On giving advice

I was happy to agree to be on an advisory panel for Shadow Chancellor John McDonnell MP. There are only two reasons why I would say no to any major political party who asked me to give them their advice. The first is if this restricted what I would otherwise write on this blog or elsewhere. No such request has been made, although if you are hoping that I will reveal in posts accounts of what happens at panel meetings you will also be disappointed.

The second reason why I might have said no is if I thought the advisory panel was for presentation only, and all advice would be ignored. I have no reason for believing that in this case, and some grounds for thinking the opposite, which I discuss today in the Independent. In particular their position on fiscal policy is similar to the one I suggested here, although getting the message clear probably requires some work. 

One rather sad comment on the formation of this group is that those joining it will be forever tainted by associating themselves with a "hard left dinasours". Or to put it another way, its members should have said no to the Labour party leadership because they now have pariah status. As I pointed out in the Independent article, the current leadership will have to come to some kind of accommodation with the rest of the parliamentary party, and so Labour policies are unlikely to be the kind of far-left platform that many in the media seem happy to imagine. As Labour are the main opposition to the current government, and I think their macro policies are pretty awful, it would have been bizzare indeed if I had said no to this invitation.

Robert Peston has a short blog post on this new panel. He asks a very good question, which is why previous party leaderships have not done anything similar. I would quibble about one phrase in his post though, and that is this group is designed "to establish an economic ideology outside the mainstream". As I have often said, my own macro is pretty mainstream. What has happened since 2010 is that macro policy has departed from that mainstream.      

The path from deficit concern to deficit deceit

I have always written that the arguments in 2010 for focusing fiscal policy on reducing debt were understandable. They were wrong, but you could understand why reasonable people might make those arguments. In particular at the time the problem of the recession appeared to be over, recovery was under way, and the Bank of England seemed confident in the power of unconventional monetary policy. It seemed reasonable to move attention to the deficit.

So when 20 economists and policy makers wrote in February 2010 apparently supporting George Osborne’s deficit reduction plans, I was not surprised. The majority of macroeconomists, like me, disagreed, and we were right, but I could understand where they were coming from. One of those signing that letter was Lord Turnbull, head of the Civil Service and Cabinet Secretary between 2002 and 2005. By August 2012 around half of those that signed the letter had the good sense and honesty to backtrack on what they had written. The Chancellor may also have (wisely) revised his original plan to end the current deficit within 5 years, but his zeal to bring down debt rapidly by cutting government spending had not disappeared. When he was re-elected in May, it was for a programme of renewed austerity.

But the story does not end there. A few days ago Lord Turnbull had the opportunity to question the Chancellor on his drive for further austerity. This is a part of what he said.

“I think what you are doing actually, is, the real argument is you want a smaller state and there are good arguments for that and some people don’t agree but you don’t tell people you are doing that. What you tell people is this story about the impoverishment of debt which is a smokescreen. The urgency of reducing debt, the extent, I just can’t see the justification for it.”

A former head of the civil service, who had initially supported Osborne on the deficit, was now accusing him of deliberate deceit. Big news you might have thought. And quite a turnaround in just 5 years.

Yet it is not surprising. Osborne’s fiscal plans really have no basis in economics. That leaves two alternatives. Either Osborne is just stupid and cannot take advice, or he has other motives. George Osborne is clearly not stupid, which leaves only the second possibility. It is therefore entirely logical that Lord Turnbull should come to agree with what some of us were saying some time ago.

What a strange world we are now in. The government goes for rapid deficit reduction as a smokescreen for reducing the size of the state. No less than a former cabinet secretary accuses the Chancellor of this deceit. Yet when a Labour leadership contender adopts an anti-austerity policy he is told it is extreme and committing electoral suicide. Is it any wonder that a quarter of a million Labour party members voted for change.

What do macroeconomists know anyway?

In an article in the Independent today I argue that what goes for a ‘credible’ economic policy among politicians and the media is often very different from what an academic economist might describe as credible. Which invites the obvious response: who cares, what do academic economists know anyway? So I look at what I regard as the three major macroeconomic policy disasters in the UK over the last 35 years, and one success.

