Some myths about government debt and how it is financed

That the Bank of England was temporarily eliminating the limit on the Ways and Means Facility caused a bit of a stir last Thursday (9th April). It in effect meant that the Bank of England could credit the government with as much money as it needed in the current crisis. That it should cause such a stir illustrates how pervasive many of the myths are around government debt. Here are three familiar examples.

1. It doesn’t matter that we are in a developing economic crisis, like a recession or a health pandemic, we still need to worry about what is happening to government debt.
   
   This is false for any country that prints its own currency, like the UK. In a crisis you should worry about dealing with the crisis. Government debt is what allows the government to put all necessary fiscal resources into fighting the crisis. To worry about debt is like worrying that a fire engine putting out a fire is using too much water.
   
   
2. OK, but we should worry about government debt the moment output stops falling (or in a pandemic, the moment any lock down is relaxed).
   
   Again false. This was the mistake that some large economies made after the Global Financial Crisis (GFC). By worrying about debt they either slowed down, killed or reversed the recovery. Because governments can get the Bank of England to buy its debt (or continue to create money), there is no need to worry about debt until the economy has fully recovered from the crisis. This will be equally true in any recovery from the pandemic.
   
   
3. When the government starts financing its deficit by printing money rather than issuing debt, rampant inflation is just around the corner.
   
   

Many thought this after the GFC, when central banks started buying government debt through their Quantitative Easing programme, because they bought the debt by creating money. Subsequent events have shown that those who thought inflation was inevitable were completely wrong, as many of us said at the time. The reason they were wrong is because interest rates are at their lower bound, and at the lower bound it does not matter too much how the government deficit is financed. The reason is intuitive: when rates are zero, you are indifferent between cash and short term debt. So why would issuing money rather than debt cause inflation when rates are zero? No reason at all.

Which brings us to the Ways and Means Facility. In practice this lifting of the limit is likely to be simple cash flow management, with the government still issuing debt at the end of the day. But the Bank of England will keep buying debt as part of their new QE scheme. Ironically it is possible that we may get some inflation this time round, but it will have nothing to do with QE, and everything to do with some sectors not hit by the pandemic taking advantage of high demand, or sectors still functioning but with some labour shortages passing on higher costs. The Bank of England is likely to ignore that inflation if it happens.

Why does the government prefer to issue debt rather than create money to cover its deficits? After all, doing so costs it money. Even when short term interest rates are zero, interest rates on long term government debt are higher, to compensate for having the money locked up or the capital risk in selling it earlier. To say that financing deficits by money creation creates inflation is too trite, because it appeals to a simple linkage between prices and central bank created money that we just noted fails to happen in recessions.

A better answer is the one Keynes gave. In a recession you can create a lot of money, because it is willingly held by nervous banks and investors. But outside a recession investors and banks will want to get rid of that money, which will force down rates of interest in the economy, encouraging too much borrowing and discouraging savings. That excess demand will create inflation. Central banks are only able to control the general level of interest rates in the economy by restricting the amount of money they create, which is why government deficits are largely financed by issuing debt.

If we shouldn’t worry about government debt during crises, or as crises are coming to an end, should we worry about it at all? It is a good question, which can only be answered by looking at why having high levels of government debt might be bad. So let’s look at three myths or misunderstandings about government debt.

1. High debt risks financing crises.
   
   The general view at the moment is that there is a shortage of safe assets in the world, and the clearest evidence for that is low interest rates on government debt. As to short term market panics, we have seen that for a country that prints its own currency that is not a concern.
   
   
2. It is a burden on future generations
   
   

The idea here is that any debt has to be serviced (the interest has to be paid), and this can only be done by raising taxes. But the level of debt interest depends on interest rates as well, so when these are low, debt can be higher with the same ‘burden’. The other thing to be said (which should be obvious but is often missed) is that failing to stimulate in a recession can cause lasting damage to future generations. As can not dealing with climate change.

The same point applies to the idea that higher taxes to service debt discourages labour supply. When interest rates are very low, the impact of debt service on taxes is also low. There is a common error often made here. People note that the amount of money required for debt service could build many new hospitals, so let’s reduce debt to get more hospitals. But getting debt down to zero would require severe fiscal consolidation for decades before that goal was achieved.

3. It crowds out investment
   
   

This is an obvious mistake during an era of low real interest rates. Government debt crowds out private capital in OLG models by raising interest rates. So if interest rates are low enough to finance any decent investment, there can be no harmful crowding out.

To sum up, in an era of very low interest rates government debt can safely be much higher.The case for reducing the debt to GDP ratio from what it ends up being after the pandemic is over has to be made, and that case needs to take account of what causes real interest rates to be so low (secular stagnation) as well as the literature on safe asset shortages. In particular, as Olivier Blanchard has emphasised, if real interest rates on government debt are less than the growth rate, positive shocks to debt caused by recessions will gradually unwind of their own accord.

I have, however, to end with one final myth. This is

Deficits don’t matter as long as they don’t create excess inflation.

