Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 25 November 2015

Political economy assignments

Suppose you have two objectives for monetary policy: financial sector stability and real economy stability. You have two main instruments: interest rates and macroprudential policy (things like changing the capital requirements of banks, or making it less easy to get a mortgage; often called macropru for short). Should you assign one instrument to one objective (often called an assignment), or try and achieve both goals with both instruments?

As Tony Yates points out, assignments are rarely optimal from a purely macro point of view. Even if, say, interest rates are less effective at achieving financial stability than macropru, you would still want interest rates to contribute something to that objective. An exception is when one instrument completely dominates the other: then assignment is optimal. An example of this exception in a certain class of model is monetary over fiscal policy as means to achieve real stabilisation, as discussed here and here (less technical discussion here). But this type of result is unusual, and even when you get a result like this for a certain class of models it is not hard to add real world complications that remove the result.

If assignment in the case of real and financial stabilisation is not optimal, does this imply that those setting interest rates should take financial stability into account? It is important to understand what we are talking about here. We are not talking about how financial conditions might influence what interest rates need to be to achieve real stabilisation, which is the kind of issue discussed in this post by Bianca De Paoli for example. Nor is it talking about allowing for risk as I discussed here. Instead it would be saying that institutions like the US Fed should have a triple mandate when setting interest rates, where the third mandate was financial stability. Interest rates could be changed if financial stability was a concern, even if this had no implications for inflation or output. Equivalently, interest rates could move to help financial stability even if this took output and inflation away from target.

However we already have assignments that are clearly suboptimal from a purely macro perspective. Fiscal policy is assigned to the control of government debt, and reducing debt is certainly not a monetary policy objective. But in standard models this assignment is clearly suboptimal: when debt is high, reducing interest rates can be quite effective in reducing debt (particularly if government debt is mostly short term), and undesirable knock on effects on output and inflation can be countered by fiscal policy. Yet the mainstream consensus is that monetary policy should not be used to reduce debt.

The reason for this suboptimal assignment is most probably because of political economy concerns. Or to put it another way policy is mainly concerned about knowingly sub-optimal decisions. Reducing interest rates to reduce debt sounds too much like fiscal dominance. There is a fear that if there is no institutional assignment, politicians will depart from optimal policy and by keeping rates too low to reduce debt they will allow excessive inflation.

Can such political economy concerns be applied to financial stability and monetary policy, particularly as the same actor - an independent central bank - is in charge of both? My instinct is that it can, because central bankers are heavily influenced by pressures from the financial sector. As a result, there is a danger that if interest rates are set with both objectives in mind, central bankers will depart from optimal policy and, for example, needlessly raise interest rates before the real economy requires them to rise. The recent experience of Sweden is a clear example where this happened. For this reason I rather like the UK institutional set-up, with a separate MPC and FPC and a clear assignment for each.

20 comments:

  1. I’m a fan of Jan Tinbergen (Dutch economics Nobel laureate) on this issue. His “Tinbergen principle” was something like, “for each policy objective there should be one policy instrument and one only”.

    I.e. I don’t agree with SW-L’s claim that “Even if, say, interest rates are less effective at achieving financial stability than macropru, you would still want interest rates to contribute something to that objective.” The latter idea contravenes the Tinbergen principle.

    Tinbergen would argue that macropru alone (assuming it’s the right “policy instrument” to deal with financial instability) should be used to bring financial stability. And interest rate adjustments alone (assuming they’re the right instrument to adjust demand) should be used to adjust demand.

    Mark Carney recently got his policy objectives and policy instruments in a muddle, I think, when he suggested that bank capital ratios should be temporarily raised so as to deal with the alleged bubble inflating effects of low interest rates. I criticised that idea in my own blog post this morning:

    http://ralphanomics.blogspot.co.uk/2015/11/carney-proposes-temporary-bank-capital.html

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  2. Dear Simon,

    Concerning
    "There is a fear that if there is no institutional assignment, politicians will depart from optimal policy and by keeping rates too low to reduce debt they will allow excessive inflation."

