Why are we governed by incompetents?

In 2016 Boris Johnson and Michael Gove narrowly won the referendum on EU membership. It turned out they had no idea how to turn their victory into a concrete policy. They had dismissed every potential difficulty as just more ‘Project Fear’, and it became clear they were not just doing this just because it was effective rhetoric. They had not throught through any of the major problems that implementing Brexit would create. They looked rather shocked when they won, realising that these problems airily dismissed would now have to be resolved.

Cameron resigned, and the Conservative party needed to choose a new Prime Minister whose main preoccupation would be negotiating the terms of our exit. Their choice was Theresa May, who was known from her previous job as being non-collegiate, slow to adapt but obstinate in the views she held. These were almost the exact opposite of the qualities needed in any negotiation with a more powerful neighbour. Perhaps knowing this, she chose David Davis to handle the details of negotiation, a man who had the charm that May lacked but who had no interest in the details, in part because he clung on to the belief that the EU would cave at the last minute.

If we cross the Atlantic, then the story is the same but more so. The hard part is thinking about an issue or decision where Donald Trump has displayed any competence. Most recently he tried and failed to appoint two people, Stephen Moore and Herman Cain, to the board of the central bank, where their main qualifications were, respectively, that their predictions were always wrong, and they ran a Pizza company.

You could perhaps put all this incompetence down to the exceptional peculiarities of Brexit and Trump. But May also appointed as Northern Irish secretary someone who didn’t realise voters there voted along sectarian lines. Chris Grayling, after his disastrous privatisation of the probation service, then awarded a Ferry contract to a company that had no ferries, and so on. A key campaign theme of the Republican party in 2016 was to repeal Obamacare, but once Trump was elected and they had control of Congress it turned out they had no idea what to replace it with.

Nor did this incompetency suddenly emerge out of thin air in 2016. David Cameron implemented a policy of cutting public spending in the middle of the worst recession since WWII, leading to the slowest recovery in centuries. He allowed his minister for health to implement a fundamental reorganisation of the NHS that turned out to be a disaster, at the same time as his austerity policy starved the service of funds. Of course it was also David Cameron who made a commitment to hold the EU referendum in the first place under terms that were most favourable to the Leave side. .

Simon Kuper, in a brilliant article in the Financial Times, has an interesting explanation for this epidemic of incompetence. He writes how leaders like Macmillan, George HW Bush or Clement Attlee had their formative experiences in fighting WWII, while Lyndon B Johnson, Bill Clinton, and John Major had a visceral experience: of poverty. They knew in their bones that government mattered. He goes on

“But both countries have now fallen into the hands of well-off baby boomers, born between 1946 and 1964 - the luckiest members of the luckiest generation in history. These people had no formative experiences, only TV shows. They never expected anything awful or unknown to happen. They went into politics mostly for kicks.”

I’m sure Kuper is right that if our current leaders had had the strong formative experience of living with poverty or living through WWII their behaviour would have been different. In particular they might have thought twice about using populist tropes like ‘the will of the people’. But surely being ‘the luckiest members of the luckiest generation in history might be a necessary but not sufficient condition for being incompetent.

An interesting example here is Tony Blair The son of a barrister, he attended a school in Edinburgh that is sometimes described as Scotland’s Eton *** and went to Oxford University. Together with Gordon Brown he presided over an administration that championed evidence-based policy. A clear example was the decision in 2003 not to enter the Euro. The Treasury spent a year researching the pros and cons of joining the Euro, consulting widely with outside experts. The 18 background studies that effort produced are excellent examples of literature reviews or, in some cases, applied research. Although Blair was predisposed to favour entry, he was content to allow the evidence the Treasury produced to persuade him not to join.

There is of course one glaring exception to this record, and that is Iraq. The war was the idea of Bush Jr, and it was a nonsensical response to 9/11. Most of the evidence at the time suggested that there was no connection between Iraq and al-Qaeda, and that although the war could be won keeping the subsequent peace would be very difficult. Blair followed Bush because of a simple but tragically incorrect idea, that the close UK-US alliance had to be preserved at all costs. He ignored domestic advice about the problems any post-war period would create.

