Thursday, 31 May 2012

Austerity, Nominal GDP targets and the Zero Lower Bound


                One part of my earlier post on monetary policy and austerity was a little cryptic. OK, it was largely unintelligible to nearly everyone (see, for example, Arnold Kling here).  My apologies. As it’s an important point, let me elaborate. What I want to show is that with monetary policy aiming to hit some level for nominal GDP (NGDP), if we are at the Zero Lower Bound (ZLB) for nominal interest rates today, austerity today will reduce welfare (by, in part, raising inflation tomorrow), and fiscal stimulus will increase welfare. I will not use maths, as even when I use the most simple of equations, my posts are described by well known blogging economists as nerdy.
                Output today depends on real interest rates today. Anything else that changes output today is called a shock. There is no Quantitative Easing (QE). For simplicity we will assume no direct linkage between output across periods. Inflation today depends on output today, but also expected inflation tomorrow. Prices were on target yesterday, and let’s assume that inflation the day after tomorrow is fixed. Now hit output today with a negative demand shock, a shock which is not repeated tomorrow. If that shock is small enough, we can offset it entirely by lowering interest rates today. Inflation today is unchanged as a result. Nothing changes tomorrow. Everyone is happy: monetary policy has done its job, by lowering nominal and real interest rates today.
                Now suppose the negative shock today is so large, that even with nominal interest rates at zero, output remains too low. This reduces inflation today. With a target for NGDP, not only would this mean we missed our target today, but it would also mean that we would miss our NGDP target tomorrow, because lower inflation today would mean lower prices tomorrow if inflation tomorrow was unchanged. So monetary policy cuts interest rates tomorrow in order to raise tomorrow’s output and inflation. If this response is expected (we assume rational expectations throughout) it does two things. It raises inflation today directly (because inflation today depends on expected inflation tomorrow), and it reduces real interest rates today (real interest rates today are nominal rates today minus expected inflation tomorrow), which raises output today which in turn raises inflation today. This is why NGDP targets can be very helpful to combat the ZLB. If we instead targeted inflation, then monetary policy tomorrow might do nothing, because policy would still hit the inflation target tomorrow.
                Now suppose that, despite relaxing monetary policy tomorrow, we still hit the ZLB today. Output and inflation are too low today, even though we hit the NGDP target tomorrow. There is absolutely no reason why this might not happen. Although inflation is higher tomorrow to compensate for low inflation today, real interest rates today are still not low enough to prevent output falling today. Sure, we could relax monetary policy tomorrow by yet more (assuming we are not at the ZLB tomorrow), and this could increase inflation tomorrow by enough to get real interest rates low enough today. But that would mean we overshoot our NGDP target tomorrow.
                So, we hit the ZLB today, undershoot the NGDP target today, but meet it tomorrow. Now let output also depend on fiscal policy, and add some austerity today. This reduces output by yet more today. Interest rates are at the ZLB today, so monetary policy today can do nothing about it. Lower output lowers inflation today still further, but because this reduces the price level tomorrow, monetary policy relaxes by more tomorrow. This is good, because higher inflation tomorrow raises both inflation and output today, which moderates the impact of austerity. But the end result must be that the net impact of austerity is to reduce output and inflation today, and raise inflation tomorrow. (If output and inflation are not lower today, inflation will not change tomorrow. But if inflation tomorrow is unchanged, why has austerity not reduced output and inflation today?)
                That is how a negative demand shock today, like austerity, can raise inflation tomorrow. It only happens because we have a target for the level of NGDP, and we cannot use interest rates to kill the impact of the demand shock today, because we are at the ZLB. But the latter is where we currently are, if you ignore QE.
                It follows directly that excess austerity today reduces welfare, even with NGDP targets. We still hit the NGDP target tomorrow, but only by having additional excess output and inflation tomorrow, and a bigger recession today. People are clearly worse off both today and tomorrow.
                This little experiment also shows us why fiscal stimulus can be more effective than a NGDP target at stabilising the economy at a ZLB. Just put the story in reverse. Instead of excess austerity, now have a fiscal stimulus today sufficient to get NGDP back to target today. As there is no shock tomorrow (fiscal or otherwise), we also hit NGDP tomorrow. We are back to where we want to be. Now the fiscal stimulus may have meant more government spending than we might have wanted in the short term, so it’s not cost free. But in terms of output and inflation, we are clearly better off as a result of the fiscal stimulus, even though we have a NGDP target.
                  
                 

