mainly macro

The Liquidity Trap and Macro Textbooks

2013-05-23T09:14:00.000-07:00

Over the last eleven days something unusual has happened – I have not only failed to post a blog of my own, but I have not even read anyone else’s posts. Instead I have taken advantage of a sabbatical term to take a break [1] in Umbria, during a time of year when it is still cool enough to walk, but not too cold in the Piano Grande. Before I left I did write a couple of things that I thought I might quickly post while away, but with the help of the Italians’ penchant for starting dinner late and eating four (or more) courses that idea somehow got lost.

So I’m spending part of today catching up, and reminding myself why Paul Krugman and Martin Wolf are such great writers. (For example, from the former, a masterful analysis of the decent into worldwide austerity, and from the latter, a perfect short account of why when it comes to government debt the Eurozone really is different.) What I want to pick up on here is this Krugman post, where he questions the description in a Nick Crafts piece of higher inflation as a way out of the liquidity trap as being ‘textbook’. (See also Ryan Avent.)

So is raising inflation expectations to avoid the liquidity trap textbook or not? Let’s take the 2000 edition of the best selling undergraduate macro textbook. Here ‘liquidity trap’ does not appear in the index. There is a page on Japan in the 1990s, and in that there is one paragraph on how expanding the money supply, even if it was not able to lower interest rates, could by raising inflation expectations and therefore reducing real interest rates stimulate demand. One paragraph among 500+ pages is not enough to make something ‘textbook’, so it seems as if Paul Krugman has a point.

Yet how can this be? It is not one of those cases where textbooks struggle to catch up with recent events, because the Great Depression was a clear example of the liquidity trap at work. How can perhaps the major macroeconomic event of the 20^th century, which arguably gave rise to the discipline itself, have so little influence on how monetary policy is discussed? Yet it is possible to argue that the discussion is there, in an oblique form. A standard way of analysing the Great Depression within the context of IS-LM, which this popular textbook takes, is to contrast the ‘spending hypothesis’ with the ‘money hypothesis’: was the depression an inevitable result of a negative shock to the IS curve, or as Freidman argued could better monetary policy have prevented this shock hitting output?

A standard objection to the money hypothesis is that nominal interest rates did (after a time) fall to their lower bound. The counterargument – which the textbook also suggests - is that, if the money supply had not contracted, long run neutrality would imply that eventually inflation would have to have been higher, and therefore real interest rates on average would be lower. So in one way the story about how higher inflation could avoid a slump is there.

What is missing is the link with inflation targeting. Because textbooks focus on the fiction of money supply targeting when giving their basic account of how monetary policy works, and then mention inflation targeting as a kind of add-on without relating it to the basic model, they fail to point out how a fixed inflation target cuts off this inflation expectations route to recovery. Quantitative Easing (QE) does not change this, because without higher inflation targets any increase in the money supply will not be allowed to be sustained enough to raise inflation. In this way inflation targeting institutionalises the failure of monetary policy that Friedman complained about in the 1930s. Where most of our textbooks fail is in making this clear.

[1] Sometimes known as holidays, these are things that we Europeans are forced to take many more of than Americans, leading to great frustration and misery (or maybe not).

Sheedy on NGDP targeting and debt contracts

2013-05-10T04:53:00.002-07:00

An argument that is sometimes made for a monetary policy that targets a path for nominal GDP (NGDP) is that it reduces risk for most borrowers who take out debt contracts with repayments fixed in nominal terms (see, for example, Nick Rowe here). However, as far as I am aware, this argument has not been quantified in a way that allows it to be compared with the more familiar benefits of inflation targeting. A recent paper by Kevin Sheedy does just that.

Before getting to the punchline, it is worth setting out the argument more precisely. A good deal of the borrowing that goes on in the economy is to smooth consumption over the life cycle. We borrow when young and incomes are low, and pay back that borrowing in middle age when incomes are high. To do this, we almost certainly have to borrow using a contract that specifies a fixed nominal repayment. The problem with this is that our future nominal incomes are uncertain - partly for individual reasons, but also because we have little idea how the economy as a whole is going to perform in the future. If the real economy grows strongly, and our real incomes grow with it, repaying the debt will be much easier than if the economy grows slowly.

As most individuals are risk averse, this is a problem. In an ‘ideal’ world this could be overcome by issuing what economists call state contingent contracts, which would be a bit like a personal version of equities issued by firms. If economic growth is weak, I have a contract that allows me to reduce the payments on my debt. However most people cannot take out debt contracts of that kind, or insure against the aggregate risk involved in nominal debt contracts. We have what economists call an incomplete market, which imposes costs.

Monetary policy can reduce these costs by trying to stabilise the path of nominal GDP, because it reduces the risks faced by borrowers. Of course monetary policy cannot remove the uncertainty about real GDP growth, but if periods of weak growth are accompanied by periods of moderately higher inflation, then this is not a problem from the borrower’s point of view. (Koenig discusses this in detail in a paper here.)

How do we quantify this benefit of NGDP targeting, and compare it to the benefits of inflation targets? Sheedy defines a ‘natural’ debt to GDP ratio, which is the private debt to GDP ratio that would prevail if financial markets were complete. Under certain conditions the natural debt to GDP ratio is likely to be constant, and Sheedy suggests that departures from this benchmark are unlikely to be great. So a goal for monetary policy could be to close as far as possible the gap between the actual and natural debt to GDP ratio, in an analogous way to policy trying to close the output gap. To do this it would target the path of NGDP.

The current standard way of modelling the welfare costs of inflation, due to Woodford, is to measure the cost of the distortion in relative prices caused by prices changing at different times to keep up with aggregate inflation. This suggests monetary policy should have an inflation target rather than a NGDP target. (I note here that typically in the literature these costs are far greater than costs associated with output gaps.) What Sheedy does is set up a model which has these costs of inflation present, but also has the costs of nominal debt contracts discussed earlier. With these two different goals, an optimal monetary policy will go for some combination of inflation targeting and NGDP targeting. The key question is which kind of costs are more important. [1]

Sheedy’s answer is that the costs of nominal debt contracts are more important. The optimal monetary policy gives a 95% weight to the NGDP target, and just 5% to the inflation target. Now of course this is just one result from a highly stylised model, and Sheedy shows that it is sensitive to assumptions about the duration of debt contracts and the degree of risk aversion. Nevertheless it is very interesting result.

A very simplistic way of describing why this may be very important is as follows. If the focus of monetary policy is always on the cost of inflation, NGDP targets will appear to non-economists at least (e.g. politicians) to be second best. They are a nominal anchor, so we will not get runaway inflation or deflation by adopting them, but why not just target inflation directly? Who cares about nominal GDP anyway? This paper suggests a simple answer - borrowers care. If we see monetary policy has being important to the proper functioning of financial markets, as we now do, then reducing the risk faced by borrowers is a legitimate goal for policy. It may make sense for inflation to be high when real growth is low, and vice versa, because this reduces the risks faced by borrowers. I think a politician that was not beholden to creditors could sell that.

[1] For those interested in government debt, there is an interesting parallel in the literature. Some authors (e.g. Chari, V. V. and Kehoe, P. J. (1999), “Optimal fiscal and monetary policy", in J. B. Taylor and M. Woodford (eds.), Handbook of Monetary Economics, vol. 1C, Elsevier, chap. 26, pp.1671-1745.) developed the idea that nominal government debt contracts could be a useful way of avoiding costly changes in distortionary taxes following fiscal shocks, because inflation could change real debt. However Schmitt-Grohe and Uribe (Schmitt-Grohe, S. and Uribe, M. (2004), “Optimal fiscal and monetary policy under sticky prices", Journal of Economic Theory, 114(2):198-230) showed that once you added in nominal rigidity to the model so that inflation was costly, inflation costs dwarfed any gains. This example makes the fact that we get the opposite result with private debt contracts particularly interesting, although as Sheedy and others have noted, this may be partly because this earlier literature assumed short maturity government debt.

Is UKIP the UK's Tea Party?

2013-05-07T15:53:00.000-07:00

The UK Independence Party (UKIP) received a quarter of the vote in the recent council elections. UKIP has been described as the UK equivalent of the Tea Party movement in the US. Its policies are certainly very much to the right. Large tax cuts (possibly one flat rate) financed by huge reductions in public spending, except for defense spending which would increase, a five year freeze in immigration, a return to coal based power stations and no more wind farms, more prison places, and so on. Unlike the Tea Party, UKIP currently fights against the Conservative Party rather than working within it, but too much should not be made of this difference. UKIP’s leader says that he could cooperate with the Conservatives if they ditched Cameron as their leader, and there is some sympathy for UKIP’s aims within the Conservative Party.

One common reading of UKIP’s rise is that it represents the disaffected right wing of conservatism, generated by Cameron’s attempt to move the Conservative Party to the centre ground. However there is one problem with this interpretation - the Conservative Party has not moved to the centre ground. Apart from the odd token issue like gay marriage, the supposed move to the centre was just spin. Under the cloak of the need to reduce debt, the government has embarked on a programme to shrink the size of the state that goes well beyond anything attempted by Margaret Thatcher. Reforms to the National Health Service and education involve the large scale private provision of services or governance.

In terms of the distribution of income, the Conservative Party seem happy with increasing inequality and poverty. The 50% tax band on top incomes was reduced to 45%, while welfare spending is cut. The impact on child poverty will emulate what Margaret Thatcher achieved, according to the latest analysis from the Institute of Fiscal Studies (IFS) released today. Updating figures that I reported recently to take account of the latest welfare cuts, the IFS estimate that the percentage of children in poverty (in families with incomes 60% below the median) will rise from 17.5% in 2010 to 23.5% by 2020. Crucially, according to the IFS the rise in this measure of relative child poverty is entirely the result of the tax and benefit reforms introduced by this government. This is, quite literally, a government created increase in child poverty.

So if we have a government where major economic and social policies are very much to the right of the political spectrum, how do we account for the rise of UKIP? One possible story is that the Conservatives are a victim of their own spin. In trying to ditch the image of the ‘nasty’ party that came to be associated with the Thatcher era, they have alienated those that rather liked her openly right wing style. The parallels with the US may be quite close. Where the Tea Party is associated with, and definitely encouraged by, Fox News and talk radio, so the values of UKIP are also the values of the UK tabloid press, by which we essentially mean Murdoch’s Sun and the Daily Mail.

Yet there is one key feature of UKIP which has no US parallel, and that is in its name - independence from the European Union (EU). Since Thatcher’s time the Conservative Party has been seriously split in its attitude to the EU. The leadership knows that a decision to exit the EU will almost certainly have serious negative consequences for the economy, which is why most business leaders would be horrified by the prospect of leaving. However the tabloid press have run a relentless campaign to highlight any negative aspects of EU membership. It has to be said that Eurozone governance in particular gives them plenty to work with, but when that is not enough, then in true tabloid style stories are made up. While the Conservative leadership seems in its element in going along with the tabloid attack on the welfare state, when it comes to the EU, the game becomes appeasement.

How all this turns out may depend on how the economy performs over the next two years, and how effective the Labour Party are at shifting the public debate. If the recovery is strong, and we see more of this kind of political naivety from Labour (yes, Ed did not read my post on the B word), then the tabloids will push Cameron as far as they can on Europe, but then rally round to support the Conservatives at the election. On the other hand if the recovery is weak, and if Labour is more effective (like here) and looks like winning, then the tabloids may continue to encourage UKIP, in the hope of engineering a reconciliation of the right under a new Conservative opposition leader hostile to the EU.

But these are dangerous games. Much of UKIP’s popularity comes from straightforward dissatisfaction with falling living standards and a lack of good jobs. It is expressed as hostility to immigration and welfare recipients, in part because the tabloid press suggest this is the cause of these problems, rather than it being the result of government economic policy [1]. Even if the recovery is strong and Labour opposition weak, this may not produce enough to enable the tabloids to put this genie back in its bottle. They may find it as difficult to control those who recently voted UKIP as the Republican Party has found it impossible to control the Tea Party.

[1] Some good posts on these tabloid myths: NEF here, the Guardian here, Ian Mulheirn here, and much more detail from Alex Marsh here.

More on Naive Fiscal Cynicism

2013-05-06T09:19:00.001-07:00

Paul Krugman is absolutely right that one of the rationales for the IMF and others framing fiscal policy in terms of the ‘speed of consolidation’ is a belief that left to themselves politicians will always and everywhere let debt rise. As he points out, the facts for the US tell a rather different story. Here I want to add a couple of additional points by looking at experience outside the US.

As should be well known by now, UK government debt was over a 100% of GDP between the wars, but declined rapidly and consistently to 50% from the second war to the mid 1970s. (See here, or this useful UK site.) The chart below, based on OBR data, takes up the story since then.

UK Debt to GDP ratio (%)

So perhaps the simplest description is that debt to GDP began to level off at around 40% of GDP (which was the target from 1998 to 2008), until the Great Recession hit. There is a lot of interesting detail here, but that would distract from the main point, which is that the UK is another clear counterexample to the idea that governments always let their debt rise.

However deficit bias is not a figment of international policymakers imagination. As I note here with Lars Calmfors, and others have noted before us, government debt in the OECD area as a whole almost doubled (40% to 75%) between the mid-70s and the mid-90s. This deficit bias came not from the UK, and not much from the US, but from Europe and Japan. (To see data on individual countries or country groups, see this nice IMF resource. [1])

So the only reasonable conclusion is that deficit bias is a problem, but not one that afflicts every government at all times. As Lars and I document, there have been various studies that have attempted to draw lessons from this diversity of experience: for example coalition governments may be more prone to deficit bias, but institutional set-ups where the finance ministry is strong less prone. My own support for fiscal councils partly stems from a desire to look for an institutional mechanism to help counter deficit bias. There is no magic bullet here, and institutional solutions will differ depending on national constitutional characteristics.

