mainly macro

What have microfoundations ever done for us?

2012-03-07T12:06:00.000-08:00

For those who do not know the reference, which I think is apposite, see here.

In my previous post on microfoundations I said I disagreed with Paul Krugman’s statement that “So as I see it, the whole microfoundations crusade is based on one predictive success some 35 years ago; there have been no significant payoffs since”. I should say why I disagree. Robert Waldmann has also challenged me along similar lines.

I think the two most important microfoundation led innovations in macro have been intertemporal consumption and rational expectations. I have already talked about the former in an earlier post, which focused on a UK specific puzzle in the late 1980s that I find difficult to address without an intertemporal consumption perspective. However I also think too strong an attachment to a very basic intertemporal view has blinded macro to some critical events in the last decade or so. (See John Muellbauer here, for example.) So let me focus on rational expectations. Again I could look at the UK in 1980/81 and talk about Dornbusch overshooting, but let me try and be less parochial.

Between the rapid inflation of the 1970s and the Great Recession, what events might we look to for rational expectations to help explain? It is not an easy question, because the adoption of rational expectations was not the result of some previous empirical failure. Instead it represented, as Lucas said, a consistency axiom. However between the 1970s and the Great Recession what needs explaining is why nothing very dramatic happened – the Great Moderation. In particular, why did the large rise in oil and other commodity prices around 2005 not lead to the kind of stagflation we saw in the mid-70s and early 80s?

I think an important part of the answer was implicit or explicit inflation targeting by independent central banks. That, in turn, reflected an understanding of the importance of rational expectations. If a central bank had a clear inflation objective, and established a reputation in achieving it, that would anchor expectations and reduce the impact of shocks on the macroeconomy. Just as the Friedman’s expectations augmented, accelerationist Phillips curve helped us understand what went wrong in the 1970s, so the New Keynesian Phillips curve led to better policy around the turn of the century.

Now virtually any empirical claim in macro is contestable. (Indeed, for some this is part of the attraction of the microfoundations approach!) There are other explanations of the weak response to oil price increases, although Blanchard and Gali (2007) do argue that the Great Moderation played an important role. Others might suggest that the Great Recession itself proved that the Great Moderation was an illusion. In a crude sense this does not follow. The Great Moderation was all about the stabilising role that monetary policy can play, and that should always (given Japan) have been conditional on not hitting the zero lower bound. A more challenging argument is that the Great Moderation prepared the ground for the financial crisis, but even if this is correct it does not follow that inflation targeting was not an improvement on what went before – we may just need to do better still. Indeed, if as a result of the Great Recession inflation targets are replaced by price level or nominal GDP targets, I believe rational expectations will be central in making that case.

I think macroeconomics today is much better than it was 40 years ago as a result of the microfoundations approach. I also argued in my previous post that a microfoundations purist position – that this is the only valid way to do macro – is a mistake. The interesting questions are in between. Can the microfoundations approach embrace all kinds of heterogeneity, or will such models lose their attractiveness in their complexity? Does sticking with simple, representative agent macro impart some kind of bias? Does a microfoundations approach discourage investigation of the more ‘difficult’ but more important issues? Might both these questions suggest a link between too simple a micro based view and a failure to understand what was going on before the financial crash? Are alternatives to microfoundations modelling methodologically coherent? Is empirical evidence ever going to be strong and clear enough to trump internal consistency? These are difficult and often quite subtle questions that any simplistic for and against microfoundations debate will just obscure.

The Other Eurozone Crisis

2012-03-06T12:43:00.000-08:00

What follows is not a new story: many people have argued that the problems of the Eurozone are as much about private sector expansion, current account imbalances and misalignment, as they are about excessive debt. What follows is an attempt to present this argument in as clear and convincing a way as possible, and say why this matters.

One of the central pieces of macro I teach undergraduates is an adaptation of the Swan diagram. For non-economists this simply plots a demand curve and a supply curve in national competitiveness and output space. As competitiveness improves, exports increase and imports fall, because the demand for domestic output rises. More technically, it describes an economy made up of producers of differentiated traded goods sold in imperfectly competitive markets, so the aggregate demand curve has an obvious interpretation. I draw the supply curve downward sloping following the textbook I use, but it could equally well be vertical.

Here is the diagram applied to the periphery and some quite central Eurozone economies.

The formation of the Eurozone led to substantial monetary easing in these economies, partly because financial markets wrongly thought that they were subject to risk levels not much different from Germany. The following table looks at two measures of real interest rates (long and short). I’ve missed off 1998-9 because entry was anticipated, so it is not clear where to put these years. I’ve taken current (CPI) inflation away from nominal rates, but hopefully with averages like these using actual rather than expected inflation is not too great a sin. Data is taken from OECD Economic Outlook.

Average Real Interest rates in the Eurozone

	Short (%)			Long (%)
	1990-97	2000-07	2008-11	1990-97	2000-07	2008-11
Germany	3.6	-0.7	-0.5	4.4	2.6	1.5
France	5.1	-0.8	-0.2	5.4	2.4	1.8
Italy	5.7	-1.1	0.4	6.6	2.2	2.4
Greece	18.4	-2.0	3.8
Ireland	4.7	-2.4	4.0	4.4	0.9	6.1
Portugal	5.4	-1.8	2.4	7.4	1.5	4.4
Spain	5.7	-2.1	0.3	6.0	1.2	2.3
Euro	4.3	-1.1	0.0

Real interest rates fell everywhere in the 2000-7 period (global savings glut?), but the fall was more modest in Germany than anywhere else. Lower real interest rates shift the AD curve to the right. With sticky prices we initially move horizontally from the 2000 point to the new demand curve (competitiveness changes slowly). However, as we are to the right of the supply curve, we get inflation and a loss of competitiveness until we reach 2007. From this date onwards country specific risk begins to return, and the aggregate demand curve shifts back. We need to go back to something like the 2000 position, which requires a recession and an internal devaluation to restore competitiveness. Different countries are at different stages in this process. The country which is furthest on the road back to a sustainable position is probably Ireland (although there are some statistical problems), but in others the process is only just beginning. Given low inflation in Germany, and the difficulty of cutting nominal wages, this road may be particularly painful and long.

Are the falls in real interest rates shown above enough to explain the loss in competitiveness seen in most Eurozone countries relative to Germany? It could be that in many periphery countries, particularly those that experienced housing booms, the key factor was a shift in risk perceptions. This shift could have been triggered by lower interest rates themselves (as some have argued for other countries like the US), or other financial supply side factors (see here, but also here). Which is true may be important because it is related to how sustainable the original shift in the AD curve was. In theory a persistent reduction in real interest rates could lead to a prolonged shift in the demand curve, and reduced competitiveness, with no reversal of the sort shown in this chart. This is equivalent to asking how sustainable are the pattern of current account deficits and surpluses that emerged in the Eurozone in 2007. As I argued here, the balance of evidence suggests that these imbalances were unsustainable. Here are current accounts over this period.

Eurozone Current Accounts (as % GDP)

The Eurozone position as a whole (not shown) has hardly changed. The swing to surplus in Germany after 2000 is dramatic. Although the current account positions in France and Italy have deteriorated, this is not nearly as large as the deterioration in the smaller countries. This may also be an indication that in the smaller countries the demand stimulus generated by lower interest rates may have been much greater (the rightward shift in the AD curve larger), perhaps caused by excessive risk taking (housing bubbles etc).

This story is all about monetary conditions. Monetary easing was greater in the periphery countries when the Euro was created, partly because policy had been tighter there before Eurozone entry, and partly because risk premiums disappeared. If you look at fiscal policy, on the other hand, you find no comparable pattern. Overall fiscal policy, as measured by underlying deficits calculated by the OECD, became a little tighter in the Eurozone as a whole over the 2000-7 period. As the Chart below shows, Spain actually tightened quicker than this average, and fiscal policy was broadly unchanged in Ireland and Portugal. Even in Greece, the story is more a gradual reversion to previous bad old ways, after a pre-entry tightening. So the shift in the AD curve was not, with the exception of Greece, a result of a fiscal expansion.

Eurozone Fiscal Positions (Underlying deficit as % GDP, OECD Economic Outlook)

This does not imply that fiscal policy was appropriate in those countries over this period. I argued in an earlier post that fiscal policy should have been much tighter, to offset the monetary stimulus. But it is important to distinguish between what actually happened (a monetary stimulus) and what might have been (countercyclical fiscal policy).

This is a story about monetary conditions and aggregate demand. Of course it is possible in theory that reduced competitiveness relative to Germany could represent some sort of wage push. However, the strong growth experienced in these countries on Euro entry is consistent with the diagram above, and is less consistent with a cost-push shock. In addition, the labour share has not shown any marked increase in most Eurozone economies over this period (see here). The fact that wages rose ahead of productivity outside Germany reflects relative demand conditions (see here). None of this takes away from the need to deal with underlying structural problems in many of these countries – it just says demand shocks can occur, and in a monetary union their impact can be substantial and persistent. This is a very familiar story in terms of both the historical experience of fixed exchange rate regimes and the academic literature.

This analysis tells us why many Eurozone countries would be in recession today, even if there had been no debt crisis. Why is this important? After all, the debt crisis is real enough, and the implications – recession in many Eurozone countries – are the same. It is important because it pinpoints the nature of the fundamental policy error that was made in the Eurozone. It was not that the Stability and Growth Pact (SGP) was ineffective – it was, but this did not lead to excessive fiscal expansion (Greece excepted) as the table above shows. The problem with the SGP was that it ignored countercyclical fiscal policy. (I argue here that the SGP’s focus on deficits actually encouraged governments not to do the right thing.) If countries had responded to their deteriorating competitiveness position relative to Germany by tightening fiscal policy, the unsustainable shift in the AD curve shown above would have been at least reduced in size. In addition, the market’s fear about fiscal sustainability would have been greatly reduced. On both counts we might have avoided recession today.

The really sad thing is that the Eurozone is continuing to make the same mistake. Such a collective failure by policy makers is really difficult to comprehend, although I will discuss in a later post how this may be related to economic orthodoxy in Germany.

Microfoundations and the Speed of Model Development

2012-03-04T01:58:00.002-08:00

In a recent post I suggested one microfoundations based argument for what Blanchard and Fischer call useful models, and I call aggregate models. Both Mark Thoma and Paul Krugman picked up on it, and I want to respond to both. While this will mostly be of interest to economists, I have not tagged this ‘for economists’ because I know from comments that some non-economists who think about the philosophy of (social) science find this interesting. If you are not in either category, this post is probably not for you.

Paul Krugman first. He makes a number of relevant points, but the bit I like best in his post is where he says “Wren-Lewis is on my side, sort of”. I really like the ‘sort of’. Let me say why.

In one sense I am on his side. I do not believe that the one and only way to think about macroeconomics is to analyse microfounded macromodels. I think too many macroeconomists today think this is the only proper way to do analysis, and this leads to a certain microfoundations fetishism which can be unhelpful. Aggregate models without microfoundations attached can be useful. On the other hand I really do not want to take sides on this issue. Most of the work I have done in the last decade has involved building and analysing microfounded macromodels, and I’ve done this because I think it is a very useful thing to do. Taking sides could too easily degenerate into a ‘for and against’ microfoundations debate – in such a debate I would be on both sides. I certainly do not agree with this: “So as I see it, the whole microfoundations crusade is based on one predictive success some 35 years ago; there have been no significant payoffs since.” The justification for aggregate models that I gave in my previous post was deliberately four square within the microfoundations methodology because I wanted to convince, not antagonise. So ‘sort of’ suits me just fine.

What I am against is what I have called elsewhere the ‘microfoundations purist’ position. This is the view that if some macroeconomic behaviour does not have clear microfoundations, then any respectable academic macroeconomist cannot include it as part of a macromodel. Why do I think this is wrong? This brings me to Mark Thoma, who linked my piece with one he had written earlier on New Old Keynesians. Part of that piece describes why economists might, at least temporarily, forsake microfounded models in favour of a ‘useful’ (to use Blanchard and Fischer’s terminology) model from the past. To quote

“The reason that many of us looked backward for a model to help us understand the present crisis is that none of the current models were capable of explaining what we were going through. The models were largely constructed to analyze policy is the context of a Great Moderation....”

and

“So, if nothing in the present is adequate, you begin to look to the past. The Keynesian model was constructed to look at exactly the kinds of questions we needed to answer, and as long as you are aware of the limitations of this framework - the ones that modern theory has discovered - it does provide you with a means of thinking about how economies operate when they are running at less than full employment. This model had already worried about fiscal policy at the zero interest rate bound, it had already thought about Says law, the paradox of thrift, monetary versus fiscal policy, changing interest and investment elasticities in a crisis, etc., etc., etc. We were in the middle of a crisis and didn't have time to wait for new theory to be developed, we needed answers, answers that the elegant models that had been constructed over the last few decades simply could not provide.”

I think this identifies a second reason why an aggregate model – a model without explicit microfoundations – might be preferred to microfounded alternatives, which Paul Krugman also covers in his point (3). This has to do with the speed at which microfoundations macro develops.

Developing new microfounded macromodels is hard. It is hard because these models need to be internally consistent. If we think that, say, consumption in the real world shows more inertia than in the baseline intertemporal model, we cannot just add some lags into the aggregate consumption function. Instead we need to think about what microeconomic phenomena might generate that inertia. We need to rework all relevant optimisation problems adding in this new ingredient. Many other aggregate relationships besides the consumption function could change as a result. When we do this, we might find that although our new idea does the trick for consumption, it leads to implausible behaviour elsewhere, and so we need to go back to the drawing board. This internal consistency criteria is partly what gives these models their strength.

It is very important to do all this, but it takes time. It takes even longer to convince others that this innovation makes sense. As a result, the development of microfounded macromodels is a slow affair. The most obvious example to me is New Keynesian theory. It took many years for macroeconomists to develop theories of price rigidity in which all agents maximised and expectations were rational, and still longer for them to convince each other that some of these theories were strong enough to provide a plausible basis for Keynesian type business cycles.

A more recent example, and one more directly relevant to Mark Thoma’s discussion, is the role of various financial market imperfections in generating the possibility of a financial crisis of the type we have recently experienced. There is a lot of important and fascinating work going on in this area: Stephen Williamson surveys some of it here. But it will take some time before we work out what matters and what does not. In the meantime, what do we do? How should policy respond today?

To answer those questions, we will have to fall back on models that contain elements that appear ad hoc, by which I mean that they do not as yet have clear and widely accepted microfoundations. Those models may contain elements discussed by past economists, like Keynes or Minsky, who worked at a time before the microfoundations project took hold. Now microfoundations purists would not (I would hope) go so far as to say that kind of ad hoc modelling should not be done. What they might well say is please keep it well away from the better economic journals. Do this ad hoc stuff in central banks, by all means, but keep it out of state of the art academic discourse. (I suspect this is why such models are sometimes called ‘policy models’.)

This microfoundations purist view is a mistake. It is a mistake because it confuses ‘currently has no clear microfoundations’ with ‘cannot ever be microfounded’. If you could prove the latter, then I would concede that – from a microfoundations perspective – you would not be interested in analysing this model. However our experience shows that postulated aggregate behaviour that does not have a generally accepted microeconomic explanation today may well have one tomorrow, when theoretical development has taken place. New Keynesian analysis is a case in point. Do the purists really want to suggest that, prior to 1990 say, no academic paper should have considered the implications of price stickiness?

So here I would suggest is a second argument for using aggregate (or useful, or ad hoc) models. Unlike my first, it allows these models not to have any clear microfoundations at present. Such analysis should be respected if there is empirical evidence supporting the ad hoc aggregate relationship, and if the implications of that relationship could be important. In these circumstances, it would be a mistake for academic analysis to have to wait for the microfoundations work to be done. (This idea is discussed in more detail in “Internal consistency, price rigidity and the microfoundations of macroeconomics” Journal of Economic Methodology (2011) Vol. 18, 129-146 - earlier version here.).

Fiscal policy heroes

2012-03-03T01:45:00.000-08:00

Have you ever wondered why anyone becomes a football (soccer) referee? You are almost certain to be hated by one team and its fans because of the decisions you make. Any mistakes you make will be subject to detailed media scrutiny. Your financial rewards are dwarfed by those earned by the people you attempt to control, and to thank you for that they regularly abuse your attempts to do your job.

One final thought from my trip to Paris is that we can ask the same question of those who run national fiscal councils. There is no glory and little power to their positions. At some time or other, they will almost certainly incur the wrath of some senior politician, who will publicly assert that the head of the fiscal council is either incompetent or politically motivated. They will have committed the sin of questioning the financial logic behind the minister’s pet project, or the assertion that certain tax breaks or spending projects can be afforded on a sustainable basis. While sections of the media can be the fiscal council’s friend, because they recognise unbiased analysis when they see it often enough, other – more partisan – sections of the media will have no scruples in doing the politician’s dirty work by slandering the fiscal council and its head.

Who are the people who run fiscal councils, and why do they take on this thankless role? They are people like Alice Rivlin, the first director of the Congressional Budget Office in the US, who would not go along with Reagan’s optimism about self financing tax cuts. Or like Lars Calmfors, the first director of the Swedish Fiscal Council, about which the finance minister said “I have established the earned income tax credit and the Fiscal Policy Council. I am convinced that at least one of the two is very useful. I am very doubtful of the other” (Calmfors and Wren-Lewis, 2011). Like George Kopits, director of the Hungarian Fiscal Council which was abolished after only two years existence. Like Kevin Page, head of Canada’s Parliamentary Budget Office, whom the Finance Minister recently called “unbelievable, unreliable, incredible” after he questioned the rationale for pension reform.

Having talked to them all, I can suggest one common motivation: a belief that economic decisions should be based on sound analysis rather than political calculation or whim. A view that not only should a proper analysis be done, but that the public has a right to know about it.

As I have suggested, this role can be thankless at the time. The silver lining is that in the longer term it may be more appreciated. It has been said that Alice Rivlin is now one of the most respected figures in Washington. Like the public finances themselves, short term unpopularity may be appreciated in the longer term.

Microfounded and other Useful Models

2012-03-01T00:26:00.000-08:00

This title harks back to one of the books that have influenced me most: Blanchard and Fischer’s Lectures on Macroeconomics. That textbook was largely in the mould of modern microfounded macroeconomics, but chapter 10 was not, and it was entitled ‘Some Useful Models’. One of their useful models is IS-LM.

The role of such models in an age where journal papers in macro theory are nearly always microfounded DSGE models is problematic. Paul Krugman has brought this issue to the forefront of debate, starting with his ‘How Did Economists Get It So Wrong?’ piece in 2009. His view has been recently stated as follows: “That doesn’t mean that you have to use Mike’s [Woodford] model or something like it every time you think about policy; by and large, ad hoc models like IS-LM are actually more useful, in my judgment. But you probably do want to double-check your logic using fancier optimization models.”

This view appears controversial. If the accepted way of doing macroeconomics in academic journals is to almost always use a ‘fancier optimisation’ model, how can something more ad hoc be more useful? Coupled with remarks like ‘the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth’ (from the 2009 piece) this has got a lot of others, like Stephen Williamson, upset. I think there are a lot of strands here, many of which are interesting.

