Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday, 7 March 2016

The 'strong case' critically examined

Perhaps it was too unconventional setting out an argument (against independent central banks, ICBs) that I did not agree with, even though I made it abundantly clear that was what I was doing. It was too much for one blogger, who reacted by deciding that I did agree with the argument, and sent a series of tweets that are best forgotten. But my reason for doing it was also clear enough from the final paragraph. The problem it addresses is real enough, and the problem appears to be linked to the creation of ICBs.

The deficit obsession that governments have shown since 2010 has helped produce a recovery that has been far too slow, even in the US. It would be nice if we could treat that obsession as some kind of aberration, never to be repeated, but unfortunately that looks way too optimistic. The Zero Lower Bound (ZLB) raises an acute problem for what I call the consensus assignment (leaving macroeconomic stabilisation to an independent, inflation targeting central bank), but add in austerity and you get major macroeconomic costs. ICBs appear to rule out the one policy (money financed fiscal expansion) that could combat both the ZLB and deficit obsession. I wanted to put that point as strongly as I could. Miles Kimball does something similar here, although without the fiscal policy perspective

Of course many macroeconomists do see the problem, but the solutions they propose are often just workarounds. Things like Quantitative Easing, or NGDP targets, or a higher inflation target. [1] None completely remove the basic difficulty created by the ZLB. (One proposal that does is negative interest rates coupled with eliminating paper money, which I will come back to.) As a result, these workarounds mean that in response to a sharp enough recession, we would still regret no longer having the possibility of undertaking a money financed fiscal stimulus.

I also think there is a grain of truth in the argument that ICBs created an environment where deficit obsession became easier. Take the UK for example. In the 2000s the organisation that came to dominate budget analysis was the IFS. They are excellent on both the microeconomics of particular budget measures and their costing. Before the Great Recession that meant that all the IFS needed was a macro forecast (of which there are many) and they had all they required to provide excellent budget analysis. The IFS did not have strong macro policy expertise, and sometimes this shows, but as long as the consensus assignment worked that did not matter.

One of the those working at the IFS during this Labour government period was Rupert Harrison. In 2006 he became chief of staff to George Osborne. He helped introduce, perhaps reflecting his IFS experience, two important and positive policy innovations: setting up the OBR (with some minor assistance from a certain UK academic), and a form of fiscal rule (a five year deficit target) which allowed debt to be a shock absorber. But he also appeared to bring the received wisdom on the consensus assignment untroubled by the ZLB, which meant that Osborne could give a speech in 2009 outlining the macroeconomic basis of his strategy in which the ZLB was not mentioned.

This is an example of a more general point, which Robert in comments reminded me I could have made to strengthen the strong argument still further. With ICBs, macroeconomic expertise can move from finance ministries to central banks, leaving finance ministries unprepared for what they may need to do in a major recession.

But this grain of truth runs up against a real difficulty, which is the major flaw in the ‘strong argument’ I set out in the earlier post. To see the flaw ask the following question: in the absence of ICBs, would our deficit obsessed governments actually have undertaken a money financed fiscal stimulus? To answer that you have to ask why they are deficit obsessed. If it is out of ignorance (my Swabian syndrome), then another piece of macro nonsense that ranks alongside deficit obsession is the evil of printing money in any circumstances. I suspect a patient suffering Swabian syndrome would also be subject to this fallacy. If the reason is strategic (the desire for a smaller state) the answer is obviously no. We would simply be told it could not be done because it would open the inflation floodgates.

Following my grain of truth idea you might counter that without ICBs the knowledge within or outside government that these excuses were without foundation would be greater, and so governments could not get away with them so easily. But you would still have plenty of economists from the financial sector telling you that not only did you need to reduce debt rapidly to appease the markets, but also that any government printing money would scare the markets even more. Indeed, would governments alone have had the courage to undertake the scale of QE that we have seen ICBs undertake?