The success was the decision not to join the Euro in 2003. It is pretty clear that this was the right decision, and it was made after what may have been the most extensive academic consultation ever undertaken by the Treasury, coupled with substantial macro analysis. (I talk more about this here.) The Prime Minister Tony Blair was initially in favour of joining, but the analysis helped persuade him otherwise.

The first failure was Mrs. Thatcher’s monetarism, which was famously opposed by 364 economists. Those on the right have tried to spin this as a failure by the economists, but the actual policy framework of money supply targets was a complete disaster and was quickly abandoned, never to be tried again. (Here is a discussion, and here is an account from one of the two movers behind the letter.)

Current austerity we all know about: if not, read this.

The third disaster was the UK’s entry into the European Exchange Rate Mechanism (ERM) in 1990 at an overvalued exchange rate, and the subsequent recession and forced exit in 1992. My argument that this went against macroeconomic analysis needs some justification. At the time I was in charge of macroeconomic research at the National Institute (NIESR) in London, and I undertook with colleagues what was easily the most extensive analysis of the consequence of entry into the ERM at different exchange rates. This was subsequently published in 1991, but all the material was first presented before we entered the ERM.

We concluded that the UK’s actual entry rate was 10-15% above the equilibrium rate. The implication was unavoidable: either we would be forced out, or trying to stay would lead to a recession as part of an ‘internal devaluation’. I remember Sam Brittan, one of the main writers at the FT at the time, saying that he thought we had won the intellectual argument, but that his instinct was still that we should enter at a high rate.

After entry into the ERM the UK entered a recession, and we were then forced out just two years later. Our analysis was vindicated. It is true that the whole system eventually collapsed as a consequence of the tight monetary policy that followed German unification, but it is no accident that the UK was the first to go (Black Wednesday). On leaving the ERM sterling depreciated by 10%, and the UK recovered quickly from recession.

There is no doubt that had the Treasury taken our advice and entered at a lower rate, less jobs would have been needlessly lost. I have often wondered if I could have done things differently to make a more persuasive case. But honestly I doubt it: the almost macho appeal of entering at a ‘strong’ rate was too great, together with the idea that the market knew best. As I say in The Independent, macroeconomists are far from perfect, but the UK evidence suggests that you ignore their advice at your peril.

Haldane on alternatives to QE, and what he missed out

Andrew Haldane, Chief Economist at the Bank of England, gave a typically well researched and thoughtful talk recently. The main subject matter was the problem of the Zero Lower Bound (ZLB): why we may hit it much more often than we would like, and why QE is not a great instrument for dealing with it. To quote:

“QE’s effectiveness as a monetary instrument seems likely to be highly state-contingent, and hence uncertain, at least relative to interest rates. This uncertainty is not just the result of the more limited evidence base on QE than on interest rates. Rather, it is an intrinsic feature of the transmission mechanism of QE.”

In the past I have emphasised the point about lack of evidence simply because it is obvious. But as Haldane’s discussion shows, the problems are more basic than that. Some people argue that we can always get the result we want with enough QE. Yet if the central bank and the public never know how effective any amount of QE will be, then lags make it a poor instrument. It is refreshing to see a senior member of the Bank finally acknowledge its limitations.

Haldane considers two alternative ways of dealing with, or avoiding, the ZLB: a higher inflation target and getting rid of cash so that negative interest rates of whatever size become possible. The first is obviously welfare reducing, but as Eric Lonergan argues the second is likely to be as well. (See also Tony Yates.) But what is really strange about Haldane’s analysis is what is missing from his discussion.

One omission is a discussion of the possibility that targeting something other than inflation might help. The other omission is any discussion of helicopter money. There are some basic contradictions in the Bank of England’s views on helicopter money, but because central bankers tend to talk to each other I suspect they remain concealed. One argument is that helicopter money will somehow reduce confidence in the currency, but then the Bank seems happy to research getting rid of cash and imposing negative rates on money as if this is all about technicalities. [Postscript - meant to link to John Cochrane's discussion, and here is a reply by Miles Kimball.] I should have referenced  Another argument is that helicopter money will threaten the Bank’s independence because it will have to rely on government to (if necessary) recapitalise it, when at the same time the Bank has already obtained an underwriting guarantee for losses on QE. Also strange is the argument that independence will be threatened once the Bank does a 'helicopter drop' because governments will want the money for themselves, as if politicians had not noticed the amount of money being created under QE. After all Jeremy Corbyn's proposal was a response to the reality of QE, not the possibility of helicopter money.