Tuesday, 29 May 2012

What if Ireland voted no to the Treaty


                On Thursday Ireland votes on the Fiscal Stability Treaty. Polls suggest the result will be yes. Will this be a solid endorsement for the clauses of the Treaty, and the vision that lies behind it? I doubt it very much. What may be much more decisive is a clause that only allows access to Europe's new bailout fund to states that ratify the treaty. Given Ireland’s current situation, you could say that voters have very little choice but to vote yes. In addition, I have read quite a few posts over the past few weeks (e.g. John McHale here) suggesting that the Treaty does not impose any additional burdens to the austerity Ireland is already implementing. In that sense, there is no immediate cost in voting yes, if you think the current austerity is unavoidable.
If that is the immediate cost benefit calculus, what about the longer term? Philip Lane writes “My own take is that, if the Treaty is implemented in an intelligent, cyclically-sensitive manner (consistent with the flexible, holistic interpretation laid out in the “six pack” regulations), the new fiscal framework will be a positive force, helping Ireland and other European countries to gradually exit from high debt levels and avoid destabilising pro-cyclical fiscal policies in the future.”
                Unfortunately, I think you could also argue exactly the opposite. If the Treaty is implemented in an unintelligent manner, with an attempt to satisfy all its numerous rules and clauses without regard to macroeconomic context, the results could be disastrous. (If you want an example of how this can happen, see the Netherlands.) As I have suggested before, the Treaty is similar to the Stability and Growth Pact (SGP). True, compared to the original SGP, the emphasis on cyclically adjusted deficits gives formal acknowledgement of the importance of automatic stabilisers. More generally, whereas in the original Pact there were two main criteria for budget deficits, now there are many more (see here, or here). That can be read as flexibility, or it can be interpreted as confusion, muddle and bad economics. Hence both optimistic views like Philip’s and more pessimistic readings (see Karl Whelan here for example) are possible.
                What I believe is clear is the overall vision that the Treaty represents. It sees the essential problem with the Eurozone as being public sector indulgence. This is a profound misreading of what happened before the recession. By far the bigger problem for most periphery countries was private sector indulgence fuelled by cheap borrowing. In Ireland, and now in Spain, this transforms itself into a public sector problem because banks are bailed out.
                The fact that it was excess private sector borrowing that was the ultimate cause of the crisis does not mean that fiscal policy was appropriate. Far from it. Fiscal policy should have been much tighter than it was, because it needed to be countercyclical. However, the idea of countercyclical fiscal policy was nowhere to be found in the original SGP, and hardly figures in the Treaty. If the Treaty had been a realistic response to the current crisis, issues to do with macroeconomic stability (e.g. relative inflation rates, real exchange rate disequilibrium) would be at its centre, rather than as the vaguely worded single paragraph that is Article 9.
                This failure in both the original SGP and the new Treaty to recognise how important countercyclical fiscal policy is to the viability of the Euro is a major, perhaps the major, design flaw. (I have written about this before, but for a similar message see here.) What is worse, the obsession with public sector profligacy has diverted Eurozone policymakers from understanding this, both before and during the crisis. It has also discouraged recognising the scale of the problems facing the banking sector, and indeed the obsession with austerity has probably made this problem worse.
                One response to this argument is political. Yes, the Treaty is a distraction, but it is a pre-requisite for other important reforms of the euro system.  In simple language, the Treaty is needed because without it there is no chance of persuading Germany to even think about Eurobonds and the like. But perhaps what has to change is this German (and Dutch, and Finnish) mindset. As long as the ‘fiscal irresponsibility’ story remains the dominant narrative, we will get either continuing policy inertia, or worse still games of chicken being played with national electorates. That road may lead to disaster, as Boone and Johnson argue here. There needs to be a collective realisation that the causes of the crisis are not as originally advertised. There are solutions (e.g. Nick Stern here), but they require Germany and others to put Euro survival ahead of national self interest. With the election of Hollande, there is a chance of this happening. In this context you could argue that an Irish yes vote does nothing to help change the austerity mindset, whereas a no vote might have contributed to the mindset’s demise.
                That is easy for me to write. It is also easy for me to conjecture from the other side of the Irish Sea that if Ireland voted no, this would make no difference to their ability to receive bail-out funds. Ireland has been the poster boy for the ‘austerity’ cure, and for this and many other reasons the Eurozone is not going to let the little matter of a popular referendum make them throw Ireland to the market wolves. However, I can quite understand that, given what Ireland has been through, it would not want to take that risk for what would, I admit, be little more than a gesture. It may also be that, ironically, Ireland’s opportunity to argue that the Treaty is a dangerous distraction is greater if it votes yes. If the vote is yes, it must take that opportunity.  

Monday, 28 May 2012

Does Monetary Policy make Austerity Irrelevant?


                There are three variations of this question that I have come across in recent posts and comments.
1) If monetary policy had targeted nominal GDP, it could have been successful whatever fiscal policy had been.
2) Even within the context of inflation targeting, Quantitative Easing (QE) allows monetary policy to overcome the problem of the zero lower bound (ZLB) for nominal interest rates. So inadequate demand can be put down to not enough QE.
3) Less austerity would have led to higher inflation, which given the recent behaviour of monetary policy makers  would have led to higher interest rates, leading demand back to where it now is.
On (1), I have said that the possibility of moving to a different monetary target has a lot to commend it, and that this should be discussed much more actively in the UK right now. However I do not think targeting nominal GDP means that the monetary authorities can achieve that target at all points in time. The main way I think it overcomes the zero lower bound (ZLB) for nominal interest rates is by promising to create higher inflation in the future, which is itself a cost. The more austerity reduces current demand, the more inflation we will have in the future to counteract it.
                Argument (2) in effect says that the ZLB does not matter: monetary policy just switches from one instrument to another. I think this is seriously wrong. Although recent studies suggest QE has some effect, everyone I talk to who is involved with monetary policy thinks the uncertainties and limitations of QE are of an order above those of conventional policy. If I had to choose between QE and fiscal policy as a way of regulating demand, I would choose fiscal policy.
                Argument (3) suggests that if we had not had austerity, inflation would have been higher, and monetary policymakers would have raised interest rates. There are two uncertainties here. First, we cannot be sure that if there had been less austerity, inflation would have been significantly higher. In the UK there is a very simple reason for this – part of the additional austerity was to raise VAT. But more generally, what we may be seeing today is that inflation is much less sensitive to the output gap when inflation is low.
Second, we cannot be sure how monetary policy makers would have reacted. As I have argued before, sensible monetary policy targets both inflation and the output gap, so when the latter is large and negative, you should be very tolerant of moderate and temporary excess inflation. You certainly do not appear to ignore the output gap. Unfortunately that is exactly what monetary policy makers did do in the Eurozone in 2011, and I really hope this decision is now regretted by the ECB. In the UK they nearly did the same, and I have discussed this episode at length. So I know what monetary policy should have done if we had had less austerity (not raise interest rates), but I do not know what they would have done.
                So I agree that, if demand was stronger because we had had less austerity and more fiscal stimulus, inflation might have been higher, and interest rates might have increased as a result. However not only am I uncertain about this, but the monetary policy response would have been a policy choice. In this situation, should I say that austerity does not matter? Should I instead blame the monetary authorities for something they might have done, had austerity not happened? This seems a bit odd to me.
                I’m also a bit concerned that all three arguments hark back to a place too many were at before (and even during) the recession, which was to believe macroeconomic stabilisation was only about monetary policy.  Now my own writing and research has been quite supportive of what I call the conventional assignment, under the right conditions. But those conditions do not apply at the ZLB, and they obviously do not apply to members of a currency union. There are also other circumstances where fiscal policy could in principle assist monetary policy in its stabilisation role. This tendency to discount the short term macroeconomic effects of fiscal policy is part of the reason we are in our current situation.

