The strong case against independent central banks

I personally think giving central banks the power to decide when to change interest rates (independent central banks, or ICBs) is a sensible form of delegation, provided it is done right. I know a number of the people who read this blog disagree. Sometimes, however, arguments against ICBs seem to me pretty weak. This is a shame, because there is I believe quite a strong case against ICBs. Let me set it out here.

In the post war decades there was a consensus, at least in the US and UK, that achieving an adequate level of aggregate demand and controlling inflation were key priorities for governments. That meant governments had to be familiar with Keynesian economics, and a Keynesian framework was familiar and largely accepted in public discourse. Here I am using Keynesian in its wide sense, such that Milton Friedman was also a Keynesian (he used a Keynesian theoretical model).

A story some people tell is that this all fell apart in the 1970s with stagflation. In the sense I have defined it, that is wrong. The Keynesian framework had to be modified to deal with those events for sure, but it was modified successfully. Attempts by New Classical economists to supplant Keynesian thinking in policy circles failed, as I note here.

The more important change was the end of Bretton Woods and the move to floating exchange rates. That was critical in allowing the focus of demand management to shift away from fiscal policy to monetary policy. The moment that happened, it allowed the case for delegation to be made. Academics talked about time inconsistency and inflation bias, but the more persuasive arguments were also simpler. Anyone who had worked in finance ministries knew that politicians were often tempted and sometime succumbed to using monetary policy for political rather than economic ends, and the crude evidence that delegation reduced inflation seemed strong.

That allowed the creation of what I have called the consensus assignment. Demand management should be exclusively assigned to monetary policy, operated by ICBs pursuing inflation targets, and fiscal policy should focus on avoiding deficit bias. The Great Moderation appeared to vindicate this consensus.

However the consensus assignment had an Achilles Heel. It was not the global financial crisis (which was a failure of financial regulation) but the Zero Lower Bound (ZLB) for nominal interest rates. Although many macroeconomists were concerned about this, their concern was muted because fiscal action always remained as a backup. To most of them, the idea that governments would not use that backup was inconceivable: after all, Keynesian economics was familiar to anyone who had done Econ 101.

That turned out to be naive. What governments and the media remembered was that they had delegated the job of looking after the economy to the central bank, and that instead the focus of governments should be on the deficit. Macroeconomists should have seen the warning signs in 2000 with the creation of the Euro. There monetary policy was taken away from individual union governments, but still the Stability and Growth Pact was all about reducing deficits with no hint at any countercyclical role. When economists told politicians in 2009 that they needed to undertake fiscal stimulus to counteract the recession, to many it just felt wrong. To others growing deficits presented an opportunity to win elections and cut public spending.

Macroeconomists were also naive about central banks. They might have assumed that once interest rates hit the ZLB, these institutions would immediately and very publicly turn to governments and say we have done all we can and now it is your turn. But for various reasons they did not. Central banks had helped create the consensus assignment, and had become too attached to it to admit it had an Achilles Heel. In addition some economists had become so entranced by the power of Achilles that they tried to deny his vulnerability.

From 2010, as austerity began, the damage caused by ICBs became clear. One ICB, the ECB, refused to back its own governments and allowed a Greek debt financing crisis to become a Eurozone crisis. The subsequent obsession with austerity happened in part because governments no longer saw managing demand as their prime responsibility, and the agent they had contracted out that responsibility to failed to admit it could no longer do the job. But it was worse than that.

Economists knew that the government could always get the economy out of a demand deficient recession, even if it had a short term concern about debt. The fail safe tool to do this was a money financed fiscal expansion. This fiscal stimulus paid for by the creation of money was why the Great Depression could never happen again. But the existence of ICBs made money financed fiscal expansions impossible when you had debt obsessed governments, because neither the government nor the central bank could create money for governments to spend or give away. Central banks were happy to create money, but refused to destroy the government debt they bought with it, and so debt obsessed governments embarked on fiscal consolidation in the middle of a huge recession.

The slow and painful recovery from the Great Recession was the result. Economists did not get the economics wrong. Money financed fiscal expansion does get you out of a recession with no immediate increase in debt. But by encouraging the creation of ICBs, economists had helped create both the obsession with austerity and an institutional arrangement that made a recession busting policy impossible to enact.

I have tried to put the argument as strongly as I can. I think it is an argument that can be challenged, but that will only happen if macroeconomists first admit the problem it exposes.

The last 7 years are an argument against inflation targeting

The big controversy since the Great Recession began has been about fiscal policy: government spending, taxes and the budget deficit. In contrast monetary policy has not hit the headlines so much. This is understandable: while fiscal policy has oscillated from fiscal stimulus in 2009 to fiscal austerity in 2010, once the recession became clear (to some earlier than others) monetary policy in the UK, US and Japan appears to have been unambiguously expansionary, with interest rates staying at historical lows. The ECB is the exception, raising rates just before a second Eurozone recession.

Look a little closer however and we find something rather more worrying. Most people who base their view on economics rather than politics would regard the recovery from the Great Recession as disappointing. We have got particularly good reasons to be disappointed in the UK, but many economists think the US and Japan could also have done better at reducing unemployment more rapidly. More worrying still, the recession and the slow recovery may have caused permanent damage. (See Antonio Fatás here on his work with Larry Summers.) In the UK in particular we appear to have permanently lost a massive 15% of income during the recession. That kind of loss over a 7 year period is totally unprecedented in peacetime.

There are well known mechanisms by which short term output losses could lead to a permanent reduction in output capacity, known collectively by economists as hysteresis mechanisms. They include deskilling of the unemployed, less capital and less capital embodied technical progress. Just how permanent they are varies by type, but they all involve real costs in terms of lost output. One that worries me a lot is how expectations about trend output get downgraded, which can become self-fulfilling for quite some time.