The Labour government of 1997 to 2010 was not flawless by any means, but it terms of competence it is clearly better than what came later. It is hard not to see that evidence based policy protects you from many, but not all, policy mistakes. Cameron made the commitment to a referendum in 2013 because the political imperative was to stop the rise of UKIP and possible defections from the party. The evidence were opinion polls at the time, which suggested that Leave could easily win. At a deeper level he should have realised the influence a very pro-Brexit press could have, and also that his own immigration missed targets and the rhetoric that he himself had used to justify them would beat economic forecasts in voters minds..

An ideology is a collection of ideas that can form a political imperative that overrides evidence. Indeed most right wing think tanks are designed to turn the ideology of neoliberalism into policy based evidence. It was this ideology that led to austerity, the failed health reforms and the privatisation of the probation service. It also played a role in Brexit, with many of its protagonists dreaming of a UK free from regulations on workers rights and the environment. It is why most of the recent examples of incompetence come from the political right.

A pluralist democracy has checks and balances in part to guard against incompetence by a government or ministers. That is one reason why Trump and the Brexiters so often attack elements of a pluralist democracy. The ultimate check on incompetence should be democracy itself: incompetent politicians are thrown out. But when a large part of the media encourage rather than expose acts of incompetence, and the non-partisan media treat knowledge as just another opinion, that safegurd against persistent incompetence is put in danger.

Postscript 08/05/19 It has been pointed out to me that at the age of 10, Blair's father had a stroke and lost the power of speech for over 2 years, meaning he could not work and his family fell on hard times. So here too Kuper's point may apply.

Raising the inflation target

The argument for a higher inflation target is straightforward, once you understand two things. First the most effective and reliable monetary policy instrument is to influence the real interest rate in the economy, which is the nominal interest rate less expected inflation. Second nominal short term interest rates have a floor near zero (the Zero Lower Bound, or ZLB). Combine the two and you have a severe problem in a recession, because to combat the recession real interest rates need to move into negative territory, and how far they can go into that territory is limited by the ZLB. That means monetary policy alone may be unable to get us out of a recession.

Raising the inflation target reduces the likelihood that interest rates will hit the ZLB. To see why, note first that the long run (economists often say ‘equilibrium’ or ‘natural’) real interest rate is positive. Let’s say it is 2%. If the inflation target is 2%, and the ZLB is 0%, that would mean that in normal times the average nominal interest rate is 4% (2% inflation target + 2% to get to a 2% real interest rate). That means nominal interest rates can be cut by a maximum of 4% if the economy falters. That may be enough for a mild downturn, but as we saw in 2008 it is not enough for a major recession. However if the inflation target was 4%, nominal rates would now be able to fall by a maximum of 6%. That is probably enough to combat all but the worst kind of recession.

Why are many economists currently arguing that we should raise the inflation target from 2% to 4%? One of the reasons is that we now believe the long run real interest rate is currently lower than it was when the 2% target was first chosen. (This is sometimes referred to as secular stagnation.) If you go through the arithmetic above, you can see why a lower long run real interest rate will make the ZLB problem worse. The argument is that we now need to raise the inflation target to make sure we hit the ZLB less often in the future.

This issue moved from an academic discussion to a real possibility in the US a few days ago. When Fed Chair Janet Yellen had been asked about raising the inflation target in the past, she has tended to dismiss the idea. However she now says that it is something that the Fed will review in the future, and that it is one of the most important questions facing central bankers today.

This will undoubtedly give new impetus to the debate over whether the inflation target should be raised. We are in standard trade-off territory here. Economists generally agree a higher inflation target will in itself inflict greater costs on the economy, but they bring the benefit that the ZLB problem will occur less often. But there is an alternative, and clearly much better way out of this dilemma.