This is just not true when independent central banks (ICBs) control interest rates, because central banks will vary interest rates to control inflation. ICBs have been very successful at bringing inflation right down to low levels, which is why no government or opposition is going to abandon them anytime soon. In that situation, deficits that are too large or small will lead to changes in interest rates rather than inflation. (ICB’s are not so good at preventing recessions when inflation is low, which is why we need a state dependent assignment.)

Once recessions, caused by whatever means, are over then it makes sense to have targets for the government deficit (excluding investment) as a share of GDP. What that target should be will depend on a view of what the ideal debt to GDP ratio should be. (For more detail see here.) These targets are there not because high deficits will be the end of the world - far from it. Instead they are a disciplining device for governments. In the past it was thought they were needed to stop left wing governments spending too much, but in the UK and US the more likely problem is of right wing governments taxing too little.

Which brings us to why so many people think government debt and deficits are much more important than they actually are. In the past spurious concern about deficits has been seen by many to be an essential way of keeping a lid on government spending when a left wing government is in power, or even as a way to shrink the state when a right wing government is in power. It is ironic that in a era when there is an imperative to reduce climate change, the importance of deficit targets may be to stop right wing governments cutting taxes.  

How to pay for the Green New Deal

The Green New Deal has recently been promoted by a group of Democrats including the inspirational Alexandria Ocasio-Cortez. I first came across it in a report in 2008 by the Green New Deal group, most of whom are pictured above a decade later (HT Andrew Simms). The view that we face a potentially existential climate change crisis, which politicians seem currently reluctant to sufficiently tackle, and which therefore requires a government led programme on the scale in each country of Roosevelt’s New Deal, is something I share.

Why a New Deal? What is wrong with treating climate change as we would any other kind of pollution, with a mixture of regulations, taxes and subsidies? I think the answer is put rather well at the end of an article in the Economist (HT Laurie Macfarlane) which seemingly complains about the Green New Deal’s departure from what it calls ‘economic orthodoxy’. They write

“In fact, the criticism of the economic approach to climate change implicit in the Green New Deal is not that it is flawed or politically unrealistic, but that it is a category error, like trying to defeat Hitler with a fascism tax.”

I would put it in the following way. Tackling climate change is resisted by powerful political forces that have in the past prevented the appropriate taxes, subsidies and regulations being applied. Which is a major reason why the world has failed to do enough to mitigate climate change despite decades of warnings from scientists. You need something like a Green New Deal to push aside those vested interests, and get the right taxes, subsidies and regulations into place. Just as proponents of a Green New Deal are savvy about the need to overcome the resistance of, for example, the oil and gas industry, they also realise that the Green New Deal needs to be politically popular. So the New Deal package has to include current benefits for the many, perhaps at the expense of the few.

What the most effective measures are to mitigate climate change, and perhaps other global environmental disasters, is a fascinating topic. We can learn a lot from the successes so far. Solar energy is now at least as cheap as coal, oil and gas, but this was not always so. It required substantial subsidies or state help for initial development, despite protests that solar energy would always be too expensive. Once a technology is widely used it tends to get cheaper to produce because innovations continue when a mass market emerges, and that is what happened with solar energy. It is impossible to pick winners in advance, so we need to try a number of things some of which will fail. Partly because of those failures a great deal of the required research and development must come from the public sector. No stone must be left unturned when the future of humanity is at stake.

Which all sounds rather expensive, and in particular will require large amounts of public money. An interesting and important issue is how this should be paid for. In the scheme proposed by among others Thomas Piketty, higher taxes on multinationals, millionaires and carbon emissions generate funds to tackle poverty, migration, and climate change. Others have suggested that this spending is better funded by borrowing or creating money. To examine who is right, I want to talk about some of the work of John Broome, an Oxford philosopher and economist.

John Broome was a key advisor to the Stern review on climate change. He argued, and Stern agreed, that we should not discount the welfare of future generations as much as market interest rates appear to do. The reason is ethical: the current generation had no justification for valuing the welfare of the unborn less than their own welfare. This helped Stern to recommend much more current action on climate change than other US based analysis. As Broome emphasised, the key argument here was ethical not economic.

In terms of the funding debate, ethical arguments are also critical. The polluter pays principle suggests that the current generation should pay to mitigate the impact of the pollution they cause. So we should all be paying more for energy, for example, so that the carbon used to produce that energy is priced to reflect its impact on climate change. The idea that the polluter should pay makes economic and ethical sense. It embodies an idea of fairness that most people would accept.

Unfortunately this does not work well enough in practice because those with an interest in selling more carbon and their political allies make people doubt that climate change is real. In addition the connections between the prices people pay and the emissions that cause climate change are often not transparent. So how do you deal with societies that for these reasons fail to pay enough to mitigate climate change?

The argument that Broome put forward (following work by Duncan Foley) is that measures to tackle climate change can be funded by issuing debt. This breaks the polluter pays principle, but it can still lead everyone to be better off (what economists call a Pareto improvement). If government debt rather than taxes are increased to pay for, for example, investment in greener infrastructure the current generation gets away with not having to pay. If future generations have to pay back the debt used to pay for these measures, that cost falls on them, but it is more than matched by the benefits to them because of the climate change avoided as a result. In other words if you cannot make the polluter pay, it is still better to take action to stop climate change even if future generations have to pay the cost of that action.

The case for using government debt to fund the Green New Deal has been strengthened by recent observations by Olivier Blanchard. He noted that interest rates on government debt have over the last half century been below the growth rate of GDP. What this means is that a one-off increase in debt may not require higher tax rates in the future, because that debt as a share of GDP will gradually shrink.

If both these reasons for using debt finance to partially pay for the Green New Deal fail to convince, just think of it this way. No one in a 100 years time who suffers the catastrophic and (for them) irreversible impact of climate change is going to console themselves that at least they did not increase the national debt. Humanity will not come to an end if we double debt to GDP ratios, but it could come to an end if we fail to combat climate change.

All this means that the question of how a measure is financed should never prevent that measure being implemented if it has a reasonable chance of reducing climate change. The whole point of the Green New Deal is that measures should be judged on how effective they will be at achieving their goal, and not on whether they can be afforded. Funding through taxes should be the first option because the polluter should pay, but if this is not politically possible then government debt should increase.

What are the chances of either of the two main political parties implementing a Green New Deal in the UK? It is hard to see a Tory government doing so because of its aversion to debt finance, its neoliberal reluctance to have government lead the way, and because the party contains many climate change deniers. The Labour party is much better placed, and has already set out plans to create its own Green New Deal. Crucially their fiscal credibility rule makes the distinction between current spending that does need to be covered by taxes in the medium term and investment spending that does not, because future generations benefit from that investment. The Green New Deal is all about investing now to improve the welfare of future generations.

Should we worry about temporarily raising government debt? - Blanchard’s AEA Address

This post not about the main part of this address, although as its my area and interesting I may write about it later. Instead I’m going to talk in a non-technical way about its premise, because that alone has implications that may be well known among economists but not elsewhere. The following is based on his presentation.

Should governments worry about temporarily paying for things by borrowing? One standard answer is yes, because although nothing obliges government to pay off this extra debt (it can be rolled over), it has to pay interest on that debt which requires higher taxes. If the government didn’t raise taxes to pay the interest on the debt, but instead just borrowed more to pay the interest, you would enter what is sometimes called a debt interest spiral, where debt goes up and up and eventually explodes.

But does a slow explosion in debt matter if the economy is also growing? A government (like a firm of individual) should look at debt as a ratio to its ability to pay, and the easiest way to do that is to look at the debt to GDP ratio. A company would not worry about increasing debt if its profits were rising even faster. For a given stock of debt, its growth rate is given by the rate of interest on the debt. So GDP rises faster than debt if its nominal growth rate (real growth plus inflation) is greater than the rate of interest on that debt. In shorthand, g > r.

Typically economists like me tend to assume that this is not true, and instead r > g. But the starting point for Blanchard’s lecture is that currently, and on average in the past, g > r. There has been only one decade since the 1950s when this hasn’t been true, and that is the 1980s when governments were pushing up interest rates to bring inflation down. Most of the time g > r. So the fact that g > r today may be the rule and not an exception.

Why do economists typically assume r > g when the opposite has generally been true? One answer is called financial repression, which is a label given to attempts by governments in the past to keep interest rates ‘artificially low’ in conjunction with various credit controls. The idea was that in a financially liberalised world where interest rates are used by central banks to target inflation there will be no financial repression, and real interest rates will be higher. So it made sense, the argument went, to assume r > g from now on even though g > r in the past. However what economists call secular stagnation suggests that the average interest rate required to keep inflation constant has actually been steadily falling, so Blanchard’s findings become relevant again. There is plenty of scope here for more research and debate.

So if normally g > r, does this mean we do not need to worry about debt? Not quite. What it means is that one of the standard objections to raising debt, which is that taxes will have to rise to pay the interest, no longer holds if g > r. If g > r the government can borrow to pay the interest, and yet the debt to GDP ratio will still gradually decline, because the economy is growing faster than debt. The objection to raising debt that taxes will have to rise in the future to pay for it disappears. Indeed the whole ‘burden on future generations’ objection to raising debt falls away, because the debt to GDP ratio declines by itself: there is no future burden.

An important proviso, however, is that we are talking about one-off increases in debt. Such one off increases would include, for example, increases in debt to build new public infrastructure or increases in debt caused by fiscal expansions to fight a recession. g>r does not mean we do not need to worry about persistent primary deficits (by which I mean spending permanently higher than taxes). A persistent primary deficit will add to the growth in debt, so the debt to GDP ratio will rise despite g > r.

This is just the starting point for Blanchard’s lecture, and if you are an economist I recommend watching it as it is very easy to follow. In policy terms I think it is the last nail in the coffin of what Paul Krugman calls the deficit scolds. Those who argued for austerity because of the burden on future generation, although on weak ground even if r > g, find their argument collapses if g > r. [1]

[1] Blanchard shows this remains true even if there are periodic shocks where r > g, as long as on average g > r.