If this last point seems obviously reasonable, then lets change the dimension from across countries to across time and states of the world. While we may observe a tendency towards deficit bias in normal times, in times like now when government debt is high we seem to be observing a quite different bias - a bias towards austerity. The apparent consensus of 2008/9 that we needed fiscal stimulus looks like the aberration rather than the rule. An international organisation wanting to push sound economics needs to be doing more than arguing for a slower speed of consolidation. By advocating fiscal consolidation when the opposite is required you risk discrediting your advice at other times.

Here is another analogy. Doctors quite rightly encourage us to take more exercise. That is because we have a tendency to sit around too much, but this bias is not universal across people types or ages. Yet when we catch flu, the doctor prescribes rest, not exercise. Indeed, a good doctor may well be specific about the length of rest required, because they know too many patients may think they are better before they have fully recovered. If a doctor told us that while we had flu we should cut down from 30 minutes exercise to 15 or 10, we might begin to doubt their credentials.

[1] To get the debt series, click on the blue subheading ‘Real GDP growth’.

Blanchard on Fiscal Policy

2013-05-04T11:58:00.000-07:00

I was recently rather negative about the way the IMF frames the fiscal policy debate around the right speed of consolidation. In my view this always prioritises long run debt control over fiscal stimulus at the zero lower bound (ZLB), and so starts us off on the wrong foot when thinking about the current conjuncture. Its the spirit of 2011 rather than the spirit of 2009.

Blanchard and Leigh have a recent Vox post, which allows me to make this point in perhaps a clearer way, and also to link it to a recent piece by David Romer. The Vox post is entitled “fiscal consolidation: at what speed”, but I want to suggest the rest of the article undermines the title. The first three sections are under the subtitle “Less now, more later”. They discuss the (now familiar from the IMF) argument that fiscal multipliers will be significantly larger in current circumstances, the point that output losses are more painful when output is low, and the dangers of hysteresis. I have no quarrel with anything written here, except the subtitle, of which more below.

A more interesting section is the one subtitled “More now, less later”. This section starts by noting that the textbook case for consolidation is that high debt crowds out productive capital and increases tax distortions. Yet these issues are not discussed further. The article does not say why, but the reason is pretty obvious. While both are long term concerns, they are not relevant at the ZLB.

Instead the section focuses on default, and multiple equilibria. After running through the standard De Grauwe argument, the text then says: “This probably exaggerates the role that central banks can play: Knowing whether the market indeed exhibits the good or the bad equilibrium, and what the interest rate associated with the good equilibrium might be is far from easy to assess, and the central bank may be reluctant to take what could be excessive risk onto its balance sheet.” This is more a description of ECB excuses before OMT than an argument.

More interesting is what comes next. Does default risk actually imply more austerity now, less later? I totally agree with the following: “The evidence shows that markets, to assess risk, look at much more than just current debt and deficits. In a word, they care about credibility.” “How best to achieve credibility? A medium-term plan is clearly important. So are fiscal rules, and, where needed, retirement and public health care reforms which reduce the growth rate of spending over time. The question, in our context, is whether frontloading increases credibility.”

So here we come to a critical point. Does more now, less later, actually increase the credibility of consolidation? If it does not, then the only argument for frontloading austerity disappears. The next paragraph discusses econometric evidence from the crisis, and concludes it is ambiguous. The whole rationale for more now, less later, is hanging by a thread. And there is just one paragraph left! Let me reproduce it in full.

“The econometric evidence is rough, however, and may not carry the argument. Adjustment fatigue and the limited ability of current governments to bind the hands of future governments are also relevant. Tough decisions may need to be taken before fatigue sets in. One must realise that, in many cases, the fiscal adjustment will have to continue well beyond the tenure of the current government. Still, these arguments support doing more now.”

Is this paragraph intentionally weak and contradictory? If credible fiscal adjustment requires consolidation by future governments, why does doing more now add to credibility? You could equally well argue that overdoing it now, because of the adverse reaction it creates (‘fatigue’ !?), turns future governments (and the electorate) away from consolidation, and so it is less credible.

So what we have is an article that appears to be a classic ‘on the one hand, on the other’ type, but is in fact a convincing argument for ‘less now, more later’. Perhaps that is intentional. But even if it is, I’m still unhappy. Although the arguments on multipliers, output gaps and hysteresis appear under the subtitle ‘less now, more later’, they in fact imply ‘stimulus now, consolidation later’, once you take the ZLB seriously. If you are walking along a path, and there is a snake blocking your way, you don’t react by walking towards it more slowly!

Why does this matter? Let me refer to recent comments David Romer made about the ‘Rethinking Macro’ IMF conference, which he suggests avoided the big questions. For example he notes “I heard virtually no discussion of larger changes to the fiscal framework.” He goes on (my italics)

“Another fiscal idea that has received little attention either at the conference or in the broader policy debate is the idea of fiscal rules or constraints. For example, one can imagine some type of constitutional rule or independent agency (or a combination, with a constitutional rule enforced by an independent agency) that requires highly responsible fiscal policy in good times, and provides a mechanism for fiscal stimulus in a downturn that is credibly temporary.”

As I argued here, it is not a matter of having a fiscal rule for consolidation that allows you to just ease up a bit at the ZLB. What we need is a rule that obliges governments to switch from consolidation to stimulus at or near the ZLB. Otherwise, the next time a large crisis hits (and Romer plausibly suggests that could be sooner rather than later), we will have to go through all of this stuff once again.

Microfounded Social Welfare Functions

2013-05-04T03:12:00.001-07:00

Leading Macroeconomist Leaves Central Bank

2013-04-30T10:50:00.000-07:00

Maybe not the most compelling title for a post, but the news that Lars Svensson is not renewing his term as Deputy Governor of Sweden’s central bank (HT Saroj Bhattarai) will be of great interest to academic macroeconomists. What I want to suggest here is that it should also be of wider interest.

Apart from making major contributions to the discipline, Svensson has also been extremely influential among policymakers, and is often associated with the idea of flexible inflation targeting. (Here is just one example.) It is interesting news because of why he is leaving. He says: "I have failed to find support for a monetary policy that I believe would lead to better performance, with both a higher inflation rate closer to the target of two percent and a lower unemployment rate." He has for some time been fighting a losing battle to persuade his colleagues that current Swedish monetary policy is too deflationary (see for example Britmouse), and he has decided to give up the fight.

Interest rates in Sweden are low, at 1%, but according to Svensson they should have got there faster and should now be even lower. Here is a plot of inflation (blue, left hand scale) and unemployment.

Inflation is currently zero, so well below the 2% target. GDP growth was 1.2% last year. Unemployment rose in the recession, came down a bit, but has begun to rise again. The case for lower interest rates over the last two or more years looks pretty clear.

So why have most of Svensson’s colleagues not been following his advice? Their concern is that low interest rates are encouraging Swedes to borrow too much. Now of course one of the ways monetary stimulus is supposed to work is that it encourages more borrowing, but the worry is that borrowing in Sweden is dangerously high, and could threaten financial stability. There are echoes here of doubts expressed by some members of the Fed (see here and here) and international organisations (Tim Taylor here). However so far these have been just concerns, which do not seem to have had a major impact in preventing expansionary policy. Except in Sweden.

Svensson’s arguments against such concerns are persuasive (pdf), and I find the argument that there are better financial instruments available to deal with these problems particularly strong. However I want to draw a slightly different parallel, with policy at the ECB. At first sight similarities appear slight: although both central banks are resisting a cut in interest rates from low to very low levels, in the Eurozone growth is negative rather than just slow, and inflation is currently only a little below target rather than zero (although the ECB itself expects it to fall to nearly 1%). In addition, the ECB has not focused on financial stability as a reason for not cutting rates. Yet the parallel is this. In both cases we have central banks making decisions that appear to contradict the wisdom of mainstream macroeconomics. So what, you may say, but in both cases the cost is being measured in unnecessary unemployment, and below target inflation. Compute the cost in terms of lost output, and they are the kind of losses that could cost a politician their job. The cost in terms of human misery is greater still. You may be pretty skeptical of the wisdom of macroeconomists, but do you really think that these central bankers know better?

Why Inflation is not falling

2013-04-28T10:25:00.001-07:00

There has been considerable interest in the recent IMF study that found that the responsiveness of inflation to the output gap (or equivalent measure) falls at low levels of inflation. But if the econometrics is right (and Nick Rowe has some cautionary tales here), what is the explanation for this? I start with two standard stories, but then suggest other possibilities that are specific to current financial conditions.

One standard explanation which the paper itself gives is based on the menu cost model of price inertia. The idea is that firms do not change their prices that often because there are costs to making any change (which economists call menu costs, perhaps betraying how often they spend in restaurants rather than buying food in supermarkets), and that often this cost might be higher than any benefit to profits in making a change. If you derive the aggregate relationship between inflation and the output gap from a model of this kind, the coefficient on the output gap will depend on how frequently prices are changed. So if price changes become more infrequent at low levels of inflation, the sensitivity of inflation to the output gap will fall.

Another quite plausible story which has solid empirical backing is that workers particularly resist nominal wage cuts. That actually implies an asymmetry in response rather than a general reduction in sensitivity (if the output gap was positive workers would happily see wages rise), but it will affect the average response in an econometric study that does not allow for asymmetry, and in current circumstances it is an entirely appropriate story.

You might think that enough, but I have a UK-centric reason for wanting more. In the UK, the ‘wages’ Phillips curve does not seem to be showing any reduction in sensitivity - indeed perhaps the opposite (although any additional sensitivity seems to predate the recession). That does not mean workers are not resisting nominal wage cuts, but the overall impact of this has either been small, or has been offset by something else.

The story I want to tell involves firms’ pricing behaviour, and the role of more risk averse banks. Suppose a firm sees demand for its output fall. Its profits are lower, but it calculates that it can reduce that decline in profits by cutting its price, if that price cut increases demand. There are two risks involved in doing this. First, the price cut might raise demand by much less than expected, with the consequence that profits fall further still. Once the firm realises this it can always put prices back up again, but in the short run profits will decline. Second, it may take time for the price cut to feed through into higher demand: those buying competing products may not immediately realise that they should switch. So although profits might rise eventually, they could fall in the short run.

So in both cases, there is a risk that profits in the short run might suffer as a result of the price cut. In normal times firms would be prepared to take those risks, either because the risks are symmetric (maybe demand will increase by more than expected), or because they represent an investment with a positive eventual payoff (as customers switch products). Critically, even if the short run might actually bring losses rather than profits, the firm’s bank will cover the losses because it is taking a long term view.

However, since the financial crisis, the firm may have noticed that the behaviour of its bank has changed. It refused the business down the road any credit, even though by all accounts its difficulties were clearly temporary. Although the firm would like to cut prices in the expectation that this will eventually raise profits, if the price cutting idea does not work out and the bank plays tough that could mean bankruptcy.

The idea is that the aftermath of the financial crisis, by raising the risk of bankruptcy associated with short term losses, has lead to greater price rigidity. In addition, there are two related effects that could actually lead to higher inflation in the short run. First, the firm does not like the fact that it can no longer depend on the bank to cover any short term losses. Who knows what might happen. So although a price increase might reduce profits if sustained (as customers gradually switch), in the short run profits will rise, and that allows the firm to pay off those debts which would otherwise keep its owners awake at night. This is the firm as a precautionary saver. Second, firms might be keeping prices low not because of existing competition, but because of the threat that a new start-up might emerge and steal some of its business. The one silver lining of the financial crisis for existing firms is that new start-ups are much less likely to get any money from the bank, so this diminished threat of new entry allows the firm to safely increase its profit margins.

I have absolutely no evidence that any of this has been happening, or indeed whether these ideas stand up to serious analysis. I don’t know of any papers that have explored the impact of financial frictions of this kind on prices, but that may well be my fault, so please point me to any you know. If there is anything in these ideas, then they caution against interpreting any current rigidity in inflation as evidence against demand deficiency.

When NGDP targets are (not) optimal

2013-04-26T15:22:00.000-07:00

This may be too technical for non-economists, yet familiar to macroeconomists, but students should find it useful. Its part of a continuing series on NGDP targets

Suppose monetary policy attempts to minimise this combination of excess inflation and the output gap each period, where we ignore discounting for simplicity.

‘c’ is a parameter. The cost function is quadratic to capture the idea that a 1% increase in inflation or the output gap is more costly if inflation or the output gap is already high than if it is low. Let’s abstract from uncertainty, and assume policy can perfectly control the output gap (there is no zero lower bound problem), and the only constraint is a forward looking Phillips curve

where ‘u’ is what is often called a cost-push shock, so it could be an increase in sales taxes for example. (Really it stands for all the things that might influence inflation besides expected inflation and the output gap, which is probably quite a lot.) The parameter ‘a’ measures how sensitive inflation is to the output gap.

Cost push shocks are in some ways the most difficult things for monetary policy to deal with, if we are ignoring uncertainty. Demand shocks that create negative or positive output gaps can in principle be eliminated entirely by an appropriate choice of interest rates. Supply shocks that change the natural rate, if known, can also be dealt with at zero cost by just moving demand to follow supply. A non-zero value of u will however result in some cost whatever policy does.