The issue I want to discuss now is very specific. What is the role of the ‘useful models’ that Blanchard and Fischer discuss in chapter 10? Can Krugman’s claim that they can be more useful than microfounded models ever be true? I will try to suggest that it could be, even if we accept the proposition (which I would not) that the microfoundations approach is the only valid way of doing macroeconomics. If you think this sounds like a contradiction in terms, read on. The justification I propose for useful models is not the only (and may not be the best) justification for them, but it is perhaps the one that is most easily seen from a microfoundations perspective.

First we must find a new name for these ‘useful’ models. They are sometimes described as ‘policy models’, but that is not a very good name because microfounded models are also used to analyse policy. Let me call them ‘aggregate models’. I think this term is useful, because the defining characteristic of the models I want to talk about is that they start with aggregate macro relationships. Like an IS curve. Microfounded models start with microeconomics, like an optimising representative consumer. I do not want to call aggregate models ‘ad hoc’, because the meaning of ad hoc is not well defined.

The typical structure of a microfounded model involves two stages. In the first stage the microfoundations are set out, individual optimisation problems solved, and aggregation assumptions made. We set out a particular world, perhaps a unique world, in all the detail required for the task in hand. This first stage may also include deriving an aggregate welfare function from individual utility. This leads to a set of aggregate relationships. The second stage involves using these aggregate relationships in some way – to find an optimum policy for example. In aggregate models we only have the second stage. A good paper of either type will often go further, and attempt to suggest (perhaps even show) what it is about the aggregate model that gives us the key results of the paper. Let us call this the critical features of the aggregate model.

Put this way, it looks as if microfounded models must be the superior tool – we get more information in the form of the model’s microfoundations. In particular, we establish that at least one microfounded support exists for the aggregate model we use in the second stage. If we start with an aggregate model, it is possible that no such microfounded support exists for that model. If that could be proved, the usefulness of that aggregate model is completely diminished from a microfoundations perspective. A more realistic case is if we cannot for the moment find any potential microfoundation for such an aggregate model (this is what some people mean by ad hoc), or the only microfoundation we can find is a little odd. In that case the usefulness of the aggregate model is highly questionable.

But suppose there is in fact more than one valid microfoundation for a particular aggregate model. In other words, there is not just one, but perhaps a variety of particular worlds which would lead to this set of aggregate macro relationships. (We could use an analogy, and say that these microfoundations were observationally equivalent in aggregate terms.) Furthermore, suppose that more than one of these particular worlds was a reasonable representation of reality. (Among this set of worlds, we cannot claim that one particular model represents the real world and the others do not.) It would seem to me that in this case the aggregate model derived from these different worlds has some utility beyond just one of these microfounded models. It is robust to alternative microfoundations.

In these circumstances, it would seem sensible to go straight to the aggregate model, and ignore microfoundations. Well, not quite – it would be good to have a sentence referring to the paper that shows at least one of these microfoundations. A classic example of what I have in mind here is Clarida, Gali and Gertler (1999) Journal of Economic Literature. If an aggregate model can be derived from a number of different microfoundations, then we actually appear to restrict the generality of what we are doing by choosing one derivation and then working with this particular microfounded model. I think this possibility is stronger still if we think about the critical features of an aggregate model – the things that generate the results we focus on.

I suspect it is this robustness aspect of aggregate models that makes them attractive to some macroeconomists. Why restrict yourself to one particular microfoundation – and let’s be honest, waste time going through yet another derivation of Euler equations and the like? Why not go straight to the set of aggregate relationships that contain the critical features we need for the problem at hand?

Now there is a danger in this approach. That sentence referencing the paper where the aggregate model is derived from microfoundations may not be written, and then further along the line it turns out that the aggregate model being used misses out something important because microfoundations were being ignored. Krugman acknowledges that danger in the last sentence of the quote I started with. However, it seems a little strong to suggest that to avoid such mistakes we should always do the full microfoundations thing.

So my claim is in many ways quite a weak one. Some aggregate models contain critical features that can be derived from a number of different microfoundations. In that situation, it is natural to want to work with these aggregate models, and to describe them as useful. We could even say that they are more useful, because they have a generality that would be missing if we focused on one particular microfoundation.

Why introductory macroeconomics should ditch the LM curve

2012-02-28T02:02:00.001-08:00

For teachers and students of economics

For the next two years I will be taking a break from teaching tutorials in first year undergraduate macro. That will be a relief for just one reason. I have become more and more embarrassed at having to teach the IS-LM model. The IS curve is fine, but the LM curve is not. The reason is obvious enough: central banks do not operate a fixed money supply policy. It would be nice to tell students that the fiction that the monetary authorities fix money is a harmless fairy story, but I do not believe this. Here are just three mistakes or confusions caused by using the LM curve.

1) Is that real or nominal rates on the vertical axis? It does not matter if expected inflation is constant, but we use the apparatus to look at price changes.

2) IS-LM leads to AS/AD. If your goal is controlling inflation, the AS curve suggests that all you need to do is to return to somewhere on the vertical AS curve. If you use a traditional Phillips curve with backward looking expectations then returning to the natural rate will not be enough. Which is the student supposed to believe?

3) IS-LM leads to textbook Mundell Fleming, which in its simplest form has domestic interest rates stuck at world levels. Everyone then learns that fiscal policy is ineffective under floating rates, which is unfortunate, because this is a special consequence of assuming fixed money. The IS curve plus UIP is a much better way to think about this, and gives a more relevant answer: a temporary demand shift is not crowded out by an appreciating real exchange rate if domestic interest rates are unchanged.

I’m currently lecturing on Oxford’s second year undergraduate macro course. There I largely ignore the LM curve, and (following the textbook by Carlin & Soskice) instead teach a three equation model involving an IS curve, a Phillips curve, and a monetary rule. The monetary rule captures the idea that the monetary authority has preferences over excess inflation and the output gap, and combining this with the IS curve and Phillips curve we can derive a Taylor rule. While the monetary rule curve is far from ideal, representing the result of a static rather than dynamic optimisation exercise, it at least captures the spirit of what central banks try and do today.

The introductory course in macro at Oxford starts with IS-LM, but it also includes the Phillips curve and the Taylor rule, presumably because they are more relevant than the AS curve and the LM curve. So first year students learn about the AS curve and the Phillips curve, the LM curve and a Taylor rule. Perhaps not surprisingly, many get very confused. It would seem to make much more sense to switch things around. Use only the IS curve, Phillips curve and monetary/Taylor rule in a first year introductory course, and only introduce the LM curve in subsequent years. (I would introduce the LM curve in stages. First, think about replacing an inflation target with a price level target for monetary policy. Maybe think about nominal GDP targets, using the current situation as clear motivation. Then go to money supply targets, with of course some discussion of money demand.)

This sequencing seems clearly preferable, so I find it puzzling that most Principles textbooks do not take this approach, but instead continue to start with IS-LM. Why are they so devoted to the LM curve? Is learning about the LM curve meant to impart some deep wisdom to students? Is there a feeling that because money is important in understanding how business cycles and inflation work, it should be introduced as part of the core model come what may? This seems strange, and is probably counterproductive. Perhaps the explanation is more mundane: that the economics of high volume textbook publishing is such that innovation is difficult to do.

I sometimes say to master’s students just starting the core macro course that they will spend some time learning about the same stuff as they did when they were undergraduates: inflation, unemployment, business cycles. The key difference is that what they learn will only be 5 or 10 years out of date, compared to material that is 30 years out of date for undergraduates. Strange, but unfortunately true.

Government debt in Europe: some good and bad news.

2012-02-27T01:49:00.002-08:00

Readers of this blog will know that I am an evangelist for fiscal councils. Fiscal councils are publicly funded independent bodies that provide analysis of national fiscal policy. (They are sometimes called ‘watchdogs’, but some – such as the CBO in the US or PBO in Canada – see themselves as serving the legislature rather than the public directly, so they flinch from that term. As some are not councils as such, but institutions with a standard hierarchical structure, then the term Independent Fiscal Institutions (IFI) may be better, but I use the term fiscal council on my webpage and elsewhere so I’ll stick to that.)

The good news is that in amongst the various directives/regulations/treaties that have recently been agreed by the European Union, there are clauses that encourage the formation of fiscal councils, together with the need for independent fiscal forecasting. (In some countries, like the UK, the fiscal council (OBR) is all about independent forecasting, while in others, like Sweden, forecasting was already reasonably independent before the council was formed.) This is a case of better late than never. Some EU countries have recently established fiscal councils through their own initiative as a response to the debt crisis (such as Ireland, Portugal and Slovakia), so this EU initiative is playing catch-up in their case.

The bad news is that the rest of the EU’s response to the debt crisis makes life difficult for these new fiscal councils, and may in effect hinder the formation of new ones. In essence this is because the broad thrust of the EU’s crisis management has been to take away national autonomy in making fiscal decisions. I complained about this in the context of the new treaty here. What I had not fully appreciated until recently is that you now almost need a fiscal council just to try and work out what the huge number of sometimes conflicting EU directives actually mean in terms of what a country is allowed and not allowed to do.

I think some economists view this development as benign, because they see it as part of an inevitable transition to a fiscal union. When others point out that so far it is no such thing, it is suggested that a fiscal union has to be done in stages for (largely German) political reasons, and that large scale European transfers will emerge once national fiscal responsibility is nailed down. Even if this was the planned pathway, I have severe doubts that it is a feasible path politically.

I have even greater doubts that the new European regime will be able to deliver fiscal responsibility. As I have often argued, simple rules that produce severely suboptimal outcomes are not sustainable. (For a recent discussion of this sub-optimality, see Karl Whelan.) This was true with the original SGP, and it is just as true now. The idea that you can have effective legally binding rules based on something as difficult to measure as a structural budget deficit is bizarre.

As Tyler Cowen suggests, a far better path would be one built on mutual trust. How can Germany begin to trust fiscal policymaking in other countries? Not, I would suggest, by placing monitors inside those countries – this is control, not trust. I far better way starts with recognition that it is in each country’s own interest to maintain fiscal discipline. The original Stability and Growth Pact was based on seeing fiscal policy as a free rider problem, where market discipline had been removed. We now know that this was a misreading, perhaps encouraged by a similar misreading by markets themselves. The pain caused by current austerity will linger long in the national memory. Once we recognise that debt responsibility is in the national interest, the aim should be to encourage the creation of national institutions that support that interest – national fiscal councils. These institutions can then be seen by other countries as their allies in maintaining fiscal discipline at the European level.

I fear the major barrier preventing this happening may be the European Commission itself. I remember attending a Commission conference soon after the Euro was formed, where I presented a paper that, among other things, explored the possibility of new institutions involved in national fiscal policy. I had a discussion with a senior Commission official, who thought this was an excellent idea - because the Commission could be that institution! Like any bureaucracy, the Commission is all about super-national control, and not subsidiarity.

One recent episode is a case in point. The Commission has recently suggested withholding funds from Hungary because it believes that country has not taken sufficient action to control its deficit. Yet only a little over a year ago Hungary had a newly created and highly effective fiscal council under George Kopits. It was abolished by the Hungarian government largely because it was doing its job (for more information on this, see my earlier post). Where was the Commission then?

Going beyond Quantitative Easing

2012-02-26T00:58:00.004-08:00

I’ve been away for a few days at the OECD, so have only just picked up Scott Sumner, fully endorsed by Tyler Cowen, asking why there are not more people advocating a higher inflation target, or a nominal GDP target, in the UK. (Being away did not in theory prevent me blogging, but I’m afraid in practice I prefer exploring Paris!) I think this is a good question. While there is a very active UK debate about fiscal austerity, most discussion on the monetary side tends to be within the parameters of current policy.

Those familiar with the case for raising the inflation target can skip the next couple of paragraphs. For those who are not, the idea is that the central bank/government could moderate the impact of the zero lower bound constraint on interest rates by announcing that it would allow inflation to go above 2% for a significant period after the recession was over. This would help stimulate the economy today through various channels. One is that expected lower future short interest rates should reduce long term interest rates today, which would in turn stimulate borrowing by firms and consumers. Another is that, according to the New Keynesian Phillips curve, expected inflation today depends on expected inflation tomorrow, so if the central bank allowed above 2% inflation in the future, this would raise actual and expected inflation today, lowering real short term interest rates today. One of the interesting things about this policy proposal is that it is very New Keynesian rather than Old Keynesian.

This policy was first suggested as a way out of Japan’s lost decade (when nominal rates were also stuck at the zero bound) by Paul Krugman, and subsequently formalised by Eggertsson and Woodford (Gauti B. Eggertsson & Michael Woodford, 2003. "Optimal Monetary Policy in a Liquidity Trap," NBER Working Papers 9968) among others. This paper suggests that the optimal policy can be approximated by replacing an inflation target with a price level target, because a price level target implies a period of excess inflation would automatically follow a period of insufficient inflation. Scott Sumner in particular has championed nominal GDP targeting, which would have similar effects, and this policy has gained a lot of support in the US and elsewhere.

So why relatively little debate on this issue in the UK? At the political level, simple politics combined with recent experience may be important. Price inflation has been, and still is, high in the UK, and this is highly unpopular because it has been associated with large falls in real wages. An argument by any political party that the Bank should target higher inflation, rather than be admonished for its inability to prevent it, would be a hard sell. Nominal GDP (NGDP) targeting may be much more palatable to a non-macro audience, as Krugman points out. However a problem here for the government may be the accusation that such a change reflects a failure of their austerity programme, for reasons discussed below. Whether this issue might be on the Labour Party’s agenda I have no idea, although I cannot see any reason in principle why it should not be.

What is perhaps more puzzling is a lack of discussion by the Bank itself. As far as I am aware, the Bank has not discussed these various alternatives to its current 2% mandate. I am also not aware of any members of the current MPC discussing them in public. Of course any decision to change the mandate would not be for the Bank or MPC to make – it’s a decision for the Chancellor - but that does not rule out discussion of options. I think this lack of ‘official’ discussion may also discourage debate elsewhere. (I know I thought of writing something myself on this a few weeks back, looked for something from the Bank as a ‘hook’ to argue with, and on finding nothing let it slide.) In contrast to the US, macroeconomic blogs in the UK are not developed or influential enough to initiate a debate themselves.

The lack of public analysis from the Bank, or MPC members, could perhaps be another example of ‘groupthink’ that Laurence Ball suggests in his analysis of Bernanke’s views on the zero lower bound. My first experience of this came at a conference organised by the Centre for Central Banking Studies in 2009. Chris Sims and Mike Woodford were the other guest speakers, and both my and Mike’s paper provoked discussion of this policy issue. I have often been in meetings where an option may be politely discussed, but you just know it has no chance of serious consideration, and this seemed like one of those. To be honest, I think this represents central bank conservatism more than anything else.

One of the main arguments against this policy option is time inconsistency. Even if a promise to raise future inflation was effective today, when the recession ended and it was time to implement the policy, the temptation would be to renege on this commitment and return to the 2% inflation target. A smart private sector would realise this, so the promise to raise future inflation would not be believed, and so it would not be effective. A price level or NGDP target is partly designed to help overcome this problem. However, in the case of the UK, where a change in policy would almost certainly have to be decided by the Chancellor rather than the Bank, this should be seen as less of a problem for the Bank or MPC. Its credibility would not be on the line, and the government rather than the Bank would come under pressure to renege.

Exactly the same could be said of another objection to raising the inflation target, which is that it might be perceived as a way of helping the government reduce the ratio of debt to GDP. This charge could be a more serious concern for the Chancellor, if it was perceived that his austerity program was not delivering the fiscal target he had set himself. However, it should be less of a concern for the Bank, because they have always deferred to the Chancellor’s authority to set the inflation target. So for both reasons, I suspect the lack of discussion by the Bank and MPC may reflect a taboo about deliberately raising inflation above 2%.

I should add that I think the advocates of NGDP targets sometimes go too far in suggesting that this is an obviously preferable way to speed economic recovery compared to fiscal stimulus. Promises to raise future inflation are costly, which is why there is a time inconsistency problem. However the current recession is, in my view, much more costly, so it needs both monetary and fiscal action to help bring it to a speedy end. Furthermore, the current recession may well indicate an endemic problem with low inflation targets, which is that we are in danger of hitting the zero bound quite frequently. (With this in mind, can anyone explain to me why the Bank of Japan has just announced an inflation target of only 1%?) This seems like an excellent time to be discussing alternatives to inflation targeting.

So it is a pity that this policy option is not being debated more actively in the UK right now, with help from the Bank and MPC members. In the absence of a discussion based around the Bank, then this seems to be exactly the kind of issue that the Treasury Select Committee of the House of Commons should investigate. The committee has always taken a keen interest in all aspects of monetary policy, and such an investigation would be a good follow-up to their recent report on Bank accountability.

The Balanced Budget Expansion Debate Begins?

2012-02-22T02:30:00.000-08:00

Less than a week ago, I wrote in a post on my blog: “So there is something we can do with fiscal policy, without increasing government debt. Why does hardly anyone talk about this?” Two days ago Ian Mulheirn from the Social Market Foundation published a detailed proposal exactly along these lines. (There is also a short piece in Monday’s Financial Times.) A coincidence of course, but very welcome.

This proposal involves bringing forward by four years £15 billion of tax increases pencilled in for after 2015, and using that money for temporary infrastructure spending in those four years. This is a specific example of a more general idea, that you can stimulate demand through additional but temporary increases in government spending financed by temporary increases in taxes. The proposition that this will stimulate aggregate demand is a pretty robust bit of macroeconomic theory. In fact we can go further, and say that the benchmark multiplier for such a policy will be at least one. This suggests that this proposal, by using OBR figures, may be rather conservative in its estimate of the impact on UK growth.

The multiplier will be one if consumers are of the simple Keynesian type who consume some constant fraction of their current income. Higher taxes will reduce their income, but as long as their propensity to consume is less than one, there is a net positive effect on demand, which gets translated into higher output and higher income. But higher income leads to higher consumption, and we get the famous ‘balanced budget multiplier’ of one which every first year undergraduate learns how to prove. However, as Professor Michael Woodford has recently shown, we get exactly the same multiplier of one if consumers are much more sophisticated, and look at their entire lifetime income when planning their consumption. The basic intuition here is that any temporary tax increase gets smoothed over their lifetime, so the impact on current consumption is small. As the simple Keynesian case shows, any short term impact there is will be offset by higher incomes generated by higher government spending.

This all assumes an unchanged level of real interest rates. Higher aggregate demand should lead to some increase in expected inflation. If the Bank of England keeps nominal interest rates unchanged (which, with inflation falling, they should), then real interest rates will fall, which will provide an additional stimulus to demand. That is why the benchmark multiplier will be at least one. If the government spending is in the form of useful infrastructure projects, this has the additional bonus of increasing future supply.

