We want helicopters, and we want them …

Not now exactly. In the UK, for example, the MPC has scope for some further reduction in interest rates. (I think they should use that scope now, but that is for another day.) But, as Mark Blyth, Eric Lonergan and I argue in the Guardian, if something serious goes wrong in the next year or two, or if another financial crisis happens in the next decade or two, monetary policy is under equipped.

Does this mean that I no longer think it is a good idea to have a fiscal stimulus in a recession when nominal interest rates are at their floor? Of course not, because helicopter money is essentially just like a tax cut. What is true is that helicopter money is not my ideal form of fiscal stimulus, partly because there is some uncertainty about how much of it will be spent. I would much prefer additional public investment, for which there is a strong microeconomic as well as macroeconomic case. [1] Michael Spence [2] is one of a huge list of eminent economists, which includes Ken Rogoff, who think additional public investment across the OECD would be beneficial.

We should continue to urge governments to recognise this, but we also have to accept the awkward fact that they are not listening. In political terms, the need to reduce deficits trumps pretty well anything else. (Perhaps things are turning in the US, but until the Republicans start losing power I’m not counting chickens.) One of the many depressing things about the Conservative election victory in the UK is that it looks like deficit obsession is an economic strategy that can win, as long as the austerity is front loaded, which is why Osborne fully intends to do it all over again. 

Because helicopter money is mainly a form of fiscal stimulus, and because the case for fiscal stimulus in a liquidity trap is largely agreed by most academic macroeconomists, the debate over helicopter money is essentially an issue in political economy. Persistent demand deficiency is clearly preventable, and represents a huge economic cost to society. Politicians will not do what economists call a bond financed fiscal stimulus because spreading scare stories about public debt is a vote winner. That leaves us with a money financed fiscal stimulus, of which helicopter money is one form. With independent central banks, that means giving these banks the power to undertake helicopter money.

I think the biggest obstacle to helicopter money is probably central banks themselves. This is for two reasons. First, they seem far too optimistic about the efficacy of creating money to buy financial assets (QE), even though they almost certainly need to create far more money by this route than they would through helicopter money, with a far less certain impact. Second, there is this residual worry that creating money now will mean they will lose the ability to control inflation in the future, as if a modern government in an advanced democracy would ever refuse to provide them with the assets they need.

The consensus among macroeconomists is that independent central banks are a good idea. The belief is that the business of macroeconomic stabilisation is best achieved if the task is delegated. But making central banks independent is not the same as completely delegating the task of macroeconomic stabilisation, because of the problem of the lower bound for nominal interest rates. Indeed independent central banks made the obvious way of getting around the lower bound problem, which is a money financed fiscal expansion, more difficult to achieve. Helicopter money is a way of making the delegation of stabilisation policy complete. 

[1] I have suggested how (see here and here and here) we could have ‘democratic helicopter money’ that could encompass additional public investment, but I’ll happily settle for the plain vanilla kind for the moment.

[2]  HT Diane Coyle

Austerity and Flood Damage

This picture is what happened to part of the mainline between the South West of the UK and London after the latest storms. I used to travel on this stretch when I lived in Devon. On bad days the waves could splash on to the trains, but luckily there were no trains running when this happened.

Large parts of the UK have their wettest January on record, leading to widespread and severe flooding, and I blame the government’s austerity policy. Ridiculous? Quite the reverse. Under a sensible macroeconomic programme for public investment, the last few years would have seen a very large increase in spending on flood prevention. Instead we saw cuts, because flood prevention had to take its share of austerity. This was a government decision, for which they alone are responsible.

But it gets worse for the government. Extreme weather events like the one we are now suffering are a predictable consequence of climate change. Just have a look at this helpful DEFRA (Department for Environment, Food and Rural Affairs) and Environment Agency webpage. It says: “Global temperatures are rising, causing more extreme weather events, like flooding and heatwaves.” As the page makes clear, this applies to the UK. So there is a need to increase spending on flood protection, and realistically that has to be public spending.

