Rapidly Reducing carbon usage and Deficit Obsession don’t mix

 

Renewables are now the cheapest form of energy generation. If all energy use in the UK was based on electricity, and all electricity was generated by renewables, our current cost of living crisis would be far less severe, and of course we would not be adding to climate change. Furthermore, there is huge potential in the UK (and most other countries) for far more renewable energy production than we currently have. So why isn’t this happening faster?

That is the question addressed in a new book by Eric Lonergan and Corinne Sawers. In many ways it is a very optimistic book, because it suggests the problem of climate change is mainly solvable with known technology, and there are no insurmountable barriers for doing this with sufficient speed to enable us to avoid severe global warming. They suggest that the reason this is not happening is, in part, because we are thinking about it in the wrong way.

Much of the discussion around avoiding climate change is framed in terms of costs. Economists are partly to blame for this, as the debate was originally framed by economists in terms of what current costs are we prepared to pay to avoid future costs (global warming). The book suggests that a better way of thinking about it is as an industrial revolution, such as the invention of telecommunications. Because renewable energy is cheaper, we are better off developing it and phasing out fossil fuels even without the problem of future global warming. When electricity was first invented, no one talked about the costs of installing electricity generation compared to future benefits, because it was obviously a better technology for everyone concerned.

An economist might retort that there is always an opportunity cost of investing in green energy and electrification, because that investment could be used for something else. In this sense it is always right to talk about costs and benefits. However in today’s world we have very low long term interest rates, and yet in many countries private and/or public investment levels are if anything lower than the past. The trade-off in many cases may not be between green investment and some other form of investment, but between green investment and the spending power of those who own shares in companies.

Another strand of thinking suggests radical change, like individually consuming less or eating different foods, or for economies to stop growing, or fundamentally changing capitalism. Again this makes stopping climate change seem rather unattractive or risky, and this puts both people and policymakers off. Framing the problem as a green industrial revolution to obtain cheaper and more stable energy is much more appealing.

In terms of doing this faster, the book suggests looking at what has worked so far, that has brought us to the point where renewable energy is also the cheapest energy: a combination of large positive incentives and hard regulations. Central to their argument are the use of “extreme positive incentives for change”. These have led to the rapid reduction in the cost of solar power, and the widespread adoption of electric vehicles in parts of China, Scandinavia and the US.

Extreme positive incentives (like providing large subsidies for electric cars or well insulated houses for example) combine three important pieces of psychology, politics and economics that are often ignored by economists. The first is that extreme incentives are much more effective than marginal incentives, because of the psychological fixed costs of changing behaviour. The second is that positive incentives (giving people money to do things) are more effective than negative incentives (like taxing carbon), because the latter generates resistance and as a result are unlikely to be pursued strongly by policymakers.

The third is that people do not ‘internalise the government’s budget constraint’, which is the idea behind Ricardian Equivalence. If they did. people would recognise that incentives had to be paid for by them one way or another, so positive incentives and taxes would work in the same way. This doesn’t happen not because people are irrational, but because it is very uncertain how governments fund incentives, and many of those methods of funding would not fall on those receiving the incentive. So people who receive an incentive really are better off, and those who are taxed are worse off, in terms of expected income. It is only the fiction of the representative agent (and various additional assumptions) that leads to the idea of internalising the government’s budget constraint. [1]

We can see all this in action when we compare the success of solar power to the many difficulties governments have had in raising appropriate carbon taxes (or permits that act like taxes). Carbon taxes make sense in many ways, because they are the economists’ standard response to an externality (i.e. a cost imposed on others that isn’t paid for by the people generating that cost). Climate change is the biggest externality of our lifetime. Yet in the case of climate change, when the costs are generated by everyone and the harm they create is in the future, the psychological, political and economic factors noted above mean positive extreme incentives are much more effective than carbon taxes.

All of which brings me to the title of this post. If extreme positive incentives are what is needed to speed up electrification and the use of renewables to generate that electricity, that will cost governments money. Ideally that should be paid for by higher general taxes rather than borrowing, because it’s better if the polluter pays. (Equally richer countries, that have already deposited a large amount of carbon in the atmosphere, should help pay poorer countries to go green.) But this ideal may not be feasible in political terms, because policymakers will resist the idea of tax increases and therefore will not provide the incentives.

The way to avoid this problem is to fund green incentives through borrowing. As I have often said, future generations suffering the effects of substantial global warming will not think that’s OK because we reduced their ‘burden’ of paying taxes on government debt. Instead they will positively welcome the borrowing required to reduce climate change in the past. [2] This is particularly so when that borrowing currently costs so little.

