Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 2 November 2014

Fighting the last war

It is often said that generals fight the last war that they have won, even when those tactics are no longer appropriate to the war they are fighting today. The same point has been made about macroeconomic policy: policymakers cannot avoid thinking about the dangers of rising inflation, and in doing so they handicap efforts to fully recover from the Great Recession.

Another military idea is the benefit of using overwhelming force. In the case of inflation we have two legacies of the last war that are designed to prevent inflation reaching the heights of the late 1970s: inflation targets and in many countries independent central banks. Do we need both, or is just one sufficient? I think this question is relevant to the debate over helicopter money (financing deficits by printing money rather than selling debt).

Why are helicopter drops taboo in policy circles? Why is it illegal in the Eurozone? The answer is a fear that if you allow governments access to the printing presses, high inflation will surely follow at some point. Many of those who worry about helicopter money are fairly relaxed about Quantitative Easing (QE), which involves much more money creation than would be involved in a helicopter drop. (Of course some are not relaxed, and (still) think that QE is about to produce rapid inflation - I will ignore that group here.) The key reason they are more relaxed is that central banks are in control of QE, whereas governments would initiate money financing of deficits. [1]

Take the recent interchange between Tony Yates and myself on helicopter money (TY, SWL, TY), and consider the following hypothetical. The economy needs a fiscal stimulus, but for some irrational reason the government will not allow debt to rise. It therefore instructs the central bank to create money to fund a fiscal stimulus (i.e. a helicopter drop). However it also tells the central bank that this action should not compromise its inflation target (which is currently being undershot), and the central bank agrees that the helicopter drop will not compromise its ability to stop inflation exceeding the target, but instead it will help inflation rise to meet that target.

Tony’s problem with this is in the instruction. In these particular circumstances the actions are not a problem, and will do some good (given the government’s irrational fear of debt). However we have crossed a barrier - the government is telling the central bank what to so. The fact that in my hypothetical example the inflation target remains is not enough: he writes “the inflation target in the UK is a very fragile thing”. He goes on: “So I don’t view the inflation target as a cast iron protection against helicopter drops undermining monetary and fiscal policy.  There’s a good reason why monetary financing is outlawed by the Treaty of Rome.  Allowing yourself tightly regulated helicopter drops is not time-consistent.  Once government gets a taste for it, how could it resist not helping itself to more?”

I think it is possible to take two quite different views to Tony on this. The first is that, in most OECD economies today where macroeconomic understanding is better and information more available, inflation targets are more than sufficient to prevent us experiencing the inflation rates of the 1970s again. The hypothetical to think about here is a government that has direct control over the inflation target, but asks the central bank to vary interest rates to achieve that target. Of course we do need to imagine this - it is the UK set-up. Would such a government happily raise the inflation target in order to finance a bit more spending? Such a move would be highly unpopular, because most people think higher inflation means lower real wages. In the UK no political party has even hinted that raising the inflation target might be a good idea, despite obvious fiscal incentives to do so. Suppose a government pretended repeated money creation would not breach the inflation target, even when the central bank advised otherwise. Would that government survive when inflation took off?

A second view is that we have the story of the 1960s and 1970s all wrong. We did not get high inflation in advanced economies because governments wanted to monetise their own profligacy. There were, after all, independent central banks in the US and Germany. Inflation occurred because of the combination of a number of specific factors: trade union pressure in the face of shocks that tended to reduce real wages, underestimation of the natural rate (and a poor understanding of how monetary policy should work), and placing too great a priority on achieving full employment. The latter might have been a legacy of the 1930s: policymakers were also fighting the last war, except in the 1970s the last war was about unemployment, not inflation.

I think both views are probably correct. As a result, I’m much more relaxed about money financing of deficits in the current situation. However in one crucial respect I do agree with those who say we have no need for helicopter money today, because there is no reason for governments to have a fear of rising debt if their central bank can undertake QE. However irrational fear of rising debt in a recession has similar characteristics to fighting the last war: deficit bias is a problem, but a recession is not the time to worry about it. I think this is why I am not persuaded by this article by Ken Rogoff: yes, in the grand scheme of things we should worry about inflation and debt, but right now we are worrying about them too much and therefore failing to deal with more pressing concerns.

