Hitting back

Not a post about a certain byelection, but a reaction to reading this:

“A more serious incident was the forecast by the Office for Budget Responsibility in the UK, which said last week that Brexit would have severe economic consequences. Coming only a few months after the economics profession discredited itself with a doomy forecast about the consequences of Brexit, this is an astonishing reminder of the inadequacy of economic forecasting models.

The truth about the impact of Brexit is that it is uncertain, beyond the ability of any human being to forecast and almost entirely dependent on how the process will be managed. “Don’t know” is the technically correct answer. Before the referendum, Project Fear was merely a monumental tactical miscalculation. Today it is stupidity. One of the debates was whether people should be listening to experts. We have moved beyond that. Because of a tendency to exaggerate, macroeconomists are no longer considered experts on the macroeconomy.”

Shrug your shoulders and move on? If it had appeared in the partisan press that would be a sensible reaction, but this was written by a widely respected journalist in the UK’s internationally renown financial newspaper. Furthermore - lest my motives be misunderstood - written by someone whose knowledge on the Eurozone is beyond dispute and whose views I often agree with. Well on this occasion this particular member of a discredited profession who is no longer apparently considered an expert on macroeconomics is not prepared to take this kind of stuff anymore, whoever it may come from.

It is difficult to know where to start with such apparent and complete ignorance. Nonsense expressed as platitudes. You can only make sense of “beyond the ability of any human to forecast” if you either think we know nothing about the impact of trade restrictions, which is false, or that forecasts are non-probabilistic. No journalist has any excuse nowadays for misunderstanding the probabilistic nature of forecasts (Bank of England fan charts), and any academic economist who knows anything about forecasting will tell you that unconditional macro forecasts are only slightly better than intelligent guesswork. They exist because it is worth being slightly better than guesswork when the stakes are so high.

You can also only make sense of these two paragraph if the writer is unaware or is just choosing to ignore the difference between conditional and unconditional forecasts. These are long words for a very simple concