Lessons for macroeconomic policy after Brexit

A curt summary of my remarks – few of them new to those who read this blog – at this year’s Centre for European Reform conference at Ditchley Park, on the topic of ‘Brexit and the economics of populism’.

In short, there are no lessons to be learned.  The defining, lesson -earning event was the financial crisis, not Brexit.  The same macro challenges that emerged after that are still here, demand the same reform and posing the same puzzles.  There are some specific instrument setting issues, post-Brexit, of course.

Before the crisis, the consensus was that business cycles had all but been extinguished;  that performance relative to the past was due to improved policy;  and that independent central banks, wielding just interest rate policy, plus automatic fiscal stabilisers, would always suffice.  In the background financial stability was guaranteed by the incentives markets provided for participants to self-monitor.

2008 revealed to us that large recessions were not abolished, but in fact likely, that the good performance between 1992 and 2008 was mostly good fortune, not due to better policy, that the zero bound was not of merely academic interest but a reality, and that asset purchases were needed too, and perhaps also cyclical financial policy, and certainly that  we needed discretionary fiscal stimulus measures on top of the automatic stabilisers.  We of course realised that financial stability was not guaranteed.

Fiscal policy during the crisis was too tight, more clearly after 2012 when it became clear the UK would not be judged to be ‘like Greece’ by financial markets.  The missing stimulus was not huge.  Remember inflation overshot by 3.5pp or so in the early phase of the crisis, and the subsequent undershoot was not small, but was not that large either by historical standards.  And fiscal policy had to bear in mind [and still does] the need for potential further injections into banks if the crisis intensified, weighed against [and still weighing] the risk of making this more likely if policy was too tight.

But looser fiscal policy, rather than changing the demand profile radically, would have offered a safer mix of monetary and fiscal policy, allowing for less monetary stimulus, so that more could have been injected later on if needed.

Overly tight policy was surely partly the product of a history of unsound fiscal frameworks, and the lack of a reputation for promise-keeping.  Against this backdrop policy approaches became the focus for political brand warfare, rather than technocratic argument.

Ideally, I’d prefer a delegated counter-cyclical macro fiscal policy, in the style of a Wren-Lewis fiscal council.  But this seems hopelessly unrealistic.  So my small step in this direction is to recommend, again, the following.  If the Bank of England judges there to be a missing stimulus [most naturally at the zero bound to interest rates] it quantifies this.  The Office for Budget Responsibility [OBR] comments.  HMT reflects and can take or ignore the advice but must explain itself either way.  If it takes the advice it devises fiscal measures to implement, and a plan to unwind later.  The OBR comments on the consistency of the plan with long-term fiscal sustainability.

What about the monetary framework?

The post-crisis and pre and post-Brexit challenge is dealing with historically low real interest rates, which mean very low nominal rates consistent with inflation at target.  That limits the amount of conventional stimulus that can be applied to counter a recession.  To combat this I urge that the inflation target is increased to something like 4%.  This would raise the average nominal interest rate by about 2pp.  We’d set about achieving this target once the current one was demonstrably hit, and not before.  In such a world, managing deleveraging and the uncertainties about the prospects for currently very weak productivity would be much less perilous [in the sense of there being lower costs of too tight policy].

Recent criticism of the Bank of England’s policies and officials have depressed me greatly, and responding to that a number of small reforms seem pertinent.  That the granting of permission to do asset purchases becomes automatic, not discretionarily granted.  Noting that HMT can anyway take monetary policy back under its own control for short periods if necessary.  I’d also make it that MPC, not the BoE executive [as currently] decide on which assets are bought.  These small reforms would avoid speculation, which the government’s own recent insinuations allowed to develop, that the BoE might be thwarted easily.

I’d urge Treasury Committee to commission regular reviews of monetary policy from qualified third parties, to head off and marginalise individuals on TC or elsewhere who feel inclined to offer their own advice about interest rate setting.  And I’d prefer some device, if it could be found, to constrain BoE officials from talking off topic.  If there had been no speeches about climate change, inclusive capitalism, volunteering, and the like, Carney could have faced down the incorrect criticism over the Bank’s stance on the economics of Brexit even more securely.  Although, I repeat, I think they called the analysis of Brexit correctly, Carney and Haldane allowed themselves to be portayed, if the Brexit culture warriors wished, as their natural political foes.

As to the specific instrument setting problems post Brexit:  We will need somewhat looser monetary and fiscal policy to head off weaker demand than otherwise, and the increased likelihood of sharp contractions associated with any of the risks around the many significant events along the route to Brexit actually crystallising.  We have already seen some of this from the BoE, and we will get our first installment from the Treasury at the Autumn Statement.

That said, I’d caution against too much Brexiting regarding macroeconomic policy, in the sense of trying to be too ambitious at flattening out the business cycle.  For a start, many seem to have concluded that Brexit was more about culture than economics.  And we simply don’t understand business cycles or the effects of our policy instrument well enough to do a great deal better than we have.

 

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Japan’s temporary overshoot attempt

The Bank of Japan has been tinkering with its monetary policy, and one thing about it struck me as curious.