Which is where debt and deficit targets get in the way. To see how ridiculous it would be if they did get in the way, just compare why we need debt and deficit targets, and compare that to why we need to mitigate climate change. Deficit targets are useful to prevent irresponsible governments from buying elections or rewarding donors by tax or spending breaks funded by borrowing. We need to reduce global warming because otherwise we will see, for example, large-scale global starvation and migration, with all the political chaos that this will cause. If you had to choose between reducing the fiscal behaviour of irresponsible governments and reducing climate change, which would you choose?

There may be ways of not choosing between the two. Perhaps we could create two separate sets of government accounts: a normal account and a green account. Deficit targets could apply to the former but not the latter. If Germany can do this for military spending following Putin’s invasion of Ukraine, why not do it for spending required to reduce climate change? [3] Of course there will be many practical political problems, and it may require a fiscal council with teeth to avoid governments cheating, but it’s clear we should be at least discussing this possibility.

If we don’t do something like this, then we may be faced with a simple choice. Do we speed up greening the economy to reduce the extent of global warming using the ideas proposed by Lonergan and Sawers, or do we do what this government and the media are doing now, and obsess about deficit and debt targets? The fate of the planet may depend on what people and governments choose.

[1] In a simple model with a representative agent, a subsidy would automatically imply an equal tax today or tomorrow, which will leave the representative agent no better off, so they would be indifferent between positive incentives (subsidies) and negative incentives (like carbon taxes). In reality the tax increases required by any subsidies may fall on different people from those receiving a specific tax cut or incentive. In addition tax cuts today may be paid for by cuts in government spending, which again may not fall on those receiving a specific incentive, and so on. In other words people see positive incentives for them as redistribution to them, and taxes on them as redistribution from them.

[2] The classic case for funding by borrowing is an investment that doesn’t just benefit people today, but also benefits people tomorrow. This is why no macro restrictions should be put on public investment. However many activities that are not classed as public investment have these characteristics. A war, for example, is often an investment in the future, which is why wars are so often accompanied by public borrowing. Greening the economy also has those characteristics.

[3] Does it make sense to treat higher military expenditure as different from other forms of spending? If it represents a one-off increase in spending, reflecting for example an unusually aggressive ruler in a nearby country then yes, it is. However if it is seen as a permanent increase in spending, it is not clear why that shouldn’t be paid for by the current generation through higher taxes.

Will we get No Deal because Brexiters want it more?

“The reason we might have a no-deal Brexit in Britain is because its advocates want it more than their enemies want to stop it. They are making it happen whilst their opponents spend their time only wishing it would stop.”

When I first read this in an article by Sky journalist Lewis Goodall I thought it was nonsense, and stopped reading. It obviously does not apply, for example, to EU citizens living in the UK or all those who march against No Deal. But then I watched this, a talk by Dominic Cummings on his referendum victory (HT @ericlonners), and I realised what Goodall was talking about.. I went back to the article, read it in full and mostly agreed with it.

The trigger was a point that Cummings makes in his talk about most of the media covering politics. They are essentially interested in the government, parliament and its MPs, and so everything they say has to be taken in this context. It is a point I have made myself before, but it is easy to forget. Goodall is not talking about those who march for Remain, or the trivial numbers that march for Leave, but instead he is talking about MPs in parliament. And I think on this he is right.

Take the discussion of a possible coalition of national unity that MPs could vote for if the only way of stopping Johnson allowing No Deal is to vote him out. The job of the coalition would be to get an extension of Article 50 and then call a General Election. The idea is that rebel Tory MPs could only do this if Corbyn does not lead that coalition, because Corbyn “has become toxic”. So avoiding No Deal is less important than allowing a Corbyn government, even if that government would last no more than a month! That supports Goodall’s thesis.

The LibDems seem to be saying the same thing. They would not vote for a Corbyn led coalition government even, it seems, if the alternative was No Deal. Again avoiding No Deal is less important than allowing a very temporary Corbyn government. That supports Goodall’s thesis too, and it comes from the so called ‘party of Remain’.

Finally the Labour leadership has ruled out any kind of coalition of national unity if it was not led by Corbyn. I can see why - it is hard to admit so publicly that your leader is toxic to other Mps just before a General Election - but nevertheless it means they are also putting party before preventing No Deal. Goodall is right again.