The really ironic argument is that helicopter money is too like fiscal policy, and that there should be democratic control over fiscal policy. This is what central bankers mean when they talk about blurring the lines between monetary and fiscal policy. The argument is ironic because I am sure that if you actually asked most people which they would prefer - being charged to hold money, 4% average inflation, or occasionally getting a cheque from the Bank - the answer would be emphatic. So we rule out helicopter money because its undemocratic, but we rule out a discussion of helicopter money because ordinary people might like the idea.

There is also an element of hypocrisy. It is sometimes argued that helicopter money is unnecessary because it has a very similar impact to conventional fiscal policy. This is true, but it deliberately ignores the fact that governments around the world have gone for fiscal contraction because of worries about the immediate prospects for debt. It is not as if the possibility of helicopter money restricts the abilities of governments in any way. If governments undertake fiscal stimulus in a recession such that helicopter money is no longer necessary, it will not happen.

So it is good that some people at the Bank are thinking about alternatives to QE, which is a lousy instrument with unfortunate, and potentially permanent, distributional consequences. It is a shame that the Bank is not even acknowledging that there is a straightforward and cost free solution to this problem. My last two posts have involved defending central bank independence, but with independence comes a responsibility not to exclude discussion of particular policy options simply because they break some kind of taboo.      

Central Bank Independence and MMT

This is a follow up to my last post on Corbyn and central bank independence (CBI). No apologies for returning to this topic: not often do you get to talk about policies that are in the process of being formulated. One of the influences that is said to be important for John McDonnell (the new shadow Chancellor) and his advisors is Modern Monetary Theory (MMT).

A comment I sometimes get on my posts is that my arguments are similar to those put forward by followers of MMT. I have not read much MMT literature, but in what I have read I have normally not found anything I take great exception to. On some issues, like the way monetary policy continues to be presented in textbooks, they definitely have good reason to complain about the mainstream. However their account of the way monetary and fiscal policy work seems quite a close match to what many mainstream economists think, which I guess is why my arguments can be similar to theirs.

One area of apparent difference, however, is CBI. You will sometimes hear MMT people talk about CBI being a ‘sham’, whereas mainstream macro attaches great importance to CBI. So which is right? Part of the problem here is that CBI in the UK (where the government decides the goal the Bank has to achieve) is rather different from that in the US (where the Fed has much more discretion over the choice of targets) and the Eurozone (where the ECB is largely unaccountable and has huge power). I’m just going to talk about the UK set up. (For a MMT perspective on the US, see here.)

CBI in the UK, established by Gordon Brown and Ed Balls in 1997, is no sham. The Monetary Policy Committee (MPC) decides when and by how much to change interest rates, and government has no influence on the MPC. How do I know this? From observation and from a huge number of conversations with MPC members. Since 2009 the MPC has decided when and by how much to do QE. Any Treasury authorisation to do QE was a formalisation that essentially followed Bank wishes, but it never specified when and how much QE should happen. So a fair description of the UK set up is that the government defines the goals and instruments of policy, and the MPC decides how to use those instruments to best meet those goals.

I would agree with the comment that this set up leaves the government taking big strategic decisions, like what the target should be. But CBI as defined in the UK still has two major advantages over the pre-1997 alternative

1. party political motives for changing interest rates are ruled out. I know such motives influenced at least the timing of rate changes before 1997. (How do I know - same answer as before.)
   
   
2. it forces governments to be explicit about their goals, and the relative priorities among these. I personally believe this has an important role in conditioning (but not determining) expectations, which is very useful. (Yes you can call me a New Keynesian for this reason.)
   
   

You could add time inconsistency and credibility issues in there as well if you like. (Giving this to secondary importance perhaps makes me less of a New Keynesian.)

Are there any negatives to set against this? One argument you often hear is that CBI is anti-democratic, but I really think this is just nonsense in the UK context. Government delegates technical decisions all the time, and as long as there is strong accountability (which in the UK there is), the right people are on the MPC and they are truly independent (from government or the financial sector) this works well. When governments only face elections every 5 years and elections are won or lost over a whole range of issues, quite why a Chancellor deciding when to change rates following secret advice is more democratic is unclear. It also improves democracy because, as Chris points out, the Chancellor is not held to account for the technical mistakes of his advisors.