Why have tax financed temporary increases in public investment not been part of the austerity versus stimulus debate so far? For those who oppose austerity, I think the problem is a (correct) belief that debt financed increases in spending would be even more effective at stimulating demand (because ‘Ricardian Equivalence’ does not hold), and that the short term dangers of increasing debt are vastly overblown. While I think this line is right in principle, I fear this debate is unwinnable so long as the Eurozone crisis continues, and the media obsesses about ratings agencies. We can argue till the cows come home that the Eurozone is different, because these countries do not have their own central bank, and that the market takes no notice of ratings agencies, but these arguments are drowned out by the daily news about Greece and other Eurozone economies.

On the other side, among those who favour austerity, I think there is a reluctance to consider policies that increase the size of the state, even though this would only be for a few years. There is also the obvious unpopularity of tax increases. However there is now a real danger that by the time of the next election UK unemployment may still be rising and the recovery will be modest. It is going to be very hard to win an election with this record. (I do not think Argentina will distract attention again as it did in 1982!) The great advantage of tax financed increases in spending is that they stimulate the economy without going back on the austerity pledge. Indeed, because they stimulate growth, they reduce headline budget deficit figures and so increase the likelihood that austerity will be successful in bringing down the ratio of debt to GDP.

So these proposals from the Social Market Foundation are very welcome indeed. They show that something can be done to stimulate the economy without increasing debt. Of course there is a great deal of discussion still to be had on what taxes to increase, and what investment to fund. However from a macroeconomic point of view most combinations will succeed in stimulating the economy. With unemployment continuing to rise, there is still time to act. It is imperative that we do.

2010 and Monetary Policy in the UK

2012-02-20T14:57:00.000-08:00

I have argued that the decision to reduce the UK budget deficit more rapidly in 2010 was a major policy error. (I looked at figures on cyclically corrected budget deficits in the UK, US and Eurozone here.) One argument against this view is that without such a tightening, the UK would have been at greater risk of a loss of confidence in UK government debt. I think many believed that at the time, because they thought what was happening in the Eurozone could happen to the UK. As interest rates on government debt continue to fall around the world, this fear looks increasingly groundless. As the IMF has recently noted, growth as well as debt levels are important influences on market perceptions.

A rather better argument (see the first comment on this post) is that if fiscal policy had not tightened in 2010, the Monetary Policy Committee (MPC) of the Bank of England would have raised interest rates in 2011. In the Spring of that year, 3 of the 9 members voted for an interest rate rise from the zero bound floor level of 0.5%. If the economy had been stronger because of less austerity, would two or more committee members have switched sides, leading to an increase in UK interest rates?

A think it is far from clear that they would. Inflation was high in part because of the result of those austerity measures. VAT was increased from 17.5% to 20% at the beginning of 2011, which probably added around 1% to inflation in 2011. You could argue that as this was always going to be a temporary influence, it was neither here nor there as far as MPC decisions were concerned. I think this would be a little naive. One of the major concerns of MPC members around that time was the loss of reputation that the MPC might suffer if inflation got too high, and here I think the actual numbers mattered.

But supposing the Bank had raised rates. Would that have been the right thing to do? In hindsight clearly not. The ECB did raise rates at this time, and that now looks like a very foolish decision, but it looked pretty foolish at the time. (See this from Rebecca Wilder.) I also argued strongly against raising UK interest rates in early 2011. My note was called ‘Ten reasons not to raise interest rates’, but the main argument was very simple. The costs of inflation exceeding its target were much lower than the costs of a persistently high output gap.

At the time it was possible to try and calculate these costs based on what the Bank itself was thinking, because it published output and inflation numbers under two alternative scenarios: one where interest rates were kept flat and another where they increased through the year (based on market expectations at the time). Here is the table I put together.

Calculating social welfare

	2012	2013	Loss	Diff
Inflation
Rising rates	2.4%	2%	0.16
Flat rates	2.6%	2.5%*	0.61	0.45
Output growth
Rising rates	2.7%	2.6%
Flat rates	3.0%	3.0%
Output gap
Rising rates	3.3%	2.7%*	18.18
Flat rates	3.0%	2.0%	13.00	-5.18

Numbers are estimated using the Bank of England’s February 2011 Inflation report. Output gap numbers assume a 4% gap in 2011 (consistent with the latest OECD Economic Outlook), and that potential grows by 2% p.a. 2013 numbers are guesses based on extrapolating the Q1 forecast.

Raising rates through 2011 had virtually no impact on 2011 numbers, so these are ignored. Higher interest rates leave inflation is a little lower in 2012, and inflation then comes back to target in 2013. In contrast, keeping rates flat would leave inflation half a percent above target in 2013. Raising rates would reduce output growth by a quarter of a percent in 2012 and by half a percent in 2013, leaving the output gap 0.7% higher in 2013. Now suppose we take the difference between the forecast number and the target for inflation each year, square this figure and sum. We do the same for the output gap. That gives a very crude measure of the social loss implied by each policy, and this is shown in the column headed loss. Take the difference between the two policies in the final column. Raising rates clearly does better on inflation, but worse on the output gap. However the output gap losses are much larger, because inflation is near its target, but the output gap is not.

This puts into numbers a very simple idea, which is that missing the inflation target by half a percent is no big deal, but raising the output gap by over half a percent when it is already high is much more costly. Now we can argue forever about the size of the output gap, but we need to remember that in these calculations it is mainly a proxy for the costs of higher unemployment, and we have real data on unemployment.

We can put the same point another way. Although 5% inflation in 2011 sounded bad, it was the result of a temporary cost push shock, caused by higher VAT and energy prices. Inflation was bound to come down again, because unemployment was high. (I think some in the Bank began to doubt this basic macroeconomic truth because they kept on underestimating inflation.) There was never any sign of higher price inflation leading to higher wage inflation. In contrast, the recovery from the recession was slow, so this was the problem to focus on.

Crucial in this analysis is the view embodied in the Bank’s forecast that it takes some time before higher interest rates influence output and inflation. What this means is that to prevent inflation rising in 2011, we really needed higher interest rates at the end of 2009. A year in which GDP fell by 5%! Those who argue that the MPC ‘failed’ because inflation reached 5% in 2011 are really arguing that the MPC should have made the recession deeper.

So, if the MPC had raised interest rates in 2011, they would have been wrong to do so. That is obviously true in hindsight, but it was also true based on the more optimistic projections made at the time. It would also have been true even if the economy had been stronger because of less austerity.

One final point on this policy error. It is just possible that, without the Eurozone crisis, the LibDems might not have been persuaded to adopt the Conservatives’ fiscal plans as part of the coalition agreement. But the real source of the error is to be found much earlier, when the Conservatives opposed the government’s fiscal stimulus measures in 2008/9. From that point on, their macroeconomic policy was all about austerity, and they denied that this would have harmful effects on the economy. I’m afraid I have no knowledge about why they decided to adopt this line, but it has proved to be a very costly mistake.

Policy errors like 2010 austerity – what can academics do?

2012-02-18T04:12:00.001-08:00

In this post I claimed that 2010 should be counted as one of the major errors of UK macroeconomic policy. In fact the claim is much more general, because 2010 was the year that the consensus among policymakers in the OECD area shifted from enacting stimulus to pursuing austerity, with damaging consequences in many countries. A number of comments and a couple of blogs added to my speculation on why this error might have occurred. Here I want to consider more generally what role academics and economists can play in preventing policy errors, and why this may depend on the reasons for those errors.

Before coming to that, let me address one common objection to my view that 2010 was a major policy error at the time, and not just in hindsight. The objection is that the slowdown in 2011 was due to factors other than austerity that could not have been foreseen. There are two problems with this argument. First, the projected speed of recovery even before these adverse shocks occurred was pitifully slow. What the IMF described in late 2010 as ‘solid UK growth’ was actually 2.5% per annum into the medium term, which on their own admission only gradually closed the output gap. The OBR’s June 2010 post-budget forecast also had GDP growth of 1.2% in 2010, 2.3% in 2011, and never above 3% thereafter. Considering GDP was estimated to have fallen by 5% in 2009, this was a tepid recovery.

The second, and more important, flaw in this argument is that it ignores the fact that good policy should allow for risks. As I elaborated here, because of the zero bound for interest rates there was no insurance policy if bad shocks did occur (as they did). In contrast, if positive shocks had led to a recovery that was too rapid, monetary policy could have been used to cool it down. To put it more simply, austerity was a huge and unnecessary gamble, and the gamble did not pay off. Much the same could be said for many other countries.

One class of explanation for this kind of policy error focuses on hidden agendas. The most obvious in the case of austerity is a desire to reduce the size of the state, as Chris Dillow suggested. As Mark Thoma put it: “The notion of "expansionary austerity" was the cover, but so long as government shrinks as a result of the policy, the expansionary part is secondary.” Chris has recently suggested even darker motives. I put forward another, more mundane, explanation that is specific to the UK: get the cuts out of the way well before an election, and hope the electorate have short memories. Perhaps an explanation specific to the US might be that it suited those opposed to the President that the economy failed.

If this type of explanation is correct, is there anything that can be done to prevent or expose this kind of subterfuge? In this post, I was rather pessimistic. I suggested that it required near unanimity amongst academics before the media would begin to question the cover stories. Without unanimity, the cover story would just be described as controversial.

Brad DeLong has persistently railed against ‘opinions on shape of the Earth differ’ type reporting. All too often journalists appear to have only two categories - either something is objectively true or it is controversial. Anything controversial requires evenly balanced reporting. A tragic example from the UK would be the debate over the MMR vaccine. As Lewis and Spears document, a single paper in the Lancet suggesting a link with autism was hyped by the media, despite widespread scepticism among health experts and overwhelming scientific evidence that the vaccine was safe. As a consequence, take up of the vaccine declined and outbreaks of measles increased. (Here is a good account of this episode from a US perspective.)

Even with academic unanimity, there is the possibility that moneyed interests could manufacture controversy through think tanks, as has happened with aspects of climate change debate. [Update 20/2/12 - on this see George Monbiot.] Of course the debate is still worth having, but it is unlikely to change things very much or very quickly.

This pessimism may be a little overdone, however, in the case of austerity. Politicians, above all, want to be re-elected. For that reason the cover story view does require a belief that the harmful impact of (early) austerity will not last long enough for it to matter at the next election. If that is not the case, academics might be able to convince politicians that it may not be in their own interests to undertake the policy.

Which brings me to another class of explanation, which is policymakers fooling themselves. The hidden agenda may still be there, but the difference is that politicians convince themselves that the cover story is also true. In the case of austerity, there are a number of stories politicians can tell themselves. They can believe in expansionary austerity, of course. They could believe that Quantitative Easing will be enough, although I would hope any central banker would tell them that they had no idea what impact QE might have. They might have believed that the recovery was well under way, so any damage done by austerity would not be noticeable.

Does this case also require near unanimity amongst academics to convince the policymaker they are fooling themselves? There are at least two reasons to suggest it might. First, (macro)economics is not held in the same regard as other sciences, for good reason. I would not go quite as far as one comment which said scientists proclaim facts while economists give out opinions – I think we are somewhere in between these two, but still. Second, the two way link between ideologies and economics makes it too easy for the politician to dismiss views they do not like by believing they are politically motivated, and it also makes it too easy for the politician to find academics who will tell them the stories they would like to hear.

A third class of explanation for policy mistakes is that they are genuine mistakes. Events may arise which come as a surprise to most academics as well as policymakers, so there is genuine uncertainty. In terms of 2010, I think the probability of Greek default with possible Eurozone contagion was important at changing attitudes among those who might otherwise have been sympathetic to more fiscal stimulus/less austerity. In the case of the UK, it may have been crucial in persuading Nick Clegg and the LibDems to support greater austerity as part of the coalition. As I wrote here: “What finance minister can sleep easy when there is a chance that they too might be forced down the road being travelled by Greece, Ireland, Spain, Portugal and Italy?” Now I go on to argue, following Paul De Grauwe, that this crisis was a crisis of the Eurozone, and not the precursor to a generalised government debt panic. Although that view is gaining increasing acceptance as interest rates on government debt elsewhere continue to fall, at the time this proposition was neither obvious (governments with their own currencies default through inflation and depreciation, and lenders will fear that) nor widely argued.

In situations of this type, academics can in principle have much more influence. Furthermore, the blogosphere allows for an immediacy that might just be able to influence opinions before mistakes are made, and positions become entrenched. In the case of 2010 and austerity, I do not think it would have been enough. The political forces pushing for austerity, the hidden agendas, were too strong, and the panic induced by events in the Eurozone too great. But academics should never become so pessimistic about their potential influence that they give up trying.

On Hidden Motives

2012-02-16T11:20:00.001-08:00

Chris Dillow has a nice follow-up to my earlier blog on balanced budget fiscal expansion. I first read the Kalecki paper when I was at Cambridge, but for better or worse this is not part of the macro lectures I give at Oxford. We all miss Andrew Glyn a lot.

Is this what I had in mind when I said that if the government argued against all the possible balanced budget spending and tax measures that might stimulate the economy, we might suspect other motives? Before trying to answer that, I should say that part of my complaint was that such policy ideas are not part of the public debate, so we do not know what the government’s response would be. (We could infer, from the fact that none of these policies are being pursued, that they would be against them). I should also note that the FT suggests that the Liberal Democrats are thinking about tax switches, although I have my doubts about whether raising the £10K tax threshold would be particularly effective at stimulating demand.

When I drew parallels in an earlier post between the current UK situation and 1981, I mentioned by way of anecdote a little speech I made at the internal meeting of Treasury economists at the time. What I did not report was that at that meeting I made exactly the argument Kalecki puts forward. (Needless to say Kalecki was not normally quoted in discussions about budgets in the Treasury! - I was young, and probably knew I was going to leave fairly soon.) I think what Kalecki says made a good deal of sense in that particular context: as we were to find out, part of the Thatcher agenda was to take on the power of organised labour.

Whether it makes sense in the current context I’m less sure. Some of the factors identified by Chris in a later post could simply be attempts to deflect sympathy for the unemployed (which in turn would translate into criticism of the government) rather than the more strategic design he suggests. What I probably had more in mind on this occasion were two things.

The first involves the point about ideology which I have mentioned several times. If your ideological perspective is that ‘government is always the problem’ and that the private sector is best left alone, then blaming all our ills on the excesses of the previous government (rather than the financial system), and pursuing austerity by government as the means of correcting those ills fits well with that perspective. To use government intervention as a way of correcting a problem with the private sector (insufficient demand) does not.

The second is that nearly all the fiscal proposals I suggest involve redistributing money from the rich to the poor. This makes macroeconomic sense, because the poor are more likely to be credit constrained than the rich. It would also make sense from an equity point of view: the poor are suffering most as the result of austerity, as the chart below from the IFS illustrates. Unfortunately it does not make political sense for the current government.

There is also a familiar but important point here about political influence and recognition. Issues to do with debt and financial markets are reported daily and major players in this area have almost guaranteed access to politicians – from whatever party. They tend to be rich, and will complain about being taxed at 50%. The young unemployed, who now make up nearly a quarter of the 16-24 age group, have by comparison very little political voice. Even when they are talked about when monthly figures are released, we are likely to get stories about motivation and how to brush up your CV, rather than recognition that with many times more people looking for a job than there are vacancies no amount of self help will make the problem go away. (See this by Zoe Williams.) These are the political reasons why the ‘counsels of despair’ that Jonathan Portes rightly complained about are able to endure.

Can Nothing Be Done?

2012-02-15T14:21:00.000-08:00

Or why is no one talking about balanced budget expansion?

As UK unemployment continues to rise, Jonathan Portes asks why the government seems to accept this as inevitable. The same question could be asked in many other countries. The answer is invariably that nothing can be done by way of fiscal stimulus because debt and deficits are so high. Jonathan argues (rightly in my view) that concerns about debt in the short term are hugely exaggerated. I’ve suggested this is particularly true when we have Quantitative Easing. We seem to be in a strange prisoners dilemma where it is absolutely clear that the world wants more safe assets (the rate of interest on indexed debt is zero if not negative), but every individual government thinks that if it provides them lenders will suddenly panic, and think they are no longer safe.

I think this fear is irrational, but unfortunately events in the Eurozone feed this fear on a daily basis. (It should not, because governments without their own central banks are in a different position from those that have, but that is a rational argument.) Taking notice of ratings agencies is also irrational (see Jonathan again), but it adds to the fear. So even though I think it is fairly easy to win the intellectual debate on debt, this may not be what is decisive.

If governments believe that they cannot add to government debt and deficits, does that mean nothing can be done? Absolutely not. A temporary increase in government spending financed by an increase in taxes will still raise demand. First year economics undergraduate students will know about the balanced budget multiplier of one: every £1 spent by the government will lead to £1 extra demand, because what consumers lose with lower taxes they gain through higher income. Readers of Michael Woodford (2011) will know that we get exactly the same multiplier with much more sophisticated consumers, if real interest rates are fixed. (I try and explain why here.) So it does not matter what sort of consumers we have, the tax increase comes out of saving, and so demand and output rises by the full extent of the spending increase. (For those who think lower savings will mean lower investment, see here.)

The news is better still if interest rates are stuck at the zero lower bound. Higher demand and output will imply some increase in inflation, and any increase in expected inflation will reduce real interest rates, further stimulating activity. The size of the multiplier will be above one.

So there is something we can do with fiscal policy, without increasing government debt. Why does hardly anyone talk about this? (One exception is Robert Schiller.) I suspect the problem is as follows. Those favouring stimulus think debt is not a constraint, and know that there are many reasons why a fiscal expansion financed by issuing more debt will be even more expansionary that one financed through taxes. So why argue for second best? But why do those who do think debt is a constraint not welcome this alternative possibility of raising demand? The reason is obvious: a tax financed fiscal expansion requires taxes to rise.

The problem is not an economic one. The distortionary effects of temporarily higher taxes are likely to be small relative to the resources wasted and permanent damage caused by high unemployment. (See Chris Dillow as well as Jonathan Portes on this.) The problem is political, particularly for countries with right of centre governments. However, just because something may be politically difficult should not stop the argument being made.

Once we get on to this territory, then there is further ground to explore. As well as tax financed government spending, we could think about tax and transfer switches that would stimulate demand. The marginal propensity to consume out of a benefit increase is likely to be quite high, whereas that out of reducing the tax relief on pension contributions for high earners would be pretty small. (Remember any tax switch need only be temporary.) Redistributing money from the old to the credit constrained young would also be likely to raise demand: raise child benefit by increasing death duties, for example. Some companies are not that short of cash at the moment: how about tax incentives to encourage them to invest today rather than tomorrow.

The idea that there is no alternative to doing nothing about rising unemployment could not be further from the truth. If governments find objections to all these ideas, one might begin to suspect that there are other motives at work.

The trouble with teaching macroeconomics: minimum wages and immigration

2012-02-14T12:43:00.000-08:00

I’m in the middle of lecturing on our second year macroeconomics course. There is so much ground to cover in a short amount of time, so on many occasions I have to stop myself launching into a long discussion about why the world is much more complicated than the simple model I’m presenting. One example that will be familiar to many is the impact of minimum wages on employment, where the evidence may not fit the standard textbook model. (The work of Card & Krueger is well known, but those in the US may be less familiar with similar work in the UK. Some recent work discussing international evidence is here.)