Saturday, 26 May 2012

Government debt and the burden on future generations


                In an earlier post, I looked at how we might think about the ‘cost’ of additional public debt, if that debt financed public investment, and our concern was intergenerational equity. Here I want to examine the question of how great the burden of extra debt is on future generations, if that debt financed not investment, but consumption spending or tax cuts that had only current period benefits.
                Our initial instinct would be that this burden is bound to be positive. The current generation gets the benefit of additional spending, or a tax cut, but future generations pay the cost in terms of finding the money to pay the interest on the debt. However, if the additional debt is never paid off, and remains a constant share of GDP, then there is a situation in which it is not a burden, which I discussed in that earlier post. Let the ‘growth corrected real interest rate’ be r-g.[1] Suppose r-g=0. In that case the interest on the outstanding debt each year could be entirely paid for by issuing new debt such that the total debt to GDP ratio remained unchanged. The debt is only a burden on the final generation, but there is no final generation.
                Normally r>g, so taxes do have to rise (or government spending has to fall) to pay part of the interest on the debt. Debt is a burden on that account. There is a trap that we can fall into here, which is the following. Suppose all the debt is owned domestically. What the government does is raise taxes to pay interest on the debt, so this is a transfer from tax payers to debt owners. The government is just taking with one hand and giving back with the other. If society is just paying itself, how can debt be a burden?
                It’s an easy mistake to make – I should know, because I made it in an earlier post, which Nick Rowe pointed out in a comment.  Incidentally, Nick has two excellent posts on these issues, here and here. The argument above is wrong because it can still involve a transfer between generations. This becomes very clear if we consider an unfunded pension scheme, which I will do in a later post. Someone who just gets interest on their wealth is clearly better off than someone who also has to pay tax increases to get that interest.
                If you are still not convinced, think of the following. Suppose the current generation gets a debt financed tax cut, but in a fit of conscience it decides to put it all into a trust fund to compensate future generations. (This is what happens under Ricardian Equivalence.) Suppose also that there is a final generation when all the extra debt is repaid, and it gets the complete trust fund. In real terms the size of the debt will cumulate up at the rate g, as each year a bit of new debt is issued to keep its total a constant proportion of GDP. However the trust fund cumulates with the real interest rate r. If r>g, the trust fund will exceed the amount of debt to be repaid, and so the final generation will be better off. As all this just involves intertemporal transfers, the final generation being better off must mean that the generations in between should have got some of the trust fund – they were losing out too.
                If there is a final generation (when the debt is paid off), then the answer to the question ‘is debt a burden’ is obvious. It is only if we think about never paying the debt off that we need to worry about the r>g condition. The argument I made in one of the earlier posts, and want to repeat now, is that there should normally be a final generation – the debt should be paid off eventually. This argument has nothing to do with intergenerational equity.
                Creating additional debt has two negative consequences aside from any intergenerational equity concerns. First, increasing taxes to pay the interest adds to the scale of tax distortions in the economy. Second, it seems likely that additional government debt will to some extent crowd out investment in productive capital, and this is a cost if, as also seems likely, we currently have less than the optimum amount of productive capital. (Economists will know that I am here assuming we do not have complete Ricardian Equivalence, and that the economy is not dynamically inefficient.) For both reasons, even if we ignored issues of equity, we should not be indifferent to the level of debt.
                So these arguments suggest we should aim to bring debt back to some target level. Those economists familiar with this area will know that there is one special, but frequently used, case where that is not true, and this paragraph is for them. As a consequence of Barro’s famous tax smoothing hypothesis, the short term costs of bringing debt back to some target can outweigh the long term benefits of doing so, if the real rate of interest is not greater than impatience (the rate of time preference). My own view is that this is a ‘knife edge’ result which really tells something different, which is that any adjustment towards a debt target should be very gradual. For more on this see another earlier post of mine.
                What the ideal level of debt should be is a complex question. But once we accept that in theory there is some ideal level of debt, this means that doing thought experiments where we forever depart from it are just that: thought experiments rather than practical policy. To put the same point more topically, if we accept that current levels of government debt are too high, we must have in mind some lower target for debt. If debt rises above this target, it should fall back towards it. In effect, that means there will be a final generation: any additional debt will eventually have to be repaid.
                So the burden of additional government debt for future generations involves the debt itself, and not just the growth corrected interest on that debt. However, the practical importance of this point for any particular generation is not great, because adjustment towards a debt target should be slow. Getting debt right is likely to be a cost for our children’s children as well as those generations currently alive.         
             
               



[1] If r is the nominal interest rate, g is the growth in nominal income. If r is a real interest rate, g is the real growth rate.

Thursday, 24 May 2012

On not taking sides, and forecast uncertainty


                The last time I can remember Chris Giles of the FT writing about fiscal policy, I came down on him pretty hard. It was the phrase “..the area in which Britain still leads the international debate is fiscal policy” that really got to me then. So before taking up something in his latest piece, let me say two things. First, after my earlier critical post, Chris took the time to send me a lengthy email defending his position. It didn’t change my view, of course, but I did appreciate the effort. It confirmed my belief that Chris is serious about trying to get things right. Second, the article today is more sensible. It basically takes the IMF view I described recently here, which is that we need more monetary expansion, and that if things become worse than expected we should have bond financed fiscal expansion. Not as far as I would want to go, and I would disagree with his arguments for keeping to current fiscal plans, but Jonathan Portes takes on that task here. What I can say is that I approve of his direction of travel, and that he is prepared to make it!
                  What I want to discuss now is a remark Chris makes about economists taking sides. The article starts by chiding the Prime Minister when he claims that low interest rates represent the result of his tough decisions. Chris argues, as Jonathan has said many times, that low rates reflect the poor prospects for UK growth. He goes on: “The prime minister must know that what he is saying is silly, so it suggests he holds the intellectual capabilities of his audience in contempt.” I have recently expressed sentiments along similar lines. He then goes on to examine a recent statement by Labour’s Ed Balls. To quote again: “Blaming changes in deficit forecasts on the pace of austerity alone is not worthy of a serious politician.” If you take the statement Chris quotes as implying that the deficit is higher just because of austerity, then that does indeed make little macroeconomic sense.
                It is what Chris says next that is interesting. “In the current hysterical climate, economists should be wary of taking sides. We know that austerity hurts, but we have little idea how much of the current economic pain is caused by deficit reduction.”  If by taking sides he means trying to argue that everything said by one political party is wrong and everything said by another is right, then this has to be sound advice in an age of macroeconomic spin.
                However, I would also argue that in a hysterical climate, economists really should go public with what they believe to be true, particularly if that belief comes from years of study. If their view reflects what is taught to students up and down the land, then I might go so far as to say that they owe it to their discipline to tell the world what they tell their students.  What in my view makes the austerity announced in 2010 a major policy error was that it attempted to deny this knowledge. We do know with reasonable certainty that fiscal contraction in the form of spending cuts will, ceteris paribus, reduce output by a significant amount. We also know that when interest rates are at their lower bound, what monetary policy can do to counteract this fiscal impact is highly uncertain. Not all macroeconomists will agree with these statements, but I would conjecture that the vast majority do. Given this, it was highly likely that additional austerity would reduce UK output compared to what it otherwise would have been, and if this led to weak or zero growth then it was a huge gamble to hope that monetary policy would put things right again.
                It was in part this belief that macroeconomics had important things to say that current policy seemed to ignore that started me blogging some five months ago. I’ve also found that among the macroeconomic blogs I read there is refreshingly little partisan commentary. OK, maybe that is partly self selection – there is a popular US blog that I do not read for this reason – but only partly. There is a bit more ideology in what I read, but unfortunately that reflects the discipline itself.   
                I also agree with the second sentence from Chris that I quote above in the following sense. Although there has been no growth since the coalition started to influence macroeconomic events, we should never claim that we know that this is all due to their fiscal plans. There are too many unknowns here – in particular, it is hard to know how much future austerity might have influenced current expectations among firms and consumers. I hope that in the past I have simply claimed what I said above, which is that austerity has just made things worse. To say that we know precisely what a policy has done to the economy is almost as bad as saying that we can accurately forecast.[1]
                What all macroeconomists know is that forecasting is a very imprecise game. Study after study has shown that macroeconomic forecasts are little better than guesswork. Forecasts are worth doing, because getting things a bit better than guesswork has benefits that exceed the costs. A corollary of being just better than guesswork is that whether you get forecasts right or wrong is largely down to luck. So to infer, as is frequently done – even in blogs – that because the Bank of England has been consistently overoptimistic about inflation this must reflect some kind of incompetence is simply wrong. Equally, to assert that the OBR were overoptimistic about UK growth because they must have been somehow infected by the government’s beliefs is wrong. Both things are possible but, given what I know in each case, highly unlikely. Given the state of our current, and in all probability, future macroeconomic knowledge, forecasts are generally wrong because the economy is too damn unpredictable. That makes it all the more important that we do not ignore the things we do know.
                  
               


[1] It is only ‘almost’ as bad because conditional forecasting (if something changes by x, then something else will change by y), involves less uncertainty that unconditional forecasting (something will be y). Note that my statement about fiscal policy is much weaker than a conditional forecast, because it just says that if government spending falls, output will be lower. That is why we can be much more certain about this kind of statement. 

Wednesday, 23 May 2012

Why I can still believe the Euro will survive, just


                Paul Krugman thinks that Greece will probably leave the Eurozone. It is generally foolish to disagree with PK, and what follows is a huge hostage to fortune, but here goes. It is clear that Greece wants to stay in the Euro. Their people do and so do most political parties, including Syriza. Their banks are losing money fast, but the Greek central bank will fill that gap, as long as the ECB allows them to. So a Greek exit will only occur if the Eurozone in some shape or form decides that Greece must go. (See John Quiggin here, for example.) This is the first reason why I think the Euro may survive. If the Greek people were less committed to the Euro, then in macroeconomic terms the option of Greece themselves deciding to leave would look quite attractive in all but the short term, so they might well take that option. (For a different view, see Jacob Kirkegaard here.)
                The spin being encouraged in Europe at the moment (and I broaden the scope here deliberately, because it includes the UK government) is that the next Greek election is in effect a referendum on Greek membership. The implication, given the previous paragraph, is that if Greece tries to renegotiate the terms of its existing loans, the Eurozone will force Greek exit.  The key question is whether this is a credible threat.
                The question is not whether Greece has some moral duty to honour its debts. Creditors will always use this type of language, because they want as much of their money back as possible. There will also be plenty of talk of moral hazard: if Greece is able to renegotiate terms on this occasion etc etc. But all this is just rhetoric. Greece has already partially defaulted. There seems to be no obvious moral reason why private creditors should lose some of their money, but governments who lent to Greece should not, particularly when the terms of the loans were largely decided by the creditors under duress.
                So is it a credible threat? The main plank of my flimsy optimism about the Euro is that the decision to abandon Greece is a Eurozone decision, rather than the decision of sections of German public opinion or particular European officials. The Eurozone remains a collection of national governments, acting mainly in their own national interests. Suppose Greece does attempt, after its elections, to renegotiate its loans. The Troika will have to decide how to respond. Let’s look at the costs and benefits of this choice.
                If it refuses to move from current agreements, and offers little or nothing in return, Greece will suspend some or all of its interest payments, and the ECB would be instructed to withdraw support to the Greek central bank. Crudely, it will stop giving Greece Euros. The outcome is forced Greek exit, which will almost surely mean that the Eurozone would lose everything it has lent to the Greek government, because Greece would default on these loans. So in these very specific financial terms, rather than restructuring existing loans to try and get something back, it would lose it all. So far, so bad.
                But, you may think, at least the Eurozone will have drawn a line in the sand, to discourage other debtor member nations to think along Greek lines. Exactly, which is why those debtor nations will not want to see Greece exit. If they have any sense, those governments will know that they too might find themselves in Greece’s current situation, and so they will not want to be treated in the same way. What about countries like France and Italy? The election of Hollande is clearly important in this respect: see Paul Mason here or Linda Barry here for example. In addition, I think both countries will fear the dangers of the contagion that Greek exit might bring much more than the benefits of discouraging future renegotiation of periphery country loans. See R.A. on this here.
                We should also not forget that the IMF is part of the Troika. The IMF knows that in every case where a borrower nation gets into severe difficulties, some flexibility has to be shown by creditors. This is usually difficult in practice because the creditors are many, with each hoping that someone else will take the hit and lose their money. But not in this case. As we saw at the recent G8, the pressure on the Eurozone to be accommodating will be huge.
                Now all this implicitly paints Germany as the odd one out. It is certainly possible, listening to some sections of German opinion, to believe that Germany will insist on taking a hard line. I suspect that in reality the German leadership is prepared to give ground to ensure the survival of the Euro in its present form, although electoral pressures may get in the way. However Germany is not in charge of the Eurozone or the ECB. Nor has it any obvious means of coercing the other Eurozone governments to take a hard line, even if it wanted to.
                So the threat of pushing Greece out of the Eurozone is not credible, if the decision to do so is made by the Troika, or the Eurozone as a whole. This makes the important assumption that the ECB will be prepared to continue to provide Euro’s to Greece. As far as I can see, there is no technical reason why they cannot. (See Marshall Auerback on this.)  I also strongly suspect that the last thing the ECB wants to do is to be seen to force Greek exit without clear political backing from the Eurozone as a whole. But the ECB is an independent body without any democratic control and little transparency, so we cannot be sure what it will do.
                To get a different perspective on the same issue, consider what might happen if the centre ‘pro-agreement’ parties do much better in the next Greek election than they did in the past. Problem over? Hardly. It is much more likely that in the near future the Greek government would still have to ask for the loan terms to be renegotiated, because its fiscal position has got much worse as a result of austerity and the crisis. So renegotiation is likely anyway. Are Eurozone countries really willing to risk so much just to get slightly better terms on restructured loans?
                If this analysis is right, it raises two questions. First, is it wise for the Eurozone to make threats which are not credible? Second (and this has some influence on the first), why does most of the media appear to act as if the threat is credible? (OK, I’m obviously talking about the media I see, and I’ve no idea how this is being discussed in Greece.) Is it lack of thought, or just because the more alarmist you sound the better the copy? I know it is a lost cause, but the media are an important part of this story. The Eurozone are hoping to influence public opinion in Greece by making these threats, and if the media called these threats as bluff, they would be ineffective and would stop being made. So they are complicit in this game of chicken. And the problem with games of chicken is that they can go horribly wrong, as the markets well know. In addition, politicians can get trapped by their own rhetoric. In which case my analysis above based on rational self interest may be worth very little at all.

Tuesday, 22 May 2012

The IMF calls for a more expansionary UK policy


                The preliminary findings of an IMF Article IV mission are always a highly political document, as Paul Krugman points out. That is why you can spin today’s report on the UK as support for the current government line, or implicit criticism of it. And a lot of the reporting focuses on just this political angle. This is a shame, because it misses the clear message of the report, which is that UK macroeconomic policy is too restrictive.
                On monetary policy the report is absolutely clear. A bold heading reads “Further monetary easing is required”. The detail calls for more QE, and perhaps a further interest rate cut. One reason why the economists at the Fund are prepared to make such a clear criticism of the current MPC stance may be outlined in my recent post.
On fiscal policy, the Fund continues to call for balanced budget fiscal expansion. The heading here is a little more opaque:  “There is scope within the current overall fiscal stance to improve the quality of fiscal adjustment to support growth.” However this from the text below is pretty clear: “Fiscal space for further growth-enhancing measures could be generated by property tax reform, restraint of public employee compensation growth, and better targeting of transfers to those in need. This fiscal space could be used to fund higher infrastructure spending, which has a high multiplier and raises potential output. It will also be important to shield the poorest from the impact of consolidation.” For more detail see Ian Mulheirn here.
Finally we should note that good policy is about allowing for risk, which is what the current government did not do when embarking on additional austerity. The IMF knows this, which is why it says, in another heading: “Fiscal easing and further use of the government’s balance sheet should be considered if downside risks materialize and the recovery fails to take off.” For downside risk read the Euro blows up. Now I would argue that the outlook even if the Euro survives is pretty grim: the latest OECD forecast is for growth of 0.5% this year, and 1.9% next. As a result, fiscal easing seems appropriate even without downside risk.
But the question I have is this. We are told that the government is making contingency plans if Greece exits the Euro. Presumably it is thinking about what it would do if there was a severe recession in the Euro area. Do they agree with the Fund that fiscal easing should be considered in these circumstances? 

Monday, 21 May 2012

The Costs of Debt Finance: Jonathan versus David


                Recently David Smith of the Sunday Times and Jonathan Portes of the National Institute had a blog-spat about what a debt financed public investment programme would actually cost. Jonathan suggested that as the current interest rate on UK government indexed linked (i.e. inflation adjusted) debt was only 0.5%, £30 billion worth of investment would only cost £150 million a year. This was something like the amount the Chancellor was aiming to raise by removing VAT loopholes, including the infamous pasty tax. David responded that the value of the index linked gilt would rise with inflation, so that cost should be allowed for on an annual basis, which amounts to using a nominal, not real, interest rate. Jonathan countered that the nominal interest rate, which would be paid on debt of fixed nominal value, was not appropriate, because inflation would steadily erode the real value of nominal debt. In terms if the debate, I think Jonathan is clearly right, but I want to use the opportunity of going a little further by considering intergenerational equity, which David mentions right at the end of his post.
                Now if you or I take out a loan, we do not just think about the interest we will have to pay on that loan. We also should think about how and when we have to pay that loan back. But governments appear different, because unlike people they can continue forever, so in theory any borrowing by a government never needs to be paid back. Indeed, most of the time governments honour the debt of their predecessors.  So if the debt is an index linked gilt, the government just has to pay £150 million at today’s prices on the debt forever more. True, the nominal value of that debt will be rising, but so will the nominal value of everything else, including VAT receipts. Jonathan is right: if we spread the real cost (or burden) of financing the public investment across all future generations equally, which we can, then it’s the real interest rate that matters.
                In fact we could go further still. If the number of people in the economy is increasing, or each individual’s real income is rising, then this £150 million becomes an ever smaller share of total real income. In that specific sense, the ‘burden’ on future generations is less than on the current generation. If we really want to equalise the burden in terms of a share of income across all generations, then we should not just take off the inflation rate from the nominal interest rate, we should take off the real growth rate as well. Let’s call this ‘r-g’ for short. Now at the moment UK real growth is about zero, so this would not make any difference to Jonathan’s numbers, but in other circumstances it would reduce the cost still further.
                Now what would happen if this growth adjusted interest rate, r-g, is actually zero. We then get what seems like a magical result. Rather than raise taxes each year by £150 million, we issue £150 million worth of new index linked debt each year. You might think that paying interest by borrowing more is the road to bankruptcy, because the debt gets larger and larger. But not as a share of national income: that debt ratio would be constant if r-g=0. So £30 billion of public investment, which is about 2% of GDP, turns out not to cost anyone anything! Another way of thinking about it is that if there was a last generation, that generation would have to pay back the full 2% of their GDP, but there will never be a last generation, because governments (and government debt) can go on forever. We really do get something for nothing.
                Now, on average, r-g is positive rather than zero, so we do not get this magical result. But r-g is normally a lot smaller than the nominal interest rate. So, in terms of the conventional way that economists do these calculations, using the nominal interest rate is clearly wrong.
However, if our main concern is intergenerational equity, then this conventional approach might be a mistake, depending on the nature of the public investment. It would only be fair to all generations if the investment has benefits which rise with GDP and last forever. In that case using r-g is appropriate. If the benefits do not rise with real GDP, then using just the real interest rate would make more sense. However the benefits of most types of investment do not last forever. Suppose that the project was a new hospital that lasts for 100 years, but then falls apart completely. Tax payers in 101 years time should not have to pay for this hospital, which will no longer exist. So our assumption that the debt will never be repaid is not a very fair one on future generations if the benefits of the investment do not last forever. It is also not fair that the generation in 100 years time has to pay back the entire loan. Instead, each generation should pay some combination of interest and repayment of capital.
                The easiest way of doing this is to assume the value of the investment depreciates at some annual rate. If the benefit of the project does not automatically increase with GDP, then the appropriate cost would be the real interest rate plus this depreciation rate. It is like paying back the part of the debt each year that corresponds to the depreciated capital. In this case the cost will be higher than the real interest rate, although there is no reason why it should equal to the nominal interest rate.
                Now all this assumes that intergenerational equity is our only concern. It should not be. It should be a factor - I do not believe we can assume that the current generation will always look after that problem for us - but not necessarily the overriding factor. In the current situation, public investment is useful because it reduces involuntary unemployment. Furthermore, DeLong and Summers have shown that because of hysteresis effects in this situation, increased government spending may not cost us anything at all in the long run, even if r>g. They looked at additional government consumption, but their argument will be even stronger for government investment because of the positive supply side effects of this investment. In short, this really is the time to increase public investment, both in the UK and US, and cutting it is a very foolish thing to do.
               