As for the argument that macroeconomic expertise gets concentrated in central banks, surely the answer here is to allow that expertise into the public domain by making central banks more open, and to directly combat the forces that make some central bank leaders routinely argue for austerity when they can no longer effectively combat deflation.
The basic flaw with my strong argument against ICBs is that the ultimate problem (in terms of not ending recessions quickly) lies with governments. There would be no problem if governments could only wait until the recession was over (and interest rates were safely above the ZLB) before tackling their deficit, but the recession was not over in 2010. Given this failure by governments, it seems odd to then suggest that the solution to this problem is to give governments back some of the power they have lost. Or to put the same point another way, imagine the Republican Congress in charge of US monetary policy.

But if abolishing ICBs is not the answer to the very real problem I set out, does that mean we have to be satisfied with the workarounds? One possibility that a few economists like Miles Kimball have argued for is to effectively abolish paper money as we know it, so central banks can set negative interest rates. Another possibility is that the government (in its saner moments) gives ICBs the power to undertake helicopter money. Both are complete solutions to the ZLB problem rather than workarounds. Both can be accused of endangering the value of money. But note also that both proposals gain strength from the existence of ICBs: governments are highly unlikely to ever have the courage to set negative rates, and ICBs stop the flight times of helicopters being linked to elections.
These are big (important and complex) issues. There should be no taboos that mean certain issues cannot be raised in polite company. I still think blog posts are the best medium we have to discuss these issues, hopefully free from distractions like partisan politics.  

[1] Please do not misunderstand what I mean by workarounds. The workaround may be still be useful in its own right (I have argued that monetary policy should be guided by the level of NGDP), but it does not completely remove the problem of the ZLB.


  1. "It was too much for one blogger, who reacted by deciding that I did agree with the argument, and sent a series of tweets that are best forgotten."

    Do you mean me? If so say so. Because I honestly can't tell. Then I can argue back that my series of tweets is best *not* forgotten. And I don't really care whether you agree with the argument or not. It's an argument, and I can argue against it.

    Actually, *part* of your argument here *looks like* a response to my series of tweets, which suggests they are best not forgotten.

    In any case, here's my response:

    It's strange how you and I understand "workaround" in almost diametrically opposed ways. I think of the ZLB problem, if it is a genuine problem, as being fundamentally monetary. It all arises because it is administratively difficult to pay (positive or negative) interest on paper currency, unlike money whose ownership is recorded on computers or on ledgers where it is administratively easy.

    It is fiscal policy that I see as a "workaround" to this monetary problem. To see this, imagine an economy that is functioning perfectly normally, but demographics (very few young people coming along) mean the natural real rate is at minus 5%. Food cannot be stored, so middle-aged people would pay young people 5% to borrow food and pay it back when the middle-aged are too old to produce food. In a hypothetical frictionless barter economy, the real rate of interest would be minus 5%.

    Now we could debate whether the young should be taxed to support the old. Should the government subsidise saving, or borrow enough to guarantee the old a better rate of return than -5%? Maybe, maybe not. But it looks to me like a strange argument to say that the government *must* subsidise savers because paper currency pays 0% nominal and it doesn't want to raise the inflation target or NGDP growth target or tax currency like Gesell.

    All that aside, I am unconvinced that the ZLB is in fact a binding constraint for any vaguely reasonable target like 2% inflation, or better yet 5% NGDP growth (which would automatically raise the implied inflation target if there were fewer young people coming along). Only when the central bank runs out of assets to buy, because it's bought up all the government bonds, commercial bonds, stocks, farmland, houses, etc., would I say OK it's binding. The real question is: would we want the central bank to have a balance sheet that big?

    "There should be no taboos that mean certain issues cannot be raised in polite company."

    Yep. Gotta remember that for the immigration debate!

    1. Nick. First, I had no problem with your tweets, because you addressed the argument, rather than attacking me for opinions I did not hold.

      Second, you argue that negative nominal interest rates are quite logical. In one sense I agree, because I did include this as one of my two responses to the ZLB that were NOT workarounds. The other is helicopter money. That makes sense because they both involve instruments, and the ZLB is an instrument problem. NGDP and higher inflation are workarounds because they involve what the central bank is trying to do with its instruments. QE is an instrument, but one whose impact is so uncertain that it robs monetary policy of its status as stabilising policy of choice, in my view.