I used to be more comfortable about using the standard labour market model, coupled with the variant involving imperfectly competitive goods and labour markets, to analyse the impact of immigration. The idea that immigration was initially unpopular because it led either to lower real wages for the indigenous workforce, or an increase in the amount of involuntary unemployment generated by imperfect competition, seemed to accord with popular perceptions (although see here (10/2/2012) for a discussion of the origin of such perceptions). And I was always careful to add that any decline in real wages would disappear in the long run, as it would be eliminated by increased investment. However work in the UK has suggested that in this case the simple model may be seriously misleading once again.

In early January the Government’s independent Migration Advisory Committee (MAC) published a report which was widely reported as finding that “an increase of 100 foreign-born working-age migrants in the UK was associated with a reduction of 23 natives in employment for the period 1995 to 2010.” However further reading of the report finds this result is not at all robust. At the same time the National Institute published findings that found no impact of immigration on unemployment. The two pieces of analysis are compared by Jonathan Portes here. Ian Preston at the Centre for Research and Analysis of Migration (CReAM) at UCL notes (16/1/2012) that ‘There have been studies in several countries and the preponderance of evidence is strongly suggestive that employment effects are small if they exist at all.’ (Here is a recent US study focusing on the impact on poverty.)

What about wages? The MAC study’s summary of empirical work on the impact of immigration on wages concludes “The majority of studies estimate that migrants had little impact on average wages, differing in their assessments of whether migrants raised or lowered average wages.” There seems to be a common finding that immigration lowers wages a little at the bottom of the income distribution, but raises them at the top. This is hardly consistent with the simple textbook labour market model.

Perhaps we can content ourselves that the textbook model might still be reliable for much larger changes in migration or minimum wages, but that for more modest changes factors like heterogeneity due to skill shortages or monopsony can account for the empirical evidence cited above. However, even if I did have time to make these qualifications to the basic model in my lectures, would students remember them, or just remember the predictions of the model?

What have Keynesians learnt since Keynes?

2012-02-12T02:51:00.000-08:00

That is the question asked by RobertWaldman (9th Feb) in a comment on my post, and also in a dialog with Mark Thoma. I’ll not attempt a full answer – that would be much too long – and Mark makes a number of the important points. Instead let me just talk about one episode that convinced me that one part of New Keynesian analysis, the intertemporal consumer with rational expectations, was much more useful than the ‘Old Keynesian’ counterpart that I learnt as an undergraduate.

In the mid 1980s I was working at NIESR (National Institute for Economic and Social Research) in London, doing research and forecasting. UK forecasting models at the time had consumption equations which included current and lagged income, wealth and interest rates on the right hand side, using the theoretical ideas of Friedman mediated through the econometrics of DHSY (Davidson, J.E.H., D.F. Hendry, F. Srba, and J.S. Yeo (1978). Econometric modelling of the aggregate time-series relationship between consumers' expenditure and income in the United Kingdom.Economic Journal, 88, 661-692.) While the permanent income hypothesis appealed to intertemporal ideas, as implemented by DHSY and others using lags on income to proxy permanent income I think it can be described as ‘Old Keynesian’.

As the decade progressed, UK consumers started borrowing and spending much more than any of these equations suggested. Model based forecasts repeatedly underestimated consumption over this period. Three main explanations emerged of what might be going wrong. In my view, to think about any of them properly requires an intertemporal model of consumption.

1) House prices. The consumption boom coincided with a housing boom. Were consumers spending more because they felt wealthier, or was some third factor causing both booms? There was much macro econometric work at the time trying to sort this out, but with little success. Yet thinking about an intertemporal consumer leads one to question why consumers in aggregate would spend more when house prices rise. (I don’t recall anyone suggesting it changed output supply, but then the UK is not St. Louis.) Subsequent work (Attanasio, O and Weber, G (1994) “The UK Consumption Boom of the Late 1980s” Economic Journal Vol. 104, pp. 1269-1302) suggested that increased borrowing was not concentrated among home owners, casting doubt on this explanation.

2) Credit constraints. In the 1980s the degree of competition among banks and mortgage providers in the UK increased substantially, as building societies became banks and banks starting providing mortgages. This led to a large relaxation of credit constraints. While such constraints represent a departure from the simple intertemporal model, I find it hard to think about how shifts in credit conditions like this would influence consumption without having the unconstrained case in mind.

3) There was also much talk at the time of the ‘Thatcher miracle’, whereby supply side changes (like reducing union power) had led to a permanent increase in the UK’s growth rate. If that perception had been common among consumers, an increase in borrowing today to enjoy these future gains would have been the natural response given an intertemporal perspective. Furthermore, as long as the perception of higher growth continued, increased consumption would be quite persistent.

Which of the second two explanations is more applicable in this case remains controversial -see ‘Is the UK Balance of Payments Sustainable?’ John Muellbauer and Anthony Murphy (with discussion by Mervyn King and Marco Pagano) Economic Policy Vol. 5, No. 11 (Oct., 1990), pp. 347-395 for example. However, I would suggest that neither can be analysed properly without the intertemporal consumer. Why is this a lesson for Keynesian analysis? Well in the late 1980s the boom led to rising UK inflation, and a subsequent crash. Underestimating consumption was not the only reason for this increase in inflation – Nigel Lawson wanted to cut taxes and peg to the DM – but it probably helped.

So this episode convinced me that it was vital to model consumption along intertemporal lines. This was a central part of the UK econometric model COMPACT that I built with Julia Darby and Jon Ireland after leaving NIESR in 1990. (The model allowed for variable credit constraint effects on consumption.) The model was New Keynesian in other respects: it was solved assuming rational expectations, and it incorporated nominal price and wage rigidities.

As I hope this discussion shows, I do not believe the standard intertemporal consumption model on its own is adequate for many issues. Besides credit constraints, I think the absence of precautionary savings is a big omission. However I do think it is the right starting point for thinking about more complex situations, and a better starting point than more traditional approaches.

One fascinating fact is that Keynes himself was instrumental in encouraging Frank Ramsey to write "A Mathematical Theory of Saving" in 1928, which is often considered as the first outline of the intertemporal model. Keynes described the article as "one of the most remarkable contributions to mathematical economics ever made, both in respect of the intrinsic importance and difficulty of its subject, the power and elegance of the technical methods employed, and the clear purity of illumination with which the writer's mind is felt by the reader to play about its subject. " (Keynes, 1933, "Frank Plumpton Ramsey" in Essays in Biography, New York, NY.) I would love to know whether Keynes ever considered this as an alternative to his more basic consumption model of the General Theory, and if he did, on what grounds he rejected it.

Central Bank Interest Rate Forecasts: It’s not about accuracy

2012-02-10T07:58:00.000-08:00

Charles Goodhart writes (FT-£) that “Proposals that central bankers report their expectations of official rates, beyond some short future horizon, are retrograde, pushed forward by fashionable theory without reference to empirical reality.” By short horizon here I think he means three or six months: much shorter than the recent move by the US Fed. Charles is usually right about most things, and similar comments have also been made by other experienced ex-central bankers, so I think it is important to set out carefully one important counter argument.

Charles writes that “whether the publication of central bank predictions of the future path of interest rates is likely to be beneficial depends on the relative accuracy of such forecasts.” I disagree. I’m happy to assume they are no better than those of forecasters in general. What is then gained by publication?

The key point is that central banks, or members of a central bank committee, have inside knowledge. Not about how the economy works, or of statistics a few days before they are published, but about themselves. Their forecasts for interest rates tell us what they are likely to do if events (inflation, growth etc) turn out as they expect, and if they are being consistent. So the important question is whether this information is useful.

Central to the academic case for delegation of interest rate decisions to central banks is that they are less susceptible to the temptations of time inconsistency. (Those familiar with what this means can skip this and the next paragraph.) A classic example involves the trade-off between inflation and output. Suppose the monetary authority wants zero inflation, but would like output above the level consistent with zero inflation (the ‘natural’ level of output). Suppose the public share those preferences. The monetary authority announces a policy of achieving zero inflation, and people form expectations on that basis. Once those expectations have been set, the monetary authority realises that outcomes would be better if output was higher than the natural rate. This will raise inflation above zero, but given their and the public’s views on output, everyone would be better off with a little bit more inflation and higher output. This is sometimes called reneging or cheating by the policy maker, but notice that everyone is apparently better off when it changes its mind.

Now, if people are smart, they will know the monetary authority will behave this way, so they will not believe the initial announcement of zero inflation. In fact the only situation in which expectations prove correct is when they are so high that it is no longer in the monetary authority’s interest to renege. So the outcome is high inflation with no gain in output. In this situation it would be much better if the monetary authority could commit to zero inflation and not renege on this commitment. It is generally thought that central banks are more likely to be able to do this than politicians, in part because politicians will be too tempted by short term gains, and will discount the longer term repercussions.

Being an independent central bank may increase your ability to commit to a policy in the face of the time inconsistency temptation, but it does not guarantee that result. Central bankers would like to be able to establish their credibility for commitment. (I gave a particular example when it might matter a lot here.) Publishing interest rate forecasts allows them to do this. If events turn out roughly as expected, yet the central bank does not follow its own forecast for interest rates, it might be because they are exploiting these time inconsistency possibilities. Following your own forecasts when nothing changes does not prove that you are resisting such temptations, but it is consistent with doing so.

Now Charles Goodhart might respond, in the spirit of his article, by saying that events never turn out roughly as expected, and so interest rate forecasts can never be used in this way. However the critical question is as follows. Is the fog of news so dense that we can never say anything useful using these forecasts? I think not. For a start, we not only have the bank’s interest rate forecasts, but also the inflation forecasts that go with them. We often have no problem saying that the balance of news about the economy over some period is – say – that activity is stronger than expected, and so inflation is expected to be higher. If, despite this, the central bank reduced interest rates compared to their own forecasts, we would be suspicious that they were being inconsistent. However, if we do not know what they were expecting to do with interest rates (because these forecasts were not published), then we are no wiser about whether they are being consistent or not.

Charles talks about the importance of putting error bands around forecasts in general (the fan charts), and I could not agree more. However in this particular case, we do not need such bands. To the first approximation, we only need to know what their best guess was for future interest rates, and the associated best guesses for inflation and other variables. This is because we are using the interest rate forecast to judge consistency, and not as a forecast per se.

Now perhaps the importance of time inconsistency problems in monetary policy is not as great as implied by the academic literature. However, I think the chances of the public being misled by the publication of interest rate forecasts is so small that on this occasion it is worth taking this academic idea seriously. I believe that in ten years time, when more central banks publish interest rate forecasts in this way, we will wonder what all the fuss was about.

More on Schools of Thought

2012-02-08T13:58:00.000-08:00

The main task of this post is to try and answer the following question: why do schools of thought seem to fragment mainstream macroeconomics but not microeconomics? However before tackling that issue, I need to clear some ground raised by some interesting comments on my earlier posts on this issue.

One point I did not make clear enough in my earlier discussion is a distinction between mainstream and heterodox economics. The latter might include neo-Marxists, post Keynesians, Austrians and others. My concern was about mainstream macroeconomics becoming fragmented into schools of thought. I can see why those challenging the mainstream might find schools of thought both convenient and useful. I also think it is very important that the mainstream should be continually challenged.

I also may not have emphasised enough the downside of the microfoundations project. I do worry that it may help to exclude good ideas, as James Galbraith suggests, and have written about how this could be dangerous for policymakers who rely on the mainstream. However I still believe that microfoundations, if interpreted flexibly, bring net benefits. But that is not the focus of what I wanted to say on schools of thought.

The success of the microfoundations project is also why I agree with Steve Williamson that academic work in macro is probably not as fragmented as it was in the 1970s. (I was not an academic at the time, so I cannot be sure.) In that sense, academic macroeconomists when doing academic work can still locate what they do within a common, mainstream framework. We all use models that abstract from many things to focus on what we think is important for some particular issue, and we receive criticism about whether those abstractions are valid or not. My concern about schools was more with the interface between academia and policy, which includes the advice academics give, what economic journalists write, and what politicians pick up.

The kind of thing I had in mind here include politicians thinking that austerity would not increase unemployment, because those that worried that it would were from the same misguided Keynesian school that opposed Margaret Thatcher’s monetarism in 1981. Journalists who find it easier to slot every debate into one between schools rather than address issues on their merits. And academics who attempt to argue that certain views are not worthy of consideration because they were confined to the dustbin 30 years earlier. Jonathan Portes gave similar examples in his post.

One of the interesting things about schools of thought in mainstream macroeconomics is that there does not seem to be anything similar in microeconomics. Now such a generalisation invites counterexamples. Some might point to the debate over the methodology of behavioural economics, for example. However most of my academic colleagues who I have road tested this idea on do agree that macroeconomics seems more prone to schools fragmentation than microeconomics. If this is true today, it is strange, because macroeconomics has become microfounded.

One simple answer to this paradox is that schools of thought are associated with macroeconomic crises, and macro synthesis follows periods of calm. Keynesian theory itself was born out of the Great Depression. The first Neoclassical Synthesis arose from the period of strong growth and low inflation in the post-war period. Monetarism gained strength from the rapid inflation of the 1970s. The more recent synthesis may be a child of the Great Moderation, and now we have the Great Recession, schools of thought have returned. Because these crises are macroeconomic, and there are no equivalent crises involving microeconomic behaviour or policy, then fragmentation of the mainstream into schools will be a macro, not micro, phenomenon.

Attractive though this account seems, I think it misses some important points. As one of the comments on my original post pointed out, the New Neo-classical Synthesis was in many ways a celebration of New Keynesian theory which was not shared by many freshwater departments in the US. Now I think there are good reasons why New Keynesian economists might have imagined that their analysis was an uncontested part of the mainstream. As I noted here, it is used in nearly all central banks as their main tool in carrying out monetary policy. With monetary policy somewhat depoliticised through central bank independence, the Great Moderation allowed this division among academic departments to remain dormant.

On the other side, there was a belief that New Classical economics had been revolutionary: a successful counter-revolution against Keynesian ideas. Once again there were good reasons to support this belief. Nick Rowe in his comment on my Anti-Keynesian School post noted how many Monetarist ideas, opposed at the time by many Keynesians, were now part of the mainstream. We could do the same for the battles between New Classical and Keynesian economists: on consumption, rational expectations, the Lucas critique and more, traditional Keynesians had unsuccessfully opposed New Classical ideas. Furthermore, many of the leaders of New Classical thought did not want to update Keynesian thinking, they wanted to destroy it.

There is a lot more that could be said here, but it would lead me to the conclusion that this counter-revolution failed. It led to fundamental and largely progressive changes in Keynesian analysis, and macroeconomics more generally, and Keynesian analysis survived and prospered. Yet, for many reasons including ideological ones, the would-be counterrevolutionaries did not want to give up their counterrevolution.

So, perhaps unlike the first (post-war) neoclassical synthesis, the New Neoclassical Synthesis was partial in terms of its coverage among academics. This incompleteness was not apparent during the Great Moderation, because the synthesis was applied in nearly every central bank. The fault lines only became apparent when monetary policy became relatively impotent at the zero bound after the Great Recession, and fiscal stimulus was used both in the US and UK. Once that happened, what I called the Anti-Keynesian school re-emerged.

This back story is important, because it raises the possibility of an optimistic (from a Keynesian point of view) way forward. This is that the New Neo-Classical synthesis becomes complete. (For possible signs that this has already begun, see here.) The microfoundation of macroeconomics does logically imply that mainstream macro should be as free from alternative schools as microeconomics. This would require freshwater macroeconomists to recognise that New Keynesian models are essentially RBC models plus sticky prices, and that the addition of price rigidity was not that offensive. All would recognise that the conditions in which fiscal policy was a major stabilisation tool were either rather unusual (the zero bound), or geographically remote (monetary union), and so not something to get so worked up about. Freshwater economists would come to realise that demand denial just did not make academic sense.

I fear a more realistic conclusion is that the Keynesian/Anti-Keynesian division is always going to be with us, because it reflects an ideological divide about state intervention. (For some supporting evidence, see here.) That divide occurs all the time in microeconomics, but because it involves arguing about many different externalities or imperfections it does not lend itself to fragmentation into schools. In macro, however, there is one critical externality to do with price rigidity, and so disagreements about policy can easily be mapped into differences about theory. Demand denial is attractive because it gives a non-ideological justification for what is essentially an ideological position about economic policy.

Budget deficits: changes, levels and risks

2012-02-05T06:23:00.000-08:00

One reasonable response to arguments that the UK, or US, needs less austerity and more fiscal stimulus is ‘deficits are already large’. Now there is an obvious trap here, which is that deficits in a recession are large because of the automatic stabilisers. However it remains the case that in many countries budget deficits are large even when they are cyclically corrected. Cyclical correction is a non-trivial task, and involves making judgements about output gaps which are far from easy at present, but it is better to try than to ignore the issue. The chart below plots ‘underlying’ budget deficits as calculated by the OECD in their end November 2011 Economic Outlook. (More accurately, they are the financial balance of general government as a percent of GDP corrected for the cycle and ‘one-offs’.)

Underlying budget deficits, OECD Economic Outlook Nov. 2011

Cyclical adjustment takes a bit more than 2% of GDP off the 2010 deficit for the UK and the US, reflecting a view that the output gap was around 3.5% that year. So in 2010 cyclically adjusted budget deficits were still very large in both countries, reflecting in part a deliberate policy of fiscal stimulus. The chart also shows the underlying deficit projected for 2013. (Projected changes over these three years are smooth enough not to make the choice of particular years important.) In terms of withdrawing stimulus, or instituting austerity, the Euro area is expected to do more than the UK, and the US less than the UK. This raises a simple question: in judging the direction of policy, should we be looking at levels or changes?

The first thing to say is that we have to be careful relating budget deficits to the stance of fiscal policy because of forward looking behaviour. Suppose the government permanently increases spending, and finances this initially through debt, but Ricardian Equivalence holds. In that case we would get a budget deficit, which generates a matching private sector surplus because consumption falls, and there is no stimulus to aggregate demand. Perhaps a more relevant example in the current situation might be that the government promises to gradually reduce spending, making the current level of taxes eventually sustainable, but the private sector does not believe this, and instead expects taxes to be raised in the future. In this case consumers would save more to help pay for the expected increase in taxes. Once again there is no stimulus, this time because the government is not believed.

For the sake of argument let’s put those concerns to one side, and assume in the case of the UK that long term plans to reduce spending without raising taxes are credible. We have a large private sector surplus not because consumers are saving to pay for future tax increases, but because they are increasing their precautionary saving, or because those that want to borrow cannot do so because banks are restricting lending. In that case, the question about levels or changes in deficits depends on what is likely to happen to private sector demand. If the private sector is expected to continue to save in this way, then we have the same demand gap, but less of it is filled by the public sector, so aggregate demand and output fall. In that sense fiscal policy is restrictive because deficits are falling. However if the increase in private saving is expected to come to an end, which it should at some point, then it is appropriate that the public deficit also declines at some point.