Governments have another instrument that has a reasonably predictable impact on aggregate demand, and which can be used to combat a recession: fiscal policy (changes to taxes and government spending). In the UK at the moment interest rates are at the ZLB in part because fiscal policy is contractionary (austerity). It would be far better to use this instrument to stimulate the economy in a recession than to raise the inflation target. Yet the institution of independent central banks have discouraged governments from using fiscal policy in this way.

It is no good central banks pretending that this is something which is up to governments, and that there is some unwritten law which means that central banks should keep quiet on such things. In reality, in both the UK and the Eurozone, the central bank actively encouraged governments to do the wrong thing with fiscal policy in the last recession. In other words, they encouraged austerity. If there is something inherent in the institution of a central bank that makes them give inappropriate advice in this way, then we should be asking how central banks can be changed as a matter of urgency.

What should happen in a recession, as soon as the central bank thinks that interest rates will hit the ZLB, is that central banks should say, out loud in public, that fiscal policy should become more expansionary. In addition central banks should say, out loud in public, that governments need not worry about rising debt and deficits due to the recession and any fiscal stimulus they undertake spooking markets because the central bank has that covered. Both statements have the merit of being true. 

Of course governments will need to restore debt to desired levels at some point, but that point should be well after interest rates have left the ZLB because then debt correction can be painless. The immediate aim of fiscal policy in a recession should be to allow interest rates to rise above the ZLB as soon as possible. That gives you the best macroeconomic outcome, and one that is far superior to raising the inflation target. The most important question facing central bankers today is why they failed to do that from 2009.

Now it is possible that, if democracy is in a bad shape (as it currently is in the US for example), the government may ignore the advice it receives from the central bank. In that case it is worth considering giving central banks some additional power to mimic a fiscal expansion, such as helicopter money for example. Or it may be worth considering institutional changes that allow nominal interest rates to go negative. Or raising the inflation target. But before doing any of those things we need to ensure that central banks give the right advice to governments when the next recession comes along.

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.  

The Fed’s macroeconomic model

There has been some comment on the decision of the US central bank (the Fed) to publish its main econometric model in full. In terms of openness I agree with Tony Yates that this is a great move, and that the Bank of England should follow. The Bank publishes some details of its model (somewhat belatedly, as I noted here), but as Tony argues this falls some way short of what is now provided by the Fed.

However I think Noah Smith makes the most interesting point: unlike the Bank's model, the model published by the Fed is not a DSGE model. Instead, it is what is often called a Structural Econometric Model (SEM): a pretty ad hoc mixture of theory and econometric estimation that would not please either a macro theorist or a time series econometrician. As Noah notes, they use this model for forecasting and policy analysis. Noah speculates that the Fed’s move to publish a model of this kind indicates that they are perhaps less embarrassed about using a SEM than they once were. I’ve no idea if this is true, but for most academic macroeconomists it raises a puzzling question - why are they still using this type of model? If the Bank of England can use a DSGE model as their core model, why doesn’t the Fed?

I have discussed the question of what type of model a central bank should use before. In addition, I have written many posts (most recently here) advocating the advantages of augmenting DSGE models and VARs with this kind of middle way approach. For various reasons, this middle way approach will be particularly attractive to a policy making organisation like a central bank, but I also think that a SEM can play a role in academic analysis. For the moment, though, let me just focus on policy analysis by policy makers.

Consider a particular question: what is the impact of a temporary cut in income taxes? What kind of methods should an economist employ to answer this question? We could estimate reduced forms/VARs relating variables of interest (output, inflation etc) to changes in income taxes in the past. However there are serious problems with this approach. The most obvious is that the impact of past changes in taxes will depend on the reaction of monetary policy at the time, and whether monetary policy will act in a similar way today. Results will also depend on how permanent past changes in taxes were expected to be. I would not want to suggest that these issues make reduced form estimation a waste of time, but they do indicate how difficult it will be to get a good answer using this approach. Similar problems arise if we relate growth to debt, money to prices (a personal reflection here) and so on. Macro reduced form analysis relating policy variables to outcomes is very fragile.