Any government minister in charge of the environment would know this. They might not believe it, however, if they were a climate sceptic. Sure enough, the environment minister Owen Patterson is just such a sceptic. Spending by DEFRA on finding ways to cope with climate change had risen by almost 20% under Paterson's predecessor, Caroline Spelman, but fell 41% after Paterson replaced her in September 2012, according to the Guardian. Patterson has noticeably failed to back David Cameron’s “suspicion” that climate change was behind our current severe weather. But of course Patterson was appointed by Cameron.

Now there is “controversy” over whether spending on flood prevention has been cut by this government or not. Except there is no real doubt, as one look at the chart in my previous post shows. (Dear BBC. This chart comes from a House of Commons document. Why isn’t it on your website?) This is only controversial because the government has tried to claim otherwise, by for example including spending in the year it took office as its own, even though it was planned by the previous government. If you want to get into how the government has tried to bend the figures, see Guy Shrubsole or Jim Pickard (HT Jonathan Portes). Yet this “debate” nicely diverts attention from two key points: spending should have been rising because of the increased threat, and the recession gave the government the ideal opportunity to accelerate this process (cheap labour, cheap borrowing). It failed on both counts, and cut instead.

As I have noted before, most macroeconomists agree that public investment should rise in a recession, including some like Ken Rogoff who have been quite supportive of austerity more generally. However, the standard response when I make this point is that it is very difficult to find “shovel ready” projects to invest in quickly. This is one reason why I originally talked about flood prevention - it was a clear example of potential UK public investment that was in a very real sense shovel ready!

So this looks like a major scandal. Except, that is, in a country in which the political right directly or indirectly controls most of the media. If you search using the three words “UK flooding austerity” in Google or Yahoo the first item that comes up is my post, followed in Yahoo by a report from Al Jazerra! Of course, the right wing media need someone to blame, so knives are out for the chairman of the Environment Agency Chris Smith, who also happens to have previously been a Labour minister. This just a month after it was announced that the Environment Agency is being forced to cut 1,500 jobs, which it says will “have an impact on flood operations such as risk management, maintenance and modelling.” As yet, those responsible for these decisions have not been held to account.

Is a currency crisis bad for you at the ZLB?

My and Paul Krugman’s comments on Ken Rogoff’s FT piece have generated an interesting discussion, including another piece from Ken Rogoff, a further response from Paul Krugman, and posts from Brad DeLong, Ryan Avent in the Economist, Matthew Klein, John McHale (follow-up here), Nick Rowe and Tony Yates. The discussion centred on the UK, but it is more general than that: a similar thought experiment is if China sells its US government debt. Paul Krugman has promised more, so this may be the equivalent of one of those annoying people in a seminar audience who try and predict with questions what the speaker will say.  

The track I want to pursue starts from my argument that Quantitative Easing (QE) will ensure that the UK government never runs out of money with which to pay the bills. The obvious response, which Paul Krugman’s comment took up, is that a market reaction against UK government debt might be accompanied by a reaction against the UK’s currency, leading to a ‘sterling crisis’. For those with a long memory of UK macro history, would this be 1976 all over again?

Ken Rogoff’s original article, and his reply, both focus on the trigger for these events being a collapse in the Euro. While such risks should be taken seriously (although, for the record, I have never thought such a break up was the likely outcome), I want to ignore this possibility here, simply because it introduces too many complicating issues. Instead I just want to look at a much more limited scenario. Specifically, suppose Labour had not lost the election, and austerity had been delayed (by more than Ken Rogoff would have thought wise, bearing in mind that he agrees that government ‘investment’ in its widest sense was in fact cut too aggressively). Suppose further that markets had decided that because of this alone it was no longer wise to buy UK debt. QE fills the gap, but the flight from UK debt is also a flight from sterling, which depreciates as a result. If the market believes the government is not solvent, it will assume some part of QE is permanent rather than temporary, so inflation expectations rise. This validates the fall in sterling, in the sense that the market does not see any capital gains to be made from its depreciation.