But what does all this actually mean? Simply that all these MPs or party leaders are prepared to put party interests ahead of national interests. We can but hope that at least some of this is posturing ahead of negotiations, but such posturing can in itself be harmful to the cause of preventing No Deal.

Of course the corollary is not that Brexiters are putting country ahead of party. A No Deal Brexit is only something that a fanatic would do. A better formulation of Goodall’s idea is that No Deal will happen because No Dealers are fanatics and opponents of No Deal are putting party before country.

What about the nonsense that No Deal is required to respect democracy in the form of the 2016 vote? This is preposterous because 2016 cannot be a mandate for a No Deal Brexit when No Deal was ruled out by the Leave campaign. Bexiters implicitly acknowledge this is true by pretending that they had talked about No Deal in that referendum. But if you want to see what kind of mandate 2016 does represent, it is well worth watching the talk by Cummings noted above.

As well as showing an acute understanding of how the UK broadcast media works, his comments on what won the referendum for Leave are interesting. He notes that before the referendum most people knew little about the EU, and in addition were not particularly exercised by it as an issue. (Polling confirms this.) So, quite simply, to win the referendum the Leave campaign had to associate the EU in a negative way with things people were exercised about. Cummings talks about keeping the original Brexiters, who did want to talk about the EU, well away from the campaign.

Cummings notes three things people did care about. The first and most obvious was immigration. He says this issue had become 'associated with the EU', and there were two reasons for this in my view. The first was the Conservative targets for total net immigration which had not been met, together with the rhetoric that blamed reduced access to public services on immigrants rather than austerity. The second was the idea put forward by the pro-Brexit press that these targets had not been met because of Freedom of Movement. In this respect the following ONS chart is revealing:

Before the referendum non-EU immigration was equal to EU immigration, so it is not at all obvious that Freedom of Movement was the only reason targets were not met. Immigration has been broadly stable since the referendum, because the fall in EU migration has been offset by a rise in non-EU immigration.

The second factor Leave had going for it, according to Cummings, was the outcome of the Global Financial Crisis, and I would add austerity. The reason is obvious, but again little to do with the EU. The third was the problems with the Eurozone, but again the Eurozone’s problems all stemmed from a single currency, and not the trade and other arrangements of the EU. Therefore what all three have in common is that they have little to do with the EU.

Which brings us back to whether the people saying they want No Deal care more about it than those who want to stop No Deal. Cummings’ analysis suggests that they don’t, because by his own admission they were voting for issues that had little to do with the EU. They evidently don’t because we have not seen hundreds of thousands march on Westminster in support of any kind of Brexit. The best they could manage were ‘thousands’ when the March deadline was missed. We have seen six million sign a petition to revoke Article 50, but a tenth of that number signing a petition for No Deal.

The fact that Remainers want to stay in the EU more than No Dealers want us to crash out should come as no surprise. Leaving the EU takes away basic rights from EU citizens in the UK and UK citizens in the EU, and confers no new rights in return It takes away the right of young people to work visa free in the EU. It takes away many people’s European identity. Crashing out will make almost everyone poorer and few better off. It will cost lives. All for the notion that we will become ‘independent’, when few Leavers can name a law imposed on them by the EU that they disagree with, and even fewer an EU law that the UK voted against. Brexit is one part of the population imposing considerable costs on the rest, for reasons that have little to do with the EU.

Macroeconomic Policy Reform the IPPR way

Monetary and fiscal policy makers in the UK seem to think they had a good recession. You can tell that because neither group seem particularly interested in learning any lessons. This is despite the fact that we had the deepest recession since the 1930s, and the slowest recovery for centuries. It is also despite the fact that the level of UK GDP is almost 20% below the level it would be if it had followed pre-recessions trends, and all previous recessions have had the economy catch up with that trend.

You can tell from this paragraph that I do think serious changes are required to how monetary and fiscal policy are done. So does the IPPR, and their detailed analysis and proposals are set out in a new report by Alfie Stirling. The analysis is not too technical, well presented, well researched and I agree with a great deal of what is said. I will look a monetary policy first, and then fiscal policy.

What the Great Recession showed us (although many macroeconomists already knew) is that once nominal interest rates hit their effective lower bound (ELB) [1], monetary policy makers lose their reliable means of combating a recession. The report is dubious about Quantitative Easing (QE) for much the same reason that I have been for anything other than a last resort instrument. In brief, the impact of QE is very uncertain because it is not routinely used, and in addition there may be important non-linearities. It is not a reliable alternative to interest rates.