It is all a question of timing, which of course is uncertain. However this uncertainty gives us a very strong argument for not reducing the size of public sector deficits too quickly. If high levels of private savings continue in the short term, then the appropriate policy is to maintain large deficits. But what if the private sector starts spending again? Will that not mean we have too much demand? Two points here. First, when there is a large degree of spare capacity, we can probably tolerate quite rapid growth in demand for a time, without this being inflationary. In fact it is a good thing, because we get rid of unutilised resources sooner. Second, if demand growth is too rapid and inflation rises (and we cannot cut government spending quickly enough because of well known institutional and implementation lags), then we can use monetary policy to cool things down.

We have an asymmetry of risks. If fiscal policy is too expansionary, we have monetary policy as a fall back. However, because of the zero bound for interest rates and uncertainty over the effectiveness of Quantitative Easing, we do not have a similar insurance policy if fiscal policy is tightened too quickly.

This is why I think the speed of fiscal tightening implied by the chart above is too rapid. In the UK in 2010, for example, there was a clear risk that private sector demand would not pick up in 2011. The risk coming from the Eurozone was also apparent. In these circumstances, the prudent policy option was not to scale back public spending too rapidly, because there was no insurance policy in place if these risks materialised. They did materialise, and UK growth stalled. The Eurozone is making exactly the same mistake, in perhaps a bigger way.

Now I have not mentioned the risks associated with rising debt, which is something I’ve discussed elsewhere. However one simple point is worth making again and again. If the recession reflects additional net saving by the private sector, they want to hold more assets. Furthermore, given the character of the recession, they want to hold relatively safe assets. There is a literature on the current shortage of safe assets. Budget deficits provide those assets, but still interest rates on debt are falling outside the Eurozone because there are not enough of them. This too points to budget deficits being cut too quickly.

When growth returns: a prediction

2012-02-04T02:45:00.000-08:00

No, I’m not about to get into the forecasting game – I did enough of that when young. What I am prepared to predict is the reaction of some when growth does return (as it may be in the US, and as it might one day in the UK and the Eurozone). My prediction is that some people will say that growth shows those Keynesian prophets of doom were all wrong. Look, the patient has recovered just fine without the need for any fiscal stimulus medicine.

If people do say this, they will be wrong on two counts. First, there are good reasons for believing that aggregate demand will start to recover at some point without any additional monetary or fiscal stimulus. One of the main reasons for the recession was the need to repair balance sheets, which for consumers meant less borrowing and more (precautionary) saving, and for banks building up capital by reducing lending. Once this process is complete, demand will begin to recover. Once it does so, firms will stop delaying new investment. There is a lot more that could be said about the dynamics of demand following the Great Recession, but a return to growth at some stage is almost inevitable.

Second, the argument was never about growth, but about the level of activity, and unemployment. Put simply, those of us who argue for more fiscal (and monetary) action want growth to come sooner and quicker, so that unutilised labour resources can get back to work. Unemployment is not only a waste of resources but also a major cause of unhappiness (see, for example, this paper by Blanchflower). Worse still, there is the likelihood that prolonged involuntary unemployment may lead to much more permanent reductions in supply, as workers become discouraged and deskilled (see, for example, this paper by Laurence Ball).

So that is my forecast. In one sense I cannot wait to see if it comes true.

P.S. The above has nothing to do with this from Tyler Cowen: Tyler can do no wrong after recently listing my blog. Those interested in that particular post should see Noah Smith.

Euro Deja Vu?

2012-02-03T04:26:00.000-08:00

I was giving a talk about the Euro crisis this week, and in preparation I looked at the new Treaty. Like Antonio Fatas I had that feeling that I had been here before. I remember reading the original Stability and Growth Pact (SGP) and wondering why the focus seemed to be entirely on debt ceilings, with no discussion of using fiscal policy as a countercyclical tool. Much the same could be said about this Treaty.

To recap, this matters because there are two crises in the Eurozone at present: a debt crisis and a competitiveness crisis. General austerity might deal with the first, but because it includes austerity in Germany it makes the second worse: we have ‘competitive austerity’ that will lead to recession and will test the cohesion of the Eurozone. (For example, read Tim Duly and follow the links.) Both crises might have been avoided, or at least mitigated, if many non-German economies had undertaken much more aggressive fiscal tightening before 2007 as they saw their inflation rates exceed those in Germany. It is possible that the SGP itself may have discouraged such tightening, partly because politicians thought that if they were within the pact’s limits things were OK, and perhaps because of reasons I explore below.

I cannot see anything in the new Treaty that encourages countries to think about their relative inflation and cyclical positions. If this Treaty had been in place in 2000 rather than the SGP, it seems likely that the crisis in competitiveness would still have emerged. Not only is the new Treaty unlikely to prevent such crises happening again, but it makes the current crisis worse, because there is no pressure on Germany to expand its economy by fiscal means.

Is there anything positive to say about the Treaty? Maybe one thing. The idea of an automatic correction mechanism if deficits stray from the cyclically adjusted balanced budget rule is modelled on the Swiss and German debt brake idea. This mechanism has some attractions (see this paper by Charles Wyplosz), although I think the devil is in the detail. A debt brake with conditionality related to relative inflation rates might work, as some research I was involved with a few years ago suggests.

The other big problem (besides ignoring countercyclical fiscal policy) which I have with the Treaty is the continuing emphasis on imposition ‘from above’. One thing that we have clearly learnt from the crisis is that it is in each country’s national interest to have adequate budgetary control. In contrast, a key idea behind the original SGP was that without it individual countries would free ride on the union, and that therefore union level control was required. This seems much less relevant today. The danger with control on individual countries coming from the union is that it becomes a ‘them and us’ game. If it is in the national interest to free ride at the union’s expense, then activities such as fiddling the figures may also be seen as in the national interest, when clearly they are not. If austerity is imposed from above rather than from within, the political dangers to the Eurozone itself are obvious. It would, in my view, be much better for individual countries to take ownership of the control of their own national budgets. This could be done through a combination of national institutional reform and nationally determined fiscal rules. Calmfors and Wren-Lewis (2011) show how this combination is becoming increasingly popular. I do not think forcing countries to pass laws to follow balanced budgets really qualifies as taking national ownership!

Chris Giles on UK Austerity

2012-02-02T03:41:00.000-08:00

According to Chris Giles in today’s Financial Times, “..the area in which Britain still leads the international debate is fiscal policy”. This might come as a surprise to many, such as Paul Krugman. I should emphasise that Chris does make one point which I totally agree with. Gordon Brown was quick to recognise the need for fiscal stimulus in 2008, and he applauds that. So, unlike some, the argument is not that fiscal stimulus is always and everywhere wrong. Instead it is that fiscal stimulus was appropriate in the downturn, but that once a recovery began, it was necessary to switch sharply from stimulus to austerity. This argument has of course been made for other countries, including the US, as well as the UK.

Chris gives some arguments against austerity that he says range from ‘mad to bad’. The first, which he attributes to Labour politicians, is the suggestion that austerity is entirely responsible for the recent downturn in UK growth. Well, if anyone said this, they are obviously wrong (although not quite mad): there are other important deflationary forces, of course. But it is equally wrong to infer that austerity has little or nothing to do with the recent poor performance. I know of no evidence to suggest that is likely. Indeed it would be rather strange if stimulus had been effective in moderating the downturn, as Chris acknowledges it was, but that withdrawing that stimulus (and more) had no impact.

The second argument against austerity which he describes as ‘bad’ is that low borrowing rates imply that we can “go on a spending spree”. Let’s forget about the ‘spending spree’ language. What I do take exception to is the suggestion that this is a bad argument. It could be wrong, but the idea that the market price might tell you something about demand and supply is hardly bad. What Chris and others seem to have in mind here is a rather unusual demand curve. Lenders want lots of UK debt under current austerity plans, but if these plans were moderated or delayed, or if a temporary stimulus package was laid on top of them, they would suddenly panic. It is possible that they might behave this way, but I think it is unlikely for various reasons.

The source for this sudden panic idea is of course the Eurozone. However I think it is generally accepted now, among economists if not coalition politicians, that the Eurozone is different, because individual countries do not have their own central banks, and the ECB’s attitude is ambivalent. Certainly market panic does seem to be confined to the Eurozone. Indeed, with Quantitative Easing in place, the UK is in a particularly good position to respond to any market panic, as I argued here. We also have some evidence that, outside the Eurozone, the market does not panic at the first suggestion of stimulus. This does not seem to have happened in Denmark, as David Blanchflower noted, and it has not happened in the US. Also, as Olivier Blanchard of the IMF said recently, if we are concerned about market psychology we should be worried about growth as well as debt.

It is far from clear why the current government’s rapid move to austerity is just sufficient to avoid market panic, but anything more moderate (like the previous government’s plans) would send them into a tizzy. The reduction in UK interest rates on debt that we have seen is part of a worldwide trend, and not an indication that the UK leads the world in finding the appropriate policy stance. Meanwhile, the UK recovery has stalled in a major way, and the scale of unutilised labour resources is large and growing. The view exemplified by Chris’s article that we should wait and see what happens, and hope that Quantitative Easing might yet do the trick, is much too complacent. It was wrong two years ago, and it is even more wrong today.

Annoying Anti-Stimulus Arguments: Numbers 1 and 2

2012-01-29T13:26:00.000-08:00

Unfortunately this may be the beginning of a series. I will try and keep it short and to the point. I will also avoid mentioning anyone in particular who has made these arguments – you know who you are! These arguments are annoying because they keep being made, despite the fact that they have shown to be inadequate over and over again.

No. 1 Arguments that ignore the zero lower bound for interest rates.

There are good arguments for saying that if monetary policy is free to do its job, then countercyclical fiscal policy is both unnecessary and welfare reducing. I have written on the subject. But having written those papers, I could see immediately the importance of that proviso about monetary policy. At the zero lower bound for interest rates (in a liquidity trap), monetary policy is clearly not free to do its job, and so different conclusions apply. See Eggertson and Woodford (2004). If the argument assumes that, despite the zero bound, monetary policy can do all that is required, then this should be said so explicitly, because it is somewhat counterfactual.

For exactly the same reasons, these arguments against countercyclical fiscal policy do not apply to individual countries in a monetary union. If monetary policy is set by the ECB, it cannot ensure output is at its natural level (‘full employment’) in each individual Eurozone country. There is a large literature on this, which I have contributed to, but a standard reference would be Gali and Monacelli (2008). There, as in most of this literature, countercyclical fiscal policy in the face of country specific shocks is welfare improving.

No.2 Arguments that say stimulus is just Econ 101, and the profession has moved on.

I have in the past been very critical of the gap between undergraduate teaching in macro and teaching at masters/PhD level. I think it is quite wrong to teach things to undergraduates that we then tell graduate students are incorrect. But the analysis of fiscal stimulus is not one of these. I know this because my work on fiscal policy uses microfounded New Keynesian models of the type Woodford and others analyse. It is not the same as old fashioned Keynesian analysis, but it can give similar answers for similar reasons. I gave an example here.

So when I teach Keynesian theory to undergraduates, I am not thinking ‘this is nonsense, as they may find out when they are older’. I’m teaching them simple, non-microfounded models that are a rough approximation to many more advanced, microfounded models. If the argument is that these approximations do not hold in the case of fiscal stimulus, then the argument should be explicit about why. It is just not good enough to say we have better models now, without saying what those models are, and why they make a difference.

If the argument is that New Keynesian models are wrong, say so, and say why. If the argument is that New Keynesian models would give different answers to Econ 101 reasoning, be specific about which models, and say why they give different answers. If the argument is that state of the art New Keynesian analysis does not support fiscal stimulus at a zero lower bound, then it is simply false: again, see Eggertson and Woodford (2004).

It is time the Bank of England started publishing interest rate forecasts

2012-01-29T09:02:00.000-08:00

In an earlier post I celebrated the announcement that the US Federal Reserve intended to publish interest rate forecasts. It has now done so. Here is the key chart.

The vertical axis in the level of expected interest rates. On the horizontal axis we have four points in time: the end of 2012, 2013, 2014 and the long run. Each dot represents the expectation of one of the FOMC members (roughly the equivalent of members of the Monetary Policy Committee in the UK).

This tells us some important information that could only be guessed at beforehand. The majority of FOMC members expect interest rates to stay at almost zero for the next two years. Every member of the FOMC expects interest rates to be below their long run level (i.e. they expect monetary policy to be expansionary) in three years time. (We know it is expansionary because we also have FOMC inflation forecasts, so we can work out what real interest rates will be.) Now these forecasts are not necessarily better than others, but that is not the point. What they tell us is what these individuals are likely to decide to do if events (inflation, growth etc) turn out as they expect, and if they are being consistent. (More formally, this makes it easier for a central bank to demonstrate its credibility in the face of potential time inconsistency: see my earlier post for an example of what this means.)

The Federal Reserve example also weakens two of the standard arguments against the Bank of England doing the same. The first argument is how you get all the MPC members to agree a forecast. As the above shows, you do not. Each member of the MPC says what they think. The second argument is that the public will confuse conditional forecasts with commitments. However, unless every MPC member has the same forecast (which seems unlikely), what you get is alternative opinions, so clearly this is not some kind of unconditional target for interest rates.

The central bank of New Zealand has been doing this for years, and those of Sweden and Norway for some time now. Those central banks have not decided it was a horrible mistake because the public did not understand what it was doing. However, these were relatively small economies, so the Bank of England could brush their experience to one side. Now that the US has followed in their footsteps, I believe the Bank has to move in the same direction.

The Anti-Keynesian school

2012-01-29T02:18:00.000-08:00

Some comments on this recent post about Schools of Thought macro have raised interesting issues which I had not thought enough about, and which I want to come back to later if I can. Here I want to put forward an idea suggested by this from Jonathan Portes. We wrote these posts simultaneously and independently, and although I think Jonathan’s is consistent and complementary with what I had written, rereading it made me think a bit more about what I was really annoyed about.

Jonathan describes his puzzlement at being labelled a Keynesian when he thought he was just following mainstream macroeconomic theory and evidence. It discusses how misleading it can be to associate views about how the economy works with policy positions which may be rather specific in time, place and circumstance. Now I think these types of criticism, which I made in my original post, apply to at least some other schools of thought in macro. For example the label monetarist has many layers of meaning, from the very specific and policy related (money supply targeting) to the much more general and theoretical (money matters). These layers may be related, but they do not have to be.

Having said that, I think it is worth saying a bit more about the use of the specific term Keynesian, which both our posts focused on. It seems to me slightly unusual when used to denote a school of thought today, because it appears to be invoked more by those who disagree with it than those who agree. Jonathan’s post gave some clear examples of this. To caricature: we do not need to think too much about fiscal stimulus, because it’s a Keynesian policy. It is true that this kind of statement is more often made by politicians, journalists or bloggers than academics, but academics are not blameless here, and others often take their cue from them.

The source for dismissive statements of this kind probably goes back to the 1980s. At the academic level, it reflects the defeat of the Keynesians at the hands of New Classical economists, without noting that things have moved on rather a lot since then. At the level of policy in the UK, it may also reflect a perception on the right of past battles won.

In contrast, those economists who use (New) Keynesian theory generally think they are just applying standard macroeconomic analysis. They are using the synthesis (e.g. the New Neoclassical Synthesis of Goodfriend and King) that I talked about in that earlier post. They do not think of themselves as members of a school of thought – they thought they were part of the mainstream.

Is that just arrogance on their part? There are two reasons for thinking it is not. First, it is this synthesis model that is used by pretty well every central bank as the main tool for doing monetary policy. That does not make it right, but it does give it a pretty good claim to being mainstream macro. After all, it is mainly in central banks where macroeconomics is applied to the real world. Second, as the evidence that prices are sticky seems overwhelming (as Paul Krugman points out, the evidence from real exchange movements is clear), and it follows almost automatically that aggregate demand then matters, it is difficult to see how Keynesian analysis can either be controversial or ignored. (Furthermore, even if prices are pretty flexible, demand will still be important in determining output after a severe negative demand shock that takes us to the zero lower bound, as I argued here.)

So I want to abolish the Keynesian school. Keynesian analysis should be part of the mainstream, and does not need to be embodied in a school of thought. However, for those that like schools of thought, I will replace it with a new one: the anti-Keynesian school of thought. It covers all those who attempt to dismiss Keynesian ideas like fiscal stimulus at the zero bound, or countercyclical fiscal policy in a monetary union, not through reasoned analysis, but by just labelling it Keynesian.

The Return of Schools of Thought Macro

2012-01-27T13:34:00.000-08:00

When I first studied macro, it was all about ‘schools of thought’. Keynesians, Monetarists, New Classicals, and probably many more I cannot remember. Macroeconomists tended to take sides. Antagonists often talked across each other, and anyone not already on one side just got totally confused. I recall reading one textbook on international macro where each chapter represented an alternative ‘view’, with no clear idea of how each view or school was related to another. One thing that was pretty clear, however, was that most schools of thought could be identified with a particular ideological position.

But then things began to change. The discipline appeared to become much more unified. It would be going much too far to suggest that there was a general consensus, but to use a tired cliché, most macroeconomists started talking the same language, even if they were not saying the same thing. I think there were two main reasons for this. The first was microfoundations: deriving the components of macro models from standard optimisation applied to representative agents. This gave macroeconomics the potential to achieve the same degree of unity as microeconomics. The second was the development of New Keynesian theory, which allowed an analysis of aggregate demand within a microfounded framework, and which integrated ideas like rational expectations and consumption smoothing into Keynesian analysis. To use the jargon, all models were now DSGE models.

Goodfriend and King coined the term ‘New Neoclassical Synthesis’ (call it ‘synthesis’ for short), and other authors wrote along similar lines. So, even as recently as five years ago, I told masters students starting a macro course to forget anything they might have been told about alternative schools of thought: they were going to learn a unified framework that most macroeconomists – the mainstream – would sign up to. It was like the first half of David Romer’s popular textbook: start with Solow, but quickly replace a fixed savings propensity by an optimising intertemporal consumer to get the basic Ramsey model. Add endogenous labour supply to get RBC. Probably talk a bit about overlapping generations. Hopefully add to what was in Romer by doing some open economy stuff. Then add New Keynesian theory built around sticky prices. If the student went on to work in a central bank, they would probably encounter this framework as a central part of that institution’s forecasting and policy analysis.

I think this synthesis and the reasons behind it may have had one or two unintended and unfortunate consequences. Sometimes the emphasis on microfoundations became a bit of a fetish. (I have written about the shaky methodological grounds on which ‘microfoundations purists’ sometimes stand here.) Some have suggested that the emphasis on microfoundations meant too much time was devoted to elements that were easy to model within that framework rather than the things that really mattered. But I personally thought this synthesis had many more positive than negative consequences. I would not wish for every single macroeconomist to sign up to the synthesis: there is an important role for heterodox economists. However I liked the fact that the majority of macroeconomists used the same analytical framework.