A more important argument against CBI is that it makes money financed fiscal expansion much more difficult. A government that is obsessed by the size of its deficit might not undertake a bond financed fiscal expansion when a fiscal expansion is needed. It might have undertaken a money financed fiscal expansion, but CBI prevents it doing this because the central bank controls money creation. However this problem can be easily avoided by (a) taking a more sensible view of government deficits and debt, as MMT would also advocate, or (b) allowing helicopter money.

It is (a) that makes the debate over Corbyn’s QE particularly ironic. A National Investment Bank can be set up perfectly well based on borrowing from the market, and you can ensure it gets the funds it needs by a government guarantee. The only reason you would avoid trying to do that is because the NIB debt would count as part of the government’s deficit, and you were worried about the size of the deficit. The last people who should be worried in this way are followers of MMT.

Scott Fullwiler has an elaborate discussion of why Corbyn’s QE does not interfere with CBI, but concludes: “As such, government guaranteed debt of the NIB would be effectively the same thing as plain vanilla deficits, which as shown above is not different in a macroeconomically significant way from Overt Monetary Financing of Government via People's QE.” Which begs the question, why not go with plain vanilla deficits to fund the NIB. If it is because you are worried about the political costs of higher deficits, that will be as nothing compared to the political costs of instructing the Bank to finance a NIB.

So where does this apparent antagonism for CBI come from? Perhaps it comes from a tendency of some from the mainstream to make too much of CBI. To imply that the more independent a central bank is the better, regardless of who determines goals, whether there is accountability and who makes the decisions. Proof that independence is not all that matters is provided by the ECB. But we should not let the bad drive out the good. If Labour abandons the innovations made by Brown and Balls, I think it will be a classic example of the triumph of ideology over both good economics and self interest. 

Labour and Central Bank Independence

Sometimes Paul Krugman can be very annoying. On a number of occasions I have written a draft of a post, and while in the process of admiring editing it, have found that PK has just written something rather better. So I bin my post on why Corbyn’s resounding victory is partly the product of Labour’s failure to oppose austerity rhetoric: read this instead.

In any case it may be more useful to look forward to what Labour’s macroeconomic policy might become under Corbyn and the shadow Chancellor John McDonnell. There has been some suggestion, encouraged by what I insist on calling Corbyn’s QE, that Labour are contemplating getting rid of an independent Bank of England. I think in macroeconomic terms this would be a bad idea, and in political terms a terrible idea. It is best to say this sooner rather than later, before commitments are made.

In essence all the Bank of England normally does is decide how to change interest rates to hit a target decided by government. Whether it is an inflation target or some other target(s) is for the government to decide. There are plenty of macroeconomists who would favour a higher inflation target, or targeting a different measure, so there is a great deal of scope for change here. But once that target has been chosen, why are politicians better at trying to hit it than a bunch of technocrats some of whom have spent their lives studying this one task?

It is vital to appreciate how different the UK set up is from the Eurozone. Many years ago I was very suspicious of central bank independence (CBI), because I thought it might lead to just the kind of deflationary bias that we see today in the Eurozone. Partly because of decisions made by Ed Balls and Gordon Brown, the Monetary Policy Committee (MPC) in the UK is quite different. The target is symmetrical, and the MPC has independent members and is very transparent and accountable. So what is there not to like which the government cannot already change?

I fear the situation has become confused because of austerity at the Zero Lower Bound. What CBI prevents either the government or the central bank doing is a money financed fiscal stimulus: a fiscal stimulus paid for by creating money rather than issuing government debt. The central bank can create money, and has done, but cannot force the government to spend more or cut taxes. The government cannot force the central bank to permanently create money to finance these things.

But this is only a problem if you have a government committed to deficit fetishism. It would be ironic indeed that a Labour party now pledged to fight austerity decided it needed to print money because they were reluctant to borrow more. It would be the ultimate triumph of austerity, and also just daft.