There is now the determination to try to overshoot the inflation target.  The idea is to try to raise the inflation expectations of a significant portion of those surveyed in Japan who think inflation will undershoot the current target.  I doubt this is going to succeed, although it may also do little harm.  The effort seems to be based on a hydraulic notion of why inflation expectations of some are under the target.  As though it’s assumed they guess inflation will be delta*target, where delta<1.  Raise the target temporarily, and you get inflation expectations equal to the old, and actually desired target.  That lowers real rates [nominal rates minus expected inflation] boosting demand, and inflation itself.

However, expectations are probably not so hydraulic, especially in a country where monetary policy failure and weak inflation/deflation has brought more scrutiny and awareness.

If expectations are undershooting the target because some think that the BoJ lacks either an effective instrument, or the necessary resolve to change the situation, then simply raising the target won’t help.

The temporary overshoot intention isn’t helped by not putting a clear number on it, nor a duration.  So we will have no way of knowing whether the BoJ succeeded or not, and what might trigger some subsequent tightening.

 

Barwell-Yates Times article on benefits of immigration

Paywalled access to article joint with Richard Barwell, BNP Paribas, here.

John Kay on helicopter money

John Kay has written the first in a series of posts on monetary policy, and he starts by trashing helicopter money.  I also disagree that HM should be contemplated, at least in any economy save Japan,  but I think he makes a misstep on his journey to the same conclusion.

The issue concerns whether fiat money is to be considered a liability of the public sector.  Many of HM’s proponents – Kay references Willem Buiter – start from the presumption that it is not.  And from there deduce that handing out paper that is an asset for the recipients, but not a liability for the issuer, will stimulate spending.

Where Kay goes wrong – I think – is in asserting that money is a liability of the public sector from having noticed that the government will currently accept it as payment by the private sector in respect of liabilities to it – eg taxes owed.

Kay’s observation that governments do this now is of course correct.  [Perhaps with the exception of a few Communist countries where state shops only accept foreign exchange].  But that is not enough evidence to decide on the question posed by the HM modellers and their adversaries.  That conversation is about whether the following statement is true:  ‘should we model the effects of HM [or any policy] by taking it that the public sector promises, come what may, to levy a stream of future taxes [net of spending] to reimburse the private sector for the real value of the entire stock of bonds and money?’

That up until now governments have taken cash in payment of taxes cannot decide this question.  It may simply tell us that the government goes along with the coordinated view that money is to be accepted because it knows that it can get rid of it again, and is behaving, therefore just like any other private individual.  It may indicate what John Kay wants it to, which is that the government is seeking to nurture the value of money by indicating that it values it, and perhaps that could be stretched to suggesting that the government stands ready to make good on all the money issued.  But we can’t be certain.  And it’s resolve to do that might be sorely tested by a sudden rush of demand to pay down tax obligations in cash.   Or, at least, expectations about its resolve might be so tested;  and especially by observing that the state was resorting to HM.

The question argued about by the HM debate participants is a behavioural one, and it concerns the behaviour of the government in the future.  So I’m not sure what evidence you could use to decide conclusively on the point at issue here.

I don’t side with Buiter, however, as I explained here some time ago.  He knocks out one assumption in the standard model – that money is not treated as a liability by the public sector – and uses the rest of the model to conclude that HM is always effective.  But in doing so he leaves in place the assumption made in that model that people value money for its own sake.  This is a piece of analytical sticking plaster.  Put there to proxy for otherwise unanswered questions about why people value money.  IMO if you take away the assumption about the public sector treating money as a liability, leaving this other assumption in – that people value money for its own sake – has less validity.

To decide properly on this, we need to go to deeper models of money, not partially dismantle a superficial one.  And that means studying HM in the kind of models built by Steve Williamson and his tribe [Wright, Lagos, Kiyotaki etc], or at east the older overlapping generations models of money.  I haven’t thought or read about HM in these models so don’t know what they would have to say on the question.

[I should acknowledge that this post came out of an exchange with AN Other anonymous monetary economist, without implicating them in any mistakes here.]

One person’s enlightened stabiliser is another’s wrong-headed sop

In my previous post I identified the vortex caused by responding to perceived grievance  with a policy sop  that is wrong headed and subsequently gives ground for further grievance and another round of misdiagnosis by the electorate.

Of course it remains a further difficulty for the chance of good outcomes to prevail that those who think they know – or are at least paid to – often disagree about whether a policy is wrongheaded or enlightened.

For example, the mainstream economics and finance establishment view the steps taken in financial regulation since the financial crisis of 2008 as an enlightened response to the risks in the system that previously were not fully apprehended. However, those with less faith in public intervention – John Cochrane being a notable example – often write about the new legislation and public trespassing in private financial markets as if this is a wrongheaded policy sop  responding to  a perceived grievance in a way that  will inevitably lead to further crises.

Relatedly  I had the honour of  a  bashing from Wolfgang Munchau  who accuses me of arrogance for pronouncing Brexit  to be a bad idea  that would not help those who voted for it.