Just five years later and it seems rather different. I’ve encountered a much larger range of economics blogs in the last week or two (you can guess why), and it does feel like going back in time. Schools of thought in macro are definitely back. Since the recession it has become clear that the synthesis had not been adopted everywhere. In particular, in sections of the profession there remained a suspicion (to put it mildly) of New Keynesian theory, and partly as a consequence of this the amount of this theory that was taught to graduates differed widely.

It is true that for some, schools of thought can be quite fun. Some students find the idea that academic macroeconomics consists of opposing forces locked in combat adds a degree of interest and motivation that might otherwise be lacking. However I am not persuaded that this spice was sufficient to offset misunderstanding. Personally when I was a student I found all the motivation I needed from socially destructive inflation, and widespread unemployment should do the same today. I do think that the schools of thought approach leads to an inexactness which can be misleading and annoying.

Take the label Keynesian. Look up Wikipedia, and in the third paragraph you will find ‘Keynesian economics advocates a mixed economy — predominantly private sector, but with a significant role of government and public sector...’. Now I have a much more limited idea of what Keynesian economics is. For me, Keynesian macro is business cycle analysis based on aggregate demand and sticky prices. By this definition, the only ‘significant role for the public sector’ required is a central bank. Even in the rather unusual (I hope) times of a zero lower bound, Keynesian advocacy of fiscal stimulus implies is that the government brings forward its bridge building, and not that it permanently build more bridges. Does my preferred definition make me narrow-minded?

Keynesian analysis as I define it implies that you need monetary policy, and occasionally countercyclical fiscal policy, to stabilise the economy, but that is not what is generally meant by a mixed economy! The extent of the public sector’s involvement in the economy will depend on microeconomics, not macro. Now it is true that those who tend to be antagonistic to state intervention may be uncomfortable with monetary and fiscal stabilisation policy, as I have suggested, but I am against ideology clouding economics, and I certainly do not want this connection hard wired as a school of thought.

School of thought thinking also tends to bracket ways of looking at the economy with policy prescriptions, even when they are not inextricably linked. Take countercyclical fiscal policy, for example. Is that an intrinsic part of Keynesian thinking? For some time there has been general agreement among most macroeconomists that monetary policy was the stabilisation tool of choice, because of issues like implementation lags. This view has been strengthened by analysis over the last ten years that explicitly looks at welfare derived from a representative agent’s utility: the analysis of a simple basic case is contained in the Woodford paper I referenced here, and some of my own collaborative work has shown this result is surprisingly robust. So linking the routine use of countercyclical fiscal policy to what I think of as Keynesian theory is just misleading.

This sort of bundling together of ideas under one label at the very least causes confusion. (Here Jonathan Portes gives one recent example.) Worse still, it leads people to take sides on issues not because of the merits of the case, but because that case is associated with a school of thought whose other elements they do or do not like. I also miss the synthesis. I very much liked the idea that disagreements could be clearly located within a common framework. With the synthesis, I felt macroeconomics began to look more like a unified discipline - more like micro, and dare I say it, more like a science than a belief system.

Optimism or Pessimism on the EuroZone Crisis?

2012-01-27T01:37:00.000-08:00

On Monday Paul De Grauwe and others wrote a letter to the Financial Times in which they warned that the Eurozone was ‘on the road to macroeconomic disaster’. They wrote: “Today’s leaders, however, behave like cult followers who refuse to avail themselves of the treatment that will save their lives”. Yesterday Fred Bergsten and Jacob Kirkegaard at VoxEU sound a much more optimistic note about the ability of European leaders to see their way through the Eurozone crisis. They say “We therefore believe the Eurozone crisis – despite the superficial appearance of the opposite – is well on the way towards stabilisation and resolution.”

(A digression. It has just been announced that Fred Bergsten will retire from running the Peterson Institute this year. He established that Institute as a major voice in international macro. This is just a small personal anecdote. In 1998 I did some work with Rebecca Driver for the Institute on equilibrium exchange rates. At the time the Yen was around ~~160~~ 140 per dollar, and our analysis suggested an equilibrium rate around 100. There was a small presentation of our work to some influential journalists at the Institute. One found the implications for the Yen incredible, and after grilling me, he turned to Fred and said ‘do you support this’? Many in his position would have been equivocal: something like ‘it’s an interesting view, but of course blah di dah’. After all, I was a relatively new academic hardly known in the US. Instead Fred replied ‘yes, I support it’.)

So two very different views, but one reason for this divergence may be that they are mainly looking at different crises. Although Bergsten and Kirkegaard note the competitiveness problem I discussed here, they focus on government debt. They note that, although the ECB has the capability of ending the crisis, to do so would create too much moral hazard. To quote: “Were the ECB to cap governments’ financing costs at no more than 5%, for instance, Eurozone politicians would probably never take the essential but painful decisions.” In other words, it is in the ECB’s perceived long term interests to allow a crisis to persist, because this will spur on institutional reforms that will avoid a similar debt crisis occurring in the future.

To some the idea of progress via crisis might seem far too chaotic. Why, for example, cannot the ECB systematically buy or sell government bonds in the market to achieve announced target interest rates for particular countries, and reduce interest rates for those countries that make progress in tackling debt problems, but raise rates for those that do not? In one sense this is what the market is doing, but while the market might have the general level of interest rates too high because of problems of multiple equilibria, the ECB could provide incentives in a more moderate and controlled way. Perhaps, but I doubt whether the ECB would want to play such an openly political role.

Under this view, the ECB’s policy is working just fine. European politicians are being forced to make changes (and in some cases are being forced from office when they do not), and institutional progress is under way. Because such changes are difficult politically they are bound to be slow and erratic, which is why the apparent crisis will continue for some time to come. But, so the argument goes, if at any stage the crisis appeared to be becoming critical, the ECB would step in to avoid this happening.

Paul De Grauwe and his colleagues are worried about a different crisis, a crisis of external imbalances. I think I’m right that as far as my discussion here is concerned, this is equivalent to a crisis of competitiveness. Eurozone countries running current account deficits have been losing competitiveness, and vice versa. To cure this crisis requires deficit countries to restrain demand, and surplus countries to expand demand. Now the first part of this cure is of course identical to the cure for excessive government debt – it requires fiscal austerity. The key difference is the second part, which involves expansion in surplus countries.

It is the absence of expansion in surplus Eurozone countries (which means Germany in particular) that leads De Grauwe et al to be so pessimistic. They see a “decade of economic stagnation entailed by current policies “. If European policy makers do not change course, they “will bear the responsibility for the implosion of the eurozone and, in the end, the failure of the whole European project”. Many others share this concern about a Eurozone recession: see Martin Feldstein for just one example.

We can put it this way. If the problem is simply one of government debt, and we have good reason to believe there is too much debt in most Eurozone countries (including Germany), then general austerity is the order of the day. Whereas the markets believe Germany will undertake austerity of their own free will, in other countries neither the markets nor the ECB believe this, so we need a continuing but controlled crisis to force these countries to act. However, if the problem is external imbalances and competitiveness, we have a danger of ‘competitive austerity’. We need more austerity outside Germany than within Germany to correct imbalances between the two. The more Germany adopts a contractionary fiscal policy the further countries outside Germany are forced to go. The end result is not only general stagnation within the Eurozone, but recession so acute in some countries that political turmoil may follow, possibly leading to the breakup of the Eurozone.

In other circumstances, competitive austerity might not be a problem, because the ECB could counteract any general stagnation by reducing interest rates. There are two reasons why this is not a way out today. First, by raising interest rates last year, the ECB appears to be too preoccupied by short term inflation, so they may not act when they should. Second, and more fundamentally, they are close to a zero lower bound, and so have lost the ability to prevent a second recession through monetary policy. So unlike the case where the problem is risk premia on government debt, the ECB cannot be sure to act effectively in a Eurozone recession.

This suggests that the key problem for the Eurozone is similar to that faced by the US, the UK and others. Too much austerity in the short term is holding back or even killing the recovery from the last recession, because monetary policy has lost its power in a liquidity trap. In these other countries this excessive austerity will ‘only’ result in significantly higher unemployment for many years to come. In the Eurozone the consequences could be more dramatic.

UK Growth reveals a major macroeconomic policy error

2012-01-25T15:14:00.000-08:00

The first estimate of UK growth in the last quarter of 2011 was negative. As these updated NIESR charts show, no other UK recovery has stalled in this way. Of course very little is ever certain, but we can be pretty sure that growth would have been significantly better if the current government had not imposed severe additional austerity measures beginning in 2010. (This is the counterfactual that matters, and just looking at GDP components can be a misleading way at getting at this for reasons I discussed here.) Of course growth might have been better too if the Euro crisis had not happened, but this government had no control over the Euro crisis, while it does decide fiscal policy.

I do not have anything very new to say about this, in part because many people predicted growth would be harmed before the policy was introduced. (See, for example, this letter from 80 economists published during the 2010 election campaign.) What was the reason for this major macroeconomic policy error? For some I think it was a political calculation that it would be advantageous to get as much of the cuts out of the way early, well before the next general election. However I think others in the coalition were genuinely spooked by events in Greece and elsewhere. Unfortunately the key difference between economies in the Eurozone and those with their own central bank was not appreciated. Today the claim that if these additional austerity measures had not been introduced UK interest rates on debt would have suffered the same fate as many Eurozone countries looks pretty implausible. In Denmark we even have an example of a country that has recently undertaken stimulus measures, and where interest rates have continued to fall in line with other countries outside the Eurozone (see David Blanchflower here).

So I believe we must add 2010 to a list of major macroeconomic policy errors made in the UK since the war. Like the failed monetarist experiment in the early 1980s, it is the result of a government adopting a policy which relied on a mistaken macroeconomic analysis that was not supported by the majority of academic opinion. And like that earlier failure, it will leave unemployment significantly higher than it need to have been for many years.

Comments on Comments

2012-01-25T05:46:00.000-08:00

I number of people have asked me why I have not replied directly to Scott Sumner’s criticism of this and subsequent posts of mine, particularly as he keeps claiming that I made some mistake. Well, for the record, I do sometimes make mistakes, and when they are pointed out I acknowledge them. However on this occasion my writing on this issue seems pretty consistent to me and as far as I’m aware error free. So, why no reply?

Well, I did in fact leave a comment on Scott’s second post. Scott then wrote another post (rather than comment on my comment). I stopped at this point, partly because the subject matter appeared to be moving away from what Cochrane and Lucas said to other issues which were not obviously relevant to my original point. I think Brad DeLong nails it here. This is one of the problems with the ‘you were inconsistent here, and you have forgotten this here, but you are a professor at Oxford so I’ll give you the benefit of doubt’ sort of exchange. I think it can muddle rather than clarify an issue.

So instead I wrote a few self contained posts which tried to throw light on some of the issues, but which also made sense on their own. The original quotes I looked at appeared to suggest that if taxes went up, consumption would immediately fall by the same amount (“it’s just a wash”). I pointed out in my original post that this will not happen because of consumption smoothing. What I had not anticipated is that some people might think that lower saving would automatically lead to an equal fall in spending on capital goods without any change in income (another wash). That is why I wrote the savings equals investment post, which explained why this would not happen. Some of the comments to my original post said hey, these guys are just assuming full employment, so I wrote this on that general issue. There also seemed to be some confusion in the debate on the difference between behavioural responses and equilibrium relationships, which Paul Krugman and subsequently Brad DeLong discussed, and which Chris Dillow brilliantly anticipated. As the debate went on, I thought I could clarify a point about multipliers and consumption smoothing (or ‘Old Keynesian’ and New Keynesian models), so I wrote this. I’m glad to see that John Cochrane is now less dismissive of fiscal stimulus, which leads Noah Smith to make observations about politics and macro that have some similarities to those in my original post.

While I’m on the subject of comments, I should say something about comments on my own posts. I had not anticipated so many people reading my stuff, and therefore so many comments, and if I tried to answer them all I would have to neglect the day job. However I do read them all, and if there is a common theme that I would like to say something on, I’ll write a new post on it (like ‘Demand Denial and Ideology’). One exception is where someone points out an error in what I wrote, or something where in retrospect I think I have been misleading or unclear, in which case I think it is sensible to recognise that immediately by replying to the comment. So thank you to those who have left comments, as I do find them useful.

The influence of macroeconomic ideas

2012-01-20T13:35:00.000-08:00

Polly Toynbee says something very sad in the Guardian today. In talking about the Labour opposition in the UK, she writes

They have lost the Keynesian argument (for now): the paradox of thrift is just too paradoxical for the public.

I agree that the line that the recession was caused by everyone (public and government) borrowing too much, and that just as consumers are now having to tighten their belts, so should government, plays well because it seems virtuous. On the other hand the idea that if consumers and government start to save more at the same time there will not be enough demand and so output will fall seems fairly intuitive, and certainly not rocket science. However I’m not really in a position to judge how someone unfamiliar with macroeconomics would see this argument, and I guess it is called a paradox for a reason.

Obviously Toynbee is not implying that every macroeconomic idea that is incomprehensible to the layperson will be ignored by policymakers. What she does seem to be saying is that when macroeconomics enters politically contested waters, politics should look to what goes down well with the public rather than what most economists think is right.

Is this true? Well just imagine the following. The opposition announces that it intends to cut most tax rates. It asserts that this will incentivise everyone to work harder, so tax revenues will actually increase. Now I’d like to think that if this happened in the UK today, the media would find it very difficult to get hold of an academic economist who would support the view that revenues would actually rise following tax cuts. The opposition would be asked at every turn, why do the experts not agree with you? As a result, although the policy might be popular initially, it would gradually lose votes. In addition, the opposition itself might begin to doubt their own claim.

Now imagine another country where there is a small minority of economists who are prepared to support this view. The media would switch to describing the claim about revenues as controversial, and would revel in setting up confrontations between economists on opposing sides. The opposition gets elected and implements the policy. Similarities between this and the story of the Laffer curve and Ronald Reagan that Paul Krugman describes in Peddling Prosperity are of course deliberate.

It therefore seems to require a near universal consensus among economists to prevent bad but populist policies either emerging in the first place, or being enacted if proposed. We need to add at least two other factors that might be important. The first is the influence of academics on the civil service. Civil servants do try and weigh up the evidence, and will be influenced by whether a particular view is a majority or minority one among academics. However politicians can override civil service advice, particularly if they have an electoral mandate, as my little story about the first Thatcher government illustrates. Second, we need nowadays to factor in the role of think tanks which are established to promote a particular point of view, and which can often manufacture apparent expertise. (There is a very nice observation from Menzie Chinn on how many staff from various US think tanks went to the ASSA meeting in Chicago. George Monbiot follows the money financing UK think tanks.) Such think tanks can generate the appearance of ‘controversy’ among experts where little actually exists, as the climate change debate illustrates.

What this all suggests is that the academic balance of opinion on macroeconomic issues carries very little weight when these issues are politically divisive. The chances of achieving the near consensus required for academic opinion to matter is also reduced by the two way interaction between politics and academic economics. Not only will politicians and their advisors seek out the academics whose views support their political prejudices, but unfortunately ideology sometimes seems to influence the academic debate. I have written about the influence of free market ideology on academic macroeconomics in the context of fiscal policy and Keynesian theory more generally, but in the past the influence has come from the left as well as the right.

All this is very pessimistic from my point of view. Indeed, as the paradox of thrift is both a very old idea and obviously correct, it is enough to make someone who wants better policy despair. In another 75 years, will the paradox of thrift still be a ‘controversial’ idea in media terms? I think it may just be possible to tell a more optimistic story on this, but that will have to wait for another post when I'm feeling less gloomy.

Counterfactuals and UK Growth in 2011

2012-01-20T01:49:00.000-08:00

Macroeconomists have a familiar complaint when it comes to how the media sometimes assesses the impact of particular policy measures. Popular comment often tries to link the measure to outturns and draw conclusions. For example, did the 2009 Obama stimulus package (ARRA) work? We cannot say that the policy did not work because U.S. unemployment did not fall through 2010, because there were lots of other influences on unemployment over this period. We have to try and work out what would have happened if the policy had not been implemented. That is what the CBO (the Congressional Budget Office - the independent fiscal council for the US) does, and it estimates that the impact on jobs was positive and substantial. (Fiscal stimulus works!)

In the UK we can get into the same confusion. Was 2011 a bad year for growth because of the greater austerity announced in 2010? We will have the Office for National Statistics’ first guess at the outturn for 2011 as a whole soon, but they should not be too far from the forecast made by the OBR in November. The OBR (Office for Budget Responsibility) is the UK’s equivalent of the Congressional Budget Office, although it is much smaller and has a much more limited remit. Brian Ashcroft, in his new blog, runs through the OBR’s estimates with some nice charts. Overall UK GDP growth in 2011 is expected to be just less than 1%, but the contribution of government spending to that growth is expected to be positive. Does that mean additional austerity had nothing to do with the recovery stalling in 2011?

The answer is no for a number of reasons. First, as Ashcroft notes, government spending in the UK and elsewhere is typically countercyclical. We normally focus on transfers like unemployment benefits when thinking about why the budget deficit goes up in a downturn, but there is evidence (for example this study by Julia Darby and Jacques Melitz) that government spending is also countercyclical. In other words, without austerity the contribution of government spending to growth might have been bigger still. Second, one of the government’s key austerity measures was an increase in VAT at the beginning of 2011. As this was preannounced, I would expect a lot of expenditure switching from 2011 into 2010, and indeed falling consumption (-1.1%) is the major reason why expected growth in 2011 is low. Third, people look forward and adjust their current plans accordingly. The OBR expects the direct effect of government spending to reduce growth in a major way over the next five years. That inevitably means job losses in the public sector: the OBR expects general government employment to fall by about 700,000 (about 2.5% of total employment) between 2011 and 2017. It would be very surprising if this had not led to an increase in precautionary saving in 2011.

What we really want to know is what GDP growth would have been if the new coalition government in 2010 had not announced additional austerity measures. To do that you need a macroeconomic model, like the one the OBR uses to make its forecast. In fact the OBR are the obvious people to ask, but unfortunately – and unlike their US counterparts - they are not allowed to tell you, or even do this kind of analysis. Read this to find out why.

Consumption smoothing and the balanced budget multiplier

2012-01-19T02:08:00.000-08:00

Only for economists

In some of the debate following this post, and then this, there often seems to be a big distinction drawn between models based on consumption smoothing, and the old fashioned balanced budget Keynesian multiplier. Even Paul Krugman felt it necessary to say that he ‘never said a word about the balanced budget multiplier’. Now of course the models are different. However I want to suggest that in the context of fiscal expansion in a recession caused by demand deficiency, the balanced budget multiplier story can be retold in a manner consistent with consumption smoothing.