    Please note this is exactly what happened in Brazil and Argentina in the past few years. And inflation indeed showed up.

    To make matters worse, Brazilian and Argentina provided fake numbers through creative accountancy for the first, and outright lying for the former.

    It's a disaster and a shame.

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  3. "But in standard models this assignment is clearly suboptimal: when debt is high, reducing interest rates can be quite effective in reducing debt (particularly if government debt is mostly short term), and undesirable knock on effects on output and inflation can be countered by fiscal policy."

    That is not obvious to me. If we have a Stackelberg game, where the central bank moves last, the fiscal authority knows that if it tightens fiscal policy the central bank will react by lowering interest rates, to prevent those undesirable knock on effects on output and inflation, which helps it reduce the debt.

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    Replies
    1. My mistake - that last part of the sentence is misleading. Here I'm talking about optimal policy, so there are no assignments, and therefore no independent central banks. Optimal policy tolerates higher short term inflation in order to get the debt stock down. For more details see my JMCB paper with Campbell Leith:

      http://onlinelibrary.wiley.com/doi/10.1111/jmcb.12060/abstract

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    2. Ah! Got it. Temporarily raise the inflation target to help reduce the real debt.

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  4. Concerning this paragraph "Reducing interest rates to reduce debt sounds too much like fiscal dominance. There is a fear that if there is no institutional assignment, politicians will depart from optimal policy and by keeping rates too low to reduce debt they will allow excessive inflation.", please note that it's more or less what has happened in both Brazil and Argentina, both of which engaged in macroeconomic-cronyism.

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  5. "Reducing interest rates to reduce debt sounds too much like fiscal dominance. There is a fear that if there is no institutional assignment, politicians will depart from optimal policy and by keeping rates too low to reduce debt they will allow excessive inflation."
    The enhanced auto stabilisation of the Job Guarantee deals with that in a highly targeted and direct manner.
    The thing needed is very strong auto stabilisers IMV

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  6. Optimal policy? Nobody knows what is optimal at a time until the time arrives. Which is why you need tight feedback and a pilot.
    "macroprudential policy (things like changing the capital requirements of banks, or making it less easy to get a mortgage; often called macropru for short). "
    Simon, the best way to regulate banks and lending is via asset side discipline. Any loan that falls outsides certain criteria is unenforceable and a gift of shareholder's funds. Too many of those and the bank goes bust. We need to regulate *what* banks can lend for.
    Banking reforms and MMT macropru ideas described in detail:
    http://www.3spoken.co.uk/2013/05/making-banks-work.html
    Any thoughts on this Simon?

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  7. "Fiscal policy is assigned to the control of government debt, and reducing debt is certainly not a monetary policy objective. But in standard models this assignment is clearly suboptimal: when debt is high, reducing interest rates can be quite effective in reducing debt (particularly if government debt is mostly short term), and undesirable knock on effects on output and inflation can be countered by fiscal policy."

    I don't really get this. Surely the monetary authorities act as a stackelberg follower so that if the government wants to reduce debt (in a situation where interest rates are substantially above the ZLB) they can simply impose austerity, safe in the knowledge that monetary policy will move to fully offset the impact on AD. As long as the government announces it's policy in advance there should be debt reduction without any economic slowdown which means that monetary will help reduce debt even under the current system without risk of fiscal dominance.

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    Replies
    1. My mistake - that last part of the sentence is misleading. Here I'm talking about optimal policy, so there are no assignments, and therefore no independent central banks. Optimal policy tolerates higher short term inflation in order to get the debt stock down. For more details see my JMCB paper with Campbell Leith:

      http://onlinelibrary.wiley.com/doi/10.1111/jmcb.12060/abstract

      Delete
  8. Great piece, Prof WL. You seem to accept the mainstream view that relying on fiscal policy to manage aggregate demand / inflation could lead policymakers to allow "excessive inflation". But what's wrong with the following:
    1. Re-assign monetary policy to debt management, sitting under the DMO
    2. Assign fiscal policy to aggregate demand / inflation management
    3. Re-task the OBR to evaluate fiscal policy as consistent with inflation-managing objectives - ie judging the 'fiscal stance', rather than the (ex post) size of the deficit

    ?