Let’s look at the case where there is a large positive cost push shock, just in the current period (t=0), and let’s make it equal to 10. This means that if the monetary authorities chose a zero output gap at t=0, then current inflation would be 10% higher. A crucial assumption here is that future inflation, assuming no known future shocks and a zero future output gap, is anchored at target, so excess inflation at t>0 will be zero. We can see in this case that by choosing a zero output gap at t=0 involves a loss of 100 at t=0, but no subsequent loss.

Now suppose all that monetary policy can do is change the output gap in the current period. Perhaps promises to change the output gap in future periods will not be believed. In that case the optimal combination of output and inflation to go for is given by

where the parameter d=c/a. Now if it so happens that d=1, this policy involves keeping nominal GDP constant. Any excess inflation is exactly matched by the same percentage negative output gap. Now if d=1 because both c=1 and a=1, then using the Phillips curve we can show that the optimal policy will be to have a 5% negative output gap, 5% inflation, with a total cost of 50. That is a lot better than the cost of 10% inflation.

Now allow monetary policy to make promises about the output gap in period t=1 as well. The equation above still describes the optimal policy combination in period t=0, but in addition we have

This is a bit different from the expression involving excess inflation at t=0, because inflation at t=1 will have implications for inflation at t=0, and therefore the choice of output gap at t=0. The neat point is that if d=1 again, this also implies we keep nominal GDP (NGDP) at t=1 constant, because this equation says the growth in NGDP should be zero, and the previous expression made the level of NGDP constant. If a=c=d=1, then we can show that the optimal policy involves having a negative output gap of 4% at t=0 and 2% at t=1. This will produce 4% inflation at t=0 and -2% inflation at t=1, but despite this rather odd combination involving inflation that is too low at t=1, the overall cost is less: 16+16+4+4=40. [1]

A potential problem with this policy is that it is time inconsistent. When period t=1 arrives, it seems better to change the policy and keep the output gap at zero, which implies zero inflation. The total cost would then be only 32. But if that is what monetary policy is going to do, people would not expect future inflation of -2% when t=0, so we would not get the benefits of this expectation. Instead inflation at t=0 would be 6% and the output gap -4%, giving an overall cost of 52, which is worse than if policymakers had only tried to change the output gap at t=0. However if d=1, and policymakers had committed to keeping the level of NGDP constant, then NGDP at t=1 would be too high, so keeping the output gap at zero in t=1 would not be an option. Policy would be committed to following the optimal path, and policy commitments would be credible if NGDP targets were credible. This is the logic behind this post. [2]

This is why, I would suggest, Michael Woodford is comfortable with targets for the level of NGDP. (A good technical reference on optimal monetary policy is here, where the equation above is an example of his equation 1.21, while his views on NGDP targets can be found here, pages 44-46.) Note that I have not had to invoke anything about the zero lower bound (ZLB) – indeed I have ignored it – which is why I have pointed out before that the case for NGDP targets does not rely on ZLB considerations.

However is it reasonable to suppose d=1? Quite often macroeconomists assume c=1: a 1% output gap has the same cost as 1% extra inflation. However recent IMF work that I talked about here suggested that the Phillips curve might be very flat at low inflation. Combine the two and d could be much larger than one. This would imply that the optimal policy would be to let most of the shock feed through into inflation. [3] In this case a NGDP target would not be optimal. [4]

So this is either good or bad news for NGDP advocates, depending on your views of these two key parameters. [5] However there is a lot left out of this simple story, such as what happens if the Phillips curve is more backward looking, or if policymakers and the private sector make mistakes.

[1] Note that the price level at t=2 in this case is just 2% higher than without the shock, compared to 5% higher when we only changed current period output. This gives us a clue to what will happen if we allow output even further ahead to change optimally – see the next footnote.

[2] If we allow policymakers to make promises about the output gap in period t=2 and beyond, we can get the cost of this shock down further still: what we get are more conditions like the last equation, for each subsequent period. The policymaker promises smaller and smaller negative output gaps, so future excess inflation approaches zero from below. What happens then is slightly magical: by summing all these conditions together, we find that all these future negative inflation rates sum to exactly offset the initial rise in inflation, so (if target inflation was zero) the price level eventually returns to its pre-shock level. More generally the optimal policy involves gradually returning the price level back to its original path. In this sense, long run price level targeting is optimal whatever the value of d.

[3] If c=1 but a=0.5 (and estimated 'a' is normally a lot smaller than this - Charlie Bean in the small model simulated here uses a=0.025), then in the first example the output gap should be -4%, and inflation would be 8%. Although that produces a total cost of 80, that is the best we can do. If the output gap was -5%, inflation would be 7.5%, giving a total cost of over 81.

[4] Keeping NGDP constant would reduce output by 6 and two thirds per cent. Although, compared to the optimal policy, inflation would be a bit more than 1% lower, output would be nearly 3% lower, and the total cost would be nearly 89.

[5] As I have already begun to read the mind of Michael Woodford, let me continue with my audacity. Michael Woodford first showed us how you can derive the first equation from a standard utility function in a model with Calvo contracts. If you do that, the ‘c’ parameter (which is actually is a function of 'a' along with other parameters) can be a lot less than one, so the chances of ‘d’ being close to one despite small 'a' are greater. The problem I have with this logic is that I do not believe the simple models used to derive these cost functions accurately capture the true costs of output gaps, in part because they typically exclude involuntary unemployment.

The UK economy in three charts

2013-04-25T04:42:00.000-07:00

It is a measure of the state we are in that the latest quarterly growth number for the UK, at 0.3% (1.2% annual rate) for 2013Q1, should be regarded as a political plus for the Chancellor. [See postscript at end.] So here is the first chart:

This extremely weak growth from a starting point of a deep recession should spell disaster for employment. But it has not, as this second chart from the Bank of England’s February Inflation report shows.

The upside of this incredibly poor productivity performance is that employment has been much more buoyant than the GDP numbers would normally imply. However a moment's thought reveals that this could be really bad news, because it might imply that the recession has led to a permanent reduction in what the UK economy can produce. I say ‘could’ and ‘might’ advisedly, because the reasons for this productivity disaster are almost totally mysterious, as I discuss here. Yet it helps explain why inflation has remained above target, and gives us a reason (although not in my view a justifiable one) why monetary policy has not been more expansionary.

Is this a reason for thinking that in fact policy in the UK has not been too bad, and that really we are suffering from some unexplained malady that the usual medicine (continuous monetary expansion and fiscal stimulus) could do nothing to cure? So we come to my third chart, which is UK unemployment (source ONS).

Despite strong growth in private sector employment, which with stagnant GDP gives us our second chart, unemployment remains high. Low earnings growth suggests that this level of unemployment is keeping real wages low, so there is no suggestion that this increase since the recession is in any way structural. (The wages Phillips curve in the UK continues to work as normal, with a natural rate way below 8%.) It reflects in part a significant increase in labour force participation (again quite different from the US), but that is no excuse to allow it to remain high.

So policy clearly has not and is not doing enough to expand demand. If it did do much more, with any luck productivity would start growing again and catch up some of the ground it has lost, but even if it does not this third chart shows us that expansion is the right policy. What has been happening instead is that fiscal policy has been working in the opposite direction, contracting demand, and monetary policy has been unwilling or unable to offset this. It is indeed one of the major UK macroeconomic policy errors since the second world war.

Postscript

As an illustration of this sad state, the normally excellent Stephanie Flanders describes 0.3% as "good news". A better description would be pathetic. How can an annualised growth rate of 1.2%, in an economy that pre-crisis had a trend growth rate above 2%, and at the bottom of a deep depression, be described as good news! If you think I'm biased, read John Van Reenen.

Scotland's future exchange rate regime

2013-04-23T06:00:00.000-07:00

I have not, until now, written anything about prospective Scottish independence. In part I admit this is because the vote is a long way off (18th September 2014), and the polls have consistently suggested that the Scottish people will reject independence. However if television keeps showing reruns of Braveheart who knows what might happen. What is clear is that macroeconomics, rather than distorted historical facts, is crucial to any informed decision.

Today the UK Treasury has published a detailed analysis of the choices an independent Scotland would face in deciding on an exchange rate regime. Partly because of pre-publication spin, but also because the document itself is very negative in tone, its arguments may be dismissed as propaganda. This would be unfortunate, because there are some real and serious problems that the paper identifies. So let’s not ask here whether independence is a good idea, but instead if the vote for independence is yes, what next? Throughout I will refer to the remaining UK after independence as rUK, rather than as the ‘continuing UK’ which the Treasury document uses.

The policy of the Scottish National Party is to retain the use of sterling (although previously it had talked about joining the Euro), rather than have its own currency. The debate about fixed versus floating rates, or the cost and benefits of currency union, are as old as macroeconomics itself. Yet what is happening in the Eurozone clearly puts a fresh perspective on this debate. It illustrates that the key issues are as much fiscal as monetary.

In terms of setting interest rates, existing arrangements could carry on almost as if nothing had happened. The MPC could continue to set monetary policy under a flexible inflation targeting regime, where the inflation target continued to be for the whole sterling union. There would be some changes in detail (external members could no longer be appointed just be the rUK Chancellor), but the MPC could remain as accountable to both governments as it is to the single UK government. This is one advantage of having a currency union of 2 rather than 17. The costs and benefits of this for Scotland would be the standard Optimal Currency Area issues, noting that the scope for migration between the two parts of the sterling union is quite high.

Scotland would inherit a significant proportion of UK government debt. So a key question is, would the Bank of England act as a Lender of Last Resort (LOLR) for that debt? As Brian Ashcroft notes, there is no way the UK government will allow the Bank of England to become sufficiently independent that it could refuse to act as a LOLR for the rUK government. So the Scottish government cannot be equal to the rUK government in this respect. If the Scottish government wants the Bank of England to act as a LOLR for Scotland, it has to persuade the rUK to allow it to do so.

Would it matter if it did not? Without such a provision, it is quite possible that Scotland might find itself in the type of bad equilibrium that the Eurozone periphery experienced in 2010/2012. They may find themselves paying a significantly higher interest rate on any new debt they issued compared to rUK, and this - or the threat of it - might restrict what they felt able to do in terms of fiscal deficits. (For a detailed discussion on this point, see Brian Ashcroft here.)

If the new Scottish government asked the Bank of England to act as a LOLR for its government debt, what price would the UK government ask in return? If the Eurozone experience is anything to go by, they might impose tough restrictions on Scottish fiscal policy - their own version of the Eurozone’s fiscal compact. This might reduce the risk of a market crisis, but the Scottish government cannot relish having rUK constantly monitoring and prescribing its fiscal decisions in the way the Troika currently does for some periphery countries. rUK might want to impose such conditions just to act as a LOLR for Scottish financial institutions, even if it did not do so for the government, on the basis that otherwise it could not be sure the Scottish government would be willing or able to pay for such support.

Would tight fiscal restrictions on Scottish government borrowing matter? In the longer term you could argue that, with exhaustible oil money playing a large role for a newly independent Scotland, it should be building up a sovereign wealth fund along Norwegian lines, in which case large budget surpluses would be the norm. In other words it should be choosing a tight fiscal policy in any case. The problem is one of transition. The UK economy is almost certain to still be very depressed at the end of 2014, and Scotland’s macroeconomic position in this respect is similar to the UK average, so it will clearly not be the moment for a sharp tightening of Scottish fiscal policy relative to rUK.

Is it inevitable that any sterling currency union would involve imposing a more restrictive fiscal policy on Scotland than it would experience without independence? In a previous post I outlined how the ECB could set conditionality for its LOLR role (OMT) in such a way as to avoid imposing an unnecessarily tight fiscal regime. I argued that they just need to be reasonably sure that the government will remain solvent, and suggested a way this could be done. The Scottish government could ask for a similar arrangement from the Bank of England. The arrangement I suggest requires that default would happen if the central bank believes the government is not solvent, so a significant default premium on Scottish debt would remain. (In contrast, LOLR would in practice be unconditional for rUK, so rUK would have a smaller default premium.) However the sterling equivalent of a fiscal compact, or worse the equivalent of Troika control, would not be imposed on Scotland.

The Scottish government might propose such an arrangement as an alternative to Eurozone type controls. It could argue, with some justification, that this arrangement was in rUK’s own interests, because the alternative policy of squeezing Scottish fiscal policy would damage rUK. It could note the harm that the current fiscal restrictions on the Eurozone periphery were doing to exports from the core, and overall political stability.

The problem is that when it comes to fiscal policy, the UK is an awfully long way from being enlightened. Just as it thinks the current UK recession has nothing to do with its own fiscal regime, it is unlikely to be sympathetic to concerns from Scotland about imposing tight fiscal policy there. It would recognise the harm that

a Scottish default could do to

rUK, but its response will be to impose tough fiscal restrictions to avoid that happening, even if it does not agree to act as a LOLR.

The real problem for Scotland is that, in forming a sterling currency union, it will be dealing with a government that thinks like Germany. What is worse, although Germany can sometimes be persuaded to go against its austerity instincts for the sake of European unity, after an independence vote rUK is unlikely to let its heart strings be pulled in a similar way! The problem for Scotland is that the rUK can provide something that in fact costs it very little, but the absence of which would cost Scotland a great deal, so rUK will be able to ask for a high price. Unless the new Scottish government is prepared to pay for a Bank of England LOLR role with some of its oil revenues, it may find it has nothing to bargain with. If no agreement can be found, the Treasury paper is quite right to conclude that using sterling unilaterally would not be attractive for Scotland. So rather than accept damaging fiscal restrictions, the new Scottish government may end up with its own currency after all.