Obviously,  and having campaigned as part of the economics Remain  effort,  I don’t agree that there is any doubt that the many  likely Brexit outcomes  will harm.  But  the piece does make, along the way, the general point that there is still debate to be had about what rational policy is and that no one expert could claim unchallengeable authority on the question.

It is somewhat ironic, however, that this point is made in the context of an article that explains something of the awful  protracted nature of the exit process and agreeing new terms of trade!

The perceived-grievance-wrong-headed sop vortex

That title, strangely, does mean something.

Post-Brexit, post-Trump, post-financial crisis, there’s a desire to respond to the perceived grievances of those who voted to give incumbent governments a kick.  But in so far as these grievances are not genuine, responding to them in ways that harm everyone and don’t address the economy’s underlying problems sets us all up for a vortex of ever diminishing prosperity and more spiteful policies and politics.

So, for example, we had ‘quantitiative easing for the people’, framed to respond to quantitative easing that was just for bankers, and harmed old savers.  This policy would dismantle monetary and fiscal credibility, likely harming those whose portfolios are unsophisticated.

Now the UK is embarked on Brexit, voted for by the older, less educated, less skilled.  This will shrink the size of the economy in the long run and seems likely to pitch us into a protracted period of weak growth or recession to which we are ill-placed to respond.  Both malaises, certainly the latter, will be disporportionately felt by those at the bottom of the pile whose Brexit vote got us here.  The journey of concluding new trade arrangements will set off a new round of industrial reallocation, and choke off immigration.  This will not benefit those who voted for Brexit, except in their imaginations.  In fact the process of reallocation may well, if past such experiences are to be repeated, hit hardest those who are oldest, and have least time or aptitude to retrain, or are least able to relocate.

Taking perceived grievances at face value entails several risks.

The policy response shrinks the aggregate size of the pie, hurting all, and does not help the aggrieved constituency.  In the next round, the wounded group takes aim at a new component of the status quo, dismantling our wealth creating machine even further.

Another risk is that responding legitimises unfounded prejudice: a slope much slippier than those involving a purely economic calculus.  It is hard to write about this without descending myself into a level of vitriol which leaves me little different from the populists.  But the point has been addressed by many others.

Yet another risk of the unfounded sop response to the perceived grievance is that it rewards dishonest political opportunism.  That industry is a machine that searches for prejudicial diagnoses, manufactures them into political power and chaos, but producing, this blog contends, just more grievance to begin the process afresh, each time more vigorously than the last.

Is there a way out of this?  I’ve no idea, but it’s incumbent on the believers to keep banging on the many drums of rational policy discourse.  That our state capacity should focus on the real problems;  improving its insurance functions for those subject to more of the adjustment costs posed by closed and open economies alike;  redistributing to the young;  relatedly, addressing the housing and planning problem [specific to the UK];  doubling down on the functions where there is a comparative advantage and need, like health and education, and not invading spheres where there is little [like industrial scale pharmaceutical research!];  that migration, whatever focus groups and opinion polls say, is almost entirely beneficial.

If only all that could be sloganised effectively enough to get enough people angry enough to vote.

Resetting the fiscal framework in the UK

Following on from my previous post….

Phillip Hammond has suggested a ‘reset’ of fiscal policy might be in order, which could be read as him recognising that monetary policy might not be able to offer an adequate response to the potentially recessionary shock that the Brexit vote imparted.

But in the absence of a proper fiscal framework, it’s he who gets to decide how much stimulus, if any, is imparted.  And there is nothing binding him to explain what the objectives are.  Moreover, while everyone else stays in the dark about what is meant by a reset, there can be no confidence over what future monetary policy will be, since that will depend in large part on the fiscal response.

Ideally, Hammond would be obliged to make up for monetary inadequacy if it was agreed that monetary policy was inadequate.  Though he could undertake more than was necessary, he could not, without suspending the fiscal framework, do less.  Something on which the BoE, and all those who depend on her to figure out their long term financing costs, could depend.

And if Hammond were to do more, perhaps by engaging in deficit financing of public investment, there would be an open and independent assessment of how the costs of this would be met by the forecast returns from that future investment.

Whatever happens, the reset has to be done with care.  It would be nice to think that the reset gets us closer to an ideal fiscal framework, one that is robust to the zero bound to monetary policy, which we are likely to live near for quite some time to come.  And it would be nice to think that after a good reset, there would fewer such resets in the future.

Monetary policy has not had any resets, really, since the enlightened one of 1997.  The Bank of England Act can be modified by a straight majority of Parliament.  The inflation target, and instructions to weigh deviations from it against fluctuations in real activity, can be modified simply by the Chancellor writing a letter.  The real obstacles to messing with monetary policy were the existence of a cross-party consensus that the Bank of England was mandated to do the right thing, and the slowly growing reputational cost that messing after a period of no messing imposes.

Given the scale of disagreements between political factions about what fiscal policy should do, these hopes might seem utopian.  But before the inflation target was first thought of in 1992 in the UK, there were similarly disagreeing and vague conceptions of the role of monetary policy.