Winner of the New Statesman SPERI Prize in Political Economy 2016

New! Lecture on 23rd May at Bush House, 44-46 Aldwych on my book 'The Lies We Were Told' with discussion from Rachel Shabi and Aeron Davis. Book here.

Friday, 14 September 2018

Another lesson of the GFC unlearnt: the Consensus Assignment is dead

Martin Sandbu recently responded to critics of an earlier piece of his arguing that central bankers could and should have done more to tackle the aftermath of the Global Financial Crisis. I stress aftermath here, because I have no doubt that central banks (including the Bank of England) were culpable in both ignoring warning signs before the crisis, and in the UK and Eurozone not reacting quickly enough to the consequent recession. (It is extraordinary that on the MPC only Danny Blanchflower understood what was going on, and I would argue that part of the reason for this was the primacy of the inflation target.)

It is also obvious that the ECB were wrong to raise rates in 2011 and not to introduce QE much earlier. That the UK almost raised rates in 2011 is not reassuring, and suggests they did take their foot off the peddle over that period. I would also argue that the ECB were very wrong to wait until September 2012 to introduce OMT.

In the UK and US I do not buy the argument that no further stimulus was needed.

UK unemployment rose from around 5% to around 8% in 2008/9, and stayed at that level until it began coming down in 2013. US unemployment was also above 8% until 2013. Both economies needed more stimulus in 2009, and in its absence in 2010 and so on. To think otherwise means you are placing too high a weight on temporary changes in inflation and too low a weight on the costs of the recession. 

Where I think I might disagree with Martin is that this stimulus could have reliably come from monetary policy. A good policy instrument is one that has a reliable impact on demand, and the only reliable monetary policy instrument that fulfills that criteria is short interest rates. Central banks could have done more QE, or they could have reduced rates below the Effective Lower Bound (ELB), but they wouldn’t have known how much to do. They might have got there in the end, but extra years of unemployment and probably a permanent hit to output through hysteresis were an avoidable cost.

The biggest mistake central banks made was not to recognise this and be honest with the public. They should have said, clearly and repeatedly, that once rates hit the ELB monetary policy was no longer the most reliable instrument to stabilise the economy, and fiscal policy should be used. This does not break any implicit concordat about not commenting on fiscal policy (which most central banks break anyway), because the statement is about a delegated authority being honest with the public about whether it can reliably do its job..

The fact that central banks in the UK and Eurozone didn’t do that may reflect dishonesty or it may reflect negligent ignorance. The fact that options like QE existed may have allowed central banks to convince themselves that they could still do the job assigned to them, and it discouraged them from being honest with the public. I say negligent ignorance, because instrument reliability is pretty basic stuff.

Martin writes
“Besides, there was broadly shared understanding among macroeconomists and central bankers of the best division of labour. Fiscal and budgetary policy should be set to achieve microeconomic and distributive goals, and the desired share of the state in the economy; while monetary policy should take care of stabilising aggregate demand.”

This is what I call the Consensus Assignment, and as the name implies it was certainly the consensus among mainstream macroeconomists before the 1990s. But the experience of Japan’s lost decade where they also had interest rates stuck at the ELB began a process of rethinking. By the time the GFC came around many macroeconomists had realised that there was an Achilles Heel in the Consensus Assignment. Fiscal stabilisation was still required when interest rates hit their ELB. That is why we had fiscal stimulus in 2009.

The importance of this cannot be overstated. The policy consensus in 2009 was that fiscal stimulus was required, because monetary policy was not enough. This consensus didn’t evaporate in 2010. What overrode it was mainly politics - what I call deficit deceit. There was also a bit of panic in some quarters caused by the Eurozone crisis. However a majority of academic macroeconomists continued to believe that further fiscal stimulus was required, and that majority got steadily larger as time went on.

Which means that the Consensus Assignment that Martin talks about is dead, or at least dead until monetary policy makers can agree some form of fiscal delegation (e.g. helicopter money) with governments. As this paper from the Boston Fed points out, downturns where interest rates hit their ELB are likely to become the new normal, but policymakers have not adjusted to this. (The exception is Labour’s fiscal credibility rule.) Quite simply, most policymakers have not learnt a major lesson of the Global Financial Crisis.


  1. Apparently on a visit to the London School of Economics shortly after the 2008 Crash, the Queen asked economists there "Why didn't you see it coming?"

    Am I being naive if I suggest that a fair response from them might have been "If we'd have been able to see what was going on inside the banks, we would. But there weren't any regulations in place which allowed us to do that. That's what happens when you deregulate."

    I don't know if it still happens, but 30 years ago it was quite common to have undercover agents (from Special Branch?) in organisations regarded as a threat to the state. They even fathered children to women activists.

    Trade unions at GCHQ were regarded as such a threat to national security that members were given £1000 by the government if they left the union.

    So were there any undercover "financial agents" in Britain's banks ten years ago passing information about their shady dealings over to the Treasury?
    Or were the banks run by such trustworthy individuals that such surveillance was considered unnecessary?
    Are there any agents in the banks today?