      Third, if negative rates require abolishing cash as we know it, do you think that might have costs?

    2. Ah, thanks Simon. Maybe I'm paranoid. Or maybe I don't understand English English any more (it's a weird language).

      I really dislike the idea of abolishing hand-to-hand currency, though not for any narrowly economic reasons. As JP Koning tweeted a few weeks ago, George Orwell got monetary policy totally wrong in 1984, because currency still exists. Margaret Atwood got it right in The Handmaid's Tale, where currency has been abolished.

      If it really came to the crunch, with a very negative natural rate, why should the government necessarily provide a price support program for savers to prevent the economy crashing? Raise the Inflation/Price level path/NGDP level path temporarily, if need be. Or just privatise currency, and let the commercial banks issue currency with a crawling peg devaluation rate.

      I think we have a theoretical disagreement on helicopter money. I insist that monetary transfers are not net wealth unless they are expected to be permanent (relative to the counterfactual), so that helicopter money is theoretically equivalent to a temporary increase in the inflation target (a permanent increase in the price level target). And (appeals to authority) I'm pretty sure Patinkin and Buiter are on my side with this. (Please take as read an old-school rant about whippersnapper New Keynesians forgetting M and the old "Is Money Net Wealth?" debate of the 60's/70's, which is another thing that got swept aside and lost in the New Classical/New Keynesian revolution.)

  2. There is still a basic inconsistency hiding in your arguments. Let me see if I can find it.

    You observed, correctly, in the first post that ICBs were created largely because governments were not be trusted with the printing press - that they would be tempted to debauch the currency for political reasons (Zimbabwe, Weimar).

    You argue above that because of the Swabian syndrome (is this in the academic discourse yet?) governments cannot be trusted to turn on the printing press, or run a fiscal deficit, when it's needed: they will be deficit bears, beholden to those (unfortunately not all) long-dead economists who believe in Ricardian equivalence.

    Have we found the inconsistency yet? We gave CBs independence because governments could not be trusted not to inflate the economy for political reasons. We shouldn't remove independence because governments cannot be trusted not to deflate the economy for political (or similar) reasons. Maybe we should go the whole hog and remove all macro-economic policy making from governments, leaving it to a combination of the CB, the IFS and some suitably qualified academics to set interest rates and manage tax and expenditure. It might work better - some would say it couldn't work worse - but it wouldn't be anything approaching a democracy.

    1. While I like your logic, I would argue with your first point, at least as far as the wave of ICBs created over the last couple of decades. When I talked about not trusting politicians, what I had in mind were relatively minor indiscretions, not creating rampant inflation. An ICB in the US did not stop 70s inflation.

      You are right that taking away fiscal policy from governments might solve the deficit obsession problem, but for many reasons that kind of delegation is much more problematic. Delegation with monetary policy does not reduce democracy in my view, because having a politician choose rates for reasons that are unclear is hardly democratic.

    2. Right, but 70's inflation was unstoppable. Massive population growth coupled with inability to produce the products at a profit for that surge led to huge price inflation. Actual, real monetary inflation was flat in the mid-late 70's

    3. Why do you assume that a rate chosen by a politician would be for reasons that are less clear than those chosen by a central bank?

      I would want the MPC to recommend publicly its proposed rate with justification. The expectation would be that the Chancellor would follow this but if he chose not to do so then he should have to present his reasons to Parliament.

      Such an arrangement would increase visibility of decision making.

    4. > "(...)having a politician choose rates for reasons that are unclear is hardly democratic. "

      But the politician's reasons would presumably be "because the people wanted them set that way", which would be democratic even if it were also wrong.

  3. Ah, 2006.
    That's when things had gone seriously wrong.
    If we were going to stop the recession, that's when we needed to start acting. By 2008 it was all too late. By 2010 the game was over.