The report makes much the same point about negative nominal interest rates: partially or perhaps fully removing the lower bound. To quote:

“Like QE, the impacts of negative rates are uncertain and, depending on the behavioural response from banks and savers, could actually reduce spending in the economy, or else increase the number of risky loans (see for example Eggertsson, Juelsrud and Wold 2017).”

I know some macroeconomists will disagree with that assessment, but I think the point is valid.

The report also rejects helicopter money as a solution to the ELB problem. Here I found their discussion less convincing, but they do recognise that a form of helicopter money has already been undertaken by some central banks through creating money to change the relationship between borrowing and lending rates, a point that Eric Lonergan has stressed.

The two reforms to monetary policy that have been suggested and which the report does support are adopting unemployment or nominal GDP as either a second target or as an intermediate target, and raising the inflation target by one or two percent. I have argued strongly for a dual mandate and also for using nominal GDP as an intermediate target, so I have no objections here.

The report recognises, however, that none of their proposed reforms to monetary policy eliminates the ELB problem completely. We have, inevitably, to think about the other reliable and effective instrument that we have to stimulate aggregate demand: fiscal policy. Their proposed fiscal rule is very similar to Labour’s fiscal credibility rule. It includes (a) a ‘knockout’ to switch to fiscal expansion if interest rates reach their ELB, (b) 5 year rolling target for a zero current balance (c) a 5 year rolling target for public investment (d) a similar target for debt to GDP. The last in this list you will not find in Portes and Wren-Lewis, in essence because it involves double counting, and debt targets are less robust to shocks than deficit targets.

If governments followed this fiscal rule, then the ELB would not be the serious problem that it is, because reliable fiscal stimulus would replace reliable monetary stimulus at the ELB. But the IPPR worry that governments might not do what the fiscal rule, and with the knockout what the Bank of England, tells them to do. They are concerned that what they call ‘surplus bias’ might be so strong that the government would not run the deficits that the Bank asks them to run.

To overcome this concern, they suggest an alternative to QE at the ELB: the Bank should create reserves to fund projects that are part of a National Investment Bank (NIB). The NIB would be independent of government in terms of the projects it funded (but not its high level mandate), and it would normally raise funds in the open market. (This makes it different from proposals that the NIB be entirely funded by the Bank: see here.) In an ELB recession, the Bank of England would ask the NIB to fund additional projects, with the Bank providing the finance.

As public investment is particularly effective as a countercyclical tool if undertaken immediately, and as it is usually possible to some degree to bring forward investment projects, this proposal seems a superior alternative to QE, as long as the link between additional purchases of NIB debt and additional investment by the NIB was reasonably clear. The key point here is that although conventional QE might try to stimulate private investment by reducing firm borrowing costs, in a situation where there is chronic lack of demand that can be like trying to push on a string. The same problem should not arise with an NIB. In that sense it just seems like a good idea.

Whether it would be enough alone to circumvent the problem of a rabid surplus bias government during a recession I doubt. The kind of public investment that is easy to ramp up quickly in a recession are things like flood defences or filling holes in the road, rather than the kind of things an NIB would fund. A government suffering strong surplus bias could cut these things quicker than an NIB could fund additional projects. Some form of QE would be more powerful in this respect. The danger in either case is that you just encourage the government to try and get down debt even faster: if QE gives money directly to people, the government just raises VAT.

How seriously should we worry about (design policy for) a government offsetting everything the Bank is able to do to stimulate demand in a recession? The answer may be given by imagining the following scenario. The government operates a fiscal rule that has an explicit ELB knockout. The Bank of England, when rates hit the ELB, requests the government undertake fiscal stimulus. If Cameron/Osborne had been faced with both those things, would they have still cut back public investment? I suspect the answer is no. That of course by implication means that central bankers in Europe played a large part in facilitating (or encouraging) austerity, which in the UK stemmed from a failure to admit the problems of the ELB because of a naive faith in QE.

Which brings us to central bank independence and what I call the conventional assignment (outwith the ELB, monetary policy deals with macroeconomic stabilisation). The IPPR stay with the mainstream macroeconomic consensus in wanting to keep both. People with a more MMT type view, like Richard Murphy, would reverse [2] the conventional assignment, and have fiscal policy doing the macroeconomic stabilisation. I have written a great deal on the distinction and will not repeat that here. However it is worth making one point on independence.