It would also be a gift horse to those currently implementing austerity. It would allow them to say that the only alternative to austerity was printing money which would lead to inflation. They have already begun to say it. It is spin that can be fatally undercut as long as CBI is preserved. But if that independence is ended, then you will create an army of mainstream academic economists who will say that high inflation is now more likely.

There will be some of those who advise Corbyn and McDonnell who might be tempted to say what have mainstream economists ever done for us. But if Paul Krugman is right, and I think he is, one of the reasons that Corbyn got elected is that Labour party members could see that the government was pursuing a policy that went against mainstream, as well as some heterodox, economics. Corbyn and McDonnell will have enough enemies in the media and the City as it is. It seems just stupid to create enemies elsewhere by foolishly ending the Bank’s independence.

Labour lost

As Corbyn’s win is all over the news, it is difficult to think about other issues. So while watching the result I read ‘Can Labour Win?’ by Patrick Diamond and Giles Radice. It sifts through a lot of polling information and conversations with candidates, and comes up with a large number of recommendations. There is a lot of good and sensible stuff here, but I cannot help feel that it - and much similar comment since the election - misses the key point.

Perhaps part of the problem is that a great deal of this analysis comes from Labour party people who are, quite rightly, really interested in policy. So all the analysis is about which policies were wrong and which way policy should move as a result. We get into territory that these people are comfortable with: what policy should be.

The point all this misses is that the Conservatives won. It used to be said that governments, not oppositions, win or lose elections. Yet all of the comment is about Labour’s policies. A much better place to start is why voters voted for a Conservative government. That quickly leads you to the fact that voters saw the Conservatives as competent in economic terms. And that is where you should stop.

You should stop because, as I have argued many times, the raw data on the economy was terrible. If you had asked any pollster or political scientist whether a government could win on economic competence having presided over a huge fall in real wages they would have said no. True things began to look less gloomy as the election approached, but the position of the Conservatives in the polls well before that time was not nearly as bad as the economic position suggested it should be.

The Conservatives won because they reframed the economic debate. Competence became reducing the deficit, not increasing prosperity. Labour’s failure was a failure to challenge that reframing. Forget the details of Labour policy - it is of little importance compared to this crucial mistake. And that crucial mistake was a symptom of a more general problem.

There is one telling result from the Diamond and Radice study. To quote

“despite never using the language of ‘equality’, voters believe the Conservatives are just as likely to achieve equality as Labour in southern England”

This was despite Miliband putting the problem of inequality at the centre of his message. I heard it, but most voters did not. Labour just failed to get its message, any message, across. As I wrote just after the election, Labour's political spin appeared to be consistently amateur compared to their opponents.

Corbyn will have some advantages. He will not let Osborne’s deficit fetishism go unchallenged. But that challenge will only work if the alternative policy is solid and simple: I agree with the authors that this must involve balance on the current deficit (although within the context of a flexible rule). What he must not do is provide material for his opponents, which I’m afraid is exactly what Corbyn’s QE did. Focusing on the current balance will allow for a large increase in public investment, which again can be spun very simply: Labour, unlike the Conservatives, invests in our future. (It is not afraid to borrow to do so, just like every successful firm.) Corbyn, and the team he selects, may not want to call it spin, but if they do not match their opponent’s ability in this area they will lose.

Media myths

At first sight the research reported here is something that only political science researchers should worry about. In trying to explain election results, it is better to use ‘real time’ data rather than ‘revised, final or vintage’ data. But as the authors point out, it has wider implications. Voters do not seem to respond to how the economy actually is (which is best measured by the final revised data), but how it is reported to be. (This does not just matter for elections: here is a discussion of some other research which suggests how the way recessions are reported can influence economic decisions.)

Just one more indication that the media really matters. I would not bother to report such things, if this point was generally accepted as an obvious truth. That it is not, in the UK at least, reflects various different tendencies. Those on the right know that the print media is heavily biased their way, and that this has a big impact on television, so they have an interest in denying that this matters (while funding think tanks whose job is in part to harass the BBC about its alleged left wing bias). Those on the centre left often react negatively to a few of those further left who discount all awkward facts by blaming the media. And the media itself is very reluctant to concede its own power.