An alternative would be for the economist to build a DSGE model, and simulate that. This has a number of advantages over the reduced form estimation approach. The nature of the experiment can be precisely controlled: the fact that the tax cut is temporary, how it is financed, what monetary policy is doing etc. But any answer is only going to be as good as the model used to obtain it. A prerequisite for a DSGE model is that all relationships have to be microfounded in an internally consistent way, and there should be nothing ad hoc in the model. In practice that can preclude including things that we suspect are important, but that we do not know exactly how to model in a microfounded manner. We model what we can microfound, not what we can see.

A specific example that is likely to be critical to the impact of a temporary income tax cut is how the consumption function treats income discounting. If future income is discounted at the rate of interest, we get Ricardian Equivalence. Yet this same theory tells us that the marginal propensity to consume (mpc) out of windfall gains in income is very small, and yet there is a great deal of evidence to suggest the mpc lies somewhere around a third or more. (Here is a post discussing one study from today’s Mark Thoma links.) DSGE models can try and capture this by assuming a proportion of ‘income constrained’ consumers, but is that all that is going on? Another explanation is that unconstrained consumers discount future labour income at a much greater rate than the rate of interest. This could be because of income uncertainty and precautionary savings, but these are difficult to microfound, so DSGE models typically ignore this.

The Fed model does not. To quote: “future labor and transfer income is discounted at a rate substantially higher than the discount rate on future income from non-human wealth, reflecting uninsurable individual income risk.” My own SEM that I built 20+ years ago, Compact, did something similar. My colleague, John Muellbauer, has persistently pursued estimating consumption functions that use an eclectic mix of data and theory, and as a result has been incorporating the impact of financial frictions in his work long before it became fashionable.

So I suspect the Fed uses a SEM rather than a DSGE model not because they are old fashioned and out of date, but because they find it more useful. (Actually this is a little more than a suspicion.) Now that does not mean that academics should be using models of this type, but it should at least give pause to those academics who continue to suggest that SEMs are a thing of the past.

Is there a case for inflation targets? The UK versus the US.

One of my projects for the year ahead is to come off the fence (one way or another) on nominal GDP targeting. As an experiment, I’ll try and track my progress on this project with blog posts, although only if my thinking might be interesting to others. It is going to be a long process, because there is a lot involved: levels vs rates of change, GDP deflator vs CPI, nominal GDP versus its price component, and uncertainty about the natural rate to name some of the most obvious issues. However there is also another issue that may be just as important, and that is whether we need targets at all. In this post I just want to think about this last issue in relation to inflation targets, and not any other kind of target.

An obvious way for a macroeconomist to approach this is to imagine a world in which the central bank acts in society’s best interests, and has as good an idea as anyone else what those interests are. (The policy maker is benevolent, and knows the appropriate measure of social welfare to maximise.) Actually, for both the US and UK I do not think that is such a bad place to start. Let’s also suppose, as is standard, that society’s best interests involve getting inflation close to some desired level, and getting the output gap close to zero. Call this a dual mandate if you like. In such a world, why impose a target on the central bank? In other words, why do what is done in the UK rather than do what is done in the US?

By target, I mean something the central bank is required to try and hit. I am not talking about the central bank’s communication strategy. I take it as given that it is a good idea for the central bank without targets to be transparent about what its goals are, including what it thinks the desired inflation rate is. That is why this is effectively a comparison between the UK and US where in both cases transparency is fairly high.

The standard academic story involves time inconsistency and inflation bias. (Those familiar with this can skip the rest of this paragraph.) Essential to the inflation bias story is that a positive output gap (output above trend) is better for society than a zero output gap, for given levels of inflation. If you think this is obvious (more output is always better), remember more output means people working longer hours. If you think a zero output gap must be best, think about monopoly distortions or the impact of distortionary taxes. If a positive output gap is best, then a central bank may be tempted, once inflation expectations are formed, to try and temporarily raise output above the natural rate, knowing that the impact on inflation will be modest because inflation expectations are given. However rational agents will anticipate this, and the implication that their expectations about inflation will therefore be wrong. So they raise their inflation expectations above the central bank’s desired level, to a point at which the central bank no longer wants to raise inflation still further to get a positive output gap. The difference between this level of inflation and its desired level is inflation bias.

Although there is a huge literature on this, I have never been that persuaded of it’s continuing relevance in a world of long standing independent central banks. Central bankers, or academics on the UK’s Monetary Policy Committee, know that it is foolish to try and go for a positive output gap in this way, so they will avoid doing so. If the public nevertheless thought otherwise and therefore set inflation expectations above desired levels, the central bank would not settle for the inflation bias equilibrium (the time consistent or discretionary equilibrium), but would deflate the economy to get inflation down. This would soon convince the public that it was not trying to achieve a positive output gap.

Even if I’m right on this, we can still use the inflation bias argument in reverse. By this I mean that the public in ignorance will want the central bank to raise output above the natural rate, and the inflation target protects the central bank from this pressure. I mention this not because I think it is that convincing, but because this ‘using targets to protect the central bank from public pressure’ argument may have much more validity when we come to level targets. Of course the time inconsistency problem is more general than just inflation bias, but effects how the monetary authority responds to shocks (often called stabilisation bias), but here again levels targets may be more useful than inflation targets. 

I suspect the actual reason for inflation targets where they exist is more political. They increase the accountability of the central bank, and in some cases (like the UK) they allow politicians to set the target. These may be important advantages, particularly at the beginning of a new policy regime.

I also suspect that many macroeconomists have traditionally assumed (as I did) that the costs of inflation targeting were small, because if that target was achieved flexibly, it was quite compatible with optimising some combination of inflation and the output gap. The reason is of course the Phillips curve, which says inflation cannot be stable in the medium to long term if the output gap is non-zero. So a regime that targeted some fixed inflation target over the medium term would automatically achieve a zero output gap over the same time horizon.  Flexibility means leaving the choice of any particular short term combination of excess inflation and non-zero output gap up to the central bank.

This rather sanguine attitude has been tested by recent events. Some countries have experienced a whole series of positive inflationary ‘shocks’, some of which just reflect fiscal policy decisions. In the UK this has exhausted any flexibility that the MPC may have felt they had in not meeting the inflation target, so that their plans now involve meeting that target (or, indeed, expecting to slightly undershooting it), even though they forecast a large negative output gap to persist. Aiming to achieve the inflation target conflicts with what a benevolent policymaker would do. In contrast, the Fed in the US has (albeit only recently) explicitly countenanced exceeding their desired inflation level in an effort to get the output gap down. In other words, the inflation target in the UK is stopping the MPC doing what the Fed signal they are prepared to do.  

As a result, monetary policy in the US is better than in the UK, as a direct result of the impact of the inflation target in the UK. A related problem is the measure of inflation used. As I have pointed out before, the CPI is particularly susceptible to inflationary shocks like tax changes or higher commodity prices. As it is not obvious what the correct measure of inflation is from a welfare point of view, focusing on a measure that over a period is persistently higher than others may be distorting policy. The more this bias is hard wired in through mandated targets, the more sub-optimal policy may become.

So, my own view at the moment is that I prefer the flexible dual mandate approach in the US to the explicit inflation targeting regime in the UK.[1] Now of course this view is predicated on US monetary policymakers being fairly close to the benevolent ideal. If instead policymakers without a mandated target acted as if they all they cared about was CPI inflation (as in the ECB, for example), the disadvantages of an inflation target fall away. Nevertheless, what my view implies is that – all other things equal – the case for a nominal GDP target relative to the current regime is rather stronger in the UK than it is in the US right now. 

[1] A possible half way house has recently been suggested by Kate Barker, who was a member of the MPC, This would be to target a range (say 1%-3%), where the point chosen within that range by the MPC would depend on other factors, like the output gap. 