The reasons for making central banks independent are not peculiar to monetary policy. They are that if the complex task of macroeconomic stabilisation is left in the hands of politicians who get secret advice, they can mess things up for political ends. [3] Messing things up can be minor (e.g. delaying necessary measures), structural (e.g. time inconsistency) or explosive (e.g. hyperinflation). Austerity shows that this fear is justified. MMT’s answer to the IPPRs concern about a surplus bias government is that this is just a cost of democracy or the good guys would always be in power, which I suspect many might not find reassuring. Yet that is also why European central bank’s encouragement of austerity was far from helpful to the case for the delegation of macroeconomic stabilisation.

[1] 'Effective' because in practice it is up to the central bank to decide at what point they cannot reduce nominal rates further. 

[2] Not strictly true. In the conventional assignment monetary policy does inflation/aggregate demand and government looks after its debt, while in MMT fiscal does inflation/aggregate demand and government debt looks after itself.

[3] I hope time inconsistency can be subsumed under this broad definition.

Negative rates, helicopter money and the Bank of England

Yesterday Mark Carney said he was against negative interest rates and helicopter money, but in reality he implemented a way of doing a version of both. Let me explain.

When negative interest rates are discussed, we normally think about savers, and the fact that they could avoid being charged to deposit money in a bank by hoarding cash. But borrowers would have no problem with negative rates: borrow £1000, and just pay back £990. The bank they borrowed from would have, unless there were negative rates on savings or they were getting a subsidy to lend.

Helicopter money is normally thought of as the central bank sending a cheque to every citizen. But the key point for economists is not the way the money is distributed, but the fact that it is created by the central bank and given away in return for nothing. (QE involves creating money to buy assets.) Who the money goes to is of course important, but it is not really the defining characteristic of the measure.

We normally think about monetary policy as changing the interest rate. If rates are cut, that benefits borrowers but is bad for savers. But suppose the central bank gave money to private banks, on condition that this money was passed on in the form of lower rates to borrowers. If it did this, but did not change the interest rate, that would be helping borrowers but not hitting savers. The Bank introduced such a scheme yesterday, called the Term Funding Scheme (TFS). What is more, this subsidy for borrowers is financed by creating money. Eric Lonergan argues that the ECB is doing something similar, and if there is any insight in this post I owe it to him (but if there isn’t it is my fault not his!).

So if you think the Bank has ruled out negative rates, you are half wrong. In principle the Bank can expand TFS to make borrowing as cheap as it likes, which could even mean negative interest rates for borrowers. If you think the Bank has ruled out helicopter money, you are half wrong. It is creating money to give away with nothing in return, but just giving the money to one particular group: borrowers.

Now if you are a saver you might say why cannot I rather than borrowers benefit from this money give away. But the Bank could argue that without TFS it would have to reduce the interest rate by even more than it has, which would make savers a lot worse off. So compared to that outcome, you are better off. Whether you find that convincing when you can always hold cash depends on the cost of holding cash.

So why did Mark Carney say that helicopter money was a flight of fancy, when he was in fact doing something quite similar? It is a good question to ask him. I suspect the real answer is that TFS looks like the kind of thing a central bank does, but giving money to every citizen looks like fiscal policy. But what it does mean is that in terms of the basic macroeconomics, the Bank of England is now doing helicopter money. But if you are neither a borrower or a saver and feel aggrieved you are not getting anything, you know who to complain to.

Money and Debt

For economists

As regular readers will know, my advocacy of helicopter money (HM) does not depend on it being different from, or better (at stimulating demand) than, fiscal policy. [1] So, for example, when Fergus Cumming from the Bank of England said that if after HM the government recapitalised a central bank this “reduces the initial stimulus to a vanilla, bond-financed fiscal transfer”, then that sounds just fine to me. Except, of course, to note that HM is not just like fiscal policy because (a) HM may be quicker to implement than conventional fiscal policy, and speed matters (b) HM can bypasses both genuine debt fears and deficit deceit (c) with HM there is no chance of monetary offset.

Much the same is true for this Vox article by Claudio Borio et al. They argue that if interest is paid on all bank reserves, then HM is “is equivalent to debt-financing from the perspective of the consolidated public sector balance sheet”. Maybe, but why should that be a problem? It is only a problem if you set up a straw man which is that HM has to be more effective than a bond financed helicopter drop.

