Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 27 May 2015

UK monetary policy is too complacent

Economists at the Bank of England and members of the Monetary Policy Committee spend a huge amount of time poring over the details of our current macroeconomic position. There is a danger in all this. The danger is a version of not ‘seeing the wood for the trees’. By focusing in great detail about what you see as the most likely scenario for the UK economy, you begin to think that something similar is the only possible future, and therefore give too little weight to the risks that this scenario is seriously wrong. That is the only way I can explain to myself why the MPC have not yet cut interest rates below 0.5%

The Bank’s central projection is that current deflation is a temporary phenomenon. We all know about oil prices, but this projection also involves a view that core inflation will rise from its current level of 0.8%. Today’s low core inflation may have a lot to do with an appreciation of sterling, which should be temporary. In addition actual deflation means that real wages have begun to rise, which should provide a boost to consumption. This could be enough to offset the impact of any renewed austerity, the impact of sterling’s recent appreciation on the demand for UK produced goods, and any delays in investment caused by the possibility of the UK leaving the EU. I could be convinced that this is the most likely outcome, and that inflation will be back at 2% within two years.

But good policy is not about just focusing on the most likely outcome. It is also about allowing for risks. So step back from the trees and just look at the wood. The most basic thing we know about the UK economy is that output is now something like 15% below where it should be if pre-recession trends had continued. For the UK that pre-recession trend had been remarkably stable. There may be reasons why the last recession should be so different from all other pre-war recessions, but we all know the dangers of convincing ourselves that this time is different. So it is possible that the scope for additional expansion is large. This is real uncertainty, but it is also one sided uncertainty. No one is seriously suggesting the economy is running at 5% above trend, let alone 15%!

Of course we get a rather different picture if we look at employment or unemployment. That is because productivity has stalled since the recession. Again quite unprecedented, and somewhat unbelievable if we are thinking about technical progress - have firms collectively thought of no ways that their production processes could be improved since 2009? Productivity growth in other countries has not been great, but are UK firms (some of which are multinational) incapable of learning from the improvements that have been made by others? We have yet to find a convincing explanation for this ‘productivity puzzle’. There is a serious possibility that, due to falling real wages, firms have simply put off making labour productivity improvements for the moment, but such improvements would come quickly if demand picked up enough (and labour became scarce). Again the risks here seem one-sided.

So there are perfectly sensible reasons to believe that the negative output gap might be much larger than currently estimated. There is no offsetting reasons to believe the output gap is large and positive. If the negative output gap is much larger than currently estimated, the social losses being currently made are huge, even if we forget about the deflation dangers ahead.

One final point. Andy Haldane has published some Bank model simulations which suggest that cutting interest rates now would be optimal, assuming that the Bank’s central projection is correct. So even if we ignore everything above about one sided risks, there is a clear case for cutting rates now. [1]

In these circumstances, the obvious thing to do, as well as the cautious and prudent thing to do, is to cut rates now to cover for the possibility that the output gap is actually much larger than estimated and inflation will therefore not return to target as hoped. The worst that can happen if this is done is that rates might have to rise a little more rapidly than otherwise in the future, and inflation might slightly overshoot the 2% target. If it is not done, there is a non-trivial probability that in 3 years time we will all be asking why on earth the MPC were so complacent. 

[1] I’m not sure if this optimisation exercise takes account of the point made here by Brad DeLong, which is that the existence of the lower bound means that you want to skew policy to avoid hitting that lower bound in the future. This is a rather different asymmetry to the one I explore in this post, but it also points to cutting UK rates now.


25 comments:

  1. The argument against lower rates would be that it encourages private sector debt, which has costs in the future.

    The truly sensible suggestion (one that you have been making recently) is central bank money to finance government spending/tax cuts.

    We are never going to get off the zero lower bound without it. I discuss why here:

    http://www.notesonthenextbust.com/2015/05/bernanke-this-is-real-reason-that.html

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    1. "The truly sensible suggestion (one that you have been making recently) is central bank money to finance government spending/tax cuts.

      We are never going to get off the zero lower bound without it."

      Why would we never get off the zero bound if the central bank were, instead, to credit every resident (irrespective of age) with the same amount, increasing until core inflation reaches, say, 4%?
      This would happen to have some inequality reduction effect which would be welcome.

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    2. This is another sensible suggestion. I fear a little too radical to be passed; but only 'radical' when judged against the the conventional money paradigm, where savers are accorded prime status and the health of the economy a secondary concern.

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  2. You are assuming that the pre-recession economy was in a healthy position, and not the result of a credit bubble.
    Maybe the post-crash figures reveal a more accurate picture of the economic situation.
    How much of the current UK economy is just a cheap-money based bubble rather than productive economic activity?

