Bill Mitchell's fantasy about Labour's fiscal rule

My last post about outlandish attacks from some MMTers on Labour’s Fiscal Credibility Rule (FCR) was designed to be read by non-economists, and I didn’t want to bore them or waste space with all the fantasies Bill Mitchell has spread about the rule. But as I’ve had one of those fantasies tweeted back to me many times in response, I want to lay it to rest here.

That fantasy is that the Bank of England somehow has control of when the knockout happens. The knockout is when the rule is suspended and instead you have as much fiscal stimulus as is necessary to get the economy out of recession. It is triggered when interest rates hit their lower bound. At that point all monetary policy has left are unconventional policies, which are less reliable than fiscal policy, so it makes sense to go for a full fiscal stimulus. 

The way this simple rule has been spun by some is that it gives the Bank of England control over when the knockout is triggered. In reality the rule does no such thing. The Bank will have announced beforehand where the lower bound for rates is, and when a recession happens such that the Bank cuts rates to this lower bound the knockout is triggered. This is simple, unless of course you hate the rule because it is not MMT.

To see how MMters spin this as the Bank being in control of the knockout, you have to construct a fairy tale where the Bank is evil. Although they are supposed to do everything to end a recession, in this fantasy they have a higher calling, which is to impose austerity. So what the evil Bank does is announce that the lower bound is X, but when a severe recession hits they cut rates to X+0.25% and no further. They undertake all kinds of unconventional monetary stimulus but insist that rates are not at their lower bound, just because they do not want any fiscal stimulus.

What the fairy tale requires is that all 9 members of the Monetary Policy Committee (MPC), who actually set interest rates, collude to deceive the Chancellor and the public. In reality the M in MPC does not stand for Masonic - 4 of their members are external members. They would have to swear in public that the real lower bound is X and have to explain to parliamentary committees why rates have not been cut to X despite being in a major recession with rapidly rising unemployment and falling output.

I know many more past and current MPC members - both from the Bank and from outside - than I suspect Bill Mitchell does. What always impresses me is how seriously they respect the mandate they are given. They might have their individual views on fiscal policy, as Mervyn King did, but there is just no way they would collude to harm the economy because of those views. Most of those I have met are quite positive about the contribution fiscal policy can make in a severe recession, so they wouldn’t even want to deceive the public on this score even if they felt able to.

But let’s put all that to one side. After all I am sure MMTers would just say this shows I’m too much part of the elite, or I am incredibly naive, or whatever. Let’s just suppose this conspiracy happened. Each member of the MPC swore blind that rates were still not at their lower bound, and had concocted some kind of story about why rates should be kept above their lower bound despite rapidly rising unemployment and falling output etc etc.If all that happened, what would a Labour Chancellor do?

The Chancellor, together with much of the non-partisan press, would see what was going on. They would observe that in the middle of a recession the MPC were deliberately not cutting rates to the stated lower bound for no good reason other than a nefarious motive. The Chancellor would first embark on a temporary (less than 5 years) fiscal stimulus, which he is free to do under the FCR rule even without the backstop. If rates stayed at the same level for months as the recession continued, and the Bank embarked on all kinds of unconventional stimulus measures, the Chancellor would conclude, as any reasonable observer would, that the lower bound had been reached. The Chancellor would then invoke the FCR backstop, allowing him to expand on their original fiscal stimulus. Once the recession was over, I doubt very much that the current monetary framework would survive, which is yet another reason why no MPC would never embark on this fairytale.

MMters sometimes retort that the Chancellor would get political flack for triggering the backstop in this situation. In the middle of a recession with unemployment rising I doubt there would be much flack at all, besides the usual nonsense from the Tory press. But I find it supremely ironic that MMTers are prepared to use media reaction as an argument, as if the media reaction to any Chancellor adopting MMT would be all sweetness and light. Just imagine how abolishing the MPC, and saying taxes do not help finance spending, would go down with most journalists. People in glass houses shouldn’t throw stones.

Mike Norman Economics, commenting on my earlier post, says compared to Bill Mitchell I’m out of my league. That would be the league for telling fairy tales I assume. While one part of the left indulges in polemic and spinning fantasies against Labour policy, thankfully we have another part that is getting on with the serious business of preparing for a transforming government that will finally reverse what neoliberalism really is.

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

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

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

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

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

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

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

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

Martin writes

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

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

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

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

How China beat the Global Financial Crisis

If you were hoping for something on yesterday’s interest rate rise, I can only direct you to the leader in the FT today which says: “There is no compelling reason to increase the cost of borrowing in the UK, but there is definitely good cause to wait.” On why nine intelligent people could all make the same mistake, you have to question their mandate, and move to something that focuses on having the right environment for growth, as I do here.

I recently finished reading the latest book by Adam Tooze (of which much more in a subsequent post), and it reminded me of a story that was not told enough in the early days of austerity. Everyone knows about how quickly the Chinese economy has grown over the last few decades, and how strong exports have been an important part of that. In dollar terms the value of Chinese exports more than quadrupled between 2000 and 2007. By 2007 Chinese exports represented 35% of GDP.

An important characteristic of the Global Financial Crisis (GFC) was how quickly world trade collapsed. If we compare the beginnings of Great Recession after the GFC with the start of the Great Depression, while world industrial production moved in a similar fashion, world trade collapsed by much more in the Great Recession than the Great Depression. Here is a chart from Barry Eichengreen and Kevin O'Rourke’s ‘A Tale of Two Depressions Redux’ VoxEU article.

Trade collapsed in the winter of 2008 around the globe, without exception. This was very bad news for China. Whereas exports had been around 35% of GDP in 2007, they fell to around 25% of GDP in 2009. That is a big hole to fill, and if it wasn’t filled, there was a chance that Chinese growth would collapse completely with damaging knock on (multiplier) effects to the rest of the economy. Above all else, China feared the political consequences of the unrest widespread unemployment would bring.

As Tooze recounts, China’s reaction was swift and bold. In November 2008 it announced a stimulus package of public spending worth 12.5% of GDP. (The Obama stimulus package, by comparison, was around 5% of GDP.) “Over the days that followed [the announcement], across China, provincial party meetings were hurriedly convened …” Within a year 50% of the stimulus projects were underway. Some of this stimulus paid for what Tooze describes as “perhaps the most spectacular infrastructure project of the last generation anywhere in the world”, the Chinese high speed rail network. Monetary policy was also relaxed.

In 2008 as a whole, before the stimulus and hardly touched by the collapse in world trade, Chinese GDP grew by 9.6%. In 2009, when GDP in the advanced countries fell by 3.4%, Chinese growth was 9.1%. The stimulus package had filled the whole left by collapsing Chinese exports. (Source)

Basic macroeconomic theory says that a negative shock to GDP, caused for example by falling exports, can be completely offset by a monetary and fiscal stimulus. China is a good example of that idea in action. What about all the naysayers who predicted financial disaster if this was done? Well there was a mini-crisis in China half a dozen years later, but it is hard to connect it back to stimulus spending and it had little impact on Chinese growth. What about the huge burden on future generations that such stimulus spending would create? Thanks to that programme, China now has a high speed rail network and is a global leader in railway construction.

Now of course people will say that China is not like an advanced democracy, and it was not part of the global banking network that caused the GFC. But the US and UK stimulus programmes could and should have been larger. Those close to the action tell me that the UK was running out of things to spend more money on in 2008/9, but I cannot help think this amounts to a failure of imagination: it is not as if UK infrastructure is great, there are no flood defence projects left to do etc. Above all else China’s example tells you what a huge mistake 2010 austerity was.

The Brexit interest rate increases and misunderstanding inflation

Last week’s rise in UK rates has been extensively analysed (see for example Tony Yates here) so I will be very selective. First, the justification for the title of this post is provided by an extract from the inflation report:

“The overshoot of inflation throughout the forecast predominantly reflects the effects on import prices of the referendum-related fall in sterling. Uncertainties associated with Brexit are weighing on domestic activity, which has slowed even as global growth has risen significantly. And Brexit-related constraints on investment and labour supply appear to be reinforcing the marked slowdown that has been increasingly evident in recent years in the rate at which the economy can grow without generating inflationary pressures.”

The last sentence is particularly important: in plain language it is saying that Brexit is contributing to lower trend productivity growth, which the Bank now put at 1.5% compared to a pre-recession level of 2.25%. The wording is chosen carefully: they are not talking about uncertainty effects, but permanent effects from a likely deal. So last year worries about the demand side effects of Brexit led the Bank to reduce rates, and now concerns about the supply side effects of Brexit are contributing to higher rates.