The IMF as a transmission mechanism for academic knowledge

In my recent post on the ‘biggest policy mistake of the last decade’, I emphasised the irrelevance of the academic consensus on austerity if politicians did not want to listen. It was, inevitably, a picture painted with a broad brush.

I did not discuss, for example, an element that should form part of the transmission mechanism for academic knowledge but didn’t, and that is European central banks. As I have discussed here, these central banks are full of economists applying state of the art macroeconomic knowledge, so they should be a source for the current academic consensus. But these central banks are also very hierarchical, and if the senior staff want to give out a different message they can. In Europe that message was that austerity was necessary, and worse still that the lower bound for interest rates was no impediment to their ability to control the economy.

This was a serious mistake for two reasons. First, central bank leaders were going against the knowledge that their own economic models and analysis gave them. Second, their implication that the lower bound for interest rates didn't matter was not only very wrong but also encouraged politicians to continue with austerity.

But there was a perhaps surprising route by which the academic consensus did get through, and that was the International Monetary Fund. The IMF itself wavered on austerity. At first (before 2010) it encouraged coordinated fiscal stimulus. As the Eurozone crisis began to unfold it changed its mind, and advocated austerity. But this did not last that long. I remember visiting the IMF in September 2012, and being told of empirical work by their Chief Economist Olivier Blanchard and Daniel Leigh that suggested multipliers might be much larger than the received Fund wisdom at the time. It was nice for me, because one of the talks I gave was why from a theoretical point of view multipliers might be large when interest rates were stuck at their lower bound.

This was not the only piece of Fund work that undermined the case for austerity. This analysis questioned the empirical case for expansionary austerity, as I discussed here. Economists at the IMF also showed clearly how unusual the behaviour of government spending after the Global Financial Crisis was compared to previous recoveries: austerity, far from being the norm, was an untried experiment. Indeed I think it is fair to say that if you wanted a source of empirical analysis on the impact of austerity, the IMF was your first port of call.

As Ben Clift discusses here, the IMF have also pioneered analysis of how inequality, and perhaps even large financial sectors, may be bad for growth, and much more that you would not have expected from the IMF of the last century. But he also points out something I emphasised in a post I wrote after my visit. The IMF is extremely heterogeneous. Alongside more modern views of the role of fiscal policy you will also find traditional fiscal hawks. The IMF also has its hierarchy with more political masters, but the difference is that at the IMF today there is no rigid control of what gets published by its economists.

For example, the IMF have an Independent Evaluations Office, which appears to be lead by economics rather than politics and which is often critical of IMF practice. I noted here, for example, a 2014 analysis of austerity, which criticised the support the IMF gave to austerity from 2010. The report essentially suggested that parts of the IMF had been panicked by the Eurozone crisis, which also presumably gave the fiscal hawks in the institution the upper hand. The report also explains why this panic was unwarranted given what we now understand about the Eurozone specific causes of that crisis, and this together with the Blanchard and Leigh analysis helped turn the tide against a belief in the virtues of austerity in the IMF.

All this IMF work was clearly very helpful to those economists like myself who were arguing against austerity at the time. It didn’t change policies in the UK and among Republicans in the US because those policies were ideologically based. I doubt it had much impact in Germany either. However it might be possible to argue it had some influence in softening the line taken by the EU Commission. If you look at the OECD’s estimate of underlying primary balances, 2013 was the last year of fiscal contraction in the EU as a whole.

Why the microfoundations hegemony holds back macroeconomic progress

When David Vines asked me to contribute to a OXREP (Oxford Review of Economic Policy) issue on “Rebuilding Macroeconomic Theory”, I think what he hoped I would write on how the core macro model needed to change to reflect macro developments since the crisis with a particular eye to modelling the impact of fiscal policy. That would be an interesting paper to write, but I decided fairly quickly that I wanted to say something that I thought was much more important.

In my view the biggest obstacle to the advance of macroeconomics is the hegemony of microfoundations. I wanted at least one of the papers in the collection to question this hegemony. It turned out that I was not alone, and a few papers did the same. I was particularly encouraged when Olivier Blanchard, in blog posts reflecting his thoughts before writing his contribution, was thinking along the same lines.

I will talk about the other papers when more people have had a chance to read them. Here I will focus on my own contribution. I have been pushing a similar line in blog posts for some time, and that experience suggests to me that most macroeconomists working within the hegemony have a simple mental block when they think about alternative modelling approaches. Let me see if I can break that block here.

Imagine a DSGE model, ‘estimated’ by Baynesian techniques. To be specific, suppose it contains a standard intertemporal consumption function. Now suppose someone adds a term into the model, say unemployment into the consumption function, and thereby significantly improves the fit of the model. It is not hard to think why the fit significantly improves: unemployment could be a proxy for the uncertainty of labour income, for example. The key question becomes which is the better model with which to examine macroeconomic policy: the DSGE or the augmented model?