The Stupid Cruelty of the Creditor

2013-04-19T14:08:00.000-07:00

In the middle ages those who could not afford to pay their debts were sent to prison by their creditors. An efficient solution to the moral hazard problem? Hardly, because the chances that the debtor could earn some money to repay something to the creditor from a prison cell were not high. So countries gradually developed rather more civilised bankruptcy laws, like Chapter 11 in the US.

Yet we are seeing the equivalent of these medieval practices in Europe at the moment. Arguably the harm being inflicted on the people of Greece by its creditors is even more cruel, and more stupid. More cruel, because the harm is being done to those totally innocent of the original contract - children indeed, as Karl Smith notes. More stupid, because those doing the damage cannot see what they are doing, either by refusing to open an economics textbook, or believing that they somehow know better.

Just look at these numbers, from the latest OECD economic outlook.

The Greek Macroeconomic Disaster

2010

2011

2012

2013

2014

Government

Consumption Growth %

-8.7

-5.2

-5.9

-7.1

-4.0

Underlying Primary Surplus (% GDP)

-3.6

1.3

4.2

6.5

7.6

Output Growth %

-4.9

-7.1

-6.3

-4.5

-1.3

Unemployment %

12.5

17.7

23.6

26.7

27.2

Why is this happening? Because the Eurozone governments that foolishly bailed out Greece after the crisis first developed in 2010/11 want all their money back. (I discuss this in more detail here.)

But surely, you may say, those who lent money to the Greek government are entitled to have their money back (with interest). No one was forcing the Greek government to accept these loans, and the conditions that go with them. The creditors are justified in doing everything they can to pressure the Greeks to repay their debts, including threatening Greece with expulsion from the Eurozone. The fact that this is causing great human suffering and misery is just one of those unfortunate things, and perhaps a necessary lesson to make others think more carefully before electing governments that secretly run up unsustainable debts.

If that is what you think, then I would suggest this view is the moral equivalent of locking debtors up in prison. It is also as stupid, because the damage being done to the Greek economy and its politics is making the scale of the eventual default greater than if some debt relief was allowed now. A fiscal contraction of this scale, in a country with no independent monetary policy, was bound to do this much damage. Any macro textbook tells you that. Those who believe that reducing one component of demand just changes its mix rather than its overall level display an ignorance which in this case is close to criminal.

But, you may say, the Greek economy has become uncompetitive, and wages need to fall if the economy wants to stay part of the Eurozone. There is no escaping macroeconomic pain. True some deflation was necessary, but deflation on this scale is totally wasteful, and the immense harm it is doing is therefore avoidable. Once again, very simple macroeconomics tells you this. And, as Ryan Avent is the most recent to point out, the core of the Eurozone is making this competitiveness correction as difficult to achieve as possible. You might say that this chaos is required to achieve necessary structural reform. I seem to remember someone else once had a similar idea, which they called perpetual revolution.

Unfortunately this would not be the first time creditors have laid waste cities in an effort to recover debts, as Peter Frankopan has reminded us. But it need not be like this. Let me end by quoting Robert Kuttner, from a review of David Graeber’s book ‘Debt: the First 5000 years’.

[The Allies] wrote off 93 percent of the Nazi-era debt and postponed collection of other debts for nearly half a century. So Germany, whose debt-to-GDP ratio in 1939 was 675 percent, had a debt load of about 12 percent in the early 1950s—far less than that of the victorious Allies—helping to produce postwar Germany’s economic miracle.

The lesson from the 1920s had been learnt. Whether this was done out of self interest, because a vibrant post-war Germany benefited everyone, or compassion, I do not know. But whichever it was, the creditors of the Eurozone could use some of that wisdom right now.

An Understandable Mistake

2013-04-18T03:46:00.000-07:00

No, I’m not talking about coding in excel - as someone who has in the past done plenty of empirical work, my overriding reaction is empathy with the researchers concerned. There - not so much by the grace of god but because no one bothered to check what we did - go us. What I’m talking about is the weak global recovery and a primary reason for it. But there is a link, which I will come to at the end.

To be honest, this post is really just to encourage you to read this Vox piece by Kose, Loungani and Terrones, which comes from the recent IMF WEO report (pdf). It tells a story in pictures (particularly comprehensive and clear pictures) that I and others - most notably Paul Krugman - have been telling for some time. In the past I have often used cyclically adjusted primary deficits as a summary measure of fiscal stance, because they are readily available and comprehensive. However as an indication of fiscal demand impact they are not ideal - just think of the standard Ricardian Equivalence experiment. So occasionally I have looked at just government spending, which is what Kose et al do in their analysis. The key chart is below.

What the chart shows is that government spending in the advanced economies has grown at a much slower rate in this recovery than in previous recoveries, and of course this recovery has been significantly slower as a result. In contrast, government spending in the emerging economies has been as rapid during the recovery as before the recession, and they have recovered rapidly from recession. Go into detail within the advanced economies group, and the pattern is clear: the greater the contraction in government spending relative to previous recoveries, the slower the recovery has been.

Their analysis also shows us one of the reasons why this happened. The advanced economies started the recovery with debt to GDP almost twice its average level in previous recoveries. At the start of the recession this was not the predominant concern, and we saw some attempt at countercyclical policy in the US, the UK and Japan, as the chart shows. But this was short lived in the UK, and was also reversed in the US and Japan, as debt concerns took over.

Kose et al also illustrate why this was a mistake. Interest rates hit the zero lower bound, so monetary policy could not offset what fiscal policy was doing. Yes, we have had Quantitative Easing (QE), but I think Jonathan Portes puts it rather nicely here. “It seems to me the idea that you risk the government’s credibility by borrowing an extra couple of percent of GDP for investment but there would be no risk to credibility by doing something [QE] which nobody in modern times in an advanced developed country has ever tried and that is generally considered to be last ditch strategy is an odd conclusion.” (The link is to a nice site by the way - on it you will also find Andrew Scott saying: “the right response for those governments wanting to hold on to AAA, whether it be Japan, US, Germany or the UK, is for government debt to show huge increases into triple digits versus GDP.”)

So we have one clear reason why the recovery from the Great Recession has been weak, and it also explains why it has been weaker in some countries than others. I’m sure its not the only reason, but is anyone seriously arguing anymore that it is not an important factor explaining our weak recovery? So the real mistake that Reinhart and Rogoff made was to push the high debt issue at the wrong time. It was I believe an honest mistake: high government debt is a concern, if only (but not only) because it makes politicians do the wrong thing in a serious recession. And of course the mistake would have happened anyway (in part because of Greece, and partly because of those who see reducing the size of the state as the overriding priority) - academics probably overestimate the importance of the research that politicians use as cover. But when history tells the story of why the Great Recession was so prolonged, charts like the one here will be what is shown.

Reduced form macro

2013-04-17T05:47:00.000-07:00

Mark Thoma has a reflective post on the ability of evidence to move us forward in macro. Noah Smith also has interesting things to say. I just want to add the following thought.

If you think about some of the recent disputed empirical results (the 90% debt to GDP, expansionary austerity, cutting spending rather than taxes, multiplier sizes), they all involve relating policy variables directly to outcomes. And if we think about some of the reasons these apparent relationships turned out not to be empirically robust, it was because they failed to think about other things that might matter for outcomes.

Lets be specific. Fiscal multipliers are bound to depend on what monetary policy is doing. In principle monetary policy can offset the impact of fiscal changes on output, but if monetary policy is constrained in some way, it cannot. So any empirical study of the impact of fiscal policy must control for what is happening to monetary policy. I have often written about why high debt may be damaging to growth, but these effects work through raising real interest rates, or discouraging labour supply. It just seems foolish to apply them to a situation where real interest rates are unusually low, and output is hardly constrained by a shortage of labour.

These are simple, obvious points, but its amazing how often they are ignored. It is if some in the profession are desperate to find universal (and perhaps convenient) simple truths, in the face of the obvious fact that the macroeconomy is complex. This is not a new phenomenon. I’m afraid what follows is a personal anecdote, but it is topical.

Monetarism was the centrepiece of Mrs Thatcher’s first government. Following Friedman, policy was based around the idea that there was a predictable causal relationship from the money supply to prices. Lags might be long and variable, but an x% change in the money supply would within a year or two lead to an x% change in prices. Parliament asked the new government to come up with evidence for this assertion. They agreed to, but for some reason I cannot remember, they promised to produce a working paper by a named Treasury economist, rather than some anonymous Treasury document.

At the time I was working in the Treasury, and my job was to help forecast prices. So they chose me to produce this paper. I was to report each week to Terry Burns on progress. Terry Burns had been recently appointed as Chief Economic Advisor and he was one of the architects of the government’s new macroeconomic strategy. The first meeting went fine: I reported that if you regressed prices on the government’s chosen monetary aggregate, you got exactly the relationship they were looking for. However I had remembered some of the econometrics I had been taught. I was worried about omitted variables, and the fact that the two time series were dominated by one particular episode. [1] To cut a long story short, the relationship fell apart if you either took that episode out, or added other explanatory variables like oil prices. Despite Terry and my best efforts, we could not rescue the relationship once you went beyond that first simple regression. To be honest I was not that surprised or unhappy about this, but for the government it was rather embarrassing.

I learnt two things from that episode. The first was to be always extremely distrustful of simple correlations between policy instruments and outcomes. The second occurred after my paper was published. As I was the named author, I was free to write what I thought was an unbiased but purely factual account of my findings, with (to Terry Burns’ credit) no pressure to spin the results to suit the government. Yet despite it being obvious to any objective reader that the results gave no support to the government’s policy, at least one well known city economist cherry picked the results to suggest it did. [2]

Pretty much all the econometric work I did subsequently involved more structural relationships rather than these simple reduced forms. I think we have learnt a great deal from estimating equations that at least try and get close to underlying behavioural relationships, whether its using cross section, time series or panel regressions. A carefully structured VAR may also tell us something. Perhaps an exhaustive robustness analysis running countless single equation regressions can reveal insights - as for example in Xavier Sala-i-Martin's AER paper 'I just ran two million regressions' trying to explain economic growth. But if the empirical evidence involves little more than a regression of outcome x on instrument y, be very very aware.

[1] Just in case anyone is interested, the expansion in M3 caused by the Competition and Credit Control reforms in 1973, and the increase in inflation associated with higher oil prices in 1975.

[2] What happened at that point is a story that I will tell publicly one day. It is probably of no interest except to those who were involved in UK policy at that time, but it reminds me of one of the nicest and most interesting acquaintances I made during my time at the Treasury who is greatly missed.

Framing: Taxpayers money and Fiscal Space at the IMF

2013-04-16T08:19:00.001-07:00

Taxpayers Money

In writing this recent post, when I discussed the potential cost of a government scheme, I initial wrote ‘a cost that taxpayers will bear’. That is what everyone does when pointing out that the government’s finances are really our finances. But I changed what I wrote, because I realised this description is actually incorrect.

One possible reading of the similar phrase ‘taxpayers money’ is that this money in some sense belongs to the taxpayer. That is clearly wrong. This money belongs to the state, and the state is meant to reflect the people’s wishes. So if we want to remind ourselves that we live in a democracy, we could talk about the people’s money, or society’s money, or our money.

Now perhaps you are thinking that the phrase ‘taxpayers money’ is simply designed to remind ourselves where the government’s money comes from. I guess some people need to be reminded that most of the government’s money once belonged to taxpayers. But of course everyone in society is a taxpayer, because we all buy things which the government levies indirect taxes on. Yet I suspect most people read taxpayer as someone who pays income tax, so I would argue that the phase is misleading compared to something like ‘society’s money’ or ‘citizens’ money’.

The actual phrase that I was going to use, and which is so often used, is that some item of government spending represents ‘a cost to the taxpayer’. Additional government spending could be financed by raising income taxes. But it might not be. It could be financed by cutting some type of government transfer. [1] In fact, in the UK at the moment, if you had to guess what was the most likely source of finance for the marginal item of government spending, it would be cuts in welfare benefits. So the probability is that the phrase ‘this is a cost that welfare recipients will bear’ will be more accurate than ‘this is a cost that taxpayers will bear’. Yet I have never seen the first phrase used.

Is this me being pedantic? I would argue this is an example of framing. A related phrase is ‘tax relief’. There is nothing incorrect about using the phrase, but it equates the idea of paying taxes with some kind of affliction. An alternative phrase might be ‘tax dodge’, which has completely the opposite connotation, invoking taxes as a duty which someone is unfairly not fulfilling. I think another example is ‘free market’. Those who favour market solutions often use ‘free market’ instead of just saying ‘market’. We all want to be free. But an alternative description might be ‘unregulated market’, which sounds (to most) less good. One final example might be intellectual property, but I am sure there are many more. [2]

Fiscal Space at the IMF

Unlike the phrases discussed above, ‘fiscal space’ is less widely used, but I want to argue that it too frames a debate in a biased way. There are many good things in the just issued ‘Rethinking Macro Policy II: Getting Granular’ by Blanchard, Dell'Ariccia and Mauro at the IMF. Their discussion of ‘Should Central Banks Explicitly Target Activity’ reflected many of the points I tried to make recently here, although of course they were not rude about the ECB. But the section on fiscal policy was strange, and it made me think about why I have always been reluctant to use the phrase ‘fiscal space’.

The section of the paper on fiscal policy goes as follows. (The letters in brackets refer to the subsections in the paper, and I will use them as references below.) Government debt is too high and needs to come down (A). For some countries where a default premium on government debt has emerged, then debt reduction has to be rapid. The idea that monetary policy could help in these circumstances raises the problem of fiscal dominance (B). In other countries there is ‘fiscal space’, so debt consolidation does not have to be so quick (C). Maybe these countries might think about redesigning their automatic stabilisers (D).