As an example, here is Rafael Behr in the Guardian talking disapprovingly about Labour supporters:

“I heard constant complaints about failure to “challenge myths” about the economy, benefits, immigration and other areas where Labour is deemed unfit to govern by the people who choose governments. The voters are wrong, and what is required is a louder exposition of their wrongness.”

What is really revealing about this paragraph is what is not there. We go straight from myths to voters, as if no one else is involved. I doubt very much that many who voice the ‘constant complaints’ Behr is talking about think that voters created and sustained these myths all by themselves.

The discussion of issues involving the economy, the welfare system and immigration among most of the ‘political class’ is often so removed from reality that it deserves the label myth. In the case of the economy, I provided chapter and verse in my ‘mediamacro myth’ series before the election. It was not just the myth that Labour profligacy was responsible for austerity, but also the myth about the ‘strong recovery’ when the recovery was the weakest for at least a century, and that this recovery had 'vindicated' austerity. Given the importance that voters attach to economic credibility, I do not believe I was exaggerating in suggesting that the mediamacro myth was in good part responsible for the Conservatives winning the election.

The media is vital in allowing myths to be sustained or dispelled. That does not mean that the media itself creates myths out of thin air. These myths on the economy were created by the Conservative party and their supporters, and sustained by the media’s reliance on City economists. They get support from half truths: pre-crisis deficits were a little too large, GDP growth rates for the UK did sometimes exceed all other major economies.

Myths on welfare do come from real concerns: there is benefit fraud, and it is deeply resented by most voters. But who can deny that much of the media (including the makers of certain television programmes) have stoked that resentment? When the public think that £24 out of every £100 spent on benefits is claimed fraudulently, compared with official estimates of £0.70 per £100, that means that the public is wrong, and we have a myth. (An excellent source for an objective view of the UK’s welfare system is John Hills’ book, which has myth in its subtitle) As I noted in that post, when people are asked questions where they have much more direct experience, they tend to give (on average of course) much more accurate answers. Its when they source the media that things can go wrong. It is well known that fears about immigration tend to be greatest where there is least immigration.

Of course reluctance to acknowledge myths may not be denial but fatalism. Fatalism in believing that voters will always believe that migrants want to come to the UK because of our generous benefit system because it suits their prejudices. Encouraging those beliefs will be in the interests of what will always be a right wing dominated press. Some argue that myths can only be changed from a position of power. But myths are not the preserve of governments to initiate. According to this, over 60% of Trump supporters think their president is a Muslim who was born overseas. [1]

Myths need to be confronted, not tolerated. The initial UK media coverage of the European migrant crisis played to a mythical narrative that migrants were a threat to our standard of living and social infrastructure (to quote the UK’s Foreign Secretary!). This reporting was not grounded in facts, as Patrick Kingsley shows. That changed when reporters saw who migrants really were and why they had made the perilous journey north. It changed when Germany started welcoming them rather than trying to build bigger fences. These facts did not fit the mythical narrative.

The UK government was clearly rattled when it realised that many people were not happy with their narrative and policies. Myths can be challenged, but it is not easy. Policy has been changed somewhat, but attempts are also being made to repair the narrative: to take some of those who have made it to the EU will only encourage more (a variant of the previous European policy of reducing the number of rescue boats), and a long term solution is to drop more bombs. Such idiotic claims need to be treated with contempt, before they become a new myth that the opposition feels it is too dangerous to challenge. Challenging these myths does not imply pretending real voter anxieties about migration do not exist, but grounding discussion and policy around the causes of those anxieties rather than the myths they have spawned.

Yes, the non-partisan media needs to recognise the responsibility they have, and use objective measures and academic analysis to judge whether they are meeting that responsibility. But more generally myths are real and have to be confronted. The biggest myth of all is that there are no myths.

[1] The probability pedants among you who read the link will know that I’m actually making an assumption in writing this!

More (dark) thoughts on interest rates

The following has numbers for the UK, but the logic if not the numbers also apply to the US: see Mark Thoma here.

Imagine the following lottery. If you win, you receive a total of £5000 over the next few years. The cost of a ticket? The risk that inflation will be 0.5% higher than it would otherwise have been for a couple of years, where inflation includes the rate that wages increase.

To enter the lottery in the UK you need to cut interest rates. This lottery is just another way of describing the key argument I made in Monday’s Independent article (now complete with chart).