A microfoundations macroeconomist will tend to say without doubt the original DSGE model, because only that model is known to be theoretically consistent. (They might instead say that only that model satisfies the Lucas critique, but internal consistency is the more general concept.) But an equally valid response is to say that the original DSGE model will give incorrect policy responses because it misses an important link between unemployment and consumption, and so the augmented model is preferred.

There is absolutely nothing that says that internal consistency is more important than (relative) misspecification. In my experience, when confronted with this fact, some DSGE modellers resort to two diversionary tactics. The first, which is to say that all models are misspecified, is not worthy of discussion. The second is that neither model is satisfactory, and research is needed to incorporate the unemployment effect in a consistent way.

I have no problem with that response in itself, and for that reason I have no problem with the microfoundations project as one way to do macroeconomic modelling. But in this particular context it is a dodge. There will never be, at least in my lifetime, a DSGE model that cannot be improved by adding plausible but potentially inconsistent effects like unemployment influencing consumption. Which means that, if you think models that are significantly better at fitting the data are to be preferred to the DSGE models from whence they came, then these augmented models will always beat the DSGE model as a way of modelling policy.

What this question tells you is that there is an alternative methodology for building macroeconomic models that is not inferior to the microfoundations approach. This starts with some theoretical specification, which could be a DSGE model as in the example, and then extends it in ways that are theoretically plausible and which also significantly improve the model’s fit, but which are not formally derived from micofoundations. I call that an example within the Structural Econometric Model (SEM) class, and Blanchard calls it a Policy Model.

An important point I make in my paper is that these are not competing methodologies, but instead they are complementary. SEMs as I describe them here start from microfounded theory. (Of course SEMs can also start from non-microfounded theory, but the pros and cons of that is a different debate I want to avoid here.) As a finished product they provide many research agendas for microfoundation modelling. So DSGE modelling can provide the starting point for builders of SEMs or Policy Models, and these models when completed provide a research agenda for DSGE modellers.

Once you see this complementarity, you can see why I think macroeconomics would develop much more rapidly if academics were involved in building SEMs as well as building DSGE models. The mistake the New Classical Counter Revolution made was to dismiss previous ways of modelling the economy, instead of augmenting these ways with additional approaches. Each methodology on its own will develop much more slowly than the two combined. Another way of putting it is that research based on SEMs is more efficient than the puzzle resolution approach used today. 

In the paper, I try to imagine what would have happened if the microfoundations project had just augmented the macroeconomics of the time (which was SEM modelling), rather than dismissing it out of hand. I think we have good evidence that active complementarity between SEM and microfoundations modelling would have investigated in depth links between the financial and real sectors before the financial crisis. The microfoundations hegemony chose the wrong puzzles to look at, deflecting macroeconomics from the more important empirical issues. The same thing may happen again if the microfoundations hegemony continues.

A self-fulfilling expectations led recession?

The only two lectures on Oxford’s core undergraduate macro course that I still teach, and which I have just taught, are the last two on fiscal policy. I use the privilege of the last lecture to end on a reflective note. I acknowledge that macro rightly got a lot of stick by largely ignoring the role of finance, but I also point out that the poor recovery has involved a vindication of the core macro model: austerity is a bad idea at the ZLB, QE was not inflationary and interest rates on government debt did not rise but fell.

So far so familiar. But I end by showing them my this chart.

And I say that we really have no idea why there has been no recovery from the Great Recession, so there are plenty of mysteries left in macro. The puzzle is sharpest in the UK because the pre-crisis trend is so stable, but something similar has happened in most places. I think it is a suitable note of humility (and perhaps inspiration) on which to end the course. 

A mechanical way to explain what has happened is to bend the trend: to suggest that technical progress has been slowing down for some time. This inevitably means that the pre-crisis period is transformed into a boom. I have been highly skeptical about that story, but I have to admit part of my skepticism comes in part from traditional ideas about what inflation would do in a boom.

However another explanation that I have always wondered about and which others are beginning to explore is that perhaps we remain in an extended period of demand deficiency. Keynesian theory is very suggestive that such a possibility could occur. Suppose that firms and consumers came to believe that the output gap was currently zero when it is not, and that they erroneously believed that the recession caused a step change both in potential GDP but also possibly its growth rate. Suppose also that unemployed workers priced themselves into jobs by cutting their (real) wage or disappearing by no longer looking for work. The former could happen because firms could choose more labour intensive production techniques: scrapping the car wash machine for workers with hoses.

In that situation, how do we know that we are suffering from demand deficiency? The traditional answer in macroeconomics is nominal deflation: falling wages and prices. But because workers have already priced themselves into jobs, nothing more will come from the wages route. So why would firms cut prices?

If the pre-crisis trend still applies, it means that there are a large number of innovations waiting to be embodied in new investment. With this new more efficient capital in place, firms would either increase their profits on selling to their existing market or try to expand their market by undercutting competitors. We would get an investment led recovery, accompanied by rising productivity and perhaps falling prices.