The people whose job it is to make sure recessions are short-lived and these kinds of mechanisms do not take hold are in central banks. Yet if you ask monetary policy makers what they think about the last 7 years, they will not hang their heads in shame. They will not say it has been a disaster, but what more could we do? They will not say that, with interest rates near zero, they were powerless to do much, because unconventional policies like Quantitative Easing were poor instruments and government fiscal policy was moving in the wrong direction. Instead they will probably say that overall the last 7 years have not been too bad. This very different view seems both odd and worrying.

The reason however is straightforward. Monetary policy makers either regard their primary target as inflation, or are explicitly told that inflation should be their primary target. While below target now, inflation was above target in 2011 and 2012, so on balance maybe the record is not too bad. So looking at what they were asked to do, monetary policy makers feel little remorse.

In the UK we can put this in a rather startling way. Imagine someone in 2011 discovered a magical new policy instrument that was guaranteed to stimulate the economy, and gifted it to the Bank of England. In all probability they would not have used it. For four months in 2011 three members of the MPC voted to raise rates. We were just two MPC members away from following the ECB’s disastrous course. Just because we avoided that calamity by a whisker does not mean we should pretend it didn’t happen.

This all comes down to what economists have called the divine coincidence. This is the idea that you do not need to target both output and inflation. Ensuring that inflation is on target in a considered way (by for example looking at inflation two years ahead) will stabilise output as well. While the US central bank has a dual mandate (essentially both inflation and output), central banks that were made independent later (like the Bank of England) have inflation as their primary target. One of the main reasons for this was a growing belief before the Great Recession that the divine coincidence would hold. Target forecast inflation and output will look after itself.

The idea of the divine coincidence has not had a good recession! As I explained in one of my better posts, if the divine coincidence worked a central bank in a parallel universe that targeted the output gap rather than inflation should feel exactly the same way about the last 7 years as our inflation targeters. Yet as I explained there and above they would instead feel ashamed and frustrated. We know there are good empirical reasons why the divine coincidence might break down when inflation is low: resistance to nominal wage cuts will mean that monetary policy makers targeting inflation in a recession will overreact to positive inflation shocks like oil price increases and underreact to below target inflation. Add hysteresis, and you can get lasting damage.

So one lesson of the last 7 years must be that relying on the divine coincidence is a mistake. A primary goal of the central bank is to end recessions quickly, and giving it a single primary target of inflation can detract from that. One obvious improvement is to give the central bank a dual mandate, although the best way to specify that is not clear. Another possibility is to combine output and inflation into a single target, and yet another is to raise the inflation target to a level where the divine coincidence might still hold. Luckily for me I have thought quite a bit about these questions already, but in the next few months I may need to come off any fences that remain.

Employment and category errors

When talking about the Great Recession in the UK, we all know (I hope) that this is still the slowest recovery for at least a century and that we have only just regained pre-recession levels of output per head. I find it very frustrating when some people respond by saying the story is quite different when it comes to employment. The frustration is because the remark reflects a confusion which is not trivial to explain to non-economists, coupled with uncertainty about whether this is a real confusion or just political banter.

I was inspired to write about this again by a very good piece by Larry Elliott in the Guardian. He puts it well by talking about how we coped with recession, but I thought I could try and summarise the point slightly differently. In a recession, looking at output is all about the size of the cake. Looking at employment is about how that cake is distributed.

The recession of the early 1980s involved a smaller decline in output, but a bigger and much more persistent increase in unemployment. In contrast the really distinctive feature of this recession has been the decline in real wages. These differences are almost surely linked: unemployment increases were smaller this time, and unemployment then fell rapidly, because real wages declined. Low wages encouraged firms to first fire fewer workers, and later to take on more. There remains a lot we do not know, such as whether this is all a result of the recession or if other factors were involved, and to what extent is a more flexible labour market responsible. This is really just the UK’s productivity puzzle expressed in a different form.

I think most economists would agree with Larry Elliott that the Great Recession in the UK was distributed in a better way than earlier recessions. The high costs of prolonged involuntary unemployment are, I hope, also well known. Whether any of this better distribution should be credited to current politicians seems doubtful: if any politician deserves credit, the most obvious is Margaret Thatcher.

If you look at this in terms of the size of the cake (output) and its distribution (employment and real wages), then you can see why those who dispute the claims about how poor the recovery from this recession has been by pointing to employment are making a category mistake. It is almost certainly better that a recession should lead to declines in real wages rather than increases in unemployment. But to argue that rapid employment growth excuses poor output growth is just another way of celebrating a disastrous productivity performance.        

The big picture

I have wasted far too much of my time killing zombies. This is what Paul Krugman calls ideas or alleged facts that, despite being shown to be wrong countless times, keep coming back to life. In terms of anti-Keynesian mythology, the zombie I have spent too much time on is that 2013 UK growth showed austerity works, but I’ve also done a bit on the mistaken idea that US growth in 2013 shows that Keynesian multipliers are zero. (I’ve been told that what I have done in the US case is deficient for a couple of reasons - neither of which I accept - but those saying this have never shown that doing it their way makes any difference. Instead they prefer to stick to gotcha economics. You can draw your own conclusions from that.) But these are particular episodes for particular countries - what about the big picture?

I happened to be using the IMF’s datamapper recently, and it contains the following for GDP growth in the advanced economies.

There was slow growth in the early 80s, but that was followed by years of around 4% growth. Another slow growth period in the early 90s, followed by years of around 3% growth. The same again for the 2000s. We then had the massive recession of 2009, followed by 3% growth in 2010. Then four years of growth below 2%, which would have been classed as a downturn based on previous experience.

Why has there been such a pathetic recovery? There is a simple, entirely conventional answer, which perfectly fits the timing: fiscal austerity. As I set out here, growth from 2010 in the US, UK and Eurozone would have been closer to previous recoveries without cuts in government consumption and investment.

Now of course there are other explanations. The most obvious is that recoveries from financial crises have been weaker and more prolonged in the past. However a point that is not made often enough is that the austerity explanation and the weak finance explanation are quite compatible with each other. In a recession private spending and public spending on goods and services do not compete, so even if private spending has been weak because of difficulties in obtaining finance, austerity in the form of public spending cuts will still reduce GDP. Furthermore, an inability by consumers to borrow can magnify the impact of cuts in transfers or increases in taxes on consumption.