Fiscal space is like a breathing space. The debate is all about the speed of fiscal consolidation, and some countries can afford to take a small breather before getting back on the consolidation path. Taking a breather might be a good idea, because going too fast may have some unintended consequences when we are stuck at a zero lower bound. The idea of active fiscal stimulus becomes reduced to a slower speed of fiscal consolidation and tinkering with automatic stabilisers.

Take this sentence from the paper. “Underlying the debate about multipliers has been the question of the optimal speed of fiscal consolidation (with some in the United States actually arguing for further fiscal stimulus).” Well one or two people outside the US have been arguing for fiscal stimulus too, but the key message here is that there is just one primary role for fiscal policy (fiscal consolidation), and anything to do with multipliers and recovering from recessions just influences its speed.

This framing is wrong. Fiscal policy has two roles. In normal times outside of a monetary union the primary role should be debt stabilisation/reduction. At the zero lower bound the primary role should be fiscal stimulus. In a monetary union both roles are equally important all the time. Framing fiscal policy discussion around the idea of fiscal space negates the countercyclical role. This negation was a key factor behind the Eurozone crisis, and more generally it has intensified and prolonged the current recession.

One of the features of framing is that it is not literally wrong (it is not like the doublespeak of Orwell’s Ministry of Peace ). In the statements above, I agree with (A). But once you concede it is all about (A), then the discussion of (B) and (C) becomes distorted, and the policy endpoint (D) becomes quite inadequate. In fact, you suspect that part of the idea is to deliberately avoid the thought that governments could use fiscal policy in a discretionary manner to stimulate the economy. (The word countercyclical appears only once in the paper.) In that sense, I’m afraid to say, the IMF inhabit the same fiscal space as the European Commission!

[1] Reaction functions relating policy to debt, for example, find no systematic tendency for taxes to respond by more than spending: some evidence is briefly reviewed here. Current austerity programs vary from spending based to tax based: see the IMF analysis reported here.

[2] An earlier version of this post, before I read the IMF paper, ended with a different link. Just as the phrase ‘taxpayers money’ presumed incorrectly that (income) taxes were the residual source of finance, too much macroeconomic analysis of temporary government spending changes uses income taxes as the residual source of finance. This allows opponents of fiscal stimulus too much scope: see for example John Taylor’s latest analysis of the impact of austerity, as discussed by Noah Smith here. The few theoretical cases of expansionary austerity that have been produced nearly all depend on these supply side effects of higher future income taxes outweighing the current impact of higher government spending: see also Campbell Leith here. It would be much better, as I have suggested before, if we instead focused in the first instance on what I have called ‘pure’ countercyclical policy: in this case higher government spending eventually paid for by lower government spending. This way we separate issues to do with intertemporal demand management (the business cycle) from issues to do with tax incentives. I couldn’t decide whether this link inspired or contrived.

Why a Dual Mandate is Essential

2013-04-14T09:39:00.000-07:00

Monetary policy has two crucial roles. The first is to set the medium/long term inflation rate. Pretty well everyone understands this. The economy will not by itself settle down to an inflation rate of 2% or whatever - it needs monetary policy to set this rate and help achieve it.

The second is to ensure that aggregate demand matches aggregate supply. Now here there is sometimes confusion, even among the best economists. [1] The basic idea is that there is a ‘natural’ level of output determined by supply side factors, like how much people want to work, the degree of monopoly in the labour market, the state of technology etc. [2] There will be a real rate of interest associated with this level of output, which we can call the natural interest rate. On the other hand how much firms produce in the short run is largely determined by aggregate demand: firms tend to set prices, and do not ration demand. There is no reason why aggregate demand has to equal supply in the short run in a monetary economy. The difference between actual output and natural output is the output gap. If the output gap is not zero, problems will arise. For example with excess demand we get inflation, and with deficient demand we can have wasted resources and the misery of involuntary unemployment.

Aggregate demand depends on real interest rates. As monetary policy can influence real interest rates in the short run, then its job is to try and match aggregate supply and demand, by bringing the real interest rate as close as possible to the natural interest rate. [3]

These two roles for monetary policy map nicely into the two objectives macroeconomists typically ascribe to policy makers: minimising excess inflation and the output gap. With two goals there will also be conflicts, producing a trade-off between short run inflation stability and eliminating the output gap. Macroeconomics has extensively examined what to do when these conflicts arise.

A permanent non-zero output gap is not compatible with stable inflation in the long run. As a result, it is possible to reduce both roles to one single objective, the stabilisation of inflation, as long as that stabilisation is done ‘flexibly’. Hence the idea of a single, but flexible, inflation target. I now believe having only an inflation target, or making it 'primary', is an important mistake for two reasons. We can label each mistake as MPC and ECB for short.

The first (MPC) is due to persistent shocks to the relationship between the output gap and inflation (or equivalently to the Phillips curve). This sets up a potential conflict between the two goals. Although we know how to optimally deal with this conflict, the policy that results can appear inconsistent with inflation targeting, which puts a strain on an inflation targeting policy. The problem can be ‘solved’ by making inflation targeting even more ‘flexible’, but this in turn makes the policy less clear.

Of course macroeconomists have always acknowledged this possibility, but have thought that the impact of excess or deficient aggregate demand would always be strong enough for this not to matter in practice. However, as the recent IMF study I discuss here shows, either low inflation or credible inflation targets (or both) seem to have weakened the impact of the output gap on inflation, which makes the problem of persistent cost-push shocks more important. This has been the problem the MPC in the UK have been grappling with in recent years, and I believe the lack of a dual mandate has made their decisions less optimal. More generally, as Paul Krugman says here, thinking that stable low inflation must mean everything is OK could be very wrong.

The second (ECB) is that, in the wrong hands, the flexible inflation targeting regime can become a severely non-optimal policy that pays too little (or asymmetric) attention to the output gap, even in the absence of supply side shocks. In academic language, we could express this in terms of Rogoff’s conservative central banker (giving less weight to the output gap than the public does), but it also allows bad policy enacted by an incompetent central bank (that does not understand the importance of the output gap) or a malevolent central bank (that wants to achieve its own objectives that may not just involve hitting an inflation target).

There is a nice quote by Duisenberg from February 2003 contained in this paper by Jörg Bibow (page 35) that a comment from an earlier post pointed me to. In discussing what price stability meant, he said it “implies that, in practice, we are more inclined to act when inflation falls below 1% and we are also inclined to act when inflation threatens to exceed 2% in the medium term.” [4] Now Andrew Watt and others would argue that this is not a good reading of the ECB’s actual mandate, but it seems to me a good reading of what they actually do, and it is one that a single rather than a dual mandate helps them to get away with.

So what is the objection to a dual mandate? As it reflects how an academic thinks about monetary policy, it should not lead to suboptimal policy in the hands of an informed and benevolent policy maker. So the fear must be that it will misdirect an uninformed policy maker, and encourage non-benevolent behaviour. The exemplar here is the 1970s, but for reasons I discussed here, I do not think that period should be used as evidence against the dual mandate. I discuss here why I think the standard inflation bias story is also overrated in this respect.

Is there any evidence that the US with its dual mandate has done better compared to inflation targeters? There has been some discussion of that recently (e.g. here and here), although the data analysis is not very sophisticated. [5] Until we see good evidence that having a dual mandate worsens outcomes, then I believe the presumption must be that the dual mandate is better because it reflects the two goals of monetary policy.

My argument here concerns higher level objectives. It is not about how best to achieve those objectives, which is where I would locate questions about the wisdom of nominal GDP targets. It does not address the relative weight that the two objectives should have, or the extent that the objectives should be vague or concrete. My own view is that the benefits of a publicly announced inflation target are overwhelming - indeed so much so that I recently forgot how new this ‘innovation’ was for the Fed. How best to express the goal of matching aggregate demand with supply is more difficult, because of the uncertainties involved in measuring the output gap. However output gap uncertainty is not so great that we should ignore the concept, and so this uncertainty cannot justify a single inflation mandate. There are lots of things in life that are difficult to define, but which are still worth striving for.

[1] See, for example, Brad DeLong here. The reasons for this confusion are interesting, but I have speculated on this elsewhere and do not want to get distracted. Of course none of this implies that the natural level of output and its associated interest rate need be in any sense optimal or efficient, but that should be a different and separable question.

[2] There is nothing mysterious about the natural level of output. It is the output which pretty much every macroeconomist not investigating problems of aggregate demand analyse. It could be called the level of output that comes out of an RBC model, for example. It is often described as the level of output that would occur if prices were completely flexible, and here I do have a quibble, because at a zero lower bound and with inflation targets I cannot see how increasing the flexibility of prices will ensure that output reaches the natural level.

[3]

If monetary policy cannot do this, then fiscal policy can help reduce the output gap. We could describe this as fiscal policy raising the natural interest rate, but an equivalent and more intuitive description is that fiscal policy just raises aggregate demand.

There are plenty of caveats to this econ 101 account, such as the possibility that actual output might have an influence on longer term aggregate supply.

[4] If the implied asymmetric differentiation between actual and possible future here was a slip, I’m tempted to suggest it was a Freudian one.

[5] For example, MPC decisions since the recession have tended to define flexibility as ‘seeing through’ actual inflation and focusing on expected inflation two years out. Inflation targets then become a constraint when the impact of cost-push shocks persist for two years or more.

The ECB as a Lender of Last Resort to Governments

2013-04-12T08:46:00.000-07:00

John McHale rightly points out that in my earlier post on the European Commission’s justification for austerity, I said little about the Lender of Last Resort to governments (LOLR) issue. What I did say is that OMT should have been established much earlier, and that this might have allowed Ireland and Portugal to continue to sell government debt to the markets at tolerable interest rates, which in turn might have allowed them to implement budget consolidation at a less damaging pace. (Whether they would have taken that opportunity is another matter.)

However this begs an obvious question, which is how OMT conditionality should operate. One possibility is that the ECB imposes as least as harsh conditions as the current Troika. Alternatively the ECB passes responsibility for imposing conditions to the Troika, and the Troika continues to do what it has already done. It would be wrong to say nothing would be gained as a result. If OMT works and the governments continue to borrow from the market, then we avoid some of the toxic intergovernmental lending that is in danger of tearing the Eurozone apart. However we will still have excessive fiscal deflation.

Do we need any conditionality at all? Unfortunately we do. To offer OMT unconditionally would take us back to the pre-2007 situation, where default was not thought possible. It revitalises the arguments that gave rise to the disastrous Stability and Growth Pact and the more recent Fiscal Compact. As Charles Wyplosz and others have emphasised, it is very difficult to run any kind of system where component parts have autonomy to borrow without having the discipline of default, unless you resort to a degree of central control that is not feasible for the Eurozone.

Conditionality should not come naturally to any independent central bank. There is no significant example of a country delegating fiscal decision making to an unelected body, and even if it did so there are reasons not to use a central bank for that task. But before addressing this dilemma, we should establish what the nature of conditionality should be.

The remit of the central bank should be short run macroeconomic stabilisation and long run price stability. OMT can be justified under this remit, as I argued here, because if a country finds itself in a bad market equilibrium, this will have a negative impact on the monetary transmission mechanism and short run macroeconomic stability. Conditionality can also be justified under this remit, because a complete failure of fiscal control in one country in a union when default is not allowed will compromise monetary policy for the union as a whole. (One of my own papers with Campbell Leith looks at this in a two country case. [1]) By complete lack of fiscal control, I essentially mean that a government is insolvent at a level of interest rates consistent with normal monetary policy. [2]

In other words, all the ECB needs to worry about is whether fiscal policy is sustainable in the long run. It should have no concern about which of the many possible sustainable fiscal paths a government chooses - that is up to the national government. There is a analogy with the well established rules for central bank support of private banks. If the bank is solvent but suffering from liquidity problems, support should be unequivocal and unlimited. If the bank is insolvent, no support should be forthcoming. [3]

The problem with this analogy is that solvency for a government involves a political as well as a technical judgement. Suppose a government submits fiscal projections that are sustainable. This could involve government debt initially rising but stabilising at some high level. If it then starts falling again so much the better. There could be two things wrong with this projection. The first is technical: for example growth assumptions may be too optimistic or tax receipts given growth are too optimistic. The second is political: the plan may involve cuts in spending, or increases in taxes, that are unlikely to be realised because the political costs are too high.

No central bank should like to be in a position where it has to make these political judgements. It would like to offload the problem on someone else. The obvious someone else is the market, but that will not work because all the market tells you is that there exists a bad equilibrium, and not whether a good equilibrium exists. To use Keynes’s famous analogy, the market is judging who the market thinks is beautiful, and not who is actually beautiful. The ratings agencies seem ‘market like’, but are in effect just a bunch of people with a (perhaps informed) opinion, and a not very good track record.

Who else could the ECB delegate conditionality to? Delegating to EU heads of state would be a bad idea, for reasons that I hope are obvious. [4] Delegating to the Commission seems too close to that. A better possibility would be the IMF. The IMF certainly knows all about this issue: see this research for example. However all of these agencies have a recent track record that does not inspire confidence. An acid test is how any arrangement would have worked in the case of Greece. What should have happened, as soon as the true extent of Greece’s fiscal problems had become clear, is that whatever body the ECB had delegated its conditionality assessment to should have concluded that default was more likely than not, and therefore OMT should not have been provided.[5]

I have an alternative suggestion, which regular readers will not find surprising. A number of Eurozone countries now have fiscal councils, whose very job is to assess the sustainability of fiscal policy. They are the obvious people to ask. Putting such an important question to the relevant national fiscal council may be politically unwise - could that council survive a decision that led to default? It would be better, for this and other reasons, for fiscal councils to act as a group in advising the ECB on the sustainability of national fiscal plans. That way expertise could be pooled, and experience shared.

Let me be quite clear what I am suggesting here. As soon as a country specific default premium began to emerge on a Eurozone member’s government debt, the ECB would ask the collective of Eurozone fiscal councils whether they thought current fiscal plans would result in a sustainable level of debt. If they did, the ECB would announce that OMT would apply to that country i.e. it would buy whatever quantity of that debt that could not be sold to the market. That decision could be reviewed annually until the default premium faded away. If the fiscal councils collective did not think current fiscal plans were realistic and sustainable, OMT would not be forthcoming. In these circumstances, there would be no bailing out by the Eurozone or IMF, and default would almost certainly follow.

The Commission plays no part in this. However, I think the Commission still has a very important role to play. The ECB, as part of the role it should have in preventing deficient aggregate demand in the Eurozone as a whole, should publicly state that because of the zero lower bound they cannot use monetary policy to fulfill this function. They should ask the Commission to coordinate fiscal actions to provide additional support to demand. In doing this, the Commission would clearly not ask that much of countries on OMT, so most of the ‘burden’ would fall on others, like Germany or the Netherlands.

Which brings me back to my previous post, and why I think what I said there was quite compatible with LOLR issues. Now some commented on that earlier post that it was not politically feasible, by which they mean Germany would not countenance it. I am sure that is right, although what has disappointed me (and others - see Kevin O’Rourke) is that the election of Hollande did not emboldened countries like France and Italy to provide any kind of counterweight to German views.

One of the advantages of being an academic is that your advice does not have to be bound by what is politically feasible. It is important that someone sets out what is best as they see it, and others can then modify it to satisfy political constraints. However the problem in this case is not so much that fiscal stimulus rather than austerity, and the ECB acting as a LOLR, are not in the German national interest. I think you could make a case that they are in fact in Germany’s long term national interest, because a well functioning Eurozone is in their interests. The problem seems more that policy makers throughout Europe have two economic blindspots. [6] Those blindspots are the fallacy of austerity at the Zero Lower Bound, and the necessity of a LOLR. What I will not do is give advice which accepts that those blindspots cannot be removed.

[1] See also Canzoneri, M. B., R. E. Cumby and B. T. Diba (2001), “Fiscal Discipline and Exchange Rate Systems”, Economic Journal, No. 474, pp 667-690.

[2] Using Eric Leeper’s terminology, it means the fiscal authority is active: for a discussion of the active/passive idea and its application to the ECB and OMT see here.

[3] One problem with the Bagehot dictum is contagion: if an insolvent bank is allowed to fail, this may create a liquidity (or even solvency) crisis for others. These contagion arguments have much less weight when it comes to countries in the Eurozone, once OMT has been established and the conditionality involved is clear and non-political.

[4] See, for example, Cyprus. Colm McCarthy describes it well here (HT Kevin O’Rourke)

[5] This may be a little unfair on the IMF, who almost certainly came under intense political pressure from the Eurozone to provide funds before the inevitability of default was conceded. I do not know whether this assistance, which allowed default to be delayed, was provided against the better judgement of some of those in the Fund.

[6] See a shrill Kevin O’Rourke here.

On the economic achievements and failures of Margaret Thatcher

2013-04-10T08:10:00.001-07:00

I was not going to write anything on Mrs T, but then I just happened to read yesterday a journal article that says something important about her legacy today. I also decided to write something to challenge some of the myths and taboos created by the political right and left. The right in the UK tends to mythologise Margaret Thatcher, in a similar way I think the right in the US does with Ronald Reagan. So its worth pointing out two major macroeconomic errors that were made while she was Prime Minister. The left is less inclined to hero worship its own Prime Ministers (generally it does the opposite), but it has its own taboos when it comes to macroeconomic history.

What was the journal article? It is a paper [1] that looks at the causal impact of fathers' job loss on their children's educational attainment and later economic outcomes. The place and time is the UK recession of the early 1980s. The study concludes: “Children with fathers who were identified as being displaced did significantly worse in terms of their GCSE attainment than those with non-displaced fathers.” Not a very surprising result, but further evidence of the long term damage done by high and prolonged unemployment (what macroeconomists call hysteresis effects).

The UK recession at the beginning of the 1980s was the worst since the second world war. UK unemployment increased dramatically, from below 6% to nearly 12%, and stayed high until the end of the decade. The chart below boxes the Thatcher years. (Unemployment would have been higher still if the government had not encouraged the unemployed to register as disabled, as John Van Reenen relates and even George Osborne admits.)

UK Unemployment

Did the government led by Margaret Thatcher intend for this to happen? Almost certainly not. Their plan involved replacing traditional macroeconomic policy by monetarism, which meant gradually declining targets for the growth of a particular monetary aggregate. As Chris Dillow points out, they expected this would lead to a steady decline in inflation, with a minor and temporary dislocation in terms of output.

Many thought that a foolish thing to believe at the time, but in macroeconomic terms Mrs Thatcher’s administration were revolutionaries who despised conventional wisdom. When presented with Treasury forecasts telling them with unusual accuracy what would happen, they rubbished the Treasury advice. As unemployment rose rapidly, and many in her party urged her to change course, she gave her famous ‘this lady’s not for turning’ speech that is so eulogised by some Conservatives today.

The attempt to hit their monetary targets failed dismally: 81/80 target money growth 7-11%, actual 19.1%, 82/81 target growth 6-10%, actual 13.7%. After that monetary targets were effectively abandoned. One of the biggest experiments in UK macroeconomic policy turned out to be a disastrous failure. As GDP fell by over 2% in 1980, and remained flat in 1981, and manufacturing output fell by 15% in two years, it is not surprising that inflation fell rapidly, although too many on the left believed it would not.

Yet, as I have noted before, this period is regarded by many as Mrs. Thatcher triumphing over doubters, including most academic economists. This myth may be partly responsible for the current government's obstinacy about austerity. So how can it be regarded as a triumph? Output did recover - well of course it did, but as the chart shows unemployment stayed persistently high, with the long run costs that I noted above. Inflation came down rapidly, but far more rapidly than was intended.

Was this unintended cold turkey cure in any sense optimal? I think that is highly unlikely for many reasons. One is that the traded sector bore the main cost of the recession. The period coincided with North Sea oil coming on stream, which in itself would have led to an appreciation in sterling and a movement of resources away from the traded sector. In these circumstances, embarking on a policy that produced a further appreciation in classic Dornbush overshooting style led to the very uneven recession. Now the Dornbusch analysis was fairly new, so perhaps the government can be forgiven for not anticipating that this would happen, but by 1980 it was all pretty clear what was going on, and that was the point at which the lady refused to turn.

But the key point remains that this skewed, cold turkey policy to reduce inflation was never part of the plan. The plan itself was a complete failure, and if you think the outcome was optimal (which I do not) then that is down to luck rather than judgement.

The second failure involved North Sea oil. I have compared how the UK and Norway responded to additional government revenue from North Sea oil before. The Norwegian government created a sovereign wealth fund, so that the gains from North Sea oil could be enjoyed by future generations. The UK government thought the people should make that choice, and so cut taxes. The people, for one reason or another, do not appear to have invested that money to replicate what a sovereign wealth fund would do. So Mrs Thatcher made the wrong choice, and whether it was for ideological reasons or more base electoral considerations is secondary. It was a major mistake that current and future generations will pay for.

Those are two major failures, but what about the successes? The Thatcher era saw the implementation of supply side reforms that ended and then reversed the relative decline of UK productivity. As Paul Krugman has pointed out, the lags here need to be long, but I think we have good reason to believe that they are. As Nick Crafts outlines here, and John Van Reenen here, this improvement came about partly through increased goods market competition, but of course it also reflected a reduction in union power that was one of the major aims of government policy. The taboo on the left is not to admit (at least publicly) that UK trade unions had grown too powerful in the 1970s, and that any benefits this had were outweighed by inefficiency and often severe dislocation.

The battles of the 1980s, and the path Mrs Thatcher took, were not inevitable, and it is possible that the UK could have moved to something like the German model where unions retain a strong presence. However the path followed by the UK is at least partly the responsibility of the left as well as the right: some of the proposals later introduced by Mrs Thatcher were first tabled by the 1969 Labour government and Barbara Castle, and were defeated by the Trade Union Congress and the later Labour Prime Minister Jim Callaghan.

This post is not meant to be comprehensive: I have said nothing about the rise in poverty under Mrs Thatcher (briefly mentioned here), inequality more generally and the role that taxation had in increasing that (of which the poll tax was just one example), selling off state assets or under investing in what was left. (Van Reenen gives more detail on some of these.) A second major UK macroeconomic disaster also occurred right at the end of her premiership. The UK entered into the European Exchange Rate Mechanism at an overvalued exchange rate, which led to another major recession. That story, and my own very small part in it, will have to wait for another time.

[1] Gregg, P., Macmillan, L. and Nasim, B. (2012), The Impact of Fathers' Job Loss during the Recession of the 1980s on their Children's Educational Attainment and Labour Market Outcomes. Fiscal Studies, 33: 237–264

Myths and Realities of the 1970s

2013-04-09T07:11:00.002-07:00

I have been pondering why inflation targeting is so popular, as opposed to the more natural idea of a dual mandate. I say more natural for two reasons. First, because the dual mandate corresponds to the two roles of monetary policy: short run demand management and determining medium/long term inflation. Second, because it maps naturally to the objectives that macroeconomists typically assume or derive when modelling monetary policy: minimising both excess inflation and the output gap.

I think a big reason for the popularity of inflation targeting is the 1970s. A common story for why inflation was allowed to rise so high for so long in that decade is that monetary policy was targeting the output gap, and policy makers got their estimate of the natural rate very wrong. (A classic reference is Orphanides (2002). [1]) A dual mandate, it is suggested, encouraged that mistake, and could lead to the same mistake being made again. So central banks given independence since the 1970s tend to have low inflation or price stability as their primary goal, rather than a dual mandate.

There is an obvious rejoinder to that argument. The US Fed maintains its dual mandate, yet it shows no signs of acquiescing to the kind of increases in inflation we saw in the 1970s. Its latest forward guidance says it will tolerate inflation up to 2.5% (as long as unemployment stays high) before it considers raising interest rates. That is hardly going back to the 1970s. There are people who think that QE will, any moment now, open the inflation floodgates, but I want to keep to serious macro in this post.

So current experience shows there is no reason why a dual mandate should inevitably lead to rising inflation. I think there were three important contributory factors to what happened in the 1970s that are just not present today. First, our knowledge of inflation output trade-offs, although hardly complete now, was much weaker back then. Second, the Fed and other monetary policy makers did not have clear inflation targets that they were publicly committed to. Third, there appeared to be an alternative instrument for dealing with inflation: direct controls on prices and wages. [Postscript: see comment from Robert Waldmann and my reply below.] The 1970s really was a different world in terms of the understanding of macroeconomic policy.

I’m reminded of all this by a fascinating chapter (released today) in the forthcoming IMF World Economic Outlook. The main focus of the chapter is on how the Phillips curve has shifted over time. There are two clear findings. The first is that the sensitivity of inflation to the output gap is much lower now than in the 1970s. Second, the importance of expectations about future inflation (compared to past inflation) is much greater. An obvious way of interpreting both results is that inflation expectations are now much more firmly anchored.

However the chapter also contains an interesting comparison between the behaviour of 1970s inflation and monetary policy in the United States and Germany. We all know that the US had to wait until Volcker in 1979 before inflation control was restored. However the Bundesbank did this much earlier: inflation was brought down to below 3% in 1978. While it could hardly be immune from the impact of the oil price shocks and high inflation elsewhere, its record in keeping inflation anchored looks much better than other countries. Here is the relevant chart from the chapter.

Now there is a popular story about this as well, which is that the Bundesbank was practicing monetary targeting during this period. But, as the WEO chapter points out, this is also a bit of a myth. Studies suggest [2] that in practice the Bundesbank was not a rigid money supply targeter in the way both the US and UK attempted to be in the early 1980s, but instead adopted a more flexible approach which can be characterised by some form of Taylor rule. Furthermore the output gap played an important role in that rule, and the Bundesbank also got its estimates of the output gap wrong.

To quote from the WEO chapter:

“the Bundesbank’s success was not linked to meticulously meeting the monetary targets, which it actually missed throughout the 1970s, or to focusing on inflation with no regard for output developments. Rather the Bundesbank’s success was a reflection of the robust framework it developed, which allowed it to keep longer-term inflation expectations anchored while flexibly responding to shorter-term output shocks.”

I think you can argue that what monetary targets did was proxy a dual mandate. Inflation would not be allowed to rise unchecked for too long, but equally movements in output would be offset by interest rate changes, in the classic IS-LM manner.

So I think the lesson of the 1970s is that it is important to have publicly stated inflation targets, but not that the short term output stabilisation role should be subordinate to hitting those targets. In the future there will surely be a similar IMF WEO chapter looking back at the divergent behaviour of US and Eurozone output in the 2010s (see Ryan Avent here). I’m sure one of its arguments will be that the US did so much better in part because monetary policy had a dual mandate, while the ECB acted as if all that mattered was inflation.

[1] Orphanides, Athanasios, 2002, “Monetary-Policy Rules and the Great Inflation,” American Economic Review, Vol. 92, No. 2, pp. 115–20.