The reason some people think it is not a straw man is that, if you set up a model where Ricardian Equivalence holds and you have an inflation targeting central bank, a bond financed lump sum tax cut would have no impact. Then you would indeed want HM to do something more. And perhaps it could, if it led agents to change their views about monetary policy. While such academic discussions may be fun, I also agree with Eric Lonergan that “theoretical games being played by some economists, which masquerade as policy insights, are confusing at best.” A good (enough) proportion of agents will spend HM - at least as many as spend a tax cut - for perfectly sound theoretical reasons. [2]

The Bario et al article does raise an interesting question. When the central bank pays interest on all reserves, what is the difference between money and bond financing? Reserves would seem to be equivalent to a form of variable interest debt that can be redeemed for cash at any time. It is exactly the same question raised in a paper by Corsetti and Dedola, an early version of which I discussed here. The answer their model uses is that the central bank would never default on reserves, whereas debt default is always an option.

I think this all kind of misses the point. Base or high powered money (cash or reserves) is not the same as government debt, no matter however many times MMT followers claim the opposite. (For a simple account of why the tax argument is nonsense, see Eric Lonergan here.) Civil servants can frighten the life out of finance ministers by saying that they may no longer be able to finance the deficit or roll over debt because the market might stop buying, but they cannot do the same by saying no one will accept the money their central bank creates. [3] Money is not the government’s or central bank’s liability. (For a clear exposition, see another piece by Eric, or this by Buiter.) Money is not an obligation to make future payments. Money is valuable because, as Eric describes here, it is an established network.

Bario et al seem to want to claim that because central banks nowadays control interest rates by using the interest they pay on reserves, this somehow creates an obligation. Reserves are like variable rate, instant access debt that banks get for nothing.

I think we can see the problem with this line of argument by asking what happens if obligations are broken. If the government breaks its obligation to service or repay its debt we have default, which has extremely serious consequences. If the central bank decides on a different method to control short term interest rates because paying interest on reserves is too much like a transfer to banks, no one but the banks will notice.

So reducing the macroeconomics of helicopter money to fiscal policy is not an argument against it. Furthermore money created by the central bank is not the same as government debt, even if interest is paid on reserves.

[1] They would also know - unlike Jörg Bibow - that I do not think there is any kind of contest between fiscal policy and HM, because the fiscal authority moves first.

[2] The two main reasons some people will spend a tax cut is if they are borrowing constrained, or if they think there is a non-zero probability that the tax cut will be paid for by reducing government spending. An additional reason for spending HM is that it might be permanent if it avoids the central bank undershooting its inflation target.

[3] If the finance minister knows some macroeconomics they would of course realise that not being frightened by the second means you should not be frightened by the first. But that does not negate the conceptual difference.           

Postscript (8/6/16): This by Biagio Bossone provides a very good complement to my analysis, looking a why HM is not 'permanent' and discussing interest on reserves

Helicopter money and fiscal policy

Both John Kay and Joerg Bibow think additional government spending on public investment is a good idea, and that helicopter money (HM) is either a distraction (Bibow) or fiscal policy by subterfuge (Kay). They are right about public investment, but wrong about HM.

We can have endless debates about whether HM is more monetary or fiscal. While attempts to distinguish between the two can sometime clarify important points (as here from Eric Lonergan) it is ultimately pointless. HM is what it is. Arguments that attempt to use definitions to then conclude that central banks should not do HM because its fiscal are equally pointless. Any HM distribution mechanism needs to be set up in agreement with governments, and existing monetary policy has fiscal consequences which governments have no control over.

Here is where Kay and Bibow are right. At this moment in time, even if a global recession is not about to happen, public investment should increase in the US, UK and Eurozone. There is absolutely no reason why that cannot be financed by issuing government debt. Furthermore, in the event of a new recession, increasing ‘shovel ready’ public investment is an excellent countercyclical tool. Indeed there would be a good case for bringing forward public investment even if monetary policy was capable of dealing with the recession on its own, because you would be investing when labour is cheap and interest rates are low.

Where Bibow is wrong is that the existence of HM in the central bank’s armory in no way compromises the points above. HM does not stop the government doing what it wants with fiscal policy. Monetary policy adapts to whatever fiscal policy plans the government has, and it can do this because it can move faster than governments.

This goes part of the way to answering Kay, but he also suggests that HM is somehow a way of getting politicians to do fiscal stimulus by calling it something else. This seems to ignore why fiscal stimulus ended. In 2010 both Osborne and Merkel argued we had to reduce government borrowing immediately because the markets demanded it.