The most basic model of consumption smoothing involves two periods. Let period 1 be a demand deficient recession, and so output is determined in a Keynesian manner by aggregate demand. Period 2, which is much longer, is Classical, and nothing changes in period 2. (If having a two period model of unequal lengths is a worry, think of period 2 as being divided into a large number of sub-periods of equal length to period 1, but where every sub-period is Classical.) We keep monetary policy neutral by assuming the real interest rate is constant. Optimising consumers will then spend a fixed proportion of their permanent income in period 1: that is consumption smoothing. Let’s call this proportion c, which could be quite small. There is no investment, and the economy is closed.

The government now increases government spending by G in period 1 only, and taxes rise by the same amount in period 1. The ‘direct’ or ‘first round’ effect is that consumption in period 1 falls by less than G, because the impact of higher taxes on consumption is smoothed via permanent income. That is as far as I needed to go in my ‘Mistakes’ post to make the point I wanted to make. However it is obviously not the end of the story, because higher output implies higher income. What happens to output eventually (call the answer Y)? Well consumption rises/falls by Y-G times the fixed proportion c, so we solve Y=G+c(Y-G), which of course implies Y=G, a multiplier of one. This is not only the same result as given by the Keynesian balanced budget multiplier, but the mechanics are identical. Consumption does not change at all: higher period 1 income offsets the higher taxes. We do not need to worry about any knock on effects in period 2, because permanent income ends up unchanged. So the simple Keynesian balanced budget multiplier need not be considered some ancient fossil that we are forced to teach undergraduate students, but a simple expression of what consumption smoothing implies in a particular context.

We could get to the same result using consumption smoothing alone, by noting that consumption in period two is tied down by (classical) Y and permanent G. Second period consumption and the Euler equation then fixes period 1 consumption, as real interest rates are unchanged by assumption. So any change in government spending in period 1 leads to an equal increase in output.

Woodford, in section 2 of the paper noted by Krugman and myself, does something with similarities to this, but with more elegance. My period 2 becomes the steady state, a steady state in which (given the usual assumptions) the real interest rate equals the rate of time preference. With real interest rates fixed at this value in all periods, consumption is equal in all periods, so any temporary change in government spending leads to an equal temporary change in output. We get a multiplier of one. With this benchmark, it is then intuitive to see how the multiplier will fall if real interest rates are not constant but rise. Equally, if we are at a zero lower bound, the multiplier will be greater than one because higher output generates inflation, which reduces real rates.

Now I am not trying to say here that the simple, most basic Keynesian multiplier apparatus is in any sense ‘as good as’ consumption smoothing. In fact, if I was writing an introductory macro textbook, I would start with the two period consumption model and consumption smoothing, and mention the current income Keynesian consumption function only in passing. (My reasons for doing this are explained here.) All I want to suggest is one way of reinterpreting the balanced budget multiplier that is consistent with consumption smoothing. I think it is also nice that all this stuff ends up with the same result, a multiplier of one. If someone wants to argue that the multiplier is zero they need some additional argument, and as I suggested here, I have yet to see one that seems appropriate to the current situation.

UK Deja Vu?

2012-01-17T08:04:00.000-08:00

Jonathan Portes has a nice chart comparing this recession to previous downturns in the UK. The most eye catching implication is the similarity between this recession and the 1930s. Although it appeared as if we were recovering more quickly, thanks to the rapid reduction in interest rates and fiscal stimulus immediately following the recession, additional austerity brought in by the new coalition government has coincided with a much slower recovery. Whether this is causal we cannot be sure, but in my view it would be very surprising if the additional austerity was not at least partly to blame.

I want to focus on a different comparison, between now and the recession of the early 1980s. These recessions were both severe, but their immediate causes were quite different. The recession that started in 1980 was the consequence of a very tight monetary policy designed to reduce inflation. RPI inflation averaged 18% in 1980, but came down to 5% by 1983. GDP fell by over 2% in 1980, and very slightly in 1981, but an unusual feature of the recession was that it was concentrated in the traded sector: manufacturing output fell by 15% over those two years. One possible explanation is ‘Dornbusch overshooting’: using monetary policy to reduce inflation in an open economy leads to a temporary loss in competitiveness that hits the traded sector.

The similarity with today lies in fiscal policy. In the 1981 budget, income tax allowances were not raised, despite rapid inflation. To put the same point using a bit of jargon, in 1981 the ‘automatic stabilisers’ provided by fiscal policy were switched off. Despite high and rising levels of unemployment, fiscal policy was tightened, as it was in 2010.

At the time I was working as a relatively junior economist in the UK Treasury, in charge of using the Treasury’s macroeconomic model to assess the economic impact of the budget. This sounds very important, but in practice it was not, because those in charge of policy did not believe the analysis that the model produced. Traditionally after every budget, the chief economic advisor, who was then Sir Terry Burns, presided over a discussion of all Treasury economists about the issues raised. Sir Terry began by presenting his analysis of why fiscal policy had to be tightened: the large budget deficit was in danger of making it difficult to hit (broad) money supply targets. When he finished, there was silence in the room. Given my role at the time, I felt I could not let this pass. I delivered a little speech suggesting the budget was totally inappropriate. It is what happened next that was noteworthy. It was like opening the floodgates: suddenly everyone wanted to speak, and with few exceptions the verdicts were equally damning. Sir Terry looked increasingly uncomfortable.

This pattern was mirrored in public through the publication of a famous letter to the Times signed by 364 academics. We are more used to such things today, but in 1981 this was a very unusual event, and to get so many distinguished academics (mostly economists) to express such a strongly critical view of government policy was a big deal. The 364 included Amartya Sen and the current governor of the Bank of England, Mervyn King. To look at the exact text of the letter is a bit of a distraction, as it included many statements which look decidedly odd today, and which I am sure many of the signatories at the time did not fully agree with. They signed it because they thought the policy was wrong.

I think it is therefore reasonable to use this letter as a proxy for the 1981 budget itself. In 2006 a number of journalists and commentators marked the 25^th anniversary of the letter. Here I want to quote from the end of a piece written by Stephanie Flanders, because I think she is a reliable guide to what the verdict at that time was on the 364.

And the letter itself? Well, unfairly or not, the letter became something of a joke on the economics profession, as Lord Howe [Chancellor at the time] confirmed. "I've actually produced a definition of economists as a result: that an economist is a man who knows 364 ways of making love, but doesn't know any women."

Was it right, given hindsight, to switch off the automatic stabilisers in 1981? In very simplistic terms you can argue both ways. Growth did pick up after 1981. Inflation came down rapidly, perhaps more rapidly than was intended. Unemployment stayed very high for the rest of the decade, clearly suggesting that the deflationary shock in 1980/1 was so sharp that it generated hysteresis, raising the natural rate for some time. This is the point emphasised by Steve Nickell, who probably has done more work on the UK unemployment/inflation trade-off over this period than anyone else. However in one crucial respect 1981 was not like 2010, in that monetary policy was still operating freely. If switching off the automatic stabilisers in 1981 had allowed an easing of monetary policy, and given how uneven the impact of monetary policy had been, then perhaps it made sense. However the conventional view today is that monetary policy should do all the work if it can, and that fiscal policy should just allow the automatic stabilisers to operate.

So it seems to me that the question of whether the 1981 budget, or the 364 economists’ protest, was right or wrong remains an interesting question. However the point I want to make here is that the view on the political right is quite clear. This piece by Phillip Booth in the Daily Telegraph from 2006, based on editing a collection of essays on the issue published by the Institute of Economic Affairs, is headlined ‘How 364 economists got it totally wrong’.

So my speculative question is this. Was this verdict on the 1981 budget influential (explicitly or implicitly) when the Conservative party in opposition decided that more austerity was needed? (I have focused elsewhere on the role of Greek default in changing the policy consensus worldwide, but the Conservative Party opposed Gordon Brown’s countercyclical policy from the start of the recession.) Did the verdict on the 364 embolden the view that it was OK, and possibly even desirable, to go against conventional (in the UK at least) academic opinion? If this verdict on history was important in influencing policy in 2010, was it appreciated that being at the zero lower bound today made the two periods crucially different?

Savings Equals Investment?

2012-01-14T10:09:00.000-08:00

This post is for first year undergraduate students (and the occasional blogger) who appear confused.

Q: If consumers spend less and save more, does this mean investment must increase?

A: Absolutely not. Someone increasing their saving does not automatically imply that some firm will decide to buy more capital goods.

Q: But surely savings equals investment by identity in the national accounts.

A: Indeed. Total output = total income = total expenditure = Y. In the most simple model of a closed economy without government, income (Y) = consumption (C) + saving (S), but also expenditure (Y) = consumption (C) + investment (I). So S=I by definition. But here investment includes what is called ‘stockbuilding’ or ‘inventory accumulation’, which includes goods that firms wanted to sell but could not. To make this clear, lets split measured investment (I) into these two components: I=DK (buying new capital goods) +DS (stockbuilding). So if people consume less (C falls), but investment in new capital (DK) stays the same, measured investment rises because firms accumulate inventories of the goods that consumers did not buy (DS rises).

Q: But this situation cannot continue, as firms may be losing money.

A: Exactly. They will cut back on their output, incomes will fall, consumption may fall further, and savings will also fall, cutting back on the initial increase that we started with.

Q: When will this process stop?

A: When firms stop accumulating inventories i.e. when DS=0. Then, and only then, will S=DK.

Q: But how can this be? We have assumed that DK stayed the same, and we started with an increase in S?

A: You have not been paying attention. Each time firms reduce their output to match lower demand, incomes and savings fall. Eventually the initial rise in savings is reversed, because overall income has fallen.

Q: Got it. But textbooks make a big thing about aggregate savings equalling investment. If it is just an accounting identity, why is it important?

A: What the textbooks really mean is that we eventually end up with a position in which S=DK. And that is important, for the reasons we have just discussed. It is called the paradox of thrift. A desire by consumers to increase savings ends up just reducing output, and savings do not increase at all. (Of course they are still saving more of their income: S/Y has gone up, but because Y has fallen, not because S has increased.)

Q: But I thought with all this ‘just in time’ production stuff, firms did not hold many inventories any more.

A: Well we could short circuit the story by forgetting about inventories and having firms accurately forecast what demand will be, and therefore what their output should be. In practice what we call involuntary inventory accumulation can still be important when looking at quarterly movements in national output.

Q: But is it realistic to assume investment – I mean DK – stays the same if savings are initially higher? If there are more savings around, it becomes cheaper to borrow, which will encourage investment, right?

A: It might, but it might not. In particular, if output is falling, firms may be reluctant to add to their capital stock.

Q: But won’t interest rates keep falling until they do? After all, the asset market has to clear.

A: Savers have an alternative, which is to just keep their savings as money.

Q: But they will put the money in a bank, and the bank will lend it.

A: Maybe, but the bank may just decide to hold on to the cash.

Q: It seems to be really important what people do with their additional savings.

A: Perhaps. But I think the key point is that, most of the time, the person doing the saving is different from, and has different motives to, the person doing any investing. A highly complex financial system links the two. And in that system, there will be lots of opportunities for the additional savings to be parked as money.

Q: Money seems very important here. It is why the extra saving does not have to find its way into more investment.

A: I think that’s right.

Q: If people hold the extra savings as money, will that not increase money demand. What happens if the central bank keeps the money supply fixed?

A: People hold money not just as a way of saving, but also to buy and sell things. And if less is being consumed, there is less need for money on this account. It is difficult to predict what will happen to the total demand for money, which is why central banks nowadays focus on determining short term interest rates rather than the money supply.

Q: That’s not what it says in my textbook. It says the central bank fixes the money supply.

A: Yes I know. I’m afraid it’s a bit out of date. Don’t ask me why.

Q: So if the central bank determines the interest rate, why don’t they ensure the interest rate is low enough to encourage firms to buy more capital goods?

A: That is what they would like to do. There are two problems. First, it may take some time for the monetary authorities to work out what is happening, and what the right interest rate is. (I could talk about real and nominal rates here, but let’s leave that for another day.) Second, nominal interest rates cannot go below zero, and maybe we would need negative interest rates to persuade firms to raise investment enough.

Q: My textbook also says that the classical model assumes interest rates adjust so S=I, by which I assume they mean S=DK. Does that mean the classical model is wrong?

A: Only if you think it applies at all times, and that there is no other reason why output cannot fall. However if we assume that the monetary authorities eventually are able to chose the right interest rate, then the classical model is fine when thinking about economies over a long enough time horizon.

Q: This all seems like common sense. I feel a bit stupid not to have understood this before.

A: Don’t worry, you are not alone.

Downgrading France

2012-01-14T09:31:00.000-08:00

One of the problems with the rating agencies’ assessments of the debt of major country governments is that they are too newsworthy. As a result, they appear to be much more important than they actually are. Jonathan Portes, before he started his own blog, had a healthily unbalanced assessment of their competence here.

Having said this, Stephanie Flanders (and subsequently Paul Krugman) is absolutely right to focus on something interesting in S&P’s justification for removing AAA from France and downgrading other Eurozone economies. To quote from S&P:

We also believe that the [9^th Dec] agreement is predicated on only a partial recognition

of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the EMU's core and the so-called "periphery". As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers' rising concerns about job security and disposable incomes, eroding national tax revenues.

It is good that the competitiveness issue that I discussed here is now considered as serious a problem as any fiscal profligacy. It is also good that the possibility that fiscal austerity could go too far is being raised. Until recently, the general view seemed to be: the more austerity the better.

However, there is a danger of inconsistency in all this. Let us focus on the competitiveness issue. To correct this problem, we need inflation in uncompetitive Eurozone countries to be below German inflation. To achieve this, we almost certainly need a period in which domestic demand in those countries is weak relative to Germany. That has already happened to a considerable extent. The key question, which I raised here, is whether what has been done already is enough, or whether the gap – in simplistic terms – between non-German and German unemployment needs to be greater still. If inflation forecasts are to be believed, competitiveness correction appears to be painfully slow, reflecting perhaps the difficulty in reducing inflation outside Germany when it is already very low.

Of course it would be great if governments outside Germany could take measures that helped competitiveness without harming growth, but the group of such measures may be an empty set. It probably is the case that some measures may have more of an immediate impact on costs than others, and so if policy could focus more on the competitiveness problem that might help. But the real issue here is Germany.

It is the outlook for Germany that makes everything so difficult. The OECD’s forecast is that German output will be below the level that will stabilise inflation over the next two years. This keeps German inflation low, making it that much harder for other countries to regain competitiveness. The Euro area desperately needs a much more rapid expansion in Germany, so that German inflation rises well above 2%. If the forecasts that this will not happen are correct, there is one policy instrument that is available that could turn this around, and that is fiscal expansion in Germany. (Yes, some more from the ECB would help too, but it is the relative position of Germany within the Eurozone that is key.) What S&P and others should be saying is: we need a large, quick but temporary increase in public spending in Germany to save the Euro.

Ideology and Demand Denial

2012-01-13T14:24:00.000-08:00

Thanks to Chris Dillow and then others, my post Mistakes and Ideology in Macroeconomics was widely read and commented on. As Chris pointed out, it is possible to think in terms of mechanisms or complete models. My post was about one mechanism, consumption smoothing, which the texts I was looking at appeared to ignore. Many responses were along the lines of ‘what the authors of these texts had in mind is a model of this type, and in this type of model fiscal policy will be ineffective’. I’m happy to pursue this, not because I would be presumptuous enough to imagine I know what the authors ‘really meant’, but because I think it strengthens the idea that antagonism towards fiscal policy in the current situation has ideological roots rather than a sound basis in macroeconomic theory.

The most widely suggested model is one where there is never any demand problem: we are always at ‘full employment’. Then, of course, increasing one component of demand will have no direct effect on output, and higher taxes will have some negative impact on supply. Expansionary fiscal policy would be quite inappropriate in these circumstances.

If that is the argument, then I would insist on asking just how it is that the economy is always at full employment. The standard response, which is that prices are flexible, is not enough when we hit a zero lower bound for interest rates. As a suggested in another post, the ‘self correction mechanism’ by which demand shocks never impact on output requires a combination of price flexibility and monetary policy. (Actually, price flexibility is not even necessary – if the monetary authorities effectively targeted the output gap, for example.) This mechanism fails when we hit a zero lower bound.

Now an argument that said that the current recession was the result of a large negative supply shock rather than a demand shock, and we hit the zero lower bound because central banks misunderstood this fact, makes perfect sense in theory – it is just a little difficult to square with the facts, as many have pointed out. But this is a contingent argument. What the debate over fiscal policy has revealed is an underlying generic antagonism towards Keynesian analysis.

There is an asymmetry here. Keynesian economists do not deny that productivity or other supply side shocks can often be important. On the other side there appears to be, among many at least, a belief that Keynesian economics is never relevant. What this amounts to is what Krugman and others call demand denial. Yet the basis in economic theory for demand denial appears very unclear. Say’s Law, or maybe some kind of quantity theory with fixed velocity, would do it – but these were really bad ideas that the profession dismissed many decades ago.

Demand denial seems both surprising (an individual firm facing a fall in demand will reduce output), and hardly something to feel passionate about. So demand denial genuinely puzzles me. Keynes had a number of thoughts on this, as the following from the General Theory shows (‘it’ in the first sentence is a theory that involves demand denial).

That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commanded it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority.

Now beautiful though this passage is, a good deal has changed since 1936. New Keynesian theory is a ‘consistent logical superstructure’, so there is no intellectual prestige involved in denying its relevance (except, perhaps, to fellow believers). Yet two sentences still ring true. The first is the idea that austerity is virtuous. Some of the popular discourse around fiscal policy has moral overtones, perhaps stemming from the idea that governments, like individuals, have to practice self control. Now while I think seeing economics as a morality play is generally unhelpful, in the case of fiscal policy there is a problem of deficit bias: governments over the last few decades have tended, on average, to spend too much or tax too little. (Some particular evidence, and a fairly comprehensive discussion of reasons for deficit bias, can be found here. For lots of data, go here, click on ‘subject: Real GDP Growth’ and select the historical debt database.) However deficit bias is a long term problem and a recession is not the time to start dealing with it.

The final sentence from Keynes also still rings true. One explanation for demand denial is that it has ideological roots. In the real world we have the problem of ensuring aggregate demand matches supply, and this requires state intervention – normally monetary policy. For those who want to argue that state intervention in the economy is generally a bad thing, it is embarrassing to acknowledge that there is one area where it is essential. But I get no joy in seeing ideology mess with economics, and so I would be more than happy to be convinced that there was another explanation for demand denial.

Correcting Eurozone Imbalances

2012-01-11T13:06:00.000-08:00

I have been thinking about the extent to which real exchange rate misalignment within the Eurozone (essentially most countries have lost competitiveness with Germany) requires austerity outside Germany. I have argued that a much tighter fiscal policy (austerity) outside Germany would have been a good idea before 2007 to prevent these imbalances occurring in the first place. However that does not necessarily imply it is required now, for two reasons. First, misalignment is eventually self-correcting, as less competitive countries sell less goods etc. Second, perceived debt risk which is driving up long term interest rates provides an additional deflationary force in many of these uncompetitive countries.