    1. Act to stop what recession? Posts like these make me wonder what you are thinking...........

    2. The Great Recession that everyone seems to think started around 2008.
      Of course, it looks like it did, but the crash was just the inevitable result of the things that were done in the years before it.
      If you wait until the crash is happening before trying to stop it, it is like trying to stop an avalanche after it has started falling.
      You have to do something about the snow piling up before it becomes a hazard.

  4. The main argument against monetary policy and magic central banks is straightforward. It requires the expansion of private debt. Which is both endogenous and unstable. The whole theory on which magic central banks is based expects debt to be exogenous and stable.

    The problem is with economists who believe that pushing debt onto private individuals is the way to expand an economy. The underlying assumption is that the private business sector has first and sole control over the resources of the economy. Everybody else has to get the begging bowl out.

    It is that philosophy of private sector first that needs throwing out - along with all the New Keynesian economists.

    Monetary policy doesn't work *at all* ever for effective demand management. It creates debt bubbles and destruction. There is no moving natural rate. The natural rate is zero.

    It is time that the central bank was merged into the DMO and the MPC sacked. Then we can get back to good old fiscal policy with enhanced auto-stabilisers to manage the business cycle, with an unlimited overdraft at the central bank and no issuance of Gilts.

  5. In an ideal world, you manage to educate the public so that governments are bound in how far against policy analysis they can get. The problem being then one to find what would, if anything, be credible enough in the eyes of the public... History is unfortunately not on our side.

    Ps Your blog is more interesting when you dive into macroeconomics.

  6. Prof. Wren-Lewis,

    You have not presented a strong case against the independence of central banks, neither in your first nor in this post. That is perhaps no surprise since you yourself are in favour of their independence.

    But in a controversy, one should at least be aware of the strengths of the other side and address them or point out there are none.

    You have done neither, so the pointlessness of the exercise gave rise to some schoolboy jokes, indignant reactions of your unconditional believers, and some commenters giving their thoughts related to the subject but not to your arguments.

    One expects better of you.

    1. I thought I had presented a case that appeared to link ICBs directly to the slow recovery from the Great Recession. I then said why I thought that case was wrong, or at least misdirected. You are welcome to disagree with both arguments, and say why.

      But quite why the exercise was 'beneath me' I cannot see. It is after all a pretty standard exercise to put what you think is the best case of the opposing side, and then try to knock it down.

    2. Prof. Wren-Lewis,

      In your two posts, you repeated what you have been saying for as long as anyone can remember: That central banks and governments were consistently wrong in their reactions to the great recession since 2007.

      But, in your two posts, there is nary a word linking those mistakes to central banks' independence, or that anyone holds such a theory.

      So you do not present anybody's case against central banks' independence, let alone a strong case.

      Some people might find that odd, or even funny.

  7. SW-L’s article essentially asks the question: how do we work our way round the fact that there are economists in positions of power who do not understand some of the basics, like the fact that national debts cannot be equated with household debts or other normal debts?

    That question gives rise to another and related question: how come economists manage to get to the top of their profession without understanding the above sort of “basic”.

    1. I'm not sure who the 'economists' you have in mind are. All the economists I can think of, plus the OECD and IMF, are arguing for higher public investment now. The problems is that economists are being ignored.

    2. Ironically, the OECD and IMF were two of the organisations I had in mind. Granted they are now (belatedly) advocating deficits and/or the investment to which you refer. But at the height of the crisis they were advocating consolidation / austerity. Bill Mitchell has done a few articles on that topic, e.g.:

    3. But this is a recent development. Part of how we got here was grandstanding by prominent economists in favour of austerity. So, for the future, it remains an important question. Even for the present, said grandstanding needs to be seen to be dealt with firmly and very publicly. For as long as it is not, the bolstering effect on politicians like Osborne will remain.

  8. You seem to assume here that independent central banks would deal competently with macroeconomic issues if only they had the powers to do so. The evidence for this is not compelling. Of the major central banks, the ECB is the least accountable and has also been the least effective. Under Trichet, it even raised interest rates at the height of the recession. Draghi’s performance has certainly been better but even under his leadership the ECB has been slower than others to take steps such as QE. Other examples also exist, e.g. under Greenspan the Fed seemed more concerned with share prices than with excess leverage. A core problem with CBI is the power it gives to unaccountable individuals who have their own preferences and who might get the macroeconomics wrong.