[2] The WEO chapter notes Clarida, R.H. and Gertler, M. (1997) “How the Bundesbank Conducts Monetary Policy” in Reducing Inflation: Motivation and Strategy eds Romer and Romer, Chicago University Press, pp 363-412 and Gerberding, C., Seitz, F. and Worms, A. (2005) “How the Bundesbank Really Conducted Monetary Policy” North American Journal of Economics and Finance, 16, 277-92. The second study reconstructs the real time data set that would have actually been available to policy makers, and finds as a result that it is the change rather than the level of the output gap that was important in their Taylor rule, and that a term in excess money growth is also significant. This slightly earlier paper by Clausen and Meier does something similar, but with results closer to a traditional Taylor rule.

Nasty politics in hard times

2013-04-08T11:39:00.000-07:00

This is a post about morality rather than economics, and as a result I am rather unsure about whether I should be writing it at all. Yet it is something that I have kept thinking about over the last few days, even though I would rather put it out of my mind. So perhaps this is blogging as therapy.

When jobs are scarce, people become understandably more exercised about the idea that some people are getting an income from the state without trying to find a job, just as they imagine that immigrants are ‘stealing‘ what jobs there are. Such views are encouraged by the tabloid press, as I noted here - the tabloids are our equivalent of Fox News.

There has recently been a particularly egregious example of this in the UK. For those UK readers I just have to say the Philpott case and the Daily Mail, and they can skip the rest of the paragraph. For those outside of the UK, a criminal case recently came to an end where someone called Mick Philpott and two others were jailed for killing their six children by burning down their house. It was not murder: the individuals intended to rescue their children and frame someone else as part of a custody battle, but the ‘plan’ did not work out. A tragic case, and as the architect of the plan, Philpott received a very heavy sentence for manslaughter. Philpott had 17 children by five different women, and received large amounts of money in benefit payments. Which allowed the Daily Mail newspaper to print the headline “Vile Product Of Welfare UK”. Not to be outdone, the Sun said “Let's hope this is the last time the state unwittingly subsidises the manslaughter of children.”

This all takes place at the same time as the government’s welfare reforms are starting to be implemented. I am far from an expert in this area, so I have not talked about these reforms in this blog, although I did recently note how they are expected to reverse recent declines in child poverty. That aside, whether these reforms make sense or not is beside the point here. What is important is that one of the government’s stated aims is to make the system more efficient, because in times of austerity money needs to be saved.

It is clear that the problem of the welfare state allowing, let alone encouraging, certain people to remain unemployed and have large families is not the main issue in trying to make the welfare system more efficient. To quote the Economist: “Though most of them seem to end up in newspapers, in 2011 there were just 130 families in the country with ten children claiming at least one out-of-work benefit. Only 8% of benefit claimants have three or more children. What evidence there is suggests that on average, unemployed people have similar numbers of children to employed people.”

What we do know is that the vast majority of welfare payments go to people who are trying to find a job but cannot because jobs are scarce, or who are disabled, or who do have a job which is very poorly paid. These are people that most citizens in the UK would never want to exchange places with, and they deserve our sympathy and support. So what do you do if you are a public figure who knows these facts, and a national newspaper like the Daily Mail not only distorts the truth with its headlines, but by implication paints all those receiving welfare in such horrible colours?

I would suggest any decent person would try to bring the debate back to reality. At the very least you might say the following: "The Philpott case is an individual tragedy. Children have died in that case. I think that is where we should let that case lie. I would not want to connect that to the much wider need to reform our welfare system." That is what Danny Alexander, the (LibDem) Chief Secretary to the Treasury said. But this is what his boss, the Chancellor George Osborne, said. "Philpott is responsible for these absolutely horrendous crimes and these are crimes that have shocked the nation. The courts are responsible for sentencing him, but I think there is a question for government and for society about the welfare state – and the taxpayers who pay for the welfare state – subsidising lifestyles like that, and I think that debate needs to be had."

So he sees no problem with the Daily Mail’s headline. Regular readers will know that I think George Osborne has been a hopeless Chancellor, and in addition that he has subordinated his economic task to the urge to make political capital. Yet even I was surprised by this attempt to use the tragic deaths of six children in a bizarre and unique case to try and score political points.

People can make up their own minds about the morality of this. Or you might take a cynical view, that all politicians will take any opportunity they can to make populist points, and that there is no morality left in politics. In which case the last thing any politician should do is say this “... do you exploit tragedy, like the Philpott tragedy? The right place for Mr Philpott is behind bars, but do you exploit the deaths of six children to try and make a political point about the welfare system, and at the same time say to people that this is somehow a common truth about people on benefits?" Perhaps there is just a little morality left in politics, whichever side you are on.

What does the ECB think it is doing?

2013-04-04T09:03:00.000-07:00

Or rather, why isn’t it doing something? Consumer price inflation is currently 1.7%. The OECD expects 1.6% as a whole for 2013, and 1.2% for 2014. The ECB sees downside risks due to the impact from lower activity, which it acknowledges is falling but which it hopes will recover soon. The OECD expects GDP to be flat this year, and increase by 1.3% next - is that what is meant by a recovery? On activity the ECB sees downside risks, but does not mention any upside risks. On the prices side they see upside risks from administered prices, VAT and oil, but for all three it is questionable whether it should react to these type of shocks at all.

In fact, if you look at other measures of inflation, the inactivity is even more puzzling. Annual increases in the GDP deflator have been at or below 1.2% since 2009, and the OECD expect a rise of only 1% in 2014. Wage increases (compensation per employee) have been below 2% since 2009, and are expected by the OECD to be around 1.5% this year and next. (Wages should normally increase by more than price inflation because of underlying productivity growth.)

With this in mind I read Draghi’s statement today, where he announced no change in the 0.75% interest rate, looking for some justification for why nothing was being done despite falling activity and below target inflation. After listing all the reasons that would normally suggest cutting interest rates, there was this: “Against this overall background our monetary policy stance will remain accommodative for as long as needed.”

I’m sorry, but this does not compute. The Eurozone is suffering from a large negative demand shock due to many things: partly austerity, but also the kind of balance sheet adjustment that we have seen elsewhere. (See, for example, Reza Moghadam of the IMF here.) In macroeconomic terms, we have a large leftward shift in the IS curve. What monetary policy is meant to do in these circumstances is to cut real interest rates to restore demand. In macroeconomics speak, to move down the IS curve until demand is restored. Moving a bit along the IS curve, and saying ‘look, we are helping’, is not good enough. Policy needs to respond to the size of the shock. Now monetary policy is difficult when signals and forecasts conflict. But when everything is pointing in the same direction, it is really easy.

The other interpretation of what the ECB is doing is that they do understand basic macroeconomics, but consumer price inflation of 1.7% prompts no action (because its close to 2%), and they expect (in contrast to the OECD) inflation to stay at this level. But is this plausible? One word that does not feature in Draghi’s statement is unemployment. The OECD expects unemployment to rise to 12% this year and next, which is 2% higher than in any year from 2000 to 2010. So how does this square with consumer price inflation stabilising at just below 2%? The answer is it does not. The ECB staff forecasts for consumer price inflation for 2014 are “between 0.6% and 2.0%” - exactly in line with the OECD.

So something is very wrong here. Even if you assume that the ECB are focused on hitting consumer price inflation alone, and care nothing for activity, unemployment or other inflation measures, they are doing nothing about future inflation falling well below 2%. So however you write the job description, they are not doing their job. What happens in this situation? Does anyone have ultimate control over the ECB? Or was the possibility that the ECB would not do their job properly never imagined?

Dealing with Increasing UK Poverty

2013-04-02T05:59:00.000-07:00

I ended a recent post with the following: “Surely it should now be clear that this is a government with at least as strong an anti-state, anti-poor ideology as Mrs Thatcher, but with rather less honesty about what it is doing.” For someone who tries to avoid hyperbole, this is pretty strong stuff. So where is the evidence for this claim?

The anti-state side should be familiar to regular readers. Once you realise that the austerity policy has no sound basis in terms of macroeconomics, and the markets are saying ‘please supply more UK government debt’, then you look for other motives. A desire to shrink the size of the state seems to account for both the composition of the austerity programme, and the refusal to undertake a balanced budget stimulus. I have obviously focused on this macro issue, but the anti-state focus of policy is also pretty clear in the NHS reforms, and in the push (I could use a stronger term) to create academy schools.

What about the anti-poor part? This is not my field, so the evidence I present below may not be the most up to date or complete. However I think its worth setting out the evidence as I see it, because it does not get the publicity it deserves. Here I focus on the standard measure of poverty, which is the number of people with income below 60% of the median for that year.

First from a historical perspective, lets go to the latest annual study by the New Policy Institute.

Different UK groups in poverty (after housing costs)

	1981	1991	2000/01	2010/11
Children	20%	31%	31%	27%
Working‑age adults with children	16%	25%	25%	24%
Working‑age adults without children	7%	15%	16%	20%
Pensioners	22%	35%	25%	17%

Source: Hannah Aldridge, Peter Kenway, Tom MacInnes and Anushree Parekh, Monitoring Poverty and Social Exclusion 2012, New Policy Institute.

Poverty increased across the board in the decade of Mrs. Thatcher, although of course correlation does not establish causation. What is really noticeable since then has been the decline in pensioner poverty, which can be seen as a success story for government action.

Poverty among other groups has been relatively static. Given that the 1997 Labour government made reducing child poverty a major priority, the relatively small reduction there is disappointing, but it was not for want of trying. Researchers at the IFS estimate that had financial support merely risen with inflation, child poverty would have risen by over one-quarter to around 4.3 million by 2010. [1]

So what of the future? The following table comes from another IFS study that tries to estimate likely levels of poverty out to 2020. It is out of date in that it takes no account of cuts in welfare provision announced by George Osborne in November last year, of which more below.

Estimates of future proportions in UK poverty

	2009 (data)	2015	2020
Children	19.5	22.2	24.4
Working‑age adults with children	17.1	18.5	20.0
Working‑age adults without children	15.0	15.9	17.5

Source: Brewer, Browne and Joyce (2011) Child and working-age poverty from 2010 to 2020, IFS.

So poverty is going back up. [2] This is a direct result of policy. The study estimates that “the impact of changes to personal tax and benefit policy announced by this coalition government is to increase relative child poverty by 200,000 in both 2015-16 and 2020-21, and to increase relative poverty for working-age adults by 200,000 in 2015-16 and 400,000 in 2020-21.” “The main culprit is the change in uprating benefits from the RPI to the CPI.”

Yet this is out of date. In the pre-budget report in November the Chancellor announced that uprating would be further reduced to 1% for three years. So the likely increase in poverty is even greater than these figures suggest.

As the government is creating this increase in poverty, how are they going to deal with the problem? The answer seems to be by stigmatising the poor. The Chancellor famously said “Where is the fairness, we ask, for the shift-worker, leaving home in the dark hours of the early morning, who looks up at the closed blinds of their next-door neighbour sleeping off a life on benefits.” Unfortunately this line appears to resonate with a growing hardening of public attitudes towards welfare provision. This in turn reflects a persistent tendency of particular tabloid newspapers to run stories about benefit scroungers. [3]

For example, Randeep Ramesh writes “Stories referring to large families had more than doubled in frequency since 2003, accounting for some 7.4% of articles. The facts are that families with more than five children account for 1% of out-of-work benefit claims. Very large households with ten or more children are a staple of tabloid shock stories: there are, according to DWP, 180 such claimant households in Britain.” As Ian Mulheirn points out here, using Department of Work and Pensions research, the percentage of those claiming unemployment benefit whose previous work record suggests they are trapped in a dependency culture is pretty small. So the facts do not support the rhetoric, which of course politicians know, so the rhetoric is part of the strategy. (There is also an unwillingness within government to try and model the impact of reforms, as Alex Marsh notes.)

Thus the solution of how to ‘deal with’ poverty is to return to Victorian attitudes (HT Mark Thoma, who also has this nice historical account from the US.) There is even the suggestion that UK ministers might change the statistics to reflect the idea that poverty is a result of character rather than circumstance. Dependency is always an issue with welfare, but as Brad DeLong writes here (and James Kwak here), it does not warrant hysterical overreaction.

When the charity Save the Children recently launched its first campaign to help UK families in poverty, the reaction from conservative MPs and the right wing press was predictably to blame the messenger. Perhaps they think the rapid growth of food banks in the UK of the last few years is also politically motivated?

[1] My reading of this was that in the case of child poverty (and unlike pensioner poverty), fiscal measures were fighting against the effects of greater wage inequality.

[2] These poverty measures are sometimes criticised because they are relative, and disguise the fact that everyone’s living standards are going up. I think this criticism is misplaced, but it is worth noting that it does not apply to the recent past and near future, where real incomes in the UK have tended to fall.

[3] I’m often surprised at how social scientists are reluctant to give newspaper reporting the importance it deserves in shaping certain social attitudes. We are often told about the ‘puzzle’ that people’s perception that crime is increasing is at odds with the fact that it is falling, yet given how crime is reported, I see no puzzle at all.

The View from Brussels

2013-03-30T07:44:00.000-07:00

When incomplete ideas get embodied in institutions and the people in them

As I have said before, its too easy to be rude about austerity. It is harder to put yourself in the mindset of reasonable individuals who take a different view, and pinpoint exactly - in ways that they will understand - why their view is wrong. So this paper from Marco Buti and Nicolas Carnot (HT Philip Lane) is useful because it shows us that mindset. [1]

The argument in the paper is essentially this. “We recall that large adjustments are needed

in most economies to restore sustainable fiscal positions, not because of the arbitrary will of the markets or of EU institutions.” So the debate is about the precise speed of adjustment, and the Commission is trying to strike the “right balance”. In particular, it recognises the need for different speeds in different countries. I think this view characterises the position of many international organisations, including the OECD, and many in the IMF.