[1] Some people imagine the central bank could itself initiate a helicopter drop, independently of government. That is simply not possible given current institutional arrangements, but as I noted in my earlier post (point 7) I think it is interesting to explore institutional changes that give the central bank some role in countercyclical fiscal policy. A simpler confusion is that helicopter money involves giving money to everyone, while tax cuts just go to taxpayers. Helicopter money is really about financing a fiscal stimulus of any kind using money: the form of that fiscal stimulus is a separate matter.


  1. Is it profligacy to spend money to fight unemployment? I'd doubt that. The neo-classical school indeed completely misinterpreted the 60s and 70s. Debt per GDP fell in the USA and the UK and kept steady in Germany. Government profligacy in these years is a myth.
    Time-consistency is a lame argument. Doing it once has the danger of doing it again? It's like saying never doing it has the danger of doing it once. Usually, actions are not taken without a reason. Helicopter money is always a possibility, yet it never happens, somehow the government is able to restrain itself - maybe because the constraint is not the "if you do it once, you'll do it again" hypothesis, but money illusion and political power.

  2. I have one small-ish quibble. Professor Wren-Lewis states that "There were, after all, independent central banks in the US and Germany." While this is technically correct, it wasn't true in practice for the US during the 1970's when inflation took off. Recorded phone conversations provide strong evidence that President Nixon exerted influence over Fed chairman Arthur Burns. Take this quote for example:

    "I know there’s the myth of the autonomous Fed... [short laugh] and when you
    go up for confirmation some Senator may ask you about your friendship with
    the President. Appearances are going to be important, so you can call
    Ehrlichman to get messages to me, and he’ll call you."
    —Richard Nixon to Arthur Burns

    As for German inflation, it was only 7% at the highest in '73.

  3. I would like to get into the policy side:
    In my opinion you wrongly assume that politicians understand how modern banking and monetary policy work. While one does not have to agree with the positive money platform to go to something like a Chicago plan, their finding that most MPs do not understand money is a real problem ( or how the balance of payments of an economy works.

    I think the fear of the people in governments who have an understanding of helicopter money is that if it has no negative consequence (i.e. rapidly rising inflation) concerning inflation (which is in my opinion quite likely given the demand constraints) this will lead to a public which demands more of this policy. In addition I do think that they fear that this policy (and the surrounding debate) could lead to public which understands modern banking and will demand for something like the Chicago plan which is not in the interest of e.g. banks.

    Btw.: Regarding (class-)war:
    I would like to recommend the following article to you which is one of the best explanations of the social and cultural background of German inflation phobia and why it was programmed into the German psyche. It is a hundred year old class war.

  4. I would return to the example I cited some months ago given by Shiller and Akerlof: research shows most people are happier with a 2% pay rise with CPI at 2% compared to a 0% rise with CPI at 0% - they think their boss is punishing them by not giving out a rise of any sort. So why not a 4% rise at 4% CPI?

    Secondly, OPEC I and II cannot recur in the current global energy market and with current energy technologies.

    Third, the Japanese economy also came through the 1970s very well indeed.

  5. Pace Rogoff, worrying about inflation too much and hurting growth makes the budget picture worse than it would have been.

    I think in the U.S. at least it was about the economy digesting the baby boom and large increase in the number of workers. The Central Bank did the best it could to accommodate the new influx of workers which meant a rise in inflation.

    In my view the worry about the public getting a taste for helicopter drops is pure demagoguery. It's like the public's taste for government spending or tax cuts. For the past 40 years it's all been the other way. By the way it's elite opinion which drives the debate, not what the public wants.

    The inflation of the 1970s is like Greece's irresponisbility in the European Feedback Cycle of Doom: a convenient stick with which to beat your debate opponents. They're both misleading.

  6. So many politicians and voters think of international economics and national macroeconomics from a microeconomic point of view. Balancing one's checkbook, making only NPV-positive investments, moral reasons, fear of debt, misunderstanding the function and nature of money, and who controls it and how.

    Politicians must produce stuff that their voters, or the so-called "very serious" people want. The advisors and officials have to mirror the attitudes of the politicians. This guarantees a mess.