In this thought experiment the UK government is solvent before the crisis, so other things being equal QE will be temporary. We are not talking about a strategy of inflating away the debt. There are two directions we could follow at this point. One would be the idea that a depreciation makes the UK government insolvent: in other words the crisis is self-fulfilling. The analogy is with a funding crisis under a fixed exchange rate, where by pushing up the interest rate on debt, markets can induce the insolvency they fear. (The government was not insolvent under pre-crisis interest rates, but is insolvent if it has to borrow at post-crisis rates.) But its not clear how this would work when exchange rates are flexible. The depreciation would do nothing to raise current or future borrowing costs, or reduce the long term tax base. At some stage markets would realise their mistake. I cannot see why there are multiple equilibria here, but maybe that is a failure of my imagination.

The second direction is to focus on the short run costs of the nominal depreciation. Some of those who commented on my original post talked about a ‘downward spiral’ in sterling. Now of course the depreciation itself may raise inflation to some extent, but this is not an unstable process. At some point sterling falls to a point where the market now thinks it is OK to hold. There is no bottomless pit.

As domestic prices are sticky, the depreciation increases UK competitiveness, which increases the demand for UK goods. If the Zero Lower Bound (ZLB) is a constraint, then this increase in demand reduces or eliminates the constraint. It may also raise inflation because demand is higher, but higher demand is what monetary policy wanted but was unable to achieve. If the depreciation is so large that demand has to be reduced through increasing interest rates, that is fine: this is what monetary policy is for. In essence the ZLB is a welfare reducing constraint that the crisis relieves, and we are all better off.

If that sounds too good to be true, I think it could be. It treats the depreciation as simply a positive demand shock, that first eliminates the cost of the ZLB, and then can be offset by monetary policy. However a sterling crisis may also involve a deterioration in the output/inflation trade-off: equivalent to what macroeconomists call a cost-push shock. Take a basic Phillips curve. If agents start to believe inflation will be higher - even if these beliefs are incorrect (the crisis, and QE, is temporary) - while these mistaken expectations last this is a cost to the economy, because the central bank will have to raise interest rates to prevent these expectations fully feeding through into actual inflation. Either output will be lower, or inflation higher, or both.

Now as long as interest rates stay at zero, this is not a problem: the ZLB constraint still dominates. [1] However if the crisis was big enough, we could overshoot Brad DeLong’s sweet spot, and end up living with a cost-push shock that was more costly than the ZLB constraint. Personally I think this is stretching non-linearities rather too much. First you have to believe that austerity, which reduces debt a bit more quickly than otherwise, is just enough to prevent a crisis, and then that the crisis is so big that it more than offsets the ZLB constraint. Unlikely, but it seems to be a coherent possibility.

But what about 1976, when pressure on sterling led the UK government to seek help from the IMF? Of course that was different, because we were not at the ZLB. I also suspect there were other differences. I was a very junior economist working in the Treasury at the time. I do not remember very much, but what I do remember was that there seemed to be a mindset among senior policy makers that sterling was on a kind of slippery slope. Once it started falling, who knows where it might end up? They seemed to believe there was a bottomless pit, and the IMF loan was required to stop us going there. I suspect that was in part just a lack of familiarity with how flexible exchange rates work. In the end, sterling did stabilise such that some of the IMF loan was not needed, and I wonder how necessary it really was. But if anyone who reads this post knows more about this period, I would be very interested in their thoughts.

[1] A possibility suggested by John McHale is that, although the interest rate set by the Bank of England could stay at its lower bound, there might be an increase in the interest rate spread, such that UK firms or consumers end up paying more. I’m not clear in my own mind why a depreciation would raise this spread. Even if the market believes the UK government is no longer solvent, the central bank still has the ability to prevent a run on UK banks. If the spread did increase, then programmes like Funding For Lending would still be possible.

Ken Rogoff on UK austerity

Ken Rogoff’s article in the FT today is a welcome return to sanity in the austerity debate. None of the nonsense about opponents of austerity believing growth would never return, or that austerity would have no impact on output. Instead Rogoff focuses on what was always the critical debate: was austerity necessary because financial markets might have stopped buying government debt. (See this post on the many justifications for austerity.)

As critical pieces go, you couldn’t have a friendlier one than this. First, Rogoff agrees that it was a mistake to cut back on public sector investment. He writes “Such projects, if done at a reasonable cost, pay for themselves. Governments should have done more ...”. He says that austerity critics “have some very solid points on their side”. When discussing key arguments, his comment after putting the austerity critics’ case is “perhaps” or “maybe”. In that sense this is a reasoned argument rather than a piece of advocacy.

The argument here is all about insurance. The financial markets are unpredictable beasts, and who knows what they might have done if – in particular – the Euro had collapsed. As Rogoff acknowledges, they might have run for cover into UK government debt, but I also agree that they might have done the opposite. His article is all about saying the UK is not immune from the possibility of a debt crisis, so we needed to take out insurance against that possibility, and that insurance was austerity.

In spirit of Rogoff’s article, I want to acknowledge a couple of points. First, it is clearly too easy to argue that the Euro did not collapse, or that the UK had no problem funding its debt (quite the opposite), and so precautionary austerity was unnecessary. You have to look at the risks ex ante, and not at what happened ex post. Second, it would also be dangerous to argue that somehow UK history meant we were immune from these risks. Others more knowledgeable can argue over the extent to which the UK government has defaulted in the past, but they should never lead us to assume that the UK is immune from a market panic.

So let us agree that it was possible to imagine, particularly in 2010, that the markets might stop buying UK government debt. What does not follow is that austerity was an appropriate insurance policy. No one sensible disagrees that the government needed to have a credible long term plan for debt sustainability, and I personally have argued that a good plan should involve reducing net debt very gradually to levels below those observed before the recession. I hope Rogoff would agree that in the absence of any risk coming from the financial markets, it is optimal to delay fiscal tightening until the recovery is almost complete. The academic literature is clear that, in the absence of default risk, debt adjustment should be very gradual, and that fiscal policy should not be pro-cyclical. So the insurance policy involves departing from this wisdom. This has a clear cost in terms of lost output, but an alleged potential benefit in reducing the chances of a debt crisis.

Seen in this light, the first point to note is that – unlike most insurance – the benefits are partial and ill-defined. Austerity might make the markets less likely to turn on you, but it clearly does not guarantee that they will not. It is also quite reasonable to suggest that – to the extent austerity delays the recovery – it might make markets more rather than less worried about long term debt sustainability. So this is an insurance policy with a large cost, and a very unclear benefit.

What the Rogoff piece does not address at all is that the UK already has an insurance policy, and it is called Quantitative Easing (QE). QE means that the monetary authority is committed to keeping long term interest rates low, so they will buy any government debt that cannot be sold to the financial markets. Rogoff says that, if the markets suddenly forsook UK government debt “UK leaders would have been forced to close massive budget deficits almost overnight.” With your own central bank this is not the case – you can print money instead.

Now pretty well everyone agrees that printing money to cover unsustainable budget deficits is inflationary. But that is not what we are talking about here. We are talking about a government with a long term feasible plan for debt sustainability, faced with an irrational market panic. In those circumstances, printing money will be purely temporary, for as long as the panic lasts. As it is taking place in the depth of a recession, it will not be inflationary. So, as I argued long ago, Quantitative Easing is our insurance policy against a debt crisis. We never needed the much more costly, far inferior and potentially dubious additional insurance policy of austerity.

  

Fiscal backing

In an earlier post I went through the logic of why we do not think higher government debt necessarily causes inflation, even if that debt is denominated in nominal terms, as long as the central bank does not monetise that debt. As I argued there, talk of monetisation is largely unnecessary: we just need to say that the central bank uses interest rates to control inflation, and can therefore offset the impact of any increase in government debt.

However, as Mervyn King said, central banks are obsessed with budget deficits. This seems to contradict the previous paragraph. Are there some ways in which central banks would either lose the power to control interest rates, or be forced to abandon any inflation targets, as a result of fiscal policy? 

In the previous post the thought experiment I considered was a sustainable increase in the level of government debt. By sustainable I mean that the fiscal authorities raise taxes (or cut spending) to service this higher level of debt. But suppose they do not: suppose the budget deficit increases because spending is higher, but there is no sign that the government is prepared either to cut future spending or raise taxes to a sustainable level.