But suppose the innovations are just not profitable enough to generate an increase in profits that would justify undertaking the investment, even though borrowing costs are low. Maybe a far more dependable motivator for embodied technical progress to take place is the need to satisfy an expanding market. The firm needs to install new capacity to satisfy growing demand for its product, and then it is obvious to investment in equipment that embodies new innovations. The accelerator remains a very successful empirical model of investment. (On both points, see this discussion by Caballero.) But if beliefs are such that the market is not going to expand that much, because firms believe the economy is ‘at trend’ and trend growth has now become pretty small, then the need to invest to meet an expanding market largely goes away.

This idea goes right back to Keynes and animal spirits of course. Others have more recently reformulated similar ideas, such as Roger Farmer. This is a little different from the idea of adding endogenous growth to a Keynesian model, as in this paper by Benigno and Fornaro for example. I’m assuming in this discussion that potential output has not been lost, because innovation has not slowed, but it is simply not being utilised.

It is this possibility which is the reason that I have always argued central banks and governments should have been much more ambitious about demand stimulation after the Great Recession. As I and others have pointed out, you do not have to attach a very high probability to the scenario that demand will create supply before it justifies a policy of ‘testing the water’ by letting the economy run hot. Every time I look at the data above, I ask whether we have brought this on ourselves by a combination of destructive austerity and timidity.

Blanchard joins calls for Structural Econometric Models to be brought in from the cold

Mainly for economists

Ever since I started blogging I have written posts on macroeconomic methodology. One objective was to try and convince fellow macroeconomists that Structural Econometric Models (SEMs), with their ad hoc blend of theory and data fitting, were not some old fashioned dinosaur, but a perfectly viable way to do macroeconomics and macroeconomic policy. I wrote this with the experience of having built and published papers with both SEMs and DSGE models.

Olivier Blanchard’s third post on DSGE models does exactly the same thing. The only slight confusion is that he calls them ‘policy models’, but when he writes

“Models in this class should fit the main characteristics of the data, including dynamics, and allow for policy analysis and counterfactuals.”

he can only mean SEMs. [1] I prefer SEMs to policy models because SEMs describe what is in the tin: structural because they utilise lots of theory, but econometric because they try and match the data.

In a tweet, Noah Smith says he is puzzled. “What else is the point of DSGEs??” besides advising policy he asks? This post tries to help him and others see how the two classes of model can work together.

The way I would estimate a SEM today (but not necessarily the only valid way) would be to start with an elaborate DSGE model. But rather than estimate this model using Bayesian methods, I would use it as a theoretical template with which to start econometric work, either on an equation by equation basis or as a set of sub-systems. Where lag structures or cross equation restrictions were clearly rejected by the data, I would change the model to more closely match the data. If some variables had strong power in explaining others but were not in the DSGE specification, but I could think of reasons for a causal relationship (i.e. why the DSGE specification was inadequate), I would include them in the model. That would become the SEM. [2]

If that sounds terribly ad hoc to you, that is right. SEMs are an eclectic mix of theory and data. But SEMs will still be useful to academics and policymakers who want to work with a model that is reasonably close to the data. What those I call DSGE purists have to admit is that because DSGE models do not match the data in many respects, they are misspecified and therefore any policy advice from them is invalid. The fact that you can be sure they satisfy the Lucas critique is not sufficient compensation for this misspecification.

By setting the relationship between a DSGE and a SEM in the way I have, it makes it clear why both types of model will continue to be used, and how SEMs can take their theoretical lead from DSGE models. SEMs are also useful for DSGE model development because their departures from DSGEs provide a whole list of potential puzzles for DSGE theorists to investigate. Maybe one day DSGE will get so good at matching the data that we no longer need SEMs, but we are a long way from that.

Will what Blanchard and I call for happen? It already does to a large extent at the Fed: as Blanchard says what is effectively their main model is a SEM. The Bank of England uses a DSGE model, and the MPC would get more useful advice from its staff if this was replaced by a SEM. The real problem is with academics, and in particular (as Blanchard again identified in an earlier post) journal editors. Of course most academics will go on using DSGE, and I have no problem with that. But the few who do instead decide to use a SEM should not be automatically shut out from the pages of the top journals. They would be at present, and I’m not confident - even with Blanchard’s intervention - that this is going to change anytime soon.

[1] What Ray Fair, longtime builder and user of his own SEM, calls Cowles Commission models.

[2] Something like this could have happened when the Bank of England built BEQM, a model I was consultant on. Instead the Bank chose a core/periphery structure which was interesting, but ultimately too complex even for the economists at the Bank.

Ricardian Equivalence, benchmark models, and academics response to the financial crisis

Mainly for economists

In his further thoughts on DSGE models (or perhaps his response to those who took up his first thoughts), Olivier Blanchard says the following:

“For conditional forecasting, i.e. to look for example at the effects of changes in policy, more structural models are needed, but they must fit the data closely and do not need to be religious about micro foundations.”