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    1. Monetary policy is more efficient at stabilising the real economy, for pure macro and institutional reasons.

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    2. Prof W-L: this may not be top of your agenda, but given the number of stubborn Post-Keynesians / MMTers (incl me) who hang around your blog, it would be great if you could at some point rehearse what gives you confidence in monetary policy being optimal for stabilising the real economy.

      Limitations with monetary policy seem to include the following:
      1. The theoretical framework underpinning the use of monetary policy seems founded on 'expectations'; and yet, in the real world, people negotiate wages based on what they (employer or employee) can get away with, only pointing to expected inflation if it helps their case. If you think you can persuade your boss to pay you 10% more, you'll ask for it, even if inflation is barely positive. Conversely, wage settlements were nil in many parts of the economy in 2010 even as the RPI spiked to 5%. Expectations of overall consumer price inflation seem irrelevant to micro pricing movements in practice.
      2. The narrative of how QE boosts the economy relies heavily on the wealth effect, mainly through real estate. But the wealth effect may be heavily compromised following a sharp correction in the housing market.
      3. Reduced interest rates are also said to work via the sensitivity of PNFCs' capital formation to lower funding costs. But most corporates have internal hurdle rates which are crude round numbers such as 10, 20 or 30%, and as such aren't touched by small movements in central bank overnight rates; and even if they are, this effect appears small relative to the corporate's assessment of future prospects.
      4. Monetary policy is immoral, since it instrumentalises a part of the economy - debtors or creditors (in a loosening or tightening cycle) - in order to boost or slow the whole economy. Any redistribution of income should be considered a political, not a technical, matter.

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  9. SWL says the OBR should become a fiscal watchdog. Yesterday the Chancellor turned it into his whipping boy. A very dodgy forecast from nineteen guys, ex Treasury civil servants, came up with a forecast that the other 5,000 civil servants at the Treasury and the BoE didn't see coming.

    If you get a chance, have a read of the "Economic and fiscal outlook November 2015" from the OBR. Particularly "the current account balance", page 80; and, "sectoral net lending" on page 81. Osborne's surplus is dependant on "unprecedented" levels of private debt. The March-of-the-Makers all having fell in a ditch just outside the northern powerhouse.

    Naturally, if the forecast goes mammaries up, the OBR gets the blame, not the politicians.
    http://budgetresponsibility.org.uk/economic-fiscal-outlook-november-2015/

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    1. "Yesterday the Chancellor turned it into his whipping boy." Utter, complete nonsense.

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  10. acorn,
    Amazing that they've changed their tune so rapidly over the last three months. Almost as though somebody had said 'these are the figures I need, create something that covers the new scenario'.

    Which is exactly what paid economists do. They write what you want to read, dress it up in econ mumbo jumbo and add their credentials to the bottom as 'evidence' of the weight of the argument.

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    Replies
    1. I do not know what fantasy world you two live in.

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    2. The OBR have a history of over optimistic forecasts.

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    3. Unfortunately the OBR pressed re-calc before GDP Q3 estimate came in at 0.5% compared with growth of 0.7% in Q2 (Apr to June) 2015.

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  11. In speaking of the efficacy of monetary policy, it is important to consider quantitative easing. How can we have confidence in monetary policy following the recession? The federal reserve purchased toxic assets from the banks and engaged in an expansionary monetary policy, yet the recovery has been anemic. In prior recession, growth rates increase right after, but following this recession growth rates were lower than average. The first round of quantitative easing was effective but the second and third were not. Often times, monetary policy is not effective, especially while fiscal policy does not act in accordance with it. Considering it is difficult for us to engage in effective monetary policy to strengthen the economy in the short term, the government should be more focused on ensuring stability and promoting long-run economic well-being. How can government or central banks promote monetary confidence through policy?

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