This question is essentially a forecasting issue, so I looked at the OECD Economic Outlook forecasts. The table below comes from there. It contains a bit of a puzzle. If you look at unemployment rates, you see just the kind of pattern you would expect if correction was underway (except perhaps for Italy). German unemployment is way below the Eurozone average, and the German average level in the decade before the recession, whereas the opposite is true for Ireland and Spain. The OECD’s calculation of the output gap tells the same relative story: everyone is below the non-inflationary level of output, but Germany by not that much, and Ireland and Spain by much more.

If we look at inflation, however, we get a much more depressing story. Take the GDP deflator (the price of domestically produced output) for example. Inflation in Ireland is less than 1% below Germany, and that is the most favourable comparison. The signs of real exchange rate correction are weak.

There are two possibilities here. One possibility is that these inflation forecasts are way too conservative. In particular, low unemployment in Germany will lead to more rapid inflation than is forecast here. The alternative story is that the inflation forecasts are broadly correct, and they illustrate both the difficulty in getting inflation down outside Germany when it is so close to zero, and the difficulty in getting inflation up in Germany when its economy remains depressed. In particular, if the output gap number is right, then it is hard to see German inflation rising much above 2%.

	Unemployment (%)				Output Gap	Ave Forecast Inflation % 2011-13
	1998-2007	2011	2012	2013	2011-13	Compensation	GDP	Consumer prices
Eurozone	8.6	10.1	10.4	10.1	-3.2%	2.1	1.3	1.8
Germany	8.8	5.7	5.7	5.4	-1.2%	2.4	1.1	1.8
Ireland	4.8	14.2	14.0	13.4	-7.1%	1.7	0.4	0.9
Spain	10.6	22.5	23.0	22.4	-5.7%	1.9	0.8	1.8
Italy	8.7	8.1	8.4	8.7	-2.3%	2.1	1.4	1.8
France	8.8	9.4	9.9	9.8	-4.2%	2.6	1.3	1.5

Mistakes and Ideology in Macroeconomics

2012-01-09T04:59:00.000-08:00

Imagine a Nobel Prize winner in physics, who in public debate makes elementary errors that would embarrass a good undergraduate. Now imagine other academic colleagues, from one of the best faculties in the world, making the same errors. It could not happen. However that is exactly what has happened in macro over the last few years.

Where is my evidence for such an outlandish claim? Well here is Nobel prize winner Robert Lucas

But, if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder -- the guys who work on the bridge -- then it's just a wash. It has no first-starter effect. There's no reason to expect any stimulation. And, in some sense, there's nothing to apply a multiplier to. (Laughs.) You apply a multiplier to the bridge builders, then you've got to apply the same multiplier with a minus sign to the people you taxed to build the bridge.

And here is John Cochrane, also a professor at Chicago, and someone who has made important academic contributions to macroeconomic thinking.

Before we spend a trillion dollars or so, it’s important to understand how it’s supposed to work. Spending supported by taxes pretty obviously won’t work: If the government taxes A by $1 and gives the money to B, B can spend $1 more. But A spends $1 less and we are not collectively any better off.

Both make the same simple error. If you spend X at time t to build a bridge, aggregate demand increases by X at time t. If you raise taxes by X at time t, consumers will smooth this effect over time, so their spending at time t will fall by much less than X. Put the two together and aggregate demand rises.

But surely very clever people cannot make simple errors of this kind? Perhaps there is some way to re-interpret such statements so that they make sense. They would make sense, for example, if the extra government spending was permanent. The only trouble is that both statements were made about a temporary fiscal stimulus package. Brad deLong tries very hard along these lines (see here for example), but just throws up inconsistencies.

I prefer to just note that if any undergraduate or graduate student in the UK wrote this in an exam, they would lose marks. The more interesting question for me is why the errors were made. Of course everyone is human, including the best economists. (And if they were not among the very best economists, I would not be talking about these errors in a blog.) You get to be a brilliant economist or physicist by having great ideas, not by never making mistakes. But I think it is still the case that we cannot imagine members of a physics department making such errors. What is different about macro?

I want to suggest two answers. The first is familiarity with models. I cannot imagine anyone who teaches New Keynesian economics, or who talked to people who teach New Keynesian economics, making this mistake. This is because, in these models, we do have to worry about aggregate demand. We focus on consumption smoothing, and Ricardian Equivalence, and teach it from the start. I often tell my first year undergraduate students that if they write anything like ‘Ricardian Equivalence says fiscal stimulus will never work’, they are in danger of failing.

Lack of familiarity does not necessarily imply believing something is wrong. In a separate piece, Cochrane writes

“New-Keynesian” thought is devoted to defending the importance of monetary policy, and incorporating specific frictions in the equilibrium tradition, not to rescuing the ancient view that fiscal stimulus is important and abandoning that tradition.

This is broadly true for New Keynesian theory when monetary policy is unconstrained (see Kirsanova, T, Leith, C and Wren-Lewis, S (2009), Monetary and Fiscal Policy Interaction: The current consensus assignment in the light of recent developments, Economic Journal, Vol 119) but not when interest rates are stuck at a lower bound. Cochrane is not saying New-Keynesian theory is wrong, but implies incorrectly that it suggests fiscal stimulus will not work.

Lack of familiarity with New Keynesian economics may be partly explained by the history of macroeconomic thought that I briefly noted in an earlier post. As New Keynesian theory is an ‘add-on’ to the basic Ramsey/RBC model, it is possible to teach macro without getting round to teaching New Keynesian theory. However, what many people find difficult to understand is how monetary policy (or at least monetary policy as seen by pretty much every central bank) could be regarded as an optional add-on in macroeconomics.

The second difference between physics and macro that could lead to more mistakes in the latter is ideology. When you are arguing out of ideological conviction, there is a danger that rhetoric will trump rigour. In the next paragraph Cochrane writes

These ideas changed because Keynesian economics was a failure in practice, and not just in theory. Keynes left Britain 30 years of miserable growth. Richard Nixon said, “We are all Keynesians now,” just as Keynesian policy led to the inflation and economic dislocation of the 1970s--unexpected by Keynesians but dramatically foretold by Milton Friedman’s 1968 AEA address. Keynes disdained investment, where we now all realize that saving and investment are vital to long-run growth. Keynes did not think at all about the incentives effects of taxes. He favored planning, and wrote before Hayek reminded us how modern economies cannot function without price signals. Fiscal stimulus advocates are hanging on to a last little timber from a sunken boat of ideas, ideas that everyone including they abandoned, and from hard experience. If we forget all that, we could repeat the economics of postwar Britain, of spend-and-inflate Latin America, and of bureaucratic, planned India.

Let’s not worry about where the idea that Keynes disdained investment comes from, or any of the other questionable statements here. This is just polemic: Keynes=fiscal expansion=planning=macroeconomic failure. It is guilt by association. What on earth does fiscal expansion have to do with planning? Well, they are both undertaken by the state.

I have argued elsewhere that the problem too many macroeconomists have with fiscal stimulus lies not in opposing schools of thought, or the validity of particular theories, or the size of particular parameters, but instead with the fact that it represents intervention by the state designed to improve the working of the market economy. They have an ideological problem with countercyclical fiscal policy. But the central bank is part of the state, and it intervenes to improve how the economy works, so this ideological view would also mean that you played down the role of monetary policy in macroeconomics. So ideology may also help explain a lack of familiarity with the models central banks use to think about monetary policy. In short, an ideological view that distorts economic thinking can lead to mistakes.

Executive Pay: acknowledging market failure

2012-01-08T09:26:00.000-08:00

David Cameron was on the BBC this morning talking about the excesses of executive pay. What I liked about what he said was his clear identification of the problem as market failure. We do not hear this phrase enough in public discourse – indeed the BBC in the linked report puts market failure in quotes! It was good to hear a Conservative Prime Minister saying it too. (Perhaps having a PPE degree helped!)

I remember naively saying after the credit crunch that at least it would put an end to the idea that markets always work, and that regulation was always unnecessary. We would instead, I hoped, have a more intelligent discussion that acknowledged market failures and focused on the best ways of dealing with them. That did not seem to happen. In part that is because the right wing think tanks that are paid to spin the ‘markets always know best/state intervention is always bad’ line carried on getting their funding. But what should have happened is that this line lost credibility because someone would immediately reply with the knock out ‘you mean like financial markets’. I’m not quite sure why this didn’t happen.

Whether the measures the government is due to announce will have any impact on executive pay is another matter. The Prime Minister talked about transparency, and shareholder power. I'm not sure strengthening either will have much impact. This is because it remains unclear exactly what the source of market failure is, and why it should have become so much more important in the last few decades. (Or perhaps the market failure was always there, and the other forces that used to restrain excessive executive pay have withered.) A key piece of evidence is that these trends have differed a lot among countries, as this wonderful database indicates. (Executive pay and the 0.1% share are not the same thing, but Atkinson, Anthony B., Thomas Piketty, and Emmanuel Saez. 2011. "Top Incomes in the Long Run of History." Journal of Economic Literature, 49(1): 3–71. suggest the former is a major cause of the recent increase in the latter.) Although this paper is full of ideas that could help explain the trends shown below, we are a long way from a comprehensive account.

Conspiracy within conspiracy in Turkey?

2012-01-06T07:37:00.000-08:00

We have all seen films where some large network of conspirators plots to overthrow the state. We have also seen films where some arm of the state manufactures evidence against some individuals. There is probably at least one where a journalist uncovers the plot, and then falls victim to the same fabrication. One is a conspiracy against the state, the other is a conspiracy by part of the state.

The Ergenekon conspiracy in Turkey has to be one of these two. So far hundreds have been arrested as part of this and associated plots, the latest being a former head of the army. Those arrested are not just army officers, but also journalists critical of the government, and academics. The analyst Gareth Jenkins suggests that “not only is the evidence ... deeply flawed, there are also increasing indications that much of it has been fabricated.” In more measured diplomatic language, the EU’s Turkey 2011 Progress Report says (p7)

concerns remain over the handling of investigations, judicial proceedings and the application of criminal procedures putting at risk the rights of the defence. The lack of any authoritative source of information on all these issues of wide public interest from either the prosecution offices or the courts raises similar concerns. All of this raised concerns in the public about the legitimacy of the cases.

Uncivil debate? Harsh words over fiscal policy

2012-01-05T15:33:00.000-08:00

Over the last two years there has been a debate through blogs and elsewhere between those who support fiscal stimulus and those who do not. Take Brad deLong’s analysis of this note by John Cochrane for example. To say the debate has been intemperate would be an understatement. People have complained that one or both sides have been too dismissive of the other (see, for example, Tyler Cowan here.)

Now I’m the last person to argue that economists are never guilty of unnecessary and off putting aggression and point scoring. However it is quite easy to understand what has happened here. For those in certain freshwater departments like Chicago, for example, the idea of an effective fiscal stimulus was something they had thought had died with the rational expectations and New Classical revolutions of the 1970s. It was therefore something of a shock to see it being resurrected, and it is understandable that they might dismiss it as invoking long discredited ‘fairy tales’. It looked as if 30 years of progress in the discipline was being ignored. It is clear from Cochrane’s piece that he is not dismissing New Keynesian theory – he just thinks New Keynesian theory is all about monetary policy.

On the other hand those advocating the effectiveness of fiscal policy knew perfectly well that while New Keynesian analysis certainly did emphasise monetary policy as the stabilisation tool in normal times, in a liquidity trap (or a currency union for that matter) it also implied that certain types of fiscal policy would work as well. In these circumstances, you do not react kindly to having your analysis dismissed as out of date and a fairy tale. (In fact you find it shocking and slightly unbelievable, in my own case.)

While this may help explain why the debate has been bitter, it does not excuse both sides. Those freshwater economists who suggested that fiscal stimulus at a zero bound was a fairy tale that was not supported by modern macroeconomic analysis were simply wrong. Why such innovative and clever people should make this mistake is interesting, and I’ll return to this later, but wrong they clearly were. If the likes of Krugman and DeLong are guilty of anything, it is that they tried too hard to make sense of what the other side was saying. Perhaps they should have simply said "go away and read the literature".

Uncertain times in Hungary

2012-01-05T15:08:00.000-08:00

Changes to the constitution in Hungary have provoked protests and critical comment. There have also been concerns about media control. I first became aware of the problem over a year ago, when the Hungarian government effectively abolished the newly established Hungarian Fiscal Council.

As I suggested in a recent post, fiscal councils are a good thing. The webpage I set up for easy links and basic information on the various councils throughout the world was inspired by attending the first ever public conference of virtually all the fiscal councils, organised by George Kopits, then head of the Hungarian Fiscal Council.

The story of the Hungarian Fiscal Council is told in Kopits, G (2011) “International Fiscal Institutions: Developing Good Practices,” OECD Journal on Budgeting, November (an early version of which can be found here.) It was doing its job effectively, which is to ask important but potentially tricky questions about the government’s fiscal plans. The whole idea of a fiscal council is that it should make life difficult for a government that gives insufficient attention to the longer term consequences of its overall fiscal plans. The Hungarian Fiscal Council did not go out of its way to pick fights with the government: it just did its job. Effective abolition came despite widespread protest by the heads of other fiscal councils and academics. Unfortunately that decision now seems part of a trend.

Some good news for the New Year! Fed to publish interest rate forecasts.

2012-01-04T08:27:00.000-08:00

The US Federal Reserve has announced that it will in future publish its own forecasts for interest rates. (The FT report is here.) Among central banks, the pioneering Reserve Bank of New Zealand has published such forecasts for many years, and they were recently joined by the central banks of Sweden and Norway. However most central banks do not.

Why is this good news? As any good undergraduate economics student will know, many important economic decisions depend not only on today’s interest rate, but also interest rates in the future. Indeed longer term interest rates are in effect a forecast of future short term interest rates. So when a central bank changes short term interest rates, they are only giving the public a part of the information they need. If interest rates are changed, everyone wants to know how long this change will last.

Central banks often present forecasts for some key macroeconomic variables, such as inflation. They nearly all use forecasts in arriving at their interest rate decisions. These forecasts, by necessity, will contain some assumption about the path of future interest rates. It therefore seems sensible for the central bank to let people know what assumptions it is making in deriving its forecasts. However most central banks have been very reluctant to do this. There are a number of rather silly arguments that have been used to justify this reluctance, but the one that keeps being mentioned is that the public will mistake conditional forecasts for policy commitments. I always thought this insulted the public’s intelligence.

On the other side, there is a compelling argument for publishing these forecasts. It has the potential to enhance the credibility of central banks. In technical terms this is to do with commitment under time inconsistency. It can perhaps best be explained by a topical example. A number of economists, and particularly the great Michael Woodford, have suggested that one way to reduce the impact of the liquidity trap (the fact that short term interest rates cannot go below zero) is for central banks to announce that once the recovery is underway, they will allow inflation to rise above target for some limited period. Let us call this the ‘excess future inflation policy’. This will mean that interest rates would stay low for longer. The excess inflation policy has an obvious future cost, but the benefit is that it keeps today's long term interest rates lower (because expected future short rates are lower), and it raises expectations about future inflation, which in turn reduces current short term real interest rates. As a result, the recovery should come sooner. (A variant on this idea is to have a nominal income target extrapolated from pre-recession levels: see here for example.)

Now whether this is a good idea or not, it suffers from a serious implementation problem. Let us suppose it is announced, and that it works. The recovery is quicker as a result. Inflation then begins to rise above target. Now it is tempting for the central bank to reason as follows. The benefits of the excess future inflation policy have been achieved, but the costs are still to come (i.e. excess inflation). Why not change our minds, and say we will not after all allow inflation above target. We get the best of both worlds. Let us call this the temptation to renege on past commitments. Unfortunately smart agents would anticipate that the central bank will give in to the temptation, and so will not believe the excess future inflation policy will ever be implemented. If it is not believed, the benefits will not happen. So to work, the central bank has to have enough commitment credibility so that the public are sure it will not succumb to the temptation to renege.

If this is too technical, think of a parent who offers sweets to induce good behaviour from a child. Even if the child does behave well, the parent does not give the reward, because sweets are bad for the child. If that happened, the child will no longer believe the parent’s promises. The parent will have lost an important tool to encourage good behaviour. The parent would be better off in the long run keeping their credibility for commitment by giving the child the reward.

But how does a central bank get a reputation for commitment? Publishing interest rate forecasts could be a very useful tool. This is because a central bank that was avoiding the temptation to renege would follow its own interest rate predictions if no new information arose. More generally, by checking new information against how interest rate decisions changed compared to earlier forecasts, we could try and judge whether the bank was avoided the temptation to renege. But if the central bank does not publish its interest rate forecast, we have no idea whether it has changed its mind or not.

It is partly for this reason that I have argued (see here, para 105 ) that the Bank of England should publish its own interest rate projections, at least when it makes interest rate changes. (At present its forecast is based on market expectations, which may or may not be what the Bank itself thinks it will do.) Up until now it has brushed such ideas aside. Now that the Fed will be publishing such forecasts, it will be interesting to see if the Bank decides, or is persuaded, to do the same.

Keynesian Economics, Price Rigidity and Demand Denial

2012-01-03T08:40:00.000-08:00

Something prompted from revising my second year undergrad lecture notes, and so mainly for economists.

In mainstream macro today, Keynesian economics is synonymous with the macroeconomics of price rigidity. Most of the time I have no problem with that. All the evidence suggests there is significant inertia in aggregate prices, and it is very difficult to tell realistic stories about how inflation moves without taking this into account. Price inertia and imperfect competition are probably essential in understanding why output tends to follow aggregate demand in the short term.

My problem with identifying Keynesian economics with the macroeconomics of price rigidity is that it allows those who would like to ignore Keynesian theory with too easy an opt out. They can argue that, despite appearances to the contrary, prices are in fact pretty flexible. They then conclude that Keynesian economics is irrelevant. Unfortunately far too many academic macroeconomists appear to implicitly or explicitly take this view.

Is it logically the case that if prices are flexible Keynesian economics can always be ignored? The answer is simply no. Price flexibility alone does not ensure demand always moves quickly towards supply: it is the combination of price flexibility and monetary policy that does this. And when something goes wrong with monetary policy, price flexibility alone may not work.

We are living through exactly such a situation. It is not just the zero lower bound for nominal interest rates that is important here. It is also the fact that monetary policy has an inflation target rather than a price level target. After a large negative demand shock, demand can only be restored in the short term (for a given fiscal stance) by a large reduction in real interest rates. Real interest rates are nominal rates minus expected inflation. The zero lower bound stops nominal rates falling enough, and inflation targeting stops inflation expectations rising enough. No amount of price flexibility can change this. (For a more detailed discussion see here.)

Students often think that price flexibility must imply that output is supply determined, because if any workers were unemployed, nominal wages would continue falling until they were employed. But just imagine an economy made up of monopolistic competitors where production was linear in labour. In that economy firms would ‘determine’ a constant real wage through their mark-up, and no amount of nominal wage cutting would reduce real wages or increase employment.

Demand denial is the belief that we can always ignore aggregate demand when analysing short term movements in output and employment. It sometimes seems to be based on a view that price flexibility alone always ensures demand is sufficient for supply. It does not.