The only theoretically plausible explanation for why austerity in the form of cuts to government consumption and investment will not reduce output in a demand deficient recession is if monetary policy eases to offset the cuts. That explanation suggests weak growth since the recession is a deliberate choice by monetary policy makers, and it gets more implausible as each day passes. Here is consumer price inflation from the same source. Whereas inflation wobbled around 2% during the Great Moderation, in 2013 and 2014 it was below 1.5%, and this year is heading towards zero.

SNP distortions, again

Judging by pageviews, my most widely read post ever was on Scottish independence, and its title was ‘Scotland and the SNP: Fooling yourselves and deceiving others’. I was extremely critical of the fiscal claims made by the SNP. I wrote

“There are many laudable reasons to campaign for Scottish independence. But how far should those who passionately want independence be prepared to go to achieve that goal? Should they, for example, deceive the Scottish people about the basic economics involved? That seems to be what is happening right now. The more I look at the numbers, the clearer it becomes that over the next five or ten years there would [be] more, not less, fiscal austerity under independence.”

That was half a year ago, and of course lower oil prices have only strengthened that view. But more recently it has been refreshing to hear Nicola Sturgeon make the case against UK austerity. So when I was asked by The Conversation to fact check this statement by her:

“In the last five years, austerity has undermined our public services, lowered the living standards of working people, pushed more children into poverty and held back economic growth.”

I was happy to provide a report which concluded:

“Nicola Sturgeon’s statement on the economic impact of austerity on the UK is correct, with no qualifications.”

Today the SNP put out a press release on the Conversation report. Unfortunately it contained the following comment from Stewart Hosie, Deputy Leader of the SNP and Treasury spokesperson:

''Professor Wren-Lewis reflects what many other experts and indeed members of the public know all too well - that Tory/Lib Dem austerity has done deep harm to the country's recovery from the Labour recession.”

Oh dear – ‘the Labour recession’. That would be the global financial crisis that originated with US subprime mortgages! Calling this the Labour recession is just stupid, and is something I would never say. It is very unfortunate (and I hope it is just a misfortunate) that Stewart Hosie appeared to suggest that I had said or implied that. Whatever the intention, it indicates that at least some in the SNP are still in the business of making highly misleading statements to advance their cause.

While on the subject of the SNP and this election, let me make one final point, just in case any prospective SNP voters read this. In the quite likely event that the Conservatives get more seats than Labour, but less seats than Labour and the SNP combined, in a situation where either side would need LibDem support Nick Clegg has made it clear he will talk to the Conservatives first. That will almost certainly lead to the current coalition government continuing. Clegg’s reasoning for doing this makes little sense, but the SNP cannot influence Clegg’s decision, and I suspect nor can his party even if they were minded to.

If that comes to pass, then every vote for the SNP rather than Labour that loses Labour seats becomes a vote to continue with the current government. That is not an opinion, but a factual statement. So, to be consistent with his own logic, I think Stewart Hosie would have to call this election result the SNP’s Tory-LibDem second term.

The size of the recent macro policy failure

In my Vox piece, I did a simple exercise to show how important fiscal austerity has been in the US, UK and Eurozone. If government consumption and investment had grown by 2% from 2010 onwards, and assuming a multiplier of 1.5, GDP could be around 4% higher in all three ‘countries’. [1]

It cannot be emphasised enough what a huge waste of resources this represents. If 1% growth was lost each year, then by 2013 that gives a cumulative loss of 10% of GDP. That approximation works well for the US. It also roughly fits with Eurozone estimates based on simulations of the NIGEM and QUEST models described here, but the Rannenberg et al study that I have discussed generates cumulative GDP losses up to twice as large. The UK is different from the US because austerity was concentrated in the early years. Using the same methodology (i.e. a multiplier of 1.5) you get a cumulated loss of around 14% of GDP.

For the UK I’ve often quoted a smaller figure of a 5% loss, but based on an analysis which I have always been careful to describe as conservative. It takes OBR estimates of the impact of austerity, which uses lower multipliers (although it does include the impact of higher taxes, which I ignore), and then assumes that all this lost GDP was recouped in 2013. Both differences are equally important in going from 14% to 5%.

Why, for the UK, do I tend to quote the conservative estimate? Four reasons. First, the government is fond of using OBR analysis when it suits them, because their work has some authority. Second, the OBR analysis is more detailed and comprehensive, and it implicitly allows for some monetary policy offset, which may be reasonable given how high inflation was in 2011. (I discuss this issue in much more detail here.) Third, I thought there was some poetic justice in assuming that all of the GDP growth in 2013 was simply a bounce back from earlier austerity, given that many people argue that 2013 growth vindicated this policy. [2] Fourth, losing 5% of GDP is bad enough, so there seemed no gain in using a higher figure, particularly when most of mediamacro act as if the number is zero. But if you asked me what my best guess is, it is nearer 14% than 5%. [3]

As I show in the Vox piece, if US GDP was 4% higher in 2013 it would be above the CBO’s current estimate of potential. The same is true for OECD estimates of potential for the UK and the Eurozone. But all three estimates assume that ‘trend’ or ‘potential’ GDP, or whatever you want to call it, has slowed substantially following the Great Recession. In a subsequent post I want to consider how reasonable it is to assume potential GDP is independent of actual GDP, and why even my 10% (14% for the UK) figure could be an underestimate.

Whether it is 5% of GDP, or 10%, or more, it is numbers like this that I had in mind when I wrote these two posts. They illustrate all too clearly the asymmetric risks that I talked about there. If these numbers are right, but monetary policy makers are nevertheless broadly content with their performance over the last five years, they either have a completely distorted view of the costs of inflation [4], or they have become fooled by a belief in the divine coincidence: that they only need to look at inflation to judge performance. (They could believe that they did not have the tools for the job, or that they had the wrong target, but if that is what they thought that is what they should have said.)