    I use a three-class categorization: 1) those who expect Germany / US / EM to eventually pull the laggards with them 2) those who want to be like Germany, and perhaps even think of themselves or their companies as Germans and 3) pure opportunists.

  7. "Inflation occurred because of the combination of a number of specific factors: trade union pressure in the face of shocks that tended to reduce real wages, underestimation of the natural rate (and a poor understanding of how monetary policy should work),"

    Given the economy has crashed and burned in a never-ending slump, it's safe to say we have no better understanding of monetary policy than economists of the 1970s.

    Monetarism and inflation-targeting ground the economy down to nothing. This didn't happen after the 2008 meltdown, it happened by the time of the dot com bust when the Fed was forced to lower interest rates to 1% in the mid 2000s. The economy at this point was already dead.

    The Great Moderation is a joke. Imagine Wile E Coyote running off a cliff. The part before he goes over the cliff is called the "Great Moderation". The part where he is suspended in mid air before falling to his doom is ignored by the monetarists while they pat themselves on the back for doing such a great job.

    It's simple enough to figure out why monetarism ground the economy into dust: using high interest rates to bust inflation meant people, businesses and governments paid a lot more real interest on their debts. This took money out of the real economy and put it in the offshore bank accounts of the super-rich. After the period of opportunistic disinflation (1979-1995) and risk-free high returns was over, the Masters of the Universe created asset-bubble Ponzi schemes to get the same rate of return.

    The Great Moderation, ironically enough, brought back boom-to-bust economic cycles. Since we have learned absolutely nothing, that means another economic crisis is around the corner if we ever get out of our present slump.

    Milton Friedman is dead. Time to drive a steak in his heart before his flaky failed ideology destroys civilization.

    1. "The first is that, in most OECD economies today where macroeconomic understanding is better and information more available, inflation targets are more than sufficient to prevent us experiencing the inflation rates of the 1970s again."

      That is preposterous. We have suffered the biggest financial crisis since the Great Depression (mostly because the profession forgot or ignored the most BASIC historical lessons learned since the interwar period) , and you (typical of most of the profession - with very few exceptions) are trying to tell us that we have a better understanding of monetary policy?

      The hubris just does not seem to cease to amaze.

    2. Sorry the above was a reply to the argument in the blogpost, not the commentators reply immediately above.

    3. "The first is that, in most OECD economies today where macroeconomic understanding is better and information more available, inflation targets are more than sufficient to prevent us experiencing the inflation rates of the 1970s again."

      When mainstream economists say things like that, that is a sure sign there are going to be some big problems very soon.

  8. "I think this is why I am not persuaded by this article by Ken Rogoff"

    If a scientist faked experiment results or an academic plagiarized someone else's work, their career would be destroyed. But if an economist is caught red-handed cooking statistics to support an agenda, it doesn't even register as a wrongdoing from other economists.

    Economics didn't fail to launch as a science because of incompetence. It's polluted with quacks and charlatans because it's in the interest of the 1% to keep it from becoming a science. Clearly economic resources are put to their most effective use when inequality is low. But none of the flaky economic models used by mainstream economists take this fundamental principle into consideration.

    What Keynes said 80 years ago is no less true today:

    "But to-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand."

    1. 1-Empirical sciences work through the progressive exclusion of models through a process of falsification... And economists do produce falsifiable models, which they do test -- even if you don't like what they have to say.

      2- Some economists either are very stupid or very well paid. They all studied and all know what the obvious conclusion is when their predictions fail to hold: something is wrong with their model.

      3-There actually are models which takes into account inequalities and some of them are meant to study the potential costs associated to it - e.g., there could be negative externalities associated to it.

      4-Instead of criticizing economists about what you don't seem to know, do your homework and make sure you're not pointing out problems that already have been or are being addressed.

    2. What exactly have neoclassical economists (including New Keynesians) actually proven? There are so many books critical of their models and assumptions, including those written by Nobel laureate Joseph Stiglitz, I would be surprised if they got anything right over the past 35 years.

    3. Clearly economic resources are put to their most effective use when inequality is low. But none of the flaky economic models used by mainstream economists take this fundamental principle into consideration.

      I'm not sure this point is that clear at all, there are an awful lot of ways to measure and define inequality and we also have to ask if we're talking income or wealth inequality. The data available is very limited because ultimately we only have a few countries we can look at for comparisons and there are plenty of other factors that could further confuse things. I'm very much against high levels of inequality and I'm glad that there's more evidence both demonstrating it's existence and it's negative effect coming to the fore but I think it's far from being clear cut.

  9. You don't need to let the debt rise...if you taxed the rich.... and/or have a taxcode that encouraged investment in socially beneficial ways

  10. Wren-Lewis and Yates worry about how to print without politicians using the printing press in an irresponsible manner. A simple solution to that problem was set out by Richard Werner, Positive Money and the New Economics Foundation in 2010. See:

    The solution is to have a committee, much like the BoE MPC, composed of independent economists, not politicians, which takes the decision as to how much to print and spend.

    It would be possible under the latter arrangement to maintain a distinction between monetary and fiscal policy. In fact the above authors advocate abolishing the distinction: i.e. they advocate having the state simply create new money and spend it (and/or cut taxes) when stimulus is needed. In support of the latter arrangement, the authors pour a lot of cold water on interest rate adjustments. I agree with them, though I wouldn’t totally rule out interest rate adjustments as a supplementary tool perhaps just to be used in emergencies.

    1. I should have mentioned that the above committee would decide on the SIZE of stimulus, but not its NATURE. That is the committee would say “£Xbn of stimulus is needed”, but politicians and the electorate would decide on whether that stimulus took the form of extra public or private spending (i.e. tax cuts).

    2. This may be a stupid suggestion but then I'm happy to learn what is wrong with it: why can't the existing central banks be given the additional task of doing helicopter drops when there is good economic reason to do so?

    3. If you are asking why couldn’t central banks do the job of the above proposed “Werner” committee, they could. But in giving CBs that job, the terms of reference of the CB changes significantly: that is, the CB would be taking a decision which is currently classified as fiscal. So the CB would no longer be a CB as the phrase is currently understood. All a bit semantic…

      Put another way, whether a Werner committee is part of the CB, or part of the Treasury or wholly independent of both doesn’t matter: the important point is its terms of reference and powers.

    4. Thanks. My question was coming from reading the recent pro helicopter money piece by Bluth and Lonegan,

      Seems they don't make the fiscal/monetary distinction the way you do. Here are two quotes, one on their problem analysis and one on their proposal.

      "In theory, governments can boost spending in two ways: through fiscal policies (such as lowering taxes or increasing government spending) or through monetary policies (such as reducing interest rates or increasing the money supply). But over the past few decades, policymakers in many countries have come to rely almost exclusively on the latter. The shift has occurred for a number of reasons. Particularly in the United States, partisan divides over fiscal policy have grown too wide to bridge, as the left and the right have waged bitter fights over whether to increase government spending or cut tax rates. More generally, tax rebates and stimulus packages tend to face greater political hurdles than monetary policy shifts. Presidents and prime ministers need approval from their legislatures to pass a budget; that takes time, and the resulting tax breaks and government investments often benefit powerful constituencies rather than the economy as a whole. Many central banks, by contrast, are politically independent and can cut interest rates with a single conference call. Moreover, there is simply no real consensus about how to use taxes or spending to efficiently stimulate the economy."

      "Governments must do better. Rather than trying to spur private-sector spending through asset purchases or interest-rate changes, central banks, such as the Fed, should hand consumers cash directly. In practice, this policy could take the form of giving central banks the ability to hand their countries’ tax-paying households a certain amount of money. The government could distribute cash equally to all households or, even better, aim for the bottom 80 percent of households in terms of income. Targeting those who earn the least would have two primary benefits. For one thing, lower-income households are more prone to consume, so they would provide a greater boost to spending. For another, the policy would offset rising income inequality. Such an approach would represent the first significant innovation in monetary policy since the inception of central banking, yet it would not be a radical departure from the status quo. Most citizens already trust their central banks to manipulate interest rates. And rate changes are just as redistributive as cash transfers. When interest rates go down, for example, those borrowing at adjustable rates end up benefiting, whereas those who save -- and thus depend more on interest income -- lose out."