HM is fiscal stimulus without any immediate increase in government borrowing. It therefore avoids the constraint that Osborne and Merkel said prevented further fiscal stimulus. To put it another way, they did not say that increasing government spending or cutting taxes were bad in itself, but just that they were extremely unwise because they had to be financed by adding to government debt. HM is not financed by increasing government debt.

Many argue that these concerns about debt are manufactured, and that in reality politicians on the right pushing austerity are using these concerns as a means of achieving a smaller state: what I call here deficit deceit. HM, particularly in its democratic form, calls their bluff. If we can avoid making the recession worse by maintaining public spending, financed in part by creating money while the recession persists, how can they object to that? Politicians who wanted to use deficit deceit will not like it, but that is their problem, not ours.

There is a related point in favour of HM that both Kay and Bibow miss. Independent central banks are a means of delegating macroeconomic stabilisation. Yet that delegation is crucially incomplete, because of the lower bound for nominal interest rates. While economists have generally understood that governments can in this situation come to the rescue, politicians either didn’t get the memo, or have proved that they are indeed not to be trusted with the task. HM is a much better instrument than Quantitative Easing, so why deny central banks the instrument they require to do the job they have been asked to do.

Helicopters are easy to fly

The debate over helicopter money seems to have got past the ‘shock, horror, people’s faith in the monetary system would collapse’ phase, and past the ‘it wouldn’t work because people wouldn’t spend the money’ phase, to the ‘what happens next’ phase. And to be fair to the critics, many proponents of helicopter money have not been clear on this issue.

The point was put very clearly yesterday in an FT Alphaville piece by Gerard MacDonell. Once the recession is over, there is likely to be too much money in the economy from the central bank’s point of view (which means, money has to be withdrawn to maintain the inflation target). We cannot say how much, but equally it would be wrong to ignore the problem. So what happens next?

I think I have been clear (at least recently) on this point. First, helicopter money as I see it is not a way to get inflation overshooting by the back door. The idea that the increase in money is ‘permanent’ is meaningless, as Eric Lonergan says. Overshooting may be a good idea, but there is no need to be devious about it. Second, the obvious way to ensure the central bank still achieves its inflation and other objectives is to recapitalise the bank if necessary. The central bank could enforce very high reserve ratios on commercial banks, but is that a desirable thing to do?

In my view helicopter money would be accompanied by a commitment by the government to recapitalise the central bank if that was needed. Yes, commitments can be broken, but only by the kind of government that would happily revoke central bank independence anyway.

The answer to what happens next is therefore easy. When it becomes clear after the recession that there is now too much money in the economy, the central bank takes it out. In other words, monetary policy acts as normal. If the central bank runs out of assets to do this, it gets recapitalised. Recapitalisation means more government debt. So we can end up in a position which is exactly equivalent to one where the distribution of money had been financed by an increase in debt in the first place: a conventional fiscal expansion.

In this world, helicopter money is (a particular type of) fiscal expansion by the back door. As Narayana Kocherlakota points out, this back door method has no purely macroeconomic advantages over the real thing. But the reason why we need a back door is obvious right now. Economists need to get real about these political constraints. Obsession with debt is not just based on ignorance, but it serves an ideological purpose which is not going to go away.

Yet even if governments were not obsessed with current levels of debt (and that is all they are obsessed by), go back to the textbooks on why monetary policy is prefered to fiscal policy as a stabilisation tool. One of the reasons you will find is that monetary policy is quick to invoke, with no institutional (aka democratic) hurdles to pass. Those who argue that helicopter money is just like fiscal policy seem to ignore this. There is also the (obvious) point that helicopter money allows what I call the consensus assignment to work (by expanding the meaning of monetary policy a little beyond interest rate changes), rather than leaving it with the rather large Achilles Heel of the zero lower bound.

Helicopter money is just another way of doing textbook demand management. What it does is move around current institutional boundaries a bit, to reflect real institutional and political constraints. There is nothing magical about the current institutional boundaries. Perhaps if you think (as Brad DeLong does) about the profits the central bank makes as a social credit that gets automatically distributed to people rather than given to an intermediary (the government), you might feel easier about it.       

Is mainstream academic macroeconomics eclectic?

For economists, and those interested in macroeconomics as a discipline

Eric Lonergan has a short little post that is well worth reading. Not because it is particularly deep or profound, but because it makes an important point in a clear and simple way that cuts through a lot of the nonsense written on macroeconomics nowadays. The big models/schools of thought are not right or wrong, they are just more or less applicable to different situations. You need New Keynesian models in recessions, but Real Business Cycle models may describe some inflation free booms. You need Minsky in a financial crisis, and in order to prevent the next one. As Dani Rodrik says, there are many models, and the key questions are about their applicability.