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    1. So where is the evidence that the supply side of the economy in 2007 was being stretched by excess demand?

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    2. Agreed. Credit was just one way to keep demand up at the right level for the economy to run at capacity. But we do now need other ways.

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    3. The recession that followed is evidence that all was not well..

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    4. Things like an overheating property market and wage increases?

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    5. The growth was real, but so were the bad consequences of too much private sector debt. The adverse consequences include slow growth now and unaffordable housing.

      Future growth can not be funded with private sector debt filling the gap in demand caused by oversaving. We need another way. Which realistically has to be printing money.

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    6. Simon, could you please someday address/comment on the claim that "an overheating property market" are evidence of too loose montary policy? I see this claim frequently. As I see it property values are soaring in specific in major cities only. This is because people these days want to live in places like London, New York, Toronto, Sydney. The way to accomodate this increase in demand is to build more housing and greatly increase public transportation. The failure of governments to either invest themselves or to accomodate private sector investments is what is driving up the cost of housing in large cities. You can't fix everything with monetary policy.

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  3. Indeed, economists at the Bank of England and members of the Monetary Policy Committee should not spend a huge amount of time pouring (what? Coffee? Tea? Coca Cola?)over the details of our current macroeconomic position. There is a danger in all this. The danger is a version of not ‘seeing the wood for the trees’.

    Quite so. Let them read Simon Wren-Lewis's blog and do what he says.

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    1. Your snarky comment would have been much more effective, if you'd used the correct word. The BoE and MPC pore over the details, they don't pour over it.

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    2. Anonymous26 May 2015 at 10:16

      You don't read very much, do you? Others caught on faster. cf.

      Peter Coomber27 May 2015 at 00:53

      below.

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  4. Simon is ignoring the huge build up of debt in the economy. Why? Households are increasing their debt levels again without considering what the impact will be when rates rise. Savings levels are awful. There's relatively little room for cutting rates further, unless you were prepared to go into serious negative territory which I think unlikely. However reducing rates further could provide a (dangerous) psychological boost to indebted consumers who've given up on looking ahead. I would not like to be a home owner in London on a variable rate mortgage.

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    1. Continuing deflation would be far worse. Look at Sweden. They raised rates following exactly this kind of argument - and the economy suffered as a result. They now have negative rates. I agree it would be preferable to raise demand by having more investment, but we have to live with the government people elect.

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    2. It should be noted the people in the UK did not elect to give the Cameron government an absolute majority, otherwise the party would've gotten 50% + 1 vote or more, not less than 37%.

      The First-Past-the-Post voting system -- a barbarous relic among first world nations -- gives parties that have the largest bloc of votes a huge unearned advantage. Given parties divide the vote arbitrarily, (e.g., a left-wing party recently won a "majority" in Alberta, where an actual majority voted for conservative parties,) this produces arbitrary election results.

      Never been to Britain. But I imagine the English Channel must be very wide. Every developed country on the other side of it (dozens of them) reformed their voting systems to ensure democratic election results, most a century ago.

      BTW, if electoral reform is put to a vote it has to be done properly. Voters are basically divided three-ways on voting systems: First-Past-the-Post, Proportional Representation and Alternative Vote (which simply makes MPs earn their seats with a majority.) Therefore, the only democratic way to choose (ensure one system has the support of a majority of voters,) is to have two referendums, the second one a runoff vote. (All party leaders, for example, are elected with some kind of runoff vote. If the UK Conservative party used FPTP, David Davis would've won in 2005, not Cameron.)

      If the UK and Canada were real democracies neither of us would've had incompetent, extremist governments rammed down our throats. Imagine the freedom!

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  5. In my honest (layperson) opinion, from the economic data I've studied and the books I've read, I believe the 2% inflation target puts civilization at risk of collapse.

    Ever since the central banks put their boot on the throat of inflation, starting back in the early 1980s ("Volcker Shock"), we have experienced: worse and worse recessions; bigger and bigger economic catastrophes; higher and higher debt (private and public); and weaker and weaker economic growth, down to our present 7-year slump. (Which is actually a 14-year slump that began after the 2001 "dot com" meltdown. 2000s GDP growth was abysmal. The business cycle was all illusory prosperity founded on various forms of financial "innovation" fraud — investment bankers playing musical chairs with the global economy.)

    So if we are experiencing, as it would certainly appear, a 35-year downward trend — caused by various free-market reforms put in place over this time, including neoclassical monetary ideology in its various forms used by central bankers over this time — how exactly are things going to change if there is no change in policy direction? If economists keep saying the same economic policies will work some time in the future — or worse yet, claim our present miserable economic conditions are prosperity — what if that future never comes?

