry that others in the markets will worry that Republicans will try it.  [Or… And so on ad infinitum.]

5 triumphs at the Bank of England

I have, occasionally, pointed out things that the Bank has done well in this blog.  However, it’s fair to say that most of what I have done is to detail things I think could be done differently.  But in case you worry that I am not objective on this subject, I thought it was worth stepping back and recapping.  It’s far more entertaining to criticise and pick holes.  And as a reader, I think I usually find that more fun too.  But it’s worth setting out what I think has gone well, so that a proper perspective is not lost, and the criticisms can be seen for what they really are:  important points of details.

So, onto 5 triumphs at the Bank of England.

1.  Most recently, resisting the UK Treasury’s incursion into operational independence by asking it to review a policy explicitly designed to inject more monetary stimulus (forward guidance), by declaring that it wasn’t injecting more stimulus.  However confusingly put, that was the intended outcome.  If the cliché ‘what doesn’t beat you makes you stronger’ has any truth in it, then this was a triumph.

2.  Absorbing the PRA.  This isn’t over yet.  But institutional change of this magnitude constitutes a mountain of projects big enough to sink other government departments.  But this didn’t happen.  Neither has there been any obvious fall-out or chaos within the Bank.  Surely this counts as a triumph too. [Their conference room also has very nice seats].

3.  Setting up the Financial Policy Committee.  Mervyn King once gave a speech under the banner ‘practice ahead of theory’.  It was a play on an old real business cycle paper entitled ‘measurement ahead of theory’.  He was talking about monetary policy, but you could say exactly the same about the new FPC.  From where I sit/sat, it seemed like the reason there was an FPC at all was because of the Bank of England.  This new institution got staffed with central banking and financial dignitaries of the appropriate calibre because of the Bank’s long-won reputation for competence and seriousness.  The FPC had to be set up amidst the ebb and flow of post-crisis and recurrent crisis management;  that it was done relatively smoothly has to go down as a triumph for the senior management in the Financial Stability function of the Bank, and the Treasury.  It also had to be done in a sea of ignorance about exactly what the right thing to do was.  Setting up the MPC was much easier by comparison.  There were role models.  And a long history about the single instrument (at that time) it was thought necessary for them to vote on.  And there was little difficulty in figuring out what the goals ought to be.  Life for the FPC builders was much different.  No real role models.  Except a deluge of anecdotes from largely emerging market countries who had been intervening in their banks’ lending for decades.  And an academic profession studying business cycles that, though rubbing its hands in glee at the interesting new questions opening up, had few practical answers to offer.  As an outside observer, I was impressed by two things:  the deluge of requests and notes about the ‘big questions’ to do with FPC design, showing a preparedness to think things through from scratch.  Combined with the relentless [for me hard to empathise with] grind through the nitty-gritty of the project management side to this.  Another potential hazard was the stark philosophical differences between Mervyn King, Paul Tucker and Andy Haldane.  This no doubt caused practical headaches for those serving the FPC and made the process feel uncomfortable at times. But, in the same way as the recurrent fights between the doves and hawks on the MPC has, in my view, left it stronger, so the FPC has survived this difficult early phase, and there are now precedents for future FPC members to have these fights without fearing that doing so will wreck the institution.  A final obstacle was the fact that the FPC was being grafted into an institution designed to do other things.  I’ll bet that when McKinsey take a look at the reporting lines and the organogram, which of course date back to before the FPC’s inception, they will think of plenty ways to wield their practiced bureaucratic chopper. But they should not forget that behind the strange structures and customs is a seething mass of clever and adaptable people throwing themselves at the shifting demands of new and old customers.

4.  The Bank’s nimble response to the financial crisis.  The resolutions of Bank failures, done on the hoof, at great political and legal risk, without a proper machinery [that we hopefully now have].  The administering of emergency lending assistance [ELA].  The reform of the Bank’s Sterling Monetary Framework, both to accommodate financial distress of Banks, and to adapt to QE.  The instigation and winding up of the Special Liquidity Scheme.  The devising of the Funding for Lending Scheme [a testament in particular to a small group of phenomenally clever youngsters at the Bank who I am probably not allowed to name].  I have been very critical of the decision to focus monetary policy efforts on quantitative easing. But, given that that was the decision, the effort in the Markets Directorate to set up the ‘reverse auctions’ used to buy the gilts under the QE program must also count as a triumph.

5.  Monetary policy through the financial crisis.  Hang on, I hear you say, haven’t you spent months getting off your chest all that you hate about monetary policy?  Well, yes, but these are details.  At least relative to the big picture.  Which is that, however described by the Bank, the MPC decided to take a risk and tolerate what was in the history of inflation targeting an unprecedentedly large overshoot in the inflation target, judging that a price worth paying to ensure that the contraction was less painful, and shorter than otherwise.  This was not an easy decision, I am sure.  And it was not always characterised as this, or as self-consciously acknowledged.  But that was its effect.  The MPC still had the chattels of a relatively recent bad inflation history.  [The equivalent on the side of fiscal policy was part of the reason why the Coalition felt they had to tie themselves up in an austerian straitjacket].  But the crisis prompted them to embrace ‘flexible inflation targeting’ long before their political masters used the term in the recent inflation target review in March.  Several years of quite high inflation is, therefore, in my view, a triumph.  That it has been pulled off without triggering inflation scares in financial markets or survey data, I think will confer a great benefit on future MPC incumbents.  It’s surely much harder and riskier for the first inflation targeters to try out ‘flexibility’.  Later flexers can simply point to their forerunners’ wise words and successes.