There is a big mistake being made here. It essentially involves the prioritisation of issues. Fiscal adjustment is seen as the overriding priority. Issues involving the state of the economy are secondary: they are one factor in judging the appropriate speed of adjustment. This is the wrong way around.

The major priority at the moment should be doing something about the demand led recession in the Eurozone (and other countries like the UK). The budgetary position of some countries is a secondary factor that may influence the country by country balance of any fiscal actions required to deal with this priority.

This point about priorities is not an expression of political preferences. It is about what basic macroeconomics tells us. The recession is a problem right now. If it is not dealt with now, the loss of resources is permanent and irretrievable, and in addition there is likely to be a more permanent scarring effect through hysteresis. Given the imbalances within the Eurozone, and the political tensions generated by creditor/debtor relationships, the costs of a recession could be greater still. Budget consolidation is a permanent, long term issue, and there is clearly a right and a wrong time to deal with it. Recessions are the wrong time, not just because it conflicts with other priorities, but because it may not even work, because of hysteresis effects, or political effects, or banking effects.

So why is this obvious to me, but not to those running policy? To repeat, my own view is in no sense about the relative importance, in some abstract sense, of deficit bias versus avoiding recessions. As regular readers will know, on deficit bias and long run goals for debt I am something of a hawk. I just do not see why we cannot avoid recessions and bring down government debt.

In some cases those running policy take a different view because of ulterior political motives, but not in all cases. I’m prepared to give those in the Commission, and other international organisations like the OECD and IMF, the benefit of the doubt on this. I believe an important influence on their mindset is that they are working in a framework in which overall demand stabilisation is not their problem. That is monetary policy, not fiscal policy. It is very revealing that in the Commission paper two phrases do not appear at all: they are ‘zero lower bound’ (ZLB) and ‘liquidity trap’. Too few in government have recognised that when we hit the ZLB, the rules of the macroeconomic game fundamentally change, and the institutions of government - and those in them - have to adapt too.

This is hardly a novel point, but as Paul Krugman keeps stressing, it is absolutely central. It is why I get annoyed by those who insist that, if only we did monetary policy differently, all would be well - what I call ZLB denial. Few (unfortunately not all) deny the central role and importance of monetary policy in getting us out of recessions. When monetary policy fails - which it patently has, mainly [2] because of the ZLB - fiscal policy has to take its place. Countercyclical fiscal policy becomes as important as monetary policy normally is. Institutions, and habits of thinking, that are set up for normal times must adapt. The IMF recognised this in 2009, but I’m not sure the OECD or European Commission ever did.

We can see how this failure to change priorities influences the subsequent discourse by looking at two issues that are covered by the paper: OMT and Germany. The paper recognises the importance of OMT in altering market expectations. But they then say “As is clear as well however, the OMT announcement per se does not address the underlying sustainability concerns.” Of course OMT does not directly change the outlook for future primary balances. However it is a game changer in allowing periphery countries to change priorities. When you cannot sell your debt, this has to take priority over recession concerns (although fiscal consolidation can still be designed to try and avoid recession). What OMT allows countries to do is change priorities. If it had been implemented earlier, priorities could have been changed earlier. The paper does not see this, because for them fiscal consolidation remains the key priority.

The paper says “In Germany, the fiscal stance is now broadly neutral [3], hence consistent with

the call for a differentiated fiscal stance according to the budgetary space”. Which makes perfect sense (albeit using the rather tortured language of international organisation space), except at the ZLB. At the ZLB we need overall fiscal expansion in the Eurozone. The differentiation point still stands, so from an overall Eurozone perspective the Commission (and the OECD, and the IMF) should be arguing for substantial fiscal expansion in Germany. However, if your priority is fiscal consolidation, advocating doing nothing can seem quite radical and brave.

Right at the end there is a hint of recognition, but in a way that reinforces my point. To quote in full:

“A dedicated stabilisation fund could improve the conduct of fiscal policies throughout

the cycle by enforcing tighter policies in good times and providing additional leeway for cushioning downturns. Such a tool could strengthen the existing automatic

stabilisers while maintaining a credible rule-based framework. It would be particularly useful in the current predicament characterised by large cyclical differentials across the zone as well as a not insignificant average output gap. However, according to the Commission blueprint such a tool should only be considered in the longer term in the context of full fiscal and economic union.”

In other words countercyclical policy at the overall Eurozone level would be useful right now, but it needs to wait until we have the institutional change that can accommodate it. [4] Which tells me that those in the Commission think institutions are very important, but it does not tell me why existing institutions (and those within them) have to be behave in such a blinkered way.

[1] This can be seen as a companion piece to two others that looked at the power austerity has over politicians, and why some economists are suspicious of Keynesian fiscal stimulus. This post is about economists working in policy institutions.

[2] Unfortunately the ECB often gives the impression that as long as consumer price inflation is around about 2%, then nothing else (like other measures of inflation, or a recession) has anything to do with them. However I doubt very much that if the ECB had done what the Fed is now doing, a Eurozone recession would have been avoided.

[3] Whether this is true is another matter: see here for example. The latest OECD Economic Outlook has the German debt to GDP ratio falling steadily since 2011, despite a widening output gap.

[4] That institutional change will come too late for the current recession. I take a critical view of whether fiscal union for the Euro is either feasible or desirable here.

Reactions to Textbook Mundell Fleming

2013-03-29T12:47:00.000-07:00

Some of the reactions to my earlier post, like Paul Krugman’s, have been that we no longer teach Textbook Mundell Fleming (TMF), but instead teach something along the lines I was suggesting. Which is great. [1] Of course I never meant to suggest everyone is taught TMF, but enough are to make the post warranted.

Another line, which I attempted (unsuccessfully) to head off in the original post, was UIP does not fit the data, so why build a core model that uses it? There are three replies to this:

1) Although UIP does terribly in the short run, its deficiencies in the longer term may not be so bad. Menzie Chinn sent me a summary of his own work that suggests this, which is here. In my two period model, where the first period is a Keynesian short run, then its the longer term predictive power that is relevant. Having said this, I also in my lectures stress that UIP is not well supported by the data, and that some people believe you can make money by betting against it (e.g. the ‘carry trade’).

2) However I do not think there is a more empirically based alternative that is satisfactory. Some people suggested a random walk for the exchange rate, and indeed - as Nick Rowe points out - we can recover TMF from UIP this way if expectations are formed on that basis. But a random walk model is inconsistent with almost any macroeconomic theory involving exchange rates that we might care to teach.

I know many people react negatively to rational expectations, but really all I’m arguing for here is common sense. Take again the example of a temporary (first period) fiscal expansion in a two period model without any backward dynamics. Unless the model contains hysteresis, we know the second period exchange rate will not change relative to the no fiscal expansion case. So to assume that agents expect any change in the first period exchange rate to carry through into the second period is the height of irrationality. I really do believe we should not be teaching models to undergraduates where people are that dumb.[2]

3) Its what macroeconomists use. I know many people do not like this, but I have always felt strongly that the core of first or second year undergraduate macro should be consistent with the macro that, say, central banks use. It is bound to be simpler, but it should be consistent. Of course we should emphasise its deficiencies, and mention alternatives, and also generally say something about the history of how we got here. The problem with too much undergraduate macro is that it is history in the wrong sort of way - its just out of date. [3]

In my earlier post I tried to emphasise the inconsistency between TMF and UIP, and not go on about the fixed money supply assumption. However, just as teaching up to date macro involves using the IS part of IS-LM along with, say, a Taylor rule, so it should be possible to adapt TMF to a world where central banks set interest rates if the model was any good. Yet if we dropped the LM curve from TMF, and assumed instead that interest rates were the policy instrument, we would conclude that an independent monetary policy in an open economy with flexible exchange rates was impossible. According to TMF, central banks cannot set interest rates to anything other than world interest rates. Why do we want to start students off with a model that suggests this?

And so finally to the LM curve itself. I have yet to hear a remotely convincing justification as to why this remains in the first macro model that we teach students. What great insight do students get when we pretend that the central bank fixes the money supply? I’ve talked about the muddles teaching the LM creates before - David Romer presents seven advantages of doing something more realistic here. [4] Is it really the conservatism of textbook writers that means that we are condemned to carry on confusing students, and cannot we do anything about this?

[1] I always recommend students read Krugman, Obstfeld and Melitz when they get confused about open economy macro, but I had my sights trained on other macro texts.

[2] Yet I do teach a backward looking (static expectations) Phillips curve alongside a New Keynesian Phillips curve (NKPC). Why the double standard? I can suggest three reasons: (1) using static inflation expectations is not so obviously silly if the monetary authorities give us little clue about what they are doing, which describes the world a few decades ago, (2) there are empirical features (e.g. Phillips curve loops) which are difficult to rationalise with the NKPC (3) firms and workers do not spend large amounts of money trying to predict future inflation.

[3] So, for example, I’m happy mentioning TMF as a lead up to UIP. Saying something like “originally economists modelled capital flows as a function of only interest rate differentials, but this either ignored expected capital gains, or made a very naive assumption about exchange rate expectations. We now know better.” For much the same reason you might mention that the original Phillips curve did not have an expected inflation term in it, but we now know better.

[4] Oddly, although Romer carries through his arguments to an open economy, he does not embrace UIP: in fact I do not think he even mentions it.

Why we should stop teaching Mundell Fleming

2013-03-26T12:33:00.000-07:00

For economists

I have complained before about IS-LM being the first macromodel most students encounter, when no major current central bank fixes the money supply. The textbook version of Mundell Fleming (TMF) [1] is the first, and often the last, short run open economy model students are taught, and it shares the same deficiency. However the problem with TMF is even greater. It is inconsistent with Uncovered Interest Parity (UIP), and if we use modern macro as our yardstick, this makes it simply wrong.

Lets take a topical issue: the impact of a temporary increase in government spending. We should be immediately worried that TMF makes no distinction between temporary and permanent increases. It says both have no impact on output. So every student learns that fiscal policy is ineffective under flexible exchange rates. For a temporary increase in spending this is incorrect.

The logic of the TMF proposition is usually demonstrated by shifting various curves, but it is in fact trivial. In TMF money demand must equal a fixed money supply. If money demand depends on prices, output and interest rates, and the first is fixed in the short run and the last is tied to world rates, then output cannot change either. This complete crowding is achieved through an appreciation in the real exchange rate.

But why should domestic interest rates equal world interest rates? UIP tells us they need not. A temporary increase in government spending will raise output, which given a fixed money supply will raise interest rates. This will lead to an appreciation, but the temporary nature of the shock means that the long run exchange rate is unchanged. So the current appreciation implies an expected depreciation, which offsets the additional return offered by higher interest rates. The result is a short run equilibrium where output and domestic interest rates are higher. There is partial crowding out through an appreciation but not full crowding out.

Now you might say what is so great about UIP. But at least UIP is based on something: a simple arbitrage theory. As far as I can see the TMF assumption that domestic and world interest rates are equal has no equivalent foundation.

We only get some crowding out in the experiment above because the money supply is fixed. If interest rates are fixed instead then we get none. With fixed interest rates, UIP implies the current exchange rate is unchanged when government spending increases, so there is no crowding out. We get exactly the same result as with fixed exchange rates - the complete opposite of what TMF suggests.

Now you might plead in mitigation for TMF that at least it gets the impact of a permanent increase in government spending right. I think this is a very weak defence. A permanent increase in government spending, assuming it increases aggregate demand, is crowded out because in a small open economy the real exchange rate equates the demand and supply of domestic output in the long run, which is a more basic result than anything in TMF. [2]

Another weak defence of teaching incorrect theories is that they are simpler than better theories. However it we combine this basic idea about the determination of the medium/long run real exchange rate with UIP, we have a complete theory of the small open economy which is no more complicated than TMF. So why does TMF survive?

Perhaps one reason is an addiction to two dimensional, and preferably static, diagrams. Yet the system I’m describing can be represented by just two equations and two periods. The first equation is the familiar aggregate demand curve. It is static, so we have

y = f ( g, r, e )

where g is a shift variable like government spending, r is the real interest rate and e is the log of the real exchange rate. Use stars to denote second period (medium/long run) values:

y* = f( g*, r*, e* )

Now here I can say that r* is equal to the world real interest rate rw (because of UIP and a constant real exchange rate), and y* is determined by some classical supply side, so this equation determines the second period real exchange rate - the basic result I mentioned above. The only other equation I need is UIP:

e = e* + rw - r

where e is defined so that an increase is a depreciation. Policy determines the short term domestic real interest rate, and therefore the short term real exchange rate.

The aggregate demand curve is already familiar to students, and the adaptation to an open economy is intuitive. UIP is easy to teach: any interest rate differential is offset by expected capital gains or losses. So it seems to me something like this should become our standard introductory short run open economy macromodel. And TMF should disappear.

[1] It is well known that in open economy macro everything important must have a three letter abbreviation.
[2] It is a basic result that may be inconsistent with PPP, but that is another story.

	2010	2011	2012	2013	2014
Government Consumption Growth %	-8.7	-5.2	-5.9	-7.1	-4.0
Underlying Primary Surplus (% GDP)	-3.6	1.3	4.2	6.5	7.6
Output Growth %	-4.9	-7.1	-6.3	-4.5	-1.3
Unemployment %	12.5	17.7	23.6	26.7	27.2