If we take that as given, the question I want to ask is whether current mainstream academic macroeconomics is also eclectic. (My original title for this post was can DSGE models be eclectic, but that got sidetracked into definitional issues, but from the way I tend to define things it is the same question.) My answer is yes and no.

Let’s take the five ‘schools’ that Eric talks about. We clearly already have three: New Keynesian, Classical, and Rational Expectations. (Rational Expectations is not normally thought of in the same terms, but I understand why Eric wanted to single it out.) There is currently a huge research programme which aims to incorporate the financial sector, and (sometimes) the potential for financial crises, into DSGE analysis, so soon we may have Minsky too. Indeed the variety of models that academic macro currently uses is far wider than this.

Does this mean academic macroeconomics is fragmented into lots of cliques, some big and some small? Not really, in the following important sense. I think that any of this huge range of models could be presented at an academic seminar, and the audience would have some idea of what was going on, and be able raise issues and make criticisms about the model on its own terms. This is because these models (unlike those of 40+ years ago) use a common language. The idea that the academic ranking of economists like Lucas should reflect events like the financial crisis seems misconceived from this point of view.

It means that the range of assumptions that models (DSGE models if you like) can make is huge. There is nothing formally that says every model must contain perfectly competitive labour markets where the simple marginal product theory of distribution holds, or even where there is no involuntary unemployment, as some heterodox economists sometimes assert. Most of the time individuals in these models are optimising, but I know of papers in the top journals that incorporate some non-optimising agents into DSGE models. So there is no reason in principle why behavioural economics could not be incorporated. If too many academic models do appear otherwise, I think this reflects the sociology of macroeconomics and the history of macroeconomic thought more than anything (see below).

It also means that the range of issues that models (DSGE models) can address is also huge. To take just one example: the idea that the financial crisis was caused by growing inequality which led to too much borrowing by less wealthy individuals. This is the theme of a 2013 paper by Michael Kumhof and colleagues. Yet the model they use to address this issue is a standard DSGE model with some twists. There is nothing fundamentally non-mainstream about it.

So why is the popular perception so different? Why do people talk about schools of thought? I think there are two reasons. First, while the above is true in the realm of academic understanding and discourse, it does not carry over into policy. When it comes to policy, we get to learn which models academic think are applicable to particular policy problems, and here divisions can be sharp. Second, there are plenty of people outside academia who have a public voice about economics (and generally a policy orientation), and they often do see themselves as school followers.

In terms of working practice rather than the hot end of macro policy decisions, most academic macroeconomists would regard themselves as eclectic in terms of the kind of work they are prepared to spend an hour or two seeing presented. But this view, and the common language that mainstream academics use, leads me to the No part of the answer to my original question. The common theme of the work I have talked about so far is that it is microfounded. Models are built up from individual behaviour.

You may have noted that I have so far missed out one of Eric’s schools: Marxian theory. What Eric want to point out here is clear in his first sentence. “Although economists are notorious for modelling individuals as self-interested, most macroeconomists ignore the likelihood that groups also act in their self-interest.” Here I think we do have to say that mainstream macro is not eclectic. Microfoundations is all about grounding macro behaviour in the aggregate of individual behaviour.

I have many posts where I argue that this non-eclecticism in terms of excluding non-microfounded work is deeply problematic. Not so much for an inability to handle Marxian theory (I plead agnosticism on that), but in excluding the investigation of other parts of the real macroeconomic world. (Start here, or type microfoundations into this blog’s search box and work backwards in time.) But for me at least this as a methodological point, rather than anything associated with any school of thought. Attempts to link the two, which I think many people including myself have been guilty of, just confuses.

The confusion goes right back, as I will argue in a forthcoming paper, to the New Classical Counter Revolution of the 1970s and 1980s. That revolution, like most revolutions, was not eclectic! It was primarily a revolution about methodology, about arguing that all models should be microfounded, and in terms of mainstream macro it was completely successful. It also tried to link this to a revolution about policy, about overthrowing Keynesian economics, and this ultimately failed. But perhaps as a result, methodology and policy get confused. Mainstream academic macro is very eclectic in the range of policy questions it can address, and conclusions it can arrive at, but in terms of methodology it is quite the opposite.