He suggests that there is wide agreement about the above. I certainly agree, but I’m not sure most academic macroeconomists do. I think they might say that policy analysis done by academics should involve microfounded models. Microfounded models are, by definition, religious about microfoundations and do not fit the data closely. Academics are taught in grad school that all other models are flawed because of the Lucas critique, an argument which assumes that your microfounded model is correctly specified.

It is not only academics who think policy has to be done using microfounded models. The core model used by the Bank of England is a microfounded DSGE model. So even in this policy making institution, their core model does not conform to Blanchard’s prescription. (Yes, I know they have lots of other models, but still. The Fed is closer to Blanchard than the Bank.)

Let me be more specific. The core macromodel that many academics would write down involves two key behavioural relationships: a Phillips curve and an IS curve. The IS curve is purely forward looking: consumption depends on expected future consumption. It is derived from an infinitely lived representative consumer, which means Ricardian Equivalence holds in this model. As a result, in this benchmark model Ricardian Equivalence also holds. [1]

Ricardian Equivalence means that a bond financed tax cut (which will be followed by tax increases) has no impact on consumption or output. One stylised empirical fact that has been confirmed by study after study is that consumers do spend quite a large proportion of any tax cut. That they should do so is not some deep mystery, but may be traced back to the assumption that the intertemporal consumer is never credit constrained. In that particular sense academics’ core model does not fit Blanchard’s prescription that it should ‘“fit the data closely”.

Does this core model influence the way some academics think about policy? I have written how mainstream macroeconomics neglected before the financial crisis the importance that shifting credit conditions had on consumption, and speculated that this neglect owed something to the insistence on microfoundations. That links the methodology macroeconomists use, or more accurately their belief that other methodologies are unworthy, to policy failures (or at least inadequacy) associated with that crisis and its aftermath.

I wonder if the benchmark model also contributed to a resistance among many (not a majority, but a significant minority) to using fiscal stimulus when interest rates hit their lower bound. In the benchmark model increases in public spending still raise output, but some economists do worry about wasteful expenditures. For these economists tax cuts, particularly if aimed at those who are non-Ricardian, should be an attractive alternative means of stimulus, but if your benchmark model says they will have no effect, I wonder whether this (consciously or unconsciously) biases you against such measures.

In my view, the benchmark models that academic macroeconomists carry round in their head should be exactly the kind Blanchard describes: aggregate equations which are consistent with the data, and which may or may not be consistent with current microfoundations. They are the ‘useful models’ that Blanchard talked about in his graduate textbook with Stan Fischer, although then they were confined to chapter 10! These core models should be under constant challenge from both partial equilibrium analysis, estimation in all its forms and analysis using microfoundations. But when push comes to shove, policy analysis should be done with models that are the best we have at meeting all those challenges, and not models with consistent microfoundations.

[1] Recognising this point, some might add some ‘rule of thumb’ consumers into the model. This is fine, as long as you do not continue to think the model is microfounded. If these rule of thumb consumers spend all their income because of credit constraints, what happens when these constraints are expected to last for more than the next period? Does the model correctly predict what would happen to consumption if the proportion of rule of thumb consumers changes? It does not.  

Blanchard on DSGE

Olivier Blanchard, former director of the IMF’s research department, has written a short critical piece about DSGE models. Forget all the econblog reaction that essentially says he has been too kind: DSGE completely dominates academic macroeconomics, and there is no way that all these academics are going to suddenly decide this research programme is a waste of time. (I happen to think Blanchard is right that it isn’t a waste of time.) What is at issue is not the existence of DSGE models, but their hegemony.

One of Blanchard’s recommendations is that DSGE “has to become less imperialistic. Or, perhaps more fairly, the profession (and again, this is a note to the editors of the major journals) must realize that different model types are needed for different tasks.” The most important part of that sentence is the bit in brackets. He talks about a distinction between fully microfounded models and ‘policy models’. The latter used to be called Structural Econometric Models (SEMs), and they are the type of model that Lucas and Sargent famously attacked.

These SEMs have survived as the core model used in many important policy institutions (except for the Bank of England) for good reason, but DSGE trained academics have followed Lucas and Sargent as viewing these as not ‘proper macroeconomics’. Their reasoning is simply wrong, as I discuss here. As Blanchard notes, it is the editors of top journals that need to realise this, and stop insisting that all aggregate models have to be microfounded. The moment they allow space for eclecticism, then academics will be able to choose which methods they use.

Blanchard has one other ‘note for editors’ remark, and it also gets to the heart of the problem with today’s macroeconomics. He writes “Not every discussion of a new mechanism should be required to come with a complete general equilibrium closure.” The example he discusses, and which I have also used in this context, is consumption. DSGE modellers have of course often departed from the simple Euler equation, but I suspect the ways they have done this (rule of thumb consumers, habits) reflect analytical convenience rather than realism.