Of course you want to know the odds of getting the prize. The odds come in the form of a puzzle. What are the chances that the economy has, over the last ten years, permanently lost 15% of its normal ability to produce goods and services. Something that has probably never happened to the UK before. [1] Those are the chances of you NOT winning.

We can of course discuss those numbers. But in the UK that discussion appears largely absent. Instead all the talk is about interest rate increases. We seem to have collectively written off 15% of national GDP with just a shrug. ‘Oh that must be supply and there is nothing conventional macro policy can do’ is the general view. That view may be right, but it is important enough that this should be the centre of the national debate. Instead we talk about the need to normalise interest rates, as if the real economy was doing just fine.

Time for a DeLong type lament. If you had told me ten years ago that a decade hence UK output per head would be 15% below the 1955-2008 trend, inflation was zero and yet people would be talking about raising interest rates I would have said you were mad. If you had said that at a time when interest rates and real wages are at record lows the government was proposing to not invest for the future because that was the best way to prepare for the next crisis I would have said you knew nothing about business and economics. If you had said that just years after a huge financial crisis, followed by a host of financial scandals, the City regulator would be sacked because the Chancellor wanted less tough regulation I would have said you were thinking about some corrupt state and not the UK. If this is all a bad dream, what will it take to wake people up?

[1] Economies do appear to suffer some permanent loss to potential output after financial crises: there is a handy summary of studies here (table 4.1) - HT Andrew Goodwin   

Making the Eurozone work better: sovereign default

Given the current problems in the Eurozone, it is understandable that many non-Eurozone economists remind us that they had doubts from the beginning. That, unfortunately, is not very helpful criticism, except in so far as it tells us how these problems were originally wished away. One lesson from the Greek tragedy is that voters' faith in the Euro project can survive even under tremendous strain. [1] The Euro was always a political project, and the political reasons for it have not gone away. For the governing elite of Europe this is likely to remain the case. So going backwards is not an option.

Yet while the people and the elite both want to keep the Euro, they part company when it comes to moving to a complete fiscal and political union: a United States of Europe. As Philippe Legrain notes, ever since the French and Dutch voted No, voter attitudes to further central control have hardened - and with good reason. If what he describes as the “Monnet method” (use any crisis to increase integration) continues, and as Andrew Watt points out it is continuing in a big way, the threat to the Eurozone could become existential. European policy makers have taken far too many liberties with democracy as it is: they should not take even more. Which is why I tend to get a little impatient with economists and institutions that spend a lot of time designed schemes for further substantial integration.

So the critical issue for now is whether the way the current union is run can be improved? I see three key unresolved areas here: sovereign default, competitiveness imbalances and the ECB. I talked about how to cope better with potential competitiveness imbalances recently. This post is about default.

I agree with Philippe Legrain that we need to have more decentralised fiscal control, and less rules from the centre. As I have noted before, there now exists in the Eurozone a system that is parallel to monitoring from Brussels, based instead on national fiscal councils. Can we design a system around that which negates any need for central control?

One way of making this work would be to deny any support to any EZ government that gets into trouble with the market. When the EZ was set up, its architects worried that market discipline would be too weak for this to work, so centralised controls were also necessary (the Stability and Growth Pact). In one sense they were right: the markets started treating Greek government debt as if it was German debt. But once a crisis happened they were wrong: governments with lower deficits than the UK were regarded as riskier by the markets.

What should now be clear is that the debt of member governments of a monetary union are subject to much greater rollover risk than equivalent countries outside the union because they do not control their own currency. That problem has been dealt with (for the moment) by OMT. But you cannot have OMT without conditions. For obvious reasons OMT cannot be a blank cheque to a monetary union member to run ever higher deficits.

So OMT has to be conditional, but who should set the conditions? Who decides that a future Greece has to default, but that a future Ireland should get the OMT guarantee without the need to default? At the moment the answer is both the other Eurozone governments and the ECB decide. But Eurozone governments have shown themselves to be hopeless at this task (see actual Greece), partly because they are subject to pressure from creditors. To leave this all to the unelected, unaccountable ECB is just asking for problems, and would represent too great a strain on ECB independence.