Going from the past to the present, Paul Krugman recently talked about the difference between insiders and outsiders on policy. This also reflects my own experience in the UK. How do we outsiders change this? I think the best place to start is by getting the insiders to think about the costs of fiscal austerity. Once you do that, you realise how large the recent failure of macro policy (but not macro theory) has been, and therefore how important it is not to carry on making the same mistake.  

[1] I write could, because any extra demand growth might - or might not - have been offset by a tighter monetary policy. If it had been offset, in this counterfactual world I would then be writing posts about the foolishness of monetary policy.

[2] We would then have a perfect example of my ‘closing a part of the economy down to boost future growth’ repost, which I used when people wanted to describe 2013 UK growth as vindicating austerity. Paul Krugman prefers being hit by a baseball bat.

[3] So rather than my conservative estimate that austerity lost every adult and child in the UK £1500, my best guess is nearer £4,000. (That is £10,000 per average UK household.) The equivalent number for the US (10% of GDP per capita) is just over $5,000, and for the Eurozone  E3,000.

 

[4] A weak recovery probably shaved the odd percentage point off inflation between 2011 and 2014, but if you ask most people how much they would have been prepared to pay for this, I doubt if the answer would be in the thousands of dollars, euros or pounds.

The Divine Coincidence in a parallel universe

The Divine Coincidence is the idea that by controlling inflation we also bring the output gap to zero, so we do not need separate targets for both. I talked about this in a recent post, but in writing that I realised I could make my point in another (and perhaps more effective) way. The Divine Coincidence essentially works both ways. So imagine a parallel universe where the monetary authority targeted the output gap, and not inflation. [1] [2] The authority said that by targeting the output gap they also controlled inflation.

Now you may make a practical objection at this point, which is that it is obvious to target inflation rather than the output gap because the latter is so difficult to measure. I think that argument becomes weak once we recognise that by targeting inflation, we are in fact trying to reduce the costs of inflation, and the published inflation rate may be a poor indicator of these costs. In a Woodford type framework, for example, inflation is costly because prices are sticky, so we should focus on those goods (and labour) where prices are sticky. This is one rationale for looking at core inflation, but core inflation is hardly a perfect measure of sticky prices. Arguably our proxies for the output gap, like unemployment, are at least as good at capturing the true costs of a non-zero output gap.

In this parallel universe they too had a Great Recession, and (being parallel and all) their recovery was of a very similar shape to ours. How would the output gap targeting monetary authority in this parallel universe perceive its performance? The story would be one of complete failure. After six years of trying, the output gap had still not been closed. A huge amount of resources had been wasted as a result. In fact, I suspect by now the monetary authority would have said quite explicitly that it just did not have the tools to do its job any more. Furthermore, they probably would have made it clear that one reason they did not have the tools (i.e. why interest rates were still stuck at the Zero Lower Bound) was because of fiscal austerity. If they did not try and blame someone else, they would look utterly incompetent.

I do not think, in our inflation targeting world, the monetary authorities have this view. Instead, based on the limited information I have, and at least outside the Eurozone, they believe performance over the last six years has not been too bad. Inflation was a bit high around 2011, and is maybe a bit low now, but nothing too serious. Yet the data they are looking at is exactly the same as the data in the parallel universe. The only difference is that they are targeting inflation, while in the parallel universe the focus is on the output gap. And by the Divine Coincidence, this difference should not matter!

My parallel universe idea illustrates two points. First, over the last six years, the Divine Coincidence has been distinctly unholy. Second, as a result it is terribly misleading to focus on inflation (and consumer price inflation in particular) rather than the output gap. I suspect in thirty years students will look back on this period with the same disbelief that we look back on the 1930s. How could they have allowed the recession to continue for so long, they will ask, when they had the tools to do much better? Part of the answer will be inflation targeting.

   

[1] It’s not quite that simple, because with either a traditional or New Keynesian Phillips curve, getting inflation to target ensures a zero output gap, but a zero output gap alone does not ensure hitting the inflation target. However I do not think this point is crucial here.

[2] Because of the dual mandate, the US Fed could in principle be in either universe. In practice they seem to focus on inflation.  

Saying the obvious

Give any student who has just done a year of economics some national accounts data for the US, UK and Eurozone, and ask them why the recovery from the Great Recession has been so slow, and they will almost certainly tell you it is because of fiscal austerity. And they would be right, as I set out in this recent VoxEU piece. There I present some back of the envelope calculations, but they are confirmed by model simulations: not just those I quoted in the text, but also others that I did not have space to mention.

When writing that piece, I kept having doubts. Not about the analysis, but just that this was all so obvious. It uses basic models (DSGE or more eclectic) that we teach undergraduates and postgraduates. It is supported by the clear majority of empirical evidence. I felt like I was telling people the macroeconomic equivalent of a rise in the demand for apples will mean an increase in their price.

The reason I put those doubts aside are also familiar. The fact that at least half the world’s politicians and mediamacro continue to ignore the obvious. The fact that too many economists continue to look for other reasons to explain this malaise (or pretend there is no malaise), because somehow they think acknowledging that fiscal policy can influence demand is old fashioned, or left wing, or something. These facts and that I was in good company.

While there are too many academic economists who want to deny that fiscal policy is largely responsible for the weak recovery from the Great Recession, I also suspect there is a majority that know it is true. This is why I wrote a post about the lessons to draw for the future. Although we teach students all about time inconsistency and say at the same time what advantages independent central banks can have, I suspect we also know that the case for independent central banks is broader than issues to do with commitment.

Economics is always in danger of being corrupted by politics and ideology, and macroeconomics seems particularly vulnerable in this respect. (I have still not entirely convinced myself if and why macroeconomics is special in this respect. Sometimes things that are actually micro, like financial regulation or labour supply responses to tax changes, seem just to get labelled macro when they become controversial or have macro consequences!) Some say that this corruption is inevitable and that we should embrace it, rather than attempt to avoid it through delegation to institutions like independent central banks. I disagree: demand management is basically a technical issue with political implications. If we did not have independent central banks today, I suspect we would be seeing the US congress voting to raise interest rates. And of course there would be a few economists with their models saying it was a good idea, even though the vast majority thought otherwise.