Whether these modest increases in interest rates continue, as the Bank are signalling, should largely depend on whether the pickup in earnings growth they anticipate actually happens. As Torsten Bell from the Resolution Foundation argues here, the set of information that might justify the Bank’s expectations of an imminent recovery in earnings growth is not empty, but nevertheless many economists regard it as a brave forecast.

However the labour market is not the only reason the Bank is raising rates. Putting labour market issues aside, they think that because firms are operating with little ‘spare capacity’, any large increases in demand will be met by firms raising prices. Ergo the Bank’s job is to use higher interest rates to stop demand rising too fast. I think this is conceptually wrong, because it underestimates the role that demand and expectations about demand play in determining investment decisions.

A firm can meet rising demand in three ways: by investing in more productive processes, by raising prices or by using more of its spare capacity. In a traditional economic upswing firms first use spare capacity, then invest, and when capacity utilisation is at a peak and there are no profitable investments to make it raises prices. At that point it is right for a central bank to step in to moderate demand growth.

This has not been a typical recovery from a recession. Firms have used up spare capacity, but have not invested in more efficient processes. This is what measures of capacity utilisation suggest (taken from an earlier Bank of England Inflation Report).

If you just take these surveys as measuring the state of the cycle (and if we ignore the Bank Agents) since 2013 the economy has been experiencing an economic boom. Yet from 2013 core inflation has been below target and falling. You can resolve this paradox by thinking about firms acting unusually, by failing to invest and meeting additional demand by utilising capacity as if they are in a boom The result of that is stagnant productivity growth.

The conceptual error is to read these capacity utilisation numbers as indicating that there are no profitable investments to make. We know these profitable investments exist, because leading firms are improving their productivity.* What we have is an innovations gap, where lagging firms are not copying leading firms and are instead holding back on investing. We do not know why they are holding back, but one obvious reason is they have expectations of low future growth and/or high uncertainty about this growth. Empirical evidence shows the strongest determinant of investment is output growth, and the obvious rationalisation for that ‘accelerator effect’ is that current growth influences expectations about future growth.

If this is right, increases in demand will be met by firms finally coming off the fence and investing, rather than raising prices. But if the central bank starts raising interest rates to choke off demand, even when it is growing slowly by historical standards, it will validate the pessimism that has been holding back investment and productivity will continue to stagnate. There is a very real danger that the Bank may be playing its part in a self-fulfilling low growth recovery.

*Postscript (8/11/17) Discussion here by Berlingieri et al shows this growing divergence between leading and lagging firms is a global phenomenon.

Productivity and monetary policy

The Bank are warning of imminent rises in interest rates. As Chris Giles points out, we have been here before, and before that, but that shouldn’t mean we should dismiss this talk, because one day it will happen. [1] They (the MPC) certainly sound serious. But why when current growth is so slow are they even contemplating it? Here is a clue from Mark Carney’s latest speech (my italics).

“On the supply side, the process of leaving the EU is beginning to be felt. Brexit-related uncertainties are causing some companies to delay decisions about building capacity and entering new markets. Prolonged low investment will restrain growth in the capital stock and increases in productivity. Indeed, if the MPC’s current forecast comes to pass, the level of investment in 2020 is expected to be 20% below the level which the MPC had projected just before the referendum. Net migration has also fallen by 25% since the Referendum.

As a result of these factors and the general weakness in UK productivity growth since the global financial crisis, the supply capacity of the UK economy is likely to expand at only modest rates in coming years.”

When people, like me, say how can the Bank be thinking of raising rates when demand is so weak, the response from the Bank would be that supply has been at least as weak.

This pessimism about the supply side comes straight from the data. If I hear people talking about the UK being a ‘strong economy’, I know they either have not seen this chart or are just lying.

UK Output per hour, whole economy (ONS)

The red line is a trend that pretty well matches the trend in the data until the end of 2007, with the amount you can produce with an hours worth of labour increasing by 2.2% a year. Since the global financial crisis (GFC) there has been almost no growth at all. If you want to know the main reason real wages have stopped increasing, this is it. [2]

I hear some people say this is just oil and financial services. It is not, as this table from a recent Andy Haldane speech shows.

Start at the bottom: total average growth has been non-existent since the crisis. The rest of the table looks at the contribution of each sector to that total. To see what productivity growth would be excluding financial services, just add that figure to the total: 1.8% 1998-2008, 0.4% 2009-2016. That table makes it clear that the productivity crisis is economy wide.

It is worth looking at aggregate productivity since the GFC period in more detail (same data). I often hear people say the productivity slowdown started before the GFC. From the chart below, it clearly did not. (We have just seen the tenth anniversary of Northern Rock going bust, and the UK productivity slowdown started shortly after that event.)

We could describe this data as five phases. 1) Productivity in the recession fell, as it often does in a recession for various reasons. 2) As the economy begins to grow again, so did productivity growth. 3) As it becomes clear, in 2011, that the ‘recovery’ is going to be very weak because of austerity, productivity growth stops growing. 4) By the end of 2013, with stronger growth under way (although still no catch up to previous trends, so not a true recovery) productivity starts growing again, although rather slowly. 5) Since the 2015 election, with the prospect and then the reality of Brexit, even that modest growth disappears. (My data does not include 2017Q2, which saw a very slight fall.) I could shorten the description as follows: recession, modest optimism, pessimism, even more modest optimism, uncertainty.

That is my gloss on the numbers, but I’ve done it to make a point. Productivity growth invariably requires an investment of some kind. It may not be physical investment, but just training someone up to be able to use some new software. Whether a firm incurs that cost will depend, in part, on their expectations about the future. There is a regrettable tendency in macro (I blame RBC theory) to treat productivity growth as manna from heaven. But the idea that potential improvements in technology stopped after the GFC, and just in the UK, is simply ridiculous. The problem is that firms are not investing in new technology. What I call the ‘innovations gap’ has emerged in the UK because of weak growth and the consequent pessimistic expectations of most firms. [3]

The idea that the economy could get itself in a low growth expectations trap is increasingly being put forward by economists: here is George Evans, for example. The UK has got itself into that trap because on the two occasions that a recovery of sorts appeared to be under way, the economy has been hit with terrible policy errors (austerity and Brexit). But the idea that UK firms are incapable of upgrading their production techniques is nonsense. They will do so initially if they can be confident that the demand for their products will increase, or subsequently when the innovation pays for itself even though demand is flat.

Which is why an increase in interest rates right now would be very bad news. It would confirm the pessimistic expectations of most firms that demand is not going to grow fast enough to make innovation worthwhile. Formally, the job of the MPC is not to worry about productivity but to control inflation. But elsewhere, where the same process may be happening to a lesser extent (the productivity slowdown is worldwide, just most acute in the UK), central banks are puzzled at why inflation just refuses to rise. 

The concept of an innovations gap is one solution to that puzzle. Expanding demand allows firms to invest in more productive techniques, and so there is less incentive to choke of demand by raising prices. I suspect in an alternative world where Brexit had not happened the Bank of England would also be puzzling over why prices were not rising. As a result, if the MPC do finally raise interest rates this year, it would be one more mistake to add to the growing list under the heading Brexit.

[1] On each occasion I also wrote a post saying that they should not raise rates, starting I think at the beginning of 2014.

[2] I discussed in earlier posts why real wages are falling by even more than output per head.

[3] Or perhaps the pessimism of the bank manager lending money to those firms. The Haldane speech shows that productivity growth has remained strong among the top, frontier companies. Why? Because these companies, given their position, will be seeing growth relative to the average, and have got to the frontier through a culture of innovation.

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.

Central Bank Independence and MMT

This is a follow up to my last post on Corbyn and central bank independence (CBI). No apologies for returning to this topic: not often do you get to talk about policies that are in the process of being formulated. One of the influences that is said to be important for John McDonnell (the new shadow Chancellor) and his advisors is Modern Monetary Theory (MMT).

A comment I sometimes get on my posts is that my arguments are similar to those put forward by followers of MMT. I have not read much MMT literature, but in what I have read I have normally not found anything I take great exception to. On some issues, like the way monetary policy continues to be presented in textbooks, they definitely have good reason to complain about the mainstream. However their account of the way monetary and fiscal policy work seems quite a close match to what many mainstream economists think, which I guess is why my arguments can be similar to theirs.

One area of apparent difference, however, is CBI. You will sometimes hear MMT people talk about CBI being a ‘sham’, whereas mainstream macro attaches great importance to CBI. So which is right? Part of the problem here is that CBI in the UK (where the government decides the goal the Bank has to achieve) is rather different from that in the US (where the Fed has much more discretion over the choice of targets) and the Eurozone (where the ECB is largely unaccountable and has huge power). I’m just going to talk about the UK set up. (For a MMT perspective on the US, see here.)

CBI in the UK, established by Gordon Brown and Ed Balls in 1997, is no sham. The Monetary Policy Committee (MPC) decides when and by how much to change interest rates, and government has no influence on the MPC. How do I know this? From observation and from a huge number of conversations with MPC members. Since 2009 the MPC has decided when and by how much to do QE. Any Treasury authorisation to do QE was a formalisation that essentially followed Bank wishes, but it never specified when and how much QE should happen. So a fair description of the UK set up is that the government defines the goals and instruments of policy, and the MPC decides how to use those instruments to best meet those goals.

I would agree with the comment that this set up leaves the government taking big strategic decisions, like what the target should be. But CBI as defined in the UK still has two major advantages over the pre-1997 alternative

1. party political motives for changing interest rates are ruled out. I know such motives influenced at least the timing of rate changes before 1997. (How do I know - same answer as before.)
   
   
2. it forces governments to be explicit about their goals, and the relative priorities among these. I personally believe this has an important role in conditioning (but not determining) expectations, which is very useful. (Yes you can call me a New Keynesian for this reason.)
   
   

You could add time inconsistency and credibility issues in there as well if you like. (Giving this to secondary importance perhaps makes me less of a New Keynesian.)

Are there any negatives to set against this? One argument you often hear is that CBI is anti-democratic, but I really think this is just nonsense in the UK context. Government delegates technical decisions all the time, and as long as there is strong accountability (which in the UK there is), the right people are on the MPC and they are truly independent (from government or the financial sector) this works well. When governments only face elections every 5 years and elections are won or lost over a whole range of issues, quite why a Chancellor deciding when to change rates following secret advice is more democratic is unclear. It also improves democracy because, as Chris points out, the Chancellor is not held to account for the technical mistakes of his advisors.

A more important argument against CBI is that it makes money financed fiscal expansion much more difficult. A government that is obsessed by the size of its deficit might not undertake a bond financed fiscal expansion when a fiscal expansion is needed. It might have undertaken a money financed fiscal expansion, but CBI prevents it doing this because the central bank controls money creation. However this problem can be easily avoided by (a) taking a more sensible view of government deficits and debt, as MMT would also advocate, or (b) allowing helicopter money.

It is (a) that makes the debate over Corbyn’s QE particularly ironic. A National Investment Bank can be set up perfectly well based on borrowing from the market, and you can ensure it gets the funds it needs by a government guarantee. The only reason you would avoid trying to do that is because the NIB debt would count as part of the government’s deficit, and you were worried about the size of the deficit. The last people who should be worried in this way are followers of MMT.

Scott Fullwiler has an elaborate discussion of why Corbyn’s QE does not interfere with CBI, but concludes: “As such, government guaranteed debt of the NIB would be effectively the same thing as plain vanilla deficits, which as shown above is not different in a macroeconomically significant way from Overt Monetary Financing of Government via People's QE.” Which begs the question, why not go with plain vanilla deficits to fund the NIB. If it is because you are worried about the political costs of higher deficits, that will be as nothing compared to the political costs of instructing the Bank to finance a NIB.

So where does this apparent antagonism for CBI come from? Perhaps it comes from a tendency of some from the mainstream to make too much of CBI. To imply that the more independent a central bank is the better, regardless of who determines goals, whether there is accountability and who makes the decisions. Proof that independence is not all that matters is provided by the ECB. But we should not let the bad drive out the good. If Labour abandons the innovations made by Brown and Balls, I think it will be a classic example of the triumph of ideology over both good economics and self interest. 

How to change the inflation target

The longer interest rates stay at the Zero Lower Bound (ZLB), the stronger the case (pdf) for raising the inflation target becomes. (No, that is not a good reason to raise interest rates today, but perhaps it helps explain why some are so keen to do so!) However there seem to be two political barriers to this happening. Central banks seem to live in mortal fear that any move to raise inflation targets will shatter their ‘hard won credibility’ and inevitably lead to inflation ‘taking off’ and inflation expectations becoming ‘unhinged’. Where politicians have control (as in the UK), they worry the public will interpret any increase in the inflation target as a further erosion of their living standards. Yes, I know Abe raised the target rate in Japan, but only to the 2% that has become the consensus for the major developed economies.

Tony Yates suggests a very British solution to this problem. In the past, a standard way that UK politicians have handled such tricky questions has been to establish an independent commission to examine the question. (One famous example in the past was the Macmillan committee, set up after 1929 to establish the causes of the UK depression. Keynes’s role on that committee is vividly described by Peter Temin & David Vines in their recent book.) Tony calls it the Inflation Remit Review Commission. This commission could take evidence (from the central bank and others) on issues such as what the medium term natural real interest rate is likely to be, and compute the costs and benefits of any change. This sounds like a good way of trying (as far as possible) to depoliticise the issue, and putting the central bank’s inflation paranoia in context.

I have just one suggestion to add. This commission, at the same time, should examine whether it remains appropriate that the inflation target should just involve the consumer price index (and in particular, whether the rate of change of wages should also be targeted), and whether the target should involve the inflation rate or a path for prices (a price level target), or indeed national income. These questions naturally go together with the choice of the level of any inflation target. If there is a target for the path of prices rather than its rate of change, then the consequences of hitting the ZLB are less severe, for example. In addition, the possibility of ending the tyranny of the consumer price index, or changing to a level target, suffer from much the same conservative bias from politicians and/or central banks as the value of the target itself.

Whether the idea of a commission would work in the US I do not know. In the Eurozone there are strong grounds for setting up a similar body, not only to review the questions set out above, but also to permanently oversee the performance of the ECB. At present the ECB has minimal accountability. Appearing every three months before the European Parliament just does not count, I’m afraid. (For further discussion, see this Bruegel paper by Claeys, Hallerberg and Tschekassin.) This in itself is a strange state of affairs for an institution with such power. In addition its performance since 2011 (at least) has been very poor relative to the Fed and Bank of England. (See for example this post written over a year ago which I think reflected the clear consensus among macroeconomists at the time.)

Tony does not suggest who might sit on this commission, except to say that they should not be part of the government, or the central bank. My own view is that it is vital that at least some are academic macroeconomists, because academic macroeconomists do understand these questions better. For the UK obvious candidates are ex-external members of the Monetary Policy Committee, unless you think they have become (or were perhaps selected because they were) too indoctrinated with the central bank view. Suggestions on who might comprise an oversight commission for the ECB would be very welcome.      

Hawkery, or is the Bank biased

An interesting contrast in my evening reading yesterday. In the US, Matt O’Brien in the Washington Post’s Wonkblog making fun of reporting that inflation is just around the corner. There is one particularly nice line: “Well, there's always demand for pieces about why we need to raise rates — mostly from 60-year-olds who think it's always 1979 …” The contrast is with the Financial Times’s Chris Giles, who in yesterdays FT accuses the Bank of England of ‘institutional dovishness’, which he compares to institutional racism. The Bank is “institutionally biased against higher interest rates.”

Now, lest I be misunderstood, let me say three things before addressing Chris Giles’s charge. First, I’m pretty sure Chris is well short of 60. Second, Chris is no fool who blindly follows some party line: this piece on the Treasury’s exercise in dynamic scoring is as good as economic journalism gets. Third, central banks can suffer from what I and others prefer to describe as ‘groupthink’. Laurance Ball argued that this happened at the Fed when it came to not trying what I call forward commitment (promising higher inflation and a positive output gap in the future to combat the zero lower bound).

Having said that, Chris can occasionally pursue a line that, while popular in some quarters, makes little macroeconomic sense. The idea that UK austerity did not matter much had him clash with not just the usual suspects (including me), but also US academics Alan Taylor and Oscar Jorda. (I discussed an earlier version of their paper here: their latest version is here). In a similar way, over the last few months Chris has relentlessly pursued the idea that UK interest rates should rise very soon.

Chris’s charge against the Bank is that they keep moving the goalposts. For example, they say they will think about raising interest rates when unemployment dips below 7%, but when unemployment does go below 7% they decide that there is no reason to raise rates, and so on. But for the Bank the goalposts are the inflation target, and inflation is below target.