    5. "Seems they don't make the fiscal/monetary distinction the way you do."
      I take that back, misread what you wrote. Anyway, the semantics of what is and isn't part of the CB definition seems not so important. If a separate institution was tasked with the helicopter drop would that not introduce the possibility for conflict between it and the CB? If so then it may be better to task CB with both jobs.

    6. Anon,

      Thanks for that Blyth / Lonergan quote. It raises basic and difficult questions about how a Werner committee should work.
      B&L are obviously right to say that “partisan divides” are so intractable in the US that it may be a waste of time having a Werner committee tell Congress to implement $X of stimulus: they’ll just spend two years quarrelling over how to do the implementation. To that extent B&L are right to suggest that the central bank should do the implementation. Possibly other countries would not have that problem.

      But the trouble with B&L’s solution to the “Congress” problem is that the CB would then be taking a POLITICAL decision: i.e. deciding to implement stimulus via tax cuts rather than via increased public spending. And Werner, Positive Money, etc are righly keen to avoid CBs intruding in that way.

      Still, if politicians were happy for the CB to do the latter, that would be OK: democratically elected politicians have the right to delegate whatever decisions they want to whoever they want. That would amount to saying, “In the event that stimulus is needed, the CB will just get on with it, until such time as politicians have stopped quarrelling and take a decision on how to adjust whatever the CB has done.”

    7. I see the worry with giving the CB discretion to make political calls. However I think we could block much of that problem by giving CB (or separate instititution) the power to do helicopter drops when they see economic reasons for private-consumption stimulus *but* politics should in advance lock the practical details and distributive profile of the drop e.g. it should always take the form of equal cash amounts to the bottom 80% of pop. That constrains the power of the CB in the matter to only decide when and how much to pull a feature locked stimulus lever, so to say. They can't willy nilly decide to instead give cash to the top 20%, instead modify interests rates, and so on. They either pull the lever some or they don't. The locked features must be justified in advance of course. But given the cumulative evidence that economic inequality is pervasive and likely harmful I think something like the distributive profile B&L suggest makes sense to lock in.

  11. Rediscovering Abba Lerner's 1943 "Functional Finance..." The state of macro is good:)

  12. As a scientist, not an economist, I come to a very different viewpoint. In the developed world many (most) people live far from Thermodynamic equilibrium, which is a sustenance level existence. Therefor most production is not for needs (food, basic shelter, ...) but wants. The economic system then operates far from a true equilibrium, but in what economists consider an equilibrium, that is where people will choose to work at nearly full employment to buy the production of other workers for mostly wants and not needs. In aggregate people could choose a very different level of production and consumption (as is evident throughout the world in the vastly different levels of production and consumption, think the stereotypical "island culture" vs. the "N European culture"). The macro economic model used by Wren-Lewis and many others requires there be no change in the aggregate demand of humans, i.e. people will always choose to produce and consume at the same rate if the "cost" of money is "natural". This is completely wacko! Housing in the US is a classic example of the fallacy of this thinking. Houses in the US went from roughly 500 sq ft/person around 1970 to 1000 sq ft/person around 2013 and cost/sq ft in constant dollars was pretty flat. But people could easily change their minds and decide that 500 sq ft/person is plenty, or that cooking at home is better and more fun than eating out, or a million other things, and decide to save. And this is the classic Keynes paradox of thrift, or the Kalecki profits equation, in clear view. The idea that interest rates are the primary driver of the economy is clearly only correct in a world where demand for production (increasingly for wants and not needs) is constant. The system is inherently unstable and becomes increasingly unstable as less real production effort is required to meet needs and not wants. We can call this Secular Stagnation or anything else, but it seems like economists, like Wren-Lewis, are operating under a fundamentally flawed view of the world (where demand for production is constant at the "correct" price).

    1. There is this widespread view that people choose to work this much, but actually people do not have a choice.

      in Germany for example 60% of people wanted shorter working times even at the expense of income while under 10% wanted longer - and those were overwhelmingly those who did involuntary part time job.

      It is quite astonishing that millions of people can go to work an suffer from undesirable work-life balance, year after year, decade after decade.

      And why this is, is in my view quite simple: people that have power, like corporate CEOs have wastly different views from general population what the working times should be.


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