What sometimes seems to be missing in macro nowadays is a connection between people working on partial equilibrium analysis (like consumption) and general equilibrium modellers. Top journal editors’ preference for the latter means that the former is less highly valued. In my view this has already had important costs. I argue that the failure to take seriously the strong evidence about the importance of changes in credit availability for consumption played an important part in the inability of macroeconomics to adequately model the response to the financial crisis (for more discussion see here and here). Even if you do not accept that, the failure of most DSGE models to include any kind of precautionary saving behaviour does not seem right when DSGE has a monopoly in ‘proper modelling’. [1]

Criticism of the DSGE hegemony from those outside economics, from macroeconomists who are not part of it, or even from economic policymakers has had little impact on those all important journal editors up until now. Perhaps similar comments from one of the best macroeconomists in the world might.

[1] I discuss the reasons why this may have occurred in relation to Chris Carroll’s work here.

Blanchard on Fiscal Policy

I was recently rather negative about the way the IMF frames the fiscal policy debate around the  right speed of consolidation. In my view this always prioritises long run debt control over fiscal stimulus at the zero lower bound (ZLB), and so starts us off on the wrong foot when thinking about the current conjuncture. Its the spirit of 2011 rather than the spirit of 2009.

Blanchard and Leigh have a recent Vox post, which allows me to make this point in perhaps a clearer way, and also to link it to a recent piece by David Romer. The Vox post is entitled “fiscal consolidation: at what speed”, but I want to suggest the rest of the article undermines the title. The first three sections are under the subtitle “Less now, more later”. They discuss the (now familiar from the IMF) argument that fiscal multipliers will be significantly larger in current circumstances, the point that output losses are more painful when output is low, and the dangers of hysteresis. I have no quarrel with anything written here, except the subtitle, of which more below.

A more interesting section is the one subtitled “More now, less later”. This section starts by noting that the textbook case for consolidation is that high debt crowds out productive capital and increases tax distortions. Yet these issues are not discussed further. The article does not say why, but the reason is pretty obvious. While both are long term concerns, they are not relevant at the ZLB.

Instead the section focuses on default, and multiple equilibria. After running through the standard De Grauwe argument, the text then says: “This probably exaggerates the role that central banks can play: Knowing whether the market indeed exhibits the good or the bad equilibrium, and what the interest rate associated with the good equilibrium might be is far from easy to assess, and the central bank may be reluctant to take what could be excessive risk onto its balance sheet.” This is more a description of ECB excuses before OMT than an argument.

More interesting is what comes next. Does default risk actually imply more austerity now, less later? I totally agree with the following: “The evidence shows that markets, to assess risk, look at much more than just current debt and deficits. In a word, they care about credibility.” “How best to achieve credibility? A medium-term plan is clearly important. So are fiscal rules, and, where needed, retirement and public health care reforms which reduce the growth rate of spending over time. The question, in our context, is whether frontloading increases credibility.”

So here we come to a critical point. Does more now, less later, actually increase the credibility of consolidation? If it does not, then the only argument for frontloading austerity disappears. The next paragraph discusses econometric evidence from the crisis, and concludes it is ambiguous. The whole rationale for more now, less later, is hanging by a thread. And there is just one paragraph left! Let me reproduce it in full.

“The econometric evidence is rough, however, and may not carry the argument. Adjustment fatigue and the limited ability of current governments to bind the hands of future governments are also relevant. Tough decisions may need to be taken before fatigue sets in. One must realise that, in many cases, the fiscal adjustment will have to continue well beyond the tenure of the current government. Still, these arguments support doing more now.”

Is this paragraph intentionally weak and contradictory? If credible fiscal adjustment requires consolidation by future governments, why does doing more now add to credibility? You could equally well argue that overdoing it now, because of the adverse reaction it creates (‘fatigue’ !?), turns future governments (and the electorate) away from consolidation, and so it is less credible.

So what we have is an article that appears to be a classic ‘on the one hand, on the other’ type, but is in fact a convincing argument for ‘less now, more later’. Perhaps that is intentional. But even if it is, I’m still unhappy. Although the arguments on multipliers, output gaps and hysteresis appear under the subtitle ‘less now, more later’, they in fact imply ‘stimulus now, consolidation later’, once you take the ZLB seriously. If you are walking along a path, and there is a snake blocking your way, you don’t react by walking towards it more slowly!

Why does this matter? Let me refer to recent comments David Romer made about the ‘Rethinking Macro’ IMF conference, which he suggests avoided the big questions. For example he notes “I heard virtually no discussion of larger changes to the fiscal framework.” He goes on (my italics)

“Another fiscal idea that has received little attention either at the conference or in the broader policy debate is the idea of fiscal rules or constraints. For example, one can imagine some type of constitutional rule or independent agency (or a combination, with a constitutional rule enforced by an independent agency) that requires highly responsible fiscal policy in good times, and provides a mechanism for fiscal stimulus in a downturn that is credibly temporary.”

As I argued here, it is not a matter of having a fiscal rule for consolidation that allows you to just ease up a bit at the ZLB. What we need is a rule that obliges governments to switch from consolidation to stimulus at or near the ZLB. Otherwise, the next time a large crisis hits (and Romer plausibly suggests that could be sooner rather than later), we will have to go through all of this stuff once again.