The reaction to my earlier post, both from comments and elsewhere, was that this weak recovery caused by fiscal austerity was not just bad luck caused by a misreading of the Eurozone crisis, but the result of a more fundamental political economy problem. We therefore need to rethink how stabilisation policy is done at the Zero Lower Bound (ZLB). Of course we also need to think about whether we should try and minimise these ZLB episodes, by either raising the inflation target, or by reformulating how monetary policy is done, or some other means. However the risk of large negative demand shocks will remain, so it would be prudent to complete the delegation of macroeconomic stabilisation policy that was begun by making the operation of interest rate policy independent of political control. Doing that would also be a good opportunity to revisit the arrangements that can ensure independence is compatible with accountability and some degree of democratic oversight.   

Post Recession Lessons

If you are familiar with this blog, you will know that I regard 2010 as a fateful year for the advanced economies in their recovery from recession. That was the year that the US, UK and Eurozone switched from fiscal stimulus to fiscal contraction. Because we were at the Zero Lower Bound (ZLB), this policy switch is directly responsible for the weak recovery in all three countries/zones. A huge amount of resources have been needlessly wasted as a result, and much misery prolonged.

This post is not about justifying that statement, but taking at as given and asking what should we conclude as a result. [1] To answer that question, what happened in Greece (in 2010, not two days ago) may be critical. To see why, let me paint a relatively optimistic picture of the recent past. 

Greece had to default because previous governments had been profligate and had hidden that fact from everyone, including the Greek people. Recessions rather than booms tend to be when things like that get exposed. If Greece had been a country with its own exchange rate, then it would have been a footnote in global macroeconomic history: fiscal stimulus that had begun in all three countries/zones in 2009 would have continued (or at least not been reversed), and the recovery would have been robust.

Instead Greece was part of the Eurozone, a monetary union that had been implemented in such a way that it was particularly vulnerable to the threat of default by one of its members. Policy makers in other union countries prevaricated, partly to protect their own banks, partly because they worried about contagion. The ECB refused to act as a lender of last resort - we only got OMT in 2012. So the Greek crisis became a Eurozone periphery crisis. (For more detail, based on an IMF evaluation of their role in this affair, see this post.) This led to panic not just in the Eurozone but in all the advanced economies. Stimulus turned to austerity. By the time some in organisations like the IMF began to realise that this shift to austerity had been a mistake, it was too late. The recovery had been anemic.

Why is that an optimistic account? Because it is basically a story of bad luck, which we have no reason to believe will be repeated again. When the next crisis comes along, the Eurozone will have OMT in place, and hopefully there will be some rational system for deciding when a Eurozone country that gets into difficulties should get ECB help or should be allowed to default. If this was just bad luck, we do not need to rethink how macro policy is made.

Now for the pessimistic version. The political right in all three countries/zones was always set against fiscal stimulus. It is true that during 2009, when no one was sure how bad things might get, Germany enacted a modest (if fairly ineffective [2]) stimulus, but in the US and UK the political right opposed it. Without Greece, we still would have had a Conservative led government taking power in the UK in 2010, and we still would have had Republicans blocking stimulus moves and then forcing fiscal austerity. The right’s strength in the media, together with the ‘commonsense’ idea that governments like individuals need to tighten their belts in bad times, would mean that opposition to austerity within the political elite would be lukewarm, and so austerity was bound to prevail. While we might hope that this right wing opportunism does not happen again during a future crisis, there is no clear reason to believe it will not. Greece may have just voted against austerity, but there is every chance that in the UK the Conservatives will retain power this year on an austerity platform and the Republicans are just the presidency away from complete control in the US.

If the pessimistic account is right, then it has important implications for macroeconomics. Although it may be true that fiscal stimulus is capable of assisting monetary policy when interest rates are at the ZLB, the political economy of the situation will mean it may well not happen, and that instead we get the fiscal instrument moving in the wrong direction. That means that macroeconomists have to start thinking about how to fundamentally change the way policy is done at the ZLB.

When some economists over the last few years began to push the idea of helicopter money, I was initially rather sceptical. The scepticism could be summed up by saying that helicopter money when you have inflation targets is identical to tax cuts plus Quantitative Easing (QE), so why not just argue for an expansionary fiscal policy? (There was also the point that tax cuts might be a rather poor form of stimulus compared to, for example, bringing forward public investment.)

However, if the pessimistic account is correct, then arguing with politicians for better fiscal policy is quite likely to be a waste of time, a lost cause. A more robust response is to argue for institutional changes so that politicians find it much more difficult to embark on austerity at the ZLB, or to allow others to effectively offset this austerity if it happens. Central banks have QE, but helicopter money would be a much more effective instrument. To put it another way, central bank independence was all about taking macroeconomic stabilisation away from politicians, because politicians were not very good at it. The last five years have demonstrated how bad at it they can be. However that move to independence was always incomplete because of the ZLB problem. We now need to make it complete.

This of course raises all kinds of questions. Do we want to give additional powers to the central bank, or should another independent institution be involved? If we do give central banks more power, could this be limited to enforcing a dialogue between central banks and government (along the lines suggested here), or should we go for something like helicopter money? If the latter, what are the knock on consequences to ensure the central bank can always tighten policy as necessary? Going down that road must in my view include thinking about how to make central banks a lot more accountable, so that they do not behave like the ECB. Arguably macroeconomics has been naive in suggesting that the more independent a central bank is the better.

However, we only need to go there if the pessimistic interpretation of the last five years is correct. Should we put the last five years down to bad luck, or to political economy forces that will not go away. I currently think the pessimistic interpretation is more persuasive, but I will be very happy to change my mind.

[1] Many argue that the recovery was weak because the recession was caused by a financial crisis, and it was always going to take a long time before banks would start to want to lend again. Even if you put a lot of weight on this argument, it implies a multiplier of one, not zero. It does not justify reducing public spending and employment i.e. making people unemployed when there was little chance they would find work in the private sector.

[2] The stimulus focused on tax cuts, which are less effective than increased government spending because some of the tax cuts will be saved. See Carare, A, Mody, A and F Ohnsorge (2009) “The German fiscal stimulus package in perspective” VoxEU  23/01/09. 

Misleading a country

When this happens (taken from a post by Jérémie Cohen-Setton), something has gone very wrong. The Euro was meant to increase growth, not create stagnation. So what, or who, is to blame?

Many outside the Eurozone, and a growing minority within it, will say the Euro itself. But that is not a very helpful response. Given the level of commitment to the Euro, it is the only correct response if there is no version of this currency union that can be made to work better.

Others will say that the only way forward is further political integration through a fiscal union. That seems like the political equivalent of going from the frying pan into the fire. The story of the Euro is as much a political failure as an economic failure. But I also suspect support among many economists for fiscal union is built upon a questionable premise. The premise is that the current difficulties arise because it is inevitable that Germany will put its national interest above the interests of the Eurozone as a whole.

This argument goes as follows. As a result of undercutting other union members, Germany has become too competitive within the Eurozone. This will be reversed. The ECB has an inflation target of almost 2%. Therefore in normal circumstances we would see inflation above 2% in Germany for some period. This is unfortunate for Germany, but those are the macroeconomic rules of the game in a monetary union.

However we are not in normal circumstances, because the interest rate set by the ECB cannot fall any further. As a result, Eurozone inflation is well below 2%. There is an obvious solution to this problem: replace monetary stimulus with fiscal stimulus. However, this is not in Germany’s interests: as a result of becoming too competitive, their economy is relatively healthy, and they do not want above 2% inflation. Therefore we need a fiscal union to impose fiscal stimulus on Germany. (There is a variant of this argument where we focus on the failure of monetary policy and German pressure on the ECB.)

It is natural for economists to reason this way, because we are used to thinking about rational self-interested individuals. But suppose the problem with German public opinion is not that it is being narrowly self-interested, but that it has been encouraged to think about this in the wrong way. There are two aspects to this. First, although Keynesian economics is taught in all universities, in appears taboo in much German public discussion. Under this anti-Keynesian view the chart above has nothing to do with fiscal contraction, so it must be all about the lack of ‘structural reform’ outside Germany. Second, German politicians are in denial about the implications of low German inflation before the crisis. Logically the only way Germany can avoid above 2% inflation is if the Eurozone as a whole goes through a prolonged depression, but as is painfully obvious from the comments on some of my recent posts, the German public is not told about this.

The two deceptions help reinforce each other. Germany says it is doing OK without the need for fiscal stimulus, so why do other countries need it? Of course Germany is doing fine because its period of relatively low inflation allowed it to uncut its Eurozone competitors.

Never underestimate the power of bad ideas, particularly if they have ideological roots. Here we have the two mistakes that led to the Great Depression being repeated. We look back at the 1930s and think if only they had known about Keynesian economics a depression could have been avoided. However the depression was as much about countries attempting to stick with the gold standard, and the problems with that were obvious at the time. Today we do know about Keynesian economics, but both mistakes continue.

It is possible to believe that balanced-budget fundamentalism is somehow hard wired into the German psyche, and I have personally experienced moments like that described in this comment to my earlier post that seem to confirm this. So I do not want to discount such explanations entirely, but I do wonder if a powerful motive behind this is just the same anti-state neoliberalism that you see elsewhere. Those on the right appear to have a greater distrust of economists and their theories. This may be true of popular attitudes (HT Tyler Cowen), but it is also the case of those running the country.

According to Der Spiegel, the three permanent secretaries running the German finance ministry have studied law rather than economics. Among the nine department heads seven are lawyers and just two are economists. While the balance between lawyers and economists has always favoured lawyers, it has apparently become worse under Schäuble (whose doctorate is also in law).

As a result of all this, it is not at all clear to me that the current problems of the Eurozone are all down to German self-interest. The case for additional infrastructure spending in Germany looks strong, as argued by Marcel Fratzscher, head of the German Institute for Economic Research (DIW). It would therefore seem more than possible to get Germany to take part in a Eurozone wide programme of additional public investment, which can be justified on a microeconomic/supply side basis as well as on macroeconomic/demand side grounds. All that stands in the way is the power of bad ideas, and its embodiment in the Eurozone’s fiscal rules.

Has the Great Recession killed the traditional Phillips Curve?

Before the New Classical revolution there was the Friedman/Phelps Phillips Curve (FPPC), which said that current inflation depended on some measure of the output/unemployment gap and the expected value of current inflation (with a unit coefficient). Expectations of inflation were modelled as some function of past inflation (e.g. adaptive expectations) - at its simplest just one lag in inflation. Therefore in practice inflation depended on lagged inflation and the output gap.

After the New Classical revolution came the New Keynesian Phillips Curve (NKPC), which had current inflation depending on some measure of the output/unemployment gap and the expected value of inflation in the next period. If this was combined with adaptive expectations, it would amount to much the same thing as the FPPC, but instead it was normally combined with rational expectations, where agents made their best guess at what inflation would be next period using all relevant information. This would include past inflation, but it would include other things as well, like prospects for output and any official inflation target.

Which better describes the data? The great attraction of the FPPC is that it can describe stagflation. We have a boom, which while it lasts steadily raises inflation. When the boom comes to an end, inflation stabilises, but at a much higher level than it began. So policy has to engineer a recession to get inflation back down again: a period in which above average unemployment is accompanied by above average inflation, which we call stagflation. If over this period we had had credible independent central banks setting inflation targets, the NKPC would not give us stagflation: when the boom came to an end, inflation would return to target. (For more explanation, see this post.) The trouble is we did not have inflation targeting during this period, so it is difficult to tell whether stagflation is evidence against the NKPC. (As an example of this ambiguity, see this survey of the empirical evidence by Nason and Smith. This enabled Robert Gordon to be quite supportive of the FPPC in 2009.)