In the past I have made the point that, given uncertainties about the size of the output gap, it is best to err on the side of expansionary policy. This is because the Bank can easily deal with inflation if it does begin to rise, but because of the lower bound the opposite is not true. Chris responds that “no one should expect that an overheating economy will quickly set prices and wages on the climb”. “As the pre-crisis period showed, economies can overheat and develop dangerous imbalances without displaying the usual warning sign of inflation.” He is of course talking about house prices. But raising rates is a very inefficient way of dealing with a housing boom, which is why we now have the Financial Policy Committee at the Bank with its macroprudential tools. It is also very inefficient for the Bank to be trying to undo effects caused by the Chancellor’s policies (Help to Buy).

To see what can happen in this situation, we just need to look at Sweden. Sweden raised interest rates from almost zero to 2% beginning in 2010, because they were worried about overheating in the housing market. They now have deflation: inflation was -0.6% in March. As a result, the central bank has had to bring interest rates back down again. Lars Svensson, one of the world’s leading macroeconomists who resigned from their equivalent of the MPC while this happened, can only say I told you so.

While we are on the subject of premature interest rate increases, let us not forget the ECB raising rates just before the second Eurozone recession. And let us not also forget that the MPC almost followed their lead - not much evidence of institutional dovishness there.

I suspect and hope that the Bank and MPC have their eyes on the big picture. UK GDP per capita is currently around 15% below the level we might have expected it to be at if it had followed pre-recession trends. At no time since WWII has the economy not come back to this trend. We have no even half decent theories about why this trend should have dramatically changed. In these circumstances, starting to put on the brakes when we have only just begun to catch up lost ground, and when inflation is below target, just seems dumb and dangerous. 

Adapting forward guidance

I have a personal form of forward guidance: that I try and wait a day between writing and publishing blog posts. So yesterday I wrote a post reacting to the previous day’s news that UK unemployment had fallen rapidly to 7.1%. That news led to some speculation that the Monetary Policy Committee (MPC) of the Bank of England might change the number for their unemployment ‘knockout’ (the point at which they might start thinking about raising rates) from 7% to, say, 6.5%. There has been similar speculation about US monetary policy. I wrote that I thought this would be unlikely, but rather than let guidance wither away, they would instead prefer to change the nature of their guidance.

So today, as that post laid waiting on my hard drive, I read that Governor Carney indicated that the Bank has decided not to revise its 7 per cent unemployment threshold. “We’re trying to get across that it’s all about overall conditions in the labour market . . . We wouldn’t want to detract from that focus by unnecessarily focusing on one indicator.” So I’ve lost my opportunity of showing that I can anticipate MPC thinking. Perhaps instead I can write about why they might be thinking this way, and what they might specifically do.

The place to start is with why unemployment has been falling much faster than expected. As Chris Dillow explains, it indicates that UK productivity continues not to grow. The Bank hoped that the return of output growth might be accompanied by a resumption in productivity growth, so that unemployment would come down more slowly. They can hardly be blamed for this. Zero productivity growth for four years during a recession was puzzling, but continuing flat productivity when there is a recovery in output growth is in macroeconomic terms just weird. 

So how might forward guidance change? Here we need to make one point, and then ask one question. The point is that forward guidance is all about providing information to the public about what policy might do if events deviate from forecasts. As a result, those critics of such guidance who use poor forecasting as an argument completely miss the point. It is not what I call forward commitment. This leads us to the question: what is it that makes the MPC relaxed about the unexpectedly rapid fall in unemployment?

The answer is in this chart, which shows year on year growth in private sector earnings (source:ONS).

  

The series can be erratic, in part because of bonuses. Indeed, to quote the Bank’s inflation report (pdf): “... growth was volatile in 2013 H1, rising from 0.1% in Q1 to 2.8% in Q2. That largely reflected some people taking advantage of the reduction in the top rate of UK income tax in April 2013, and deferring bonus payments and earnings they would have received in 2013 Q1.” So we can call this the ‘Osborne hiccup’. However smoothing this out, year on year growth has been gradually moving down towards a little above 1%, and there is no sign so far of any reaction to falling unemployment. (Public sector earnings are not growing at all.)