Monetary Policy Innovations

It is always interesting to compare the Fed, ECB and Bank of England. For both the Fed and ECB it has been quite a year for innovation. At the Fed the most recent announcements in terms of forward guidance can be seen as just a development of how it began the year, by publishing its own forecasts for interest rates. Once you tell others how you expect policy to develop given one (central) projection of how the economy will go, it is natural to say how it might develop in other circumstances. Just as it seemed to me the first development was eminently sensible (but others disagreed), so I think recent moves are as well.

Do they mark a substantial shift in policy? Brad DeLong thinks so, but Paul Krugman is more downbeat. I think the answer depends on the timespan you are looking at. In terms of the very recent developments, they are perhaps not a huge shift, although I agree with Mark Thoma that raising the inflation target from an ‘apparent 2%’ to a ‘definitely at least 2.5%’ is significant. Seen over the year as a whole, and including the idea of continuing QE, I think it is an important change.

The ECB has also had an innovative year, but from a different starting point. OMT was a big deal not in terms of central bank practice - it just allows the ECB to do what others are doing already, but with a much more limited remit and under conditionality - but it was a big deal in terms of the mindset of the ECB. However, whereas I think the Fed has been consistently building one innovation on top of another, it seems as if OMT was such an effort for the ECB that they want a rest for at least a year or so. But the Eurozone is starting a new recession, while the US is at least growing. So in terms of what is needed, the ECB is looking at least as out of touch with reality as they did a year ago.

Which brings us to the UK. Now it was only a Christmas Party, but Stephanie Flanders’ account of Bank reactions to the Fed moves sound depressingly plausible. I remember hearing similar reactions to Fed policy as the financial crisis began (‘they will regret cutting rates so quickly’), and to their publication of interest rate forecasts (‘a rod for their backs’). Now if everything was hunky dory in the UK such conservatism might be forgiven, but its not. So it seems that if you want innovation at the Bank, it needs to be imposed from outside.

Which is why this recent speech from Mark Carney has attracted a lot of interest. It has been interpreted by some as arguing for NGDP targets, but I think it is more nuanced than that. Carney clearly argues that forward guidance is useful, but it is much more useful for a country like the US which does not have an overriding inflation mandate than it could ever be for the UK which does. The Bank of England, whoever is Governor, will never say that they will not think about raising interest rates until inflation goes beyond 2.5% because they would be clearly going outside their remit.

On NGDP targets, Carney is quite equivocal about their use in normal times, but sees clear advantages as a device for dealing with the Zero Lower Bound (ZLB). So one interpretation of his remarks is that, yes, they might have been useful back in 2008/9, but they are less useful today. However I think its also possible to take a more optimistic view. As long as we do not treat the survey evidence too seriously, acknowledging that there is a significant output gap (x% say) implies that any NGDP path has to start at a point x% above current NGDP. So even if the long term desired NGDP growth rate is 4% (2% real + 2% nominal), the target for NGDP growth for the year the policy begins will be 4%+x%, which implies a much more aggressive monetary expansion than we have at present.

To get this aggressive monetary stimulus for the UK, I still prefer my suggestion of moving temporarily to a 4% earnings growth target. (Latest number 1.3%.) There are two reasons. First, this puts no upper limit on GDP growth. If in fact the output gap is y% rather than x%, where y is much higher than x, a 4% earnings path will not stop us closing that gap quickly, whereas a NGDP path based on x% might. Second, I take a pessimistic view that x% will be chosen very conservatively, as a price for what will be seen by the indigenous Bank as a radical move. I can also see it taking time to come, because the new Governor will want to persuade, rather than impose his views. If, indeed, these are his views, which as I suggest above the speech leaves open.

I want to end by returning to the general theme of central bank innovation, and the lack of it in the UK. In the reaction on the Carney speech, one report suggested that the Chancellor was open to new ideas that might come from the new Governor. I think this tells you a lot about the current Chancellor. Even though he is in charge of the monetary policy framework and the target itself, he still waits for any suggestion of change to come from the Bank. I cannot imagine Gordon Brown, or indeed Alistair Darling or Nigel Lawson, waiting to hear from the Bank before thinking about changing macroeconomic policy. Perhaps the curtains of No.11 are closed while others do all the hard work?