The Great Recession could provide a much better test. In some countries output fell sharply in 2009, but has since seen a slow but steady recovery, such that the output gap today is less than it was in 2009. With the FPPC, inflation should have been steadily falling over this period, reaching its lowest level today. So if we plotted the output gap (x axis) and inflation (y axis) together, we should see a line pointing South East. With the NKPC, we can consider two polar cases. In the first, agents fully anticipate that the recovery will be slow, so we will get a sharp immediate fall in inflation, but subsequently inflation will rise towards the target. That will give us a line pointing North East. In the second, agents keep thinking inflation will return to target next year. That also gives us a line pointing North East, but it is flatter. [Postscript - I should have added that this last gives us what Krugman calls the Neo-paleo-Keynesian Phillips curve.]

Here is this plot for four countries, using OECD estimates for the output gap on the horizontal axis, consumer price inflation less 2% on the vertical axis, and OECD forecasts for 2014 and 2015. I’ve chosen these countries simply because in most of Europe we had a double dip recession, which is a more complicated experiment. If you do not like the idea of including forecasts, just ignore the last two points for each country.

The lines point North East, not South East. This gives more support to the rational expectations NKPC than the adaptive expectations FPPC. To take just one example, US inflation in 2013 is higher than it was in 2009, which is consistent with the NKPC. The traditional FPPC, on the other hand, would suggest that after a string of negative output gaps, US inflation should be a lot lower in 2013 than it was in 2009.

OK, now the caveats. Commodity prices will have an important influence on the CPI, and these are not part of either simple Phillips curve story. They may help explain the blip in inflation around 2011 in some countries, but they also helped depress inflation in 2009. Exchange rate changes will also matter. The simple Phillips curve also takes no account of non-linearity caused by a reluctance to cut nominal wages. And of course estimates of the output gap may be wrong.

In the case of Japan, we also had a recent increase in the inflation target. This may explain the forecast upward shift in inflation in 2014/5. If it does, that is clear evidence in favour of rational rather than adaptive expectations. 

All these caveats point to the need to do more empirical analysis. Nevertheless we can see why some more elaborate studies (like this for the US) can claim that recent inflation experience is consistent with the NKPC. It seems much more difficult to square this experience with the traditional adaptive expectations Phillips curve. As I suggested at the beginning, this is really a test of whether rational expectations is a better description of reality than adaptive expectations. But I know the conclusion I draw from the data will upset some people, so I look forward to a more sophisticated empirical analysis showing why I’m wrong.

Yes, economic policy did fail

Tony Yates today criticises Paul Krugman’s argument that economics had the answer to how to respond to the crisis, but policy failed to follow the prescription. As I completely agree with Paul Krugman on this, let me say why I think Tony’s criticism is completely wrong. 

The argument he is criticising is that, following the recession, we had a demand deficit that fiscal stimulus could have tackled, but from 2010 policy went for fiscal contraction instead. How do we know that we had a demand deficit? Because interest rates went to their zero lower bound pretty well everywhere. Monetary policymakers had to go for largely untried and untested Quantitative Easing to try and plug the demand gap. Fiscal stimulus is a much more reliable method of achieving the same goal. That logic is, in my view, unassailable.

Tony’s first argument is that, despite this, we got lucky. If you look at inflation, “conventional demand-side fiscal policy was roughly on track”. So, when economists in twenty years time look back on the 2008/9 recession, Tony thinks they will describe it as a textbook example of how policy should deflate the economy in response to an inflationary shock. Policy did good - the recession was just what was needed to stop inflation going higher. Somehow I really doubt that is the story they will tell.

Tony defends this argument by invoking the social welfare functions implied by New Keynesian models, where inflation is much more costly than non-zero output gaps. At which point I do worry about what today’s macroeconomists actually believe. These social welfare functions may capture the costs of inflation - or at least the costs due to relative price distortions - but they certainly do not capture the costs of output gaps at all. We have a huge amount of evidence that tells us this. Just because we have not yet microfounded why people hate being unemployed so much does not mean they really don’t mind.

Tony acknowledges this, but then says “But, with the models thus binned, you are in the dark about what should be done.” That is just silly. New Keynesian models do not stand and fall according to the accuracy of the social welfare functions they imply. After all, many NK models have a labour market that clears. Economists use them not because they think the labour market actually clears, but because they give answers about output gaps and what to do about them that are not too far off. So there is absolutely no problem using a NK model with an ‘ad hoc’ social welfare function where weights follow the evidence rather than the model. If we do that, and use other measures of inflation besides consumer prices (as theory suggests we should), then 2009-13 does not look like an optimal response to an inflationary shock.

Then Tony falls back on the argument that there is so much we still do not understand about the financial crisis, so how can anyone argue that the economics is clear.

“PK seems to be backing away from all these intractable debates about the detail, and saying that we can ignore it.  Big picture, demand was weak, public demand had to be stronger.  Politicians did not get this message clearly enough, and were able to ignore it.  End of story.  Well, maybe.  Maybe not.  Perhaps only great minds can see the wood for all these unfinished modelling trees.”

No, you do not need to be a great mind to do this, and I should know. You just need to assess whether the things we do not understand can seriously compromise what we do know, which was that we had deficient demand and we knew how to deal with that. The only possible factor was - briefly - the Eurozone debt crisis, but then a balanced budget fiscal expansion could have been used to avoid increasing debt.

So Tony’s argument that the reason for this “policy failure is that our economics profession had not yet come up with clear answers” is not tenable. As he knows, monetary policymakers cope with uncertainty all the time, but we still tell them (or at least most of us do) that you cut rather than raise interest rates in a recession. For exactly the same reason, you undertake fiscal stimulus, not contraction, when interest rates are at the zero lower bound. It really is that simple. 

New versus traditional Phillips curves and the Great Recession

For economists

One of the questions I like asking students is whether inflation following the Great Recession has tended to favour the New Keynesian (NK) Phillips curve or its more traditional counterpart (TK). I like it because it allows me to draw a nice diagram, and also because it shows students how difficult it is to discriminate between theories in macro.