    Like it or not, the ultimate problem does lie with government and unless government acts then it will not be resolved. Even if central banks should have more powers, it would still rest with governments to determine those extra powers and that would have political implications. As you noted in an earlier post, helicopter money is itself a fiscal instrument. Deciding that a central bank should be given power to create this would be a conscious decision to favour stimulus through consumer spending rather than public investment. That would be a political decision. Governments would also have to decide the rules for distributing the money.

    You cannot take politics out of this. We have to win the argument against austerity.

    1. ICBs have at least been trying to get us out of deflation, while governments have been acting against them. My earlier case against ICBs did not rest on their competence, both rather that the institution took away an instrument.

      As I said in an earlier post, helicopter money does not preclude using fiscal policy in a more sensible way. Think of it as a way a government can commit itself not to screw up the economy at some later date after a recession. Or as the government giving the ICB the instrument it needs when the ZLB arises.

    2. When governments get it wrong, we need to change the government.

    3. "helicopter money does not preclude using fiscal policy in a more sensible way. Think of it as a way a government can commit itself not to screw up the economy at some later date after a recession."

      Of course it does! Do you think your readers are dumb? If the central bank hands outs free money there is less fiscal space without causing inflation. Combined with high interest rates will mean your project cannot be funded. Much better low interest rates + no free money.

      Couldn't ICBs blackmail governments by refusing helicopter money? Or conversely government pressures CB to introduce HM?

      "ICBs have at least been trying to get us out of deflation, while governments have been acting against them."

      Sure the Conservative government has, but the opposition has supported "money financed" PQE or at least did until it was dropped for "CB Independence."

      BTW Carney has been scaremongering over the EU Referendum:

      "EU referendum: Mark Carney warns Brexit is biggest risk to Britain's financial stability"

    4. We are already out of deflation. The problem is sloppy handling of inflation that under counts it persistently.

      Central Banks are a mess largely because of poor government accounting do to the 70's inflation hoax(aka population boom created shortages). The key is the massive technological revolution jacking up production like crazy in the late 20th century. We can produce so much, much more than we would ever need. It keeps prices down. It even hit commodities. We can produce far more than in 1970.

      ICB's have a extremely loose monetary policy in response, of what they think is low inflation as a result.

  9. "that ranks alongside deficit obsession is the evil of printing money in any circumstances."

    I can never understand that.

    All bank lending is balance sheet expansion aka printing money. All government spending is printing money.

    Factoring companies and debt recovery firms that trade delinquent debts are creating money. Any liability that passes around changing title is a form of endogenous money. It allows spending without requiring saving ahead of time.

  10. "Another possibility is that the government (in its saner moments) gives ICBs the power to undertake helicopter money."

    Disagree. I think the government should give me the power to create money to buy chocolate and have my own theme park. That is a far superior suggestion. Or am I lacking an awesome beard?

  11. by what workhorse model do the non-work arounds produce the causal dynamics?

    i think Nick Rowe's answer for negative rates is the IS curve plus Phillips curve (with expectations playing big role in both).

    i think the big problem with this account--although i should say its the best imho, is that it might seriously muddy our nominal/real distinction in that monetary policy might have a strong real effect and a tenuous nominal effect.

    take the following special case where nominal perpetual bonds yield zero and cash yields zero--now lets say zero nominal yields happen to be exactly those required for full employment (pick what ever inflation rate you want towards which these nominal bond yields are in the service and guarantee this outcome)

    now lets say that the monetary authority lowers bond yields and cash yields--while keeping them equal--more than 1-1 to offset a fall in inflation expectations. my argument is that this is more than sufficient to restore full enployment, but that its effect on the future price level is ambiguous. one could think of many reasons why this might be true in theory, for eample the future price level could adjust downwards by the slight margin needed to ensure only full employment and no more and the monetary authority might passively accept this change. While this specific example is highly stylized, this is not just academic, if you look at the ratio of m2/gdp in various countries, even BROAD monetary aggregates are very sensitive to the opportunity cost of holding money (and btw the Pigou effect doesnt seem to pull up the price level even at very large real money balance---incidentally why i am very skeptical of helicopter money).