    The real problem is that if we experience another 2008 meltdown — or an even lessor catastrophe than a mass-market-manipulation scheme where financial wizards defraud taxpayers and investors out of trillions of dollars — the whole system could, quite possibly, collapse.

    With another meltdown, comes the need for more bailout money to "save the economy" (notice how the creation of the US Federal Reserve was not enough to stop the bank runs of the 1930s — so will post-2008 half-hearted watered-down regulations be enough to prevent a repeat?)

    There will be the need for more helicopter money (more drastic measures than previous courses of QE). Need for more stimulus spending. Another massive recession would be triggered (unless, of course, central banks target NGDP… ) Labor would be weakened further and with that comes more corporate downsizing and lower real incomes (income deflation of the bottom 80% makes high debt-burden levels worse; deleveraging, if it were to occur, would add deflationary pressures.) All of this, plus the cost of automatic stabilizers, would cause another round of skyrocketing government debt — already near or past crisis levels.

    Already many people are saying that capitalism has failed. So what kind of alternatives are out there to "capitalism"? As humanity discovered in the 1930s, fascism can be a popular choice. We're already seeing the "green shoots" of fascism in Europe: ultra-nationalist parties on the rise; traditional and non-traditional forms of racism getting more violent. Given the euro-zone is already in an impossible situation, the fallout from another meltdown could be earthshaking.

    One would hope that economists would take these kind of things into consideration as they measure the performance of their controversial and unscientific hypotheses put in practice over the past 35 years. But given the economists promoting these reforms believe there are no kinks in their designs, (despite all the metaphorical rockets that have spiraled to the ground), that's obviously not going to happen.

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  6. Consider this little extract from the article:
    "Again quite unprecedented, and somewhat unbelievable if we are thinking about technical progress - have firms collectively thought of no ways that their production processes could be improved since 2009?"

    That is a neat way to demonstrate how viewing economies as a bunch of aggregated statistics leads to confusion and ultimately bad policy recommendations. Measured in aggregate, the author could well be right about no growth in productivity. However, I know that some firms in some sectors have shown outstanding productivity growth and some other firms in other sectors have been going backwards. Add them together and maybe they cancel each other out (I haven't checked, largely because I don't believe there is any point in doing so.)

    What the author really needs to understand is why some do very well and some do very badly. Get to the bottom of that and perhaps better recommendations will come out the other end. You can't tell very much by looking at aggregated statistics.

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    1. I would completely disagree. Look at the graph below since 1959:
      http://www.tradingeconomics.com/united-kingdom/productivity

      Is there any technological reason that this should suddenly stop in 2008? The aggregate worked perfectly fine until then.

      Aggregation is fine. The fact that it stopped abruptly in 2008 suggests that we need to look at the money related reasons why this stopped.

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    2. Anonymous at 20:16. You have totally missed the point of SWL's article. In addition your grasp of how statistics work and their purpose is confused. The point is that total UK productivity has fallen when compared to 2008, when both have measured using the same methodology. Within the data used as the basis for these data-sets were compiled different values is highly probable and in this instance, some will have been above the mean average and some below. Finally, you have made a very basic error in in your analysis, in that, those above will have cancelled out those. For if that was correct the productivity change between to the two period would be the same. That some firms have made productivity gains could be of interest to a micro-economist interested into the productivity of an individual firm (or a number of), but that is not what is being looked at here.

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    3. Ari at 00:35 - Pre and post 2008 measurement is not distinguished by one independent variable only (in your assessment, money-related reasons). Stopping your consideration of other factors at play when you find a difference (in productivity) supposedly caused by the factor you suspect is at work (let's say your null hypothesis) is called confirmation bias, which is best avoided.

      Anonymous at 12:48 - ditto. Further, the distinction between micro and macro economics is arbitrary and meaningless. To understand economics requires an understanding of how individuals (families, households) behave. Studying aggregated statistics is illuminating only to those who seek to have their bias confirmed. Says me, but I will admit, a number of years have passed since my econometrics degree and it's 20 years since I qualified as an actuary so I'm probably a bit fuddy/duddy in your assessment.

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  7. The analysis seems sound to me. However, the first sentence of the post contains the wrong kind of ‘pouring’. The type which means closely to examine does not have a ‘u’. Accordingly, ‘poring’ not ’pouring’ is the word required. You can take this as proof that pedants are alive and well and living in Cambridge, albeit that this one has no link with the university.

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    1. Thanks. One of the offside benefits of righting a blog is that my english gets more good.

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    2. My "English".

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  8. I argued something a little similar about Australia's much higher cash rate here.

    http://clubtroppo.com.au/2015/05/07/overton-window-overton-juggernaut-part-three/

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