So first the theory. The two competing models are

• NK: Inflation at t = expected inflation at t+1 together with a term in the output gap
• TK: inflation at t = inflation at t-1 together with a term in the output gap

I’m ignoring discounting in the NK Phillips curve for simplicity. Assume expectations about inflation are rational, and suppose the economy is hit by an unexpected recession of known size and duration. The two models predict the following:

With the traditional model, inflation gradually falls as the recession continues, and once it comes to an end, inflation remains lower. In the New Keynesian model, assuming that the inflation target is credible, inflation jumps down when the unexpected recession occurs, and then inflation gradually rises towards its target as the recession progresses. (We assume here that the output gap is constant while the recession lasts, again for simplicity.) For the NK model, it is critical in drawing this diagram that the extent of the recession is known – more on this below. The patterns implied by the two models are distinct, and this difference is likely to persist even if each curve becomes flatter as we approach zero inflation because of nominal wage rigidities.

To see what has actually happened, see this nice post from Gavyn Davies. The immediate aftermath of the recession looked more like the NK model: a sharp fall followed by a gradual rise. Furthermore I would argue that – once the recession hit – most people expected it to be large and persistent, so my diagram is not totally unrealistic. But if we look at what has been happening in the last two years, it looks much more like the TK model, with inflation gradually falling below target.

That is probably as far as we should go without doing some econometrics, and also taking account of some of the complexities discussed here. We could probably get any pattern to fit the NK model by imagining a suitable sequence of expectations errors. In addition if we are looking at consumer price inflation we should account for commodity price changes, which neither model does. (If we look at GDP deflators, you could tell a story where agents were initially expecting a recession lasting three or four years, and have been surprised that the recession has persisted ever since.) That is why some proper econometrics is required, preferably looking at both price and wage inflation together with expectations data. (If such studies have been done, please let me know.)

However perhaps I can suggest two possible conclusions that such studies could test more rigorously. First, the traditional Phillips curve, where expectations are implicitly naive and backward looking, does not look like a promising basis for explaining inflation following the recession. Either the New Keynesian model, or some combination of the two models, looks more like providing an adequate foundation for a reasonable explanation. Second, an explanation based on the NK model that treats the size and extent of the recession (whatever that turns out to be) as one initially unexpected but then completely anticipated shock is also going to struggle to fit the data.    

Teaching macroeconomics after the crisis

A slight variation on an old theme

                I was asked the other day how macroeconomics teaching at Oxford had changed as a result of the Great Recession of 2008-9. My answer, which was not much, seemed a little surprising at first. Does this reflect insularity or intellectual arrogance? Surely the failure to foresee the financial crisis must have led to some change in what was taught. Does this not confirm something rotten at the heart of economics?

                First I need to explain ‘not much’. [In what follows I only deal with core macro courses, and not options at either undergraduate or graduate level.] John Vickers, who gives the first year macro lectures, has added material on bank runs, leverage and banking reform, where for the latter he has of course played a major role in current UK policy. My own second year undergraduate lectures include a wealth of topical examples to illustrate basic theory. And perhaps most significantly, Martin Ellison now gives a couple of weeks of lectures on recent developments in modelling financial frictions as part of the core post-grad macro course.

                So why was my answer not much? Because although the crisis has added material, nothing has really been thrown away as a consequence of what has happened. We have not, either individually or collectively, decided that the Great Recession implies that some chunk of what we used to teach is clearly wrong and should be jettisoned as a result. Speaking for myself and my second year undergraduate lectures, quite the opposite is the case. As Paul Krugman has pointed out many times, recent developments have in many ways been a vindication of the basic Keynesian model that lies at the heart of any undergraduate macro course.

                Indeed, I would go even further. The mess we are currently in is due in part to policy makers ignoring this basic macroeconomic analysis. As a result, I teach this stuff with renewed vigour and determination. As many people know, both our current Prime Minister and the Leader of the Opposition will have attended a past version of the course I teach (although well before, I hasten to add, I started teaching it). Although George Osborne read Modern History at Oxford (and here ‘modern’ means from 1330, so the Great Depression was not necessarily covered in depth!), one of his principle advisors also read PPE (Politics, Philosophy and Economics). If any future Prime Minister or Chancellor follows a similar path, I want them to remember basic macro theory.

                Now I also teach the first part of the core macro for our MPhil (Oxford’s two year masters) course, and you might think that the basic Ramsey model which is covered there has less relevance to recent events. To some extent this is true: I’ve noted how the standard intertemporal consumption model is not going to explain trends in savings in the UK or US over the last few decades, and my colleague John Muellbauer has written extensively on this. On the other hand, I find the Ramsey model and its OLG variant very useful in discussing issues around the control of government debt.

                So while the Great Recession has clearly shown that macroeconomics is incomplete in important respects, it has not shown that what we thought we knew is all wrong.  In many respects it has shown it is exactly right.

                However I think I should add one important rider to this. Anyone wanting to understand what has happened over the last five years would be better off reading an undergraduate macro textbook like Mankiw than a masters textbook like Romer. This is not because the former is less technical than the latter, but because the former is more old fashioned in academic terms. They might do even better still by reading The General Theory. Before I am misunderstood, I am not suggesting anything is wrong with what we currently teach. Rather that the inevitable focus at the masters level on the recent macroeconomic literature leaves no place for the history of macroeconomic thought, and that is a problem.

                Now I must confess two things here. First, I have not always held this view. Indeed until quite recently, when I thought most macroeconomists signed up to the New Neoclassical Synthesis, I imagined economics might be like a physical science, where knowledge of bygone theory added little to our understanding of the world today. The Great Recession changed that view, for me at least. Second, this argument to teach the history of macroeconomic thought is one that tends to be made by those of a certain age, and even though they might also be very eminent (for example), don’t we all want to pretend we are still young? Well maybe it’s time to admit my age.