With earnings growth at 1%, and productivity flat, that means unit labour costs are rising well below the inflation target of 2%. If earnings growth stays at 1%, there is no reason coming from the labour market for raising interest rates. If private sector earnings do start increasing by more than 2%, then the focus will then shift to productivity growth. Only if this fails to match the increase in earnings will a rise in rates become a distinct possibility.

So the natural way to change forward guidance is to incorporate this thinking. The unemployment knockout could be replaced with one that says interest rates increases will not be considered as long as private sector earnings growth is not more than 2% above private sector productivity growth. And now I think I should post this, to avoid another rewrite. 

Will the MPC raise UK interest rates in 2014?

Chris Giles of the FT thinks they will. His reason is straightforward: economic growth will continue to outstrip productivity growth, implying unemployment will fall below the MPC’s 7% threshold, and the MPC will worry that inflation will start rising.

While I try an avoid making forecasts (see my first answer to the FT questionnaire here), I would agree that strong growth in 2014 is more than possible. The savings ratio could continue to fall, net trade could pick up and non-residential investment may begin to recover. It would be bad news if this was accompanied by continuing near zero productivity growth, but as we do not know why UK productivity growth has stalled, we cannot rule this out.

Yet if interest rates did rise as a result, it would be extraordinary. To see why, just compare the UK with the US. US GDP began growing strongly at the end of 2009. So the UK is a full three years behind. Yet the US still has interest rates at their zero lower bound, four years after their recovery began, and has only just begun to scale back increases in its quantitative easing programme. (The MPC stopped increasing their programme some time ago.) So if we followed the US, there would be no question of raising rates this year.

The UK has been unusual in the past because of inflation. While US inflation has been at or below target for the past year and a half, it has been above target in the UK for 4 years. Yet the UK inflation rate is now down to 2.1%, despite the recovery in output. So it increasingly looks like high UK inflation in the past was down to a number of temporary factors, which the MPC rightly ignored. This is consistent with other measures of UK inflation, which have been lower throughout.

Now of course if inflation really does look like taking off in 2014, the MPC will raise rates. But what would ‘taking off’ mean precisely. As the MPC focuses on inflation two or so years down the line, I think it would have to mean a sudden tightening in the labour market. Given that unemployment is currently around 7.4%, and averaged 5.25% between 2000 and 2008, and earnings growth is currently running at 0.9% in nominal terms (!), we seem to have a long way to go before anyone could argue the labour market is about to initiate a wage price spiral.

Think of it another way. UK GDP is currently between 15% and 20% below where it would have been if it had followed past trends and there had been no recession. Past trends involved average growth rates of at least 2%. With that historically unprecedented gap, if two years of GDP growth one or two per cent above that past average meant monetary policy had to be tightened, it would mean accepting that something catastrophic and irredeemable had happened to the UK economy. That is why a rate rise this year would be extraordinary.

Now you might say a small increase in UK short term interest rates would still mean that monetary policy was easy, but just a little less so, and so a modest rate rise would be no big deal. The Resolution Foundation would strongly disagree. In a recent report they looked at the impact that various different scenarios for interest rates would have on households. The following chart indicates the key point.

The left hand panel gives the proportion of households paying over 25% of their disposable income in debt repayments (light pink), and over 50% (dark pink). The key point is this. The 2011 proportions are not very different from the average over the previous two decades, despite interest rates being much lower. In other words, we have not seen a wave of defaults and repossessions following the recession because the MPC cut interest rates to the bone. If interest rates rise but real wages do not (because productivity growth continues to stall), then that wave may happen after all. (See the right hand panel.)

As a result, even a small increase in interest rates is likely to have a large impact on at least some parts of the UK economy. The Bank is well aware of this (pdf, HT Pieria), so members of the MPC should not take this action lightly. As I have argued before, given the risks and uncertainties associated with the economy’s current position, it makes much more sense to take risks with inflation than to risk stalling the recovery. But I also thought that in 2011, when GDP growth was flat, and a third of the MPC disagreed, so nothing is for sure.

We can at least be thankful that interest rate decisions are not made by the so called ‘Shadow MPC’, a group set up by the Institute of Economic Affairs. They have been voting since February 2013 to raise interest rates! How can you vote for higher rates before a recovery starts, when it is obvious that there is large scale involuntary unemployment and underemployment? Well back in the 1940s Michal Kalecki had a theory, but then he was a Polish immigrant!