                  

Friday, 18 May 2012

Dangerous Voices and Macroeconomic Spin


                Dangerous voices are what the British Prime Minister called those who criticised austerity in a speech on Thursday. In response one of those dangerous voices, Martin Wolf, became shrill in Friday’s FT ($). After noting the observation by Jonathan Portes that public investment could currently be financed very cheaply because UK long term real interest rates are so low, he writes “it is impossible to believe that the government cannot find investments .... that do not earn more than the real cost of funds. Not only the economy, but the government itself is virtually certain to be better off if it undertook such investments and if it were to do its accounting in a rational way. No sane institution analyses its decisions on the basis of cash flows, annual borrowings and its debt stock. Yet government is the longest-lived agent in the economy. This does not even deserve the label primitive. It is simply ridiculous.”
                Ridiculous it is, but as a piece of spin, the focus on reducing debt works as long as the Euro crisis lasts. I was puzzled at first by the phrase ‘dangerous voices’ in the Prime Minister’s speech. Why focus on the act of saying, rather than the content (as in ‘dangerous advice’ for example). Maybe it is just a little Freudian. They are dangerous voices, not because the advice they offer is dangerous, but because they offer a persuasive alternative to the dominant macroeconomic spin. Let’s start with that spin.
                It is good politics to say that “there, but for austerity, go us”. I doubt very much that the government actually believes what it says, but the spin is too good to abandon. Why can I claim that the government does not believe what it says? Because, if debt was the constraint, the government would have tried balanced budget fiscal expansion. Balanced budget fiscal expansion is the growth plan that does not conflict with (and probably helps) the debt problem. Sure, long term supply side reform is good too, but we need demand stimulus now. See, for example, Ian Mulheirn here, or indeed the IMF. I’ve explained the logic many times, and Pontus Rendahl gives a nice theoretical account of why this works (and a new model) here.
                If the government really believed that the markets would not let them borrow to expand, but wanted to do something nevertheless, then this is the obvious way out. So why have they not taken it? One answer (there are others) is that the short term lack of growth in the economy, and rising unemployment, is not actually a big problem for the government (or at least the major part of it). It is consistent with their five year strategy. The prime aim of this strategy is to shrink the size of the state, and the need to reduce debt provides an obvious public justification for this. Balanced budget expansion goes in the wrong direction, at least for a time.
                But the government wants to get re-elected. Here the calculation might be as follows. First, the recession has not hit the Conservative’s political base hard, so in the short term there is no overwhelming internal pressure to change policy. Second, by the time of the next election in 2015, economic growth will have returned, and the macroeconomic spin will be “we said it would be hard, but growth shows the policy has been successful”. Some economists will complain about the output gap, but that will get lost in argument over what the size of the output gap really is. Others will point to average growth over five years, but then the well tested line about clearing up the mess we were left will come back into play.
                In terms of macroeconomic spin, I think it is a pretty good strategy. Good spin is simple, and plays off real events. So the line “we have to reduce debt quickly because otherwise we will be like Greece, or Spain” works, while the response “but the Eurozone is special because member countries do not have their own central bank” is too technical to be an effective counter. In contrast the argument that Wolf and Portes put forward above – why not invest when it’s so cheap to borrow – is effective, which is why it is dangerous. So of course is “austerity is stifling growth”, as long as growth is negative or negligible. However, come 2015, the spin “we have done the hard work and the strategy has worked” will accord with (relatively) strong growth, while talk of output gaps and lost capacity will have less resonance. True, unemployment will still be high, but not many of the unemployed are Conservative voters, and the immunising spin about lack of willingness to work can be quite effective.[1]
Will the strategy, and the associated spin, work? The risk that growth will not be respectable in 2014 must be low: by then consumers and firms should have adjusted their borrowing and wealth sufficiently such that growth can resume.  If there is a chance that it might not be, I expect to see some measures in next year’s budget that do not conflict with the overriding ideological objective, such as incentives for firms to bring forward investment. The fact that the main fiscal mandate involves a rolling five year horizon means there is always room for such measures.
The Office for Budget Responsibility, that very positive innovation by the current government, will in all likelihood be pointing to the need for continuing austerity, because the earlier absence of growth will have (or appear to have) reduced capacity through hysteresis effects. I suspect that this was not in the original game plan. However I also doubt that it will be a fatal flaw either. Indeed, while austerity may be becoming unpopular now, do not be surprised to hear the following bit of spin in 2015: “Austerity laid the foundation for our current growth, so we need to stick with it to ensure growth continues”.  As you can see, I think the connection between macroeconomic spin and macroeconomic reality is pretty tenuous. Please someone convince me that I’m being too cynical.
                  