    to wrap up, in the basic model, if you keep pusing rates below r*, eventually you get inflation via the phillips curve--otherwise you could just push unemployment to zero--and if you perform the counterfactual of holding rates constant at that time, real rates would get progressively more negative reinforcing the whole loop and driving inflation up, up and away. it is precisely the prohibition of this path via a policy rule that estabishles a RE equilibrium.

    as far as it goes, this is a credible and causally robust model. it has one major deficit though.

    if the return to bonds and cash is expected to be equal for a functionally long enough period, i dont think its very good at tieing down the future price level. Nothing new here at all of course.

  12. "Perhaps it was too unconventional setting out an argument (against independent central banks, ICBs) that I did not agree with"

    Isn't that a strawman?

  13. If ICBs are good because they avoid Monetary Policy motivated by political factors (dropping rates at election times) then do you believe that the same applies to Fiscal Policy, and would you accept that an independent Treasury is a step to far down the road of technocracy?

    Equally is Monetary Policy not inherently a political decision to be made by politicians. You have argued before that Monetary expansion is better than Fiscal expansion based on the assumption that the current public/private good mix is optimal: which is certainly subjective idea for politicians and not Central Bankers to decide.

  14. Historically at least, the culture of ICBs, from NZ onwards has been much more focussed on the inflation side of things and much less concerned with jobs or growth. Indeed, much of the theorising of ICB credibility has rested on the willingness to "do a Volcker" and "crash the economy for the greater good." It's a long time since an ICB was significantly and effectively reprimanded for undershooting the inflation target.

    (Note, I have no useful solution to this conundrum.)

    All of this is of course amplified by the fuzzy way inflation is discussed. The colloquial ways of both non-economists and many economists leads to conflation of any move in the inflation index with "wage inflation" which then leads us back to the "being as tough as Volcker" moments...

  15. I am 100% agree on this point that You have not presented a strong case against the independence of central banks, neither in your first nor in this post. That is perhaps no surprise since you yourself are in favor of their independence.

  16. I have a cunning (Post K) plan. Set the central bank base rate to zero and leave it there. Shut down the "monetary policy" unit and the MPC. Central bank reverts to being the reserves clearing bank, with permanent overdraft facilities, for deposit taking commercial banks and small business free factoring.

    The newly named national clearing bank, becomes part of the Treasury and amalgamated with the Treasury Debt Management Office. The National Loans Fund is the consolidated fund. The Treasury “full funding” rule is abandoned, Gilts and Treasuries will only be issued for operational purposes, not free money for pension funds.

    Fiscal policy becomes the inflation controller applied across each main / sub sector of the economy. Treasury spending and dynamic taxing, will be used to take up spare capacity and increase employment in desired sectors; or, tax it if you want to cool down a sector, or divert some of its output into the public sector. That includes taxing excessive credit creation in the private sector, that creates bubbles like housing and the sub-prime mortgage disaster of 2008. Simples ;-)

    This will put all the responsibility on elected politicians. They will no longer be able to hide behind a central bank governor (redundant) and his/her well passed its sell buy date, monetary policy.

  17. Hi Simon,

    I am not sure this is the right place, but I would like to have your opinion on this idea :
    inequality targeting policies. Inflation ( or a similar macro target ) targeting is debatable but overall a great idea and there is an international consensus on it. There is also a consensus on the fact that it is not efficient to counter the rising concern of our time on inequalities, which is more a political issue to be tackled by governments.

    Don't you think that the equivalent of inflation targeting by the ICBs would be some form of inequality targeting by governments ?

    I strongly feels that governments in general set too many micro objectives that they often cannot control and miss the big picture.

    The primary tool for inequality targeting would be fiscal policies and minimum income, but the important idea is to set a target.

    That would also be a key to overcome short term politics, and maybe create a new independent institution responsible for the inequality mandate.


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