  2. I understand your concerns Simon. Perhaps central banks should have done more to shout from the rooftops about impotence in the face of the ZLB. In the U.K. context the BoE began to make statements buried in the inflation report in 2014 about how fiscal consolidation was depressing demand over the forecast horizon but by that point the damage was done. That said, I think 2 things can be said in CBs defence.

    Firstly as you know central banking is, by its nature, a confidence trick. It is about making people credibly believe that growth is on its way to justify optimism now. Claiming that there is no ammunition (and that statement is in itself uncertain) causes self-fulfilling pessimism. Why would any central banker want to produce a certain recession when there are still tools that have a non-zero chance of success. I guess you could argue that it forces the government's hand. But that leads on to my second point. Politicising the role of the central bank is risky. Politicians and the public would object to unelected power dictating how the government should spend its money. People forget how young independent central banks are and think they have earnt a permanent place in the institutional framework. I am not so certain.

    I know people who work in central banks and have spoken to them about the implications of the fact that moving forward countries will spend longer up against the ELB. It is clear to them that long term if the scenario persists some change in the goal or regime will be needed (e.g. new fiscal rules, nominal GDP targeting, higher inflation target etc) but that ultimately this will be a question for parliament.

  3. In contrast to SW-L, who still claims interest rate adjustments are the best way of adjusting demand when interest rates are above zero, there are many who claim interest rate adjustments are a poor tool for that purpose and that they should be abandoned, except perhaps in emergencies. Milton Friedman and Warren Mosler advocated that. Plus Positive Money and the New Economics Foundation advocated the same in their submission to Vickers. Relevant links are in a paper I recently put online:

    I also argued (in my section 3) that there is a fundamental theoretical flaw in interest rate adjustments. It’s that come a recession, the free market mechanism that WOULD get us out of recessions if the free market was allowed to work is not the failure of interest rates to fall: it’s the failure of wages and prices to fall (because of Keynes’s “wages are sticky downwards” phenomenon). Falling prices would raise the real value of the stock of money, base money in particular, which would raise demand (the Pigou effect).

  4. Never had the pleasure of meeting Danny Blanchflower but in his (frequent) media pronouncements (despite being in general agreeemnt usually) he tends to comes across as self-opinionated, somewhat self-righteous and non-collegiate (more so than the established economist average), which, perhaps, did not help his case on the MPC.

    Insofar that MPC decisions are committee decisions decided by majority vote, if necessary (as it was designed to be by Balls et al), it will inevitably affected by the accompanying dynamics of its members. Others, such as Andrew Sentance argued that QE was being (in lay-person terms) over-used and was distorting the economy, as indeed it has.

    No particular writ for the BoE, but to accuse it of effectively 'corporate negligence' seems a bit strong.

    There was no political consensus in favour of a fiscal stimulus in 2011.The alternative monetary response to QE (recognising the blurred distinction between unconventional monetary actions and fiscal stimulus, which surely also applies to a degree with QE) really was for the BoE to target its bond purchases towards the real economy: that required, however, prior institutional reform.

    Direct money-financing of the government deficit, or other types of 'helicopter financing',he BoE will always resist because it cannot, or is difficult to, be reverse and thus in its eyes risks accelerating inflation.
    Is there a coherent and politically communicable New Keynesian answer to that, other than fiscal stimulus should be used until the output gap is closed, when interest rates can then once again stabilise demand? The real issue to what extent output and inflation should be allowed to overshoot before being dampened.

    Labour's Fiscal Credibility Rule was agreed in a committee room after the horse had bolted. It is not clear when it would apply in the future (technical future recession of two negative gdp quarters, or in conditions of continuing stagnation?). Such fiscal rules can, of course, be distorted, misapplied, mismeasured, or ignored, if political circumstances or convenience dictate, as has tended to be the rule rather than the exception.

    The recent IPPR report advocated that not only that the BoE primary inflation target be supplemented by intermediate employment and nominal GDP but it is joined by a FPC house price target. Labour has demanded that a productivity target should also be added. The economics was not really spelt out. Who is going to do that?

    The IPPR proposal for the a newly-eatablished NIB to act as the future main conduit for BoE-financed fiscal stimulus, also neglects the gestation period before a NIB can becomes operative. Given also that the NIB proposal is already owned by Labour, why would it be necessary for a future Labour government to rely on a fiscal rule delegation to the BoE to do something that it could do itself? Why not delegate an equality and social mobility target to the BoE?

    Lots to discuss: it is great that the debate is widening. But consistent with above, there is ground for concern that political choices and decisions are being proposed to be delegated to the BoE, as an a lazy default response. First and foremost, both the economics and the politics needs to change at higher-order level.

  5. Surely the implication of the paper by the Boston Fed is that fiscal stimulus will be required during most downturns due to the lowering of the ELB. What does this imply for debt dynamics? It seems to me that this is recipe for unsustainable expansion of public debt.

    However, as you have said before the fact that rates are at the ELB renders this expansion cheap to finance but you must surely admit that it has a limit and that when rates do go up then this will have a significant impact due to a higher interest bill and also a potential effect on the currency.

  6. Prof. Wren-Lewis, on the unlearned lesson from the crisis perhaps you and readers might be interested in this comment of a few years back (with similar title, by the way)

  7. I do like "consensus assignment" as a tool for evaluating policy.
    Some feedback for you, Simon.


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