[1] Some argue that the “Labour isn’t working” advert in the 1979 election was effective. However high unemployment did not prevent Mrs Thatcher being re-elected. Perhaps unemployment is more of a problem for Labour than Conservative governments? 

Thursday, 17 May 2012

The Fruits of European Austerity


                In an earlier post I argued that austerity in Eurozone countries like Ireland was not necessarily self defeating, if those governments were put in a position where they had to convince markets that they would not default. Even if DeLong and Summers were right that austerity would eventually raise the debt to GDP ratio, this was not the key issue for default risk. John McHale makes a similar point. In this post I want to add two important caveats to this argument, which I can label Spain and Greece.
                Spain first. Most of the discussion of austerity focuses on the government’s budget constraint. However, when it comes to default risk in Eurozone countries, it may be more appropriate to look at the consolidated balance sheet of the government and banking sectors. A good proportion of the banking sector in countries like Spain is fragile because too much was lent before the recession. Because this proportion is large, these banks will be seen as too important to fail, and so the government will bail them out at some point, which is why the consolidated balance sheet becomes relevant. (It is the lack of a banking union, rather than a fiscal union, in the Eurozone that is arguably the major problem, as Vallee suggests.)
                If this is the case, then we need to rethink whether austerity can actually make the current position worse. When looking at just the government, the impact of cutting spending on the deficit is very unlikely to be offset by lower taxes or higher transfers generated by lower output – multipliers would have to be extremely large for this to happen. However, when lower output generates falls in asset prices and adds to personal or company liquidations, this could make a big difference to the solvency of highly leveraged banks. If the government is going to have to bail out these banks as a result, then it would be entirely rational for the market to raise interest rates on government debt following additional austerity measures. (I will not get into how markets actually do react: when there is a lot of noise, it is too easy for casual empiricism to cherry pick the data, as this post looking at recent events in the Netherlands points out.)
                That is one reason why austerity might be self defeating. The second, which is happening in Greece right now, is that austerity is pushed so far that it loses democratic support. Demonstrations of austerity designed to show that the government will not default become pointless if those demonstrations mean the government falls to others who would default. And allowing output to remain depressed as a consequence of austerity clearly does undermine the political centre.
                Some commentary, like this FT piece ($) by Lorenzo Bini Smaghi, suggests Greek voters are being irrational. Like Kevin O’Rourke, I disagree. I might even go further than Kevin. When debtors threaten to default, creditors always want to get their money back, but whether they can achieve this depends on how powerful the position of each side is. When the debtor is a government running a primary deficit, complete default does not look attractive because additional austerity will have to be implemented immediately, and creditors know this makes the default threat weak. However in this case the creditors' position looks at least as weak.  Politicians would have to explain to their already restive electorates why they have just lost a lot of money in their failed attempts to keep Greece in the Eurozone (or, indeed, why Greece was allowed in at all). More importantly, the analogy with Lehman’s looks appropriate. If Greece left the Eurozone there would be an immediate run on other ‘vulnerable’ Eurozone country banks, and here I agree with Lorenzo Bini Smaghi that the “contagion will be devastating”.
                Greek voters are also said to be illogical in wanting to stay in the Euro but not wanting austerity. Other Eurozone governments and European officials like to present it that way – they would, wouldn’t they. But it is unclear to me who exactly will do the deed of expelling Greece, if Syriza leads a government and interest stops being paid. Germany might be prepared to force a Greek exit, but following Hollande’s election I strongly suspect that they would not find a majority of countries supporting them. Too many would fear the consequences for themselves. Instead some compromise would be put on the table.
            Now we may never get to see this poker game play out. The rest of the Eurozone hopes that their show of contemplating Greek exit will convince Greek voters not to try and call their bluff. Alternatively, as Greek banks run out of money, the ECB may feel that it has no choice but to pull the plug on Greek banks, although I could imagine it is very reluctant to do this. Whatever happens, the moral of this story is that creditors have to be very careful when inflicting austerity on debtors. In some cases, like Ireland, they may succeed in doing so on quite painful terms, and the debts will be repaid. In other cases, they may go too far, with highly damaging results for everyone. It has happened before in Europe, as Miller and Skidelsky remind us.       
                

Wednesday, 16 May 2012

Inflation targeting is not working


                We teach students that monetary policymakers have two objectives: to hit an inflation target and to minimise the output gap.[1] Thanks to Michael Woodford, we can now claim that this objective function can be derived from the maximisation of representative agent utility, or we can simply appeal to a more informal discussion of the costs of involuntary unemployment and inflation. The question then arises why some countries, like the UK, have an explicit inflation target but no comparable output target.
                In teaching terms, this becomes an opportunity to emphasise the key implication of the Phillips curve, which is that the two objectives are consistent with each other, so that if we succeed in keeping to the inflation target we must also be eliminating the output gap.[2] We will, of course, talk about cost-push shocks to this relationship, adding an error term to the Phillips curve, but we will probably conclude by saying that therefore ‘flexible’ inflation targeting is quite compatible with the ‘dual mandate’ implied by the objective function. That I believe is the conventional wisdom.
                Now to reality. The latest Bank of England Inflation Report sees CPI inflation above the target (2%) for the” next year or so”, and it now expects only 0.8% growth in 2012. Over the last four years CPI inflation has averaged about 3.5%, and unemployment has risen to above 8% following the recession. It may be possible to explain, within the Phillips curve framework, this conjunction of above target inflation and a large negative output gap by looking at a series of cost-push shocks (VAT, commodity prices, depreciation), perhaps coupled with some upward movement in inflation expectations . But even if it is, I think this combination has blown a large hole in the story that inflation targeting is compatible with our standard objective function.
                We can see this in the decision by the Bank’s Monetary Policy Committee (MPC) not to undertake any further Quantitative Easing. Given the outlook for inflation and the output gap, a concern for both would normally imply the need for further monetary stimulus, rather than doing nothing.[3] (I've disagreed with Chris Giles on fiscal policy, but I agree with him on this.) However, if the Bank’s inflation forecast is correct, additional monetary stimulus would probably involve inflation staying for a time nearer 3% rather than falling towards 2%, which clearly conflicts with the Bank’s own interpretation of inflation targeting. This is probably why it has chosen to sit on its collective hands.
                Now you might argue that the MPC is nevertheless still being too timid, and that the inflation target is not that much of a constraint. Or that the forecast for inflation is wrong. However look at the US, where there is formally a dual mandate, and inflation has been more benign. Here again monetary policy makers appear content with an outcome involving roughly on target inflation and a large negative output gap. In other words, they seem happy not to maximise social welfare.
                It is of course interesting to speculate why this is. Perhaps it is, as John Kay suggests, an obsession with credibility, involving a misreading of the theoretical literature. Perhaps they suspect, like Chris Dillow, further QE will be ineffective, so there is nothing they can do. (But if it is that, they should say so.) Perhaps it is because policymakers are really serving particular economic interests, as Steve Waldman suggests. Perhaps Rogoff was right, and central bankers really are ‘conservative’, in the sense of caring much less about unemployment than the rest of society. But whatever it is, it is not producing good policy for society as a whole. So we should think about moving to a monetary policy target that better reflects social costs. Maybe, as Britmouse in the UK and many others elsewhere suggest, that is a nominal GDP target, or maybe it is something else, but the status quo is not looking too good right now.             