Let’s imagine the following. The Italian government at some time in the future finds that interest rates on its debt begin to rise well above average Eurozone levels. We get into a situation where a self-fulfilling default is possible. Should the ECB supply OMT cover to end that possibility or not? What conditions should be imposed on Italy as the price for that cover?

It would be nice if we could write down some simple rules (even complex rules) that could choose between a Greece and an Ireland. Fabian Lindner discusses some possibilities here. The major problem is that a great deal depends on something that embodies a political judgement: just how large will future primary surpluses be? Italy, because of its large debt, is used to running much larger primary surpluses than other countries. How do you judge what the upper limit is?

This is why ‘leaving it to the market’ is so attractive, because you appear to be asking a huge number of people to take a bet on the answer. But that method is flawed, because with rollover risk what they are actually taking a bet on is what they think other market participants think about rollover risk. OMT removes that rollover risk.

So if the market cannot do this, and the ECB and EZ governments should not do this, who is left? Do we set up a new institution of experts to decide and set conditions? (Conditions have to be set, because actions may change after OMT is granted.)

One obvious response is that we do not need a new institution, because we already have one, and it is called the IMF. It is imperfect, with at the moment too much influence from EZ governments on its decisions, but that means reforming the IMF rather than reinventing it. This may happen as a result of the Greek debacle. Philippe Legrain suggests using the IMF in a similar role here, although as a transitional measure while a new EZ institution is set up. However it is difficult to imagine EZ governments setting up a new institution that was truly independent of political pressure from member states.

The proposal would work like this. When Italy got into difficulties, it would go to the IMF. No EZ assistance would be allowed before this. The IMF would decide what level of default (if any) was required. The IMF, and not EZ governments, would set any conditionality thought necessary to return deficits to a sustainable level. That would include a path for deficits that the country could reasonably achieve without creating unnecessary unemployment. (If the country was uncompetitive, some unemployment would be inevitable.)

If Italy agreed to those conditions, then OMT would automatically be extended by the ECB. It is quite possible that in those circumstances Italy would regain market access at reasonable rates. If it did not, the IMF (and NOT other EZ governments) should provide the finance necessary to cover transitional deficits.

I suspect this scheme would not be attractive to many Eurozone policy makers, because they would be losing influence and control. But a better way to think about it is that the Eurozone contracts out (to the IMF) the tricky business of deciding whether a government’s debt is sustainable or not. That seems to me to be a small price to pay to avoid the kind of conflict between governments that became so clear in the recent Greek ‘negotiations’.

[1] Of the countries polled here, only two had more people thinking the euro had been bad rather than good for their country: Italy and Cyprus. See also Andrew Watt here.

The UK as a test case for NGDP targets

In an article in the Independent today, I argue that it is about time the Bank of England changed UK interest rates. But they should go down, not up. The essence of the argument is there remains a significant risk that we have substantial deficient demand. Even if the probability of this is below 50%, if it is true the costs of it persisting far outweigh the costs of some mild inflation overshooting.

One point I do not consider in the article are the implications for nominal GDP (NGDP) targeting. Here is the picture.

I use nominal GDP per head, because that is robust to changes in migration flows, which for the UK have been important and variable. The serious arguments are for a levels target, so I’ve drawn in a reference path for 4.25% growth. That is a combination of 2% output price inflation and 2.25% real growth per head, the latter being the 1955-2008 average rate.

If the Bank of England had adopted a NGDP target, as many have recommended, the MPC would be tearing their collective hair out right now trying to stimulate the economy. There would be zero talk of interest rate increases. So there seem to be just two possibilities. Either NGDP targeting is nuts, or monetary policy has slowly gone off the rails by focusing on CPI inflation alone.

Time will tell. But if the possibility that the UK could really grow quite fast right now without inflation getting out of control turns out to be true (and the argument I make in the Independent is just that there is a non-trivial possibility that it might be true), what will history say? I suspect they will talk about Goodhart’s law, which says “when a measure becomes a target, it ceases to be a good measure”. Targeting inflation and ignoring output seemed like a good idea, because of what is called the divine coincidence. I talked about this in what I think is one of my better posts. Goodhart’s law applied to this case says CPI inflation ceases to be a good indicator of both the state of the economy and maybe also the costs of inflation when you try using it as a target.