In 1981 Sargent and Wallace published a well known paper which said that, in this situation, the central bank could in the short term control inflation, but in the longer term inflation would have to rise to create the seignorage to make the government budget constraint balance. In other words, to keep the economy stable the central bank would eventually be forced to monetise. This was later generalised by the Fiscal Theory of the Price Level (FTPL). If the government did not act to stabilise debt itself (which Eric Leeper called – a little oddly - an active fiscal policy, and which others - including Woodford, Cochrane and Sims - have called even more confusingly a non-Ricardian policy [1]), then the price level would adjust to reduce the real value of government debt. Fiscal policy determines inflation.

One of the critiques of this theory is that the government budget constraint appears not to hold at disequilibrium prices. See, for example, Buiter here, and a response from Cochrane. I do not want to go into that now. Let’s also concede that if the monetary authority does either follow a rule that allows the price level to rise (by fixing the nominal interest rate for example), or tries to move interest rates to both stabilise debt and inflation (as in my recent paper with Tatiana Kirsanova), then the FTPL is correct.

The case I want to focus on here is where the central bank refuses to do either of those things, but carries on controlling inflation and ignoring debt. Suppose the government is running a deficit which is only sustainable if we have a burst of inflation which devalues the existing stock of government debt, but the central bank refuses to allow inflation to rise. You can say it does this by fixing the stock of money, or by raising the rate of interest - I do not think it matters which. This is an unstable situation: interest payments on the stock of debt at the low price level can only be paid for by issuing more debt, so debt explodes. In this situation, we have a game of chicken between the government and central bank.

Now the game of chicken would probably end when the markets refused to buy the government’s debt. That would be the crunch moment: either the central bank would bail the government out by printing money, or the government would default, which forces it to change fiscal policy. But in Buiter there is an elegant equilibrium outcome: the market just discounts the value of debt by an amount that allows the central bank to set the price level, but for the government’s budget constraint to hold at that price level. We get partial default. This discount factor becomes the extra variable that solves for the tension that both fiscal and monetary policy are trying to determine the price level.

You could quite reasonably suggest that such a central bank could not exist, because the government has ultimate power. It can always instruct the central bank to monetise the debt. However suppose the central bank actually managed the currency for a whole group of nations, and could only be instructed to do anything if they all agreed to do so. Furthermore that central bank was located in the one country in that group that would never contemplate monetisation, so it would be immune to pressure ‘from the street’. That central bank should be pretty confident it could win any game of chicken. [1]

Has any of this any relevance to today’s advanced economies? It seems to me pretty clear that these governments are not playing any game of chicken. Quite the opposite in fact: they are being far too enthusiastic in doing what they can to stabilise debt, despite there being a recession. So we certainly do not seem to be in a FTPL type world. Instead monetary policy right now retains fiscal backing.

Yet in a way we are having the wrong conversation here. Rather than trying to convince central banks that their fears are groundless, we should be asking whether monetary policy should – of its own free will – raise inflation to help reduce high levels of debt. I agree with Ken Rogoff that it should, and have argued the case here. Yet however optimal such a policy might be, the chances of it happening in today’s environment are nil. It looks like we may have to go through a lost decade before we are allowed to contemplate such things. 

[1] I guess a rationale for calling this fiscal policy ‘active’ is that stable regimes in Leeper require one partner to be active and the other passive. So in the normal regime monetary policy is active and fiscal passive, and this flips in a FTPL regime. In a FTPL regime, Ricardian Equivalence no longer holds (because taxes are not raised following a tax cut) – hence the label non-Ricardian.

[2] In this situation, would buying that government’s debt ‘show weakness’ in the game? If we follow Corsetti and Dedola and treat reserves as default free debt issued by the central bank rather than money, then not at all. Instead the central bank is giving the fiscal authority the best chance it can to put its house in order, by removing any bad equilibrium, but it retains the power to force default at any point. We no longer have Buiter’s method of resolving that game, but only because the central bank has the means which could force a win. As long as the government believes that the central bank would prefer the government to default rather than see inflation rise, the government should back down.