[1] When, that is, we stop pretending they fix the money supply. If I ever I need more evidence against teaching the LM curve to novices, this post from Nick Rowe is all I need, although I don’t think that is what he had in mind.
[2] Strictly this is not true in the New Keynesian Phillips curve, where there is a very small long run inflation/output gap trade-off.
[3] Suppose you had to choose between doing nothing, leading to inflation on target in two years time but an output gap of 3%, say, and monetary stimulus that might cut the gap to 2% but raise inflation temporarily 1% above target. If the social welfare function is quadratic in inflation and the output gap, you would only do nothing if excess inflation was five or more times more important than the output gap.  

Monday, 14 May 2012

The Zero Lower Bound and Output Gap Uncertainty


            There is currently a great deal of uncertainty about the size of the output gap in the US, UK and elsewhere. Given the significant lags between fiscal policy decisions and their impact, does that mean we should be especially cautious in setting policy? This might seem like a rather academic question at present, because policymakers are not even trying to use fiscal policy to close the output gap, as this crystal clear post from Jonathan Portes shows. (The charts and arguments are for the UK, but you could write something similar for the US or elsewhere.) However, uncertainty about the output gap is often used as a justification for maintaining current policies, so it is a relevant question in that sense.
             I believe that there is a strong argument that goes in exactly the opposite direction. Uncertainty about the output gap should make us less cautious. This argument rests on two very reasonable assumptions: that monetary policy can impact on the economy more rapidly than fiscal policy, and that the Zero Lower Bound (ZLB) for nominal interest rates means that there is an asymmetry in what monetary policy can do. Let me try and illustrate the point with some stylised numbers.
            Imagine we are trying to set fiscal policy today with the aim of producing an outcome for the output gap and excess inflation in 2/3 years time. Interest rates are stuck at the ZLB, so as this outcome requires expansionary policy, we cannot use conventional monetary policy today. However we have the option of raising interest rates at any time.
Suppose our best guess is that output today is x% below the natural (constant inflation) rate, but we could easily be wrong. Suppose we set policy today to aim to eliminate that gap in 2/3 years: call this Policy A. Let us also assume for simplicity that if we are right about the output gap our policy succeeds. Call this scenario M. However, we think an equally likely case is that natural output today is 2% higher (scenario H), or 2% lower (scenario L). For simplicity those are the three possible states of the world, and they are all equally likely. In other words we are uncertain about the size of the output gap, but we want to close it and we have complete control over actual output.
 What is the expected outcome of this policy? In all three scenarios output is the same. However inflation will be below our target in scenario H, because we underestimated the size of the output gap. Again for simplicity, assume that for every 1% that output is below the natural rate, inflation is below its target by 1%. So in scenario H, where the natural level of output is higher than we thought inflation will be 2% below target. Assume symmetry: in scenario L, where we overestimate today’s output gap, inflation would be 2% above target, if interest rates stay at the ZLB.
However that is not the complete story, because in scenario L monetary policy can raise interest rates. It will do so, but assume that because of lags it only manages to cut excess inflation and the output gap by half. So with endogenous monetary policy, excess output and inflation will only be 1% in scenario L.
What are the expected costs of this policy? If our estimate of the output gap was right (scenario M), zero. But the other two scenarios are equally likely. If our loss function is quadratic in inflation and the output gap, then the social loss in scenario H is 4, but thanks to raising interest rates only 1 in scenario L. As all three scenarios are equally likely, the average loss is 5/3.
            Now consider Policy B where we aim to produce 1% more output in 2/3 years time. Call this the 'overshooting' policy. This might seem an odd thing to try and do, because under scenario M, where our estimate of the output gap is correct, we produce excess output and inflation. Once again conventional monetary policy rescues us to some extent, so in fact both inflation and output would be half a percent above target. But is it still an odd thing to do? No, because we should allow for uncertainty. The outcomes under the other two scenarios are shown in the table below. The average loss is 3.5/3.




Excess inflation/output for unchanged interest rates
Excess inflation/output with endogenous interest rates
Loss
Policy A





Scenario M
0
0
0

Scenario L
2
1
1

Scenario H
-2
-2
4
Policy B





Scenario M
1
0.5
0.25

Scenario L
3
1.5
2.25

Scenario H
-1
-1
1
            


            In turns out we do better under the overshooting policy, Policy B. If this result seems paradoxical, think of it this way. In scenario H, where the current output gap is higher than we think it is, we can do nothing to correct our error. We suffer the full consequences of our mistake: higher unemployment. However in the opposite case, scenario L where the output gap is lower than we think, we have an insurance policy that can cover our mistake to some extent, because we can raise interest rates to moderate inflation. Because of the ZLB, this insurance policy only operates one way.
            Now of course these numbers are arbitrary, but the principle holds: with a one way insurance policy, its best to go for an overshooting policy to some degree.
            The only uncertainty in this story was the size of the output gap. We could achieve, using fiscal policy, exactly the level of output we wanted in 2/3 years time. In reality we cannot, of course. However exactly the same principle operates if the uncertainty is about the output forecast rather than (or as well as) the output gap. It is best to aim too high, because we have a one-way insurance policy. This is why a government that undertook austerity based on the assumption that, if everything went as expected, things would turn out OK was making an obvious mistake – the ZLB meant it had no option if things turned out worse.
So, the next time someone argues that we need austerity because we are uncertain about how large the output gap is, ask them why they are ignoring the option of raising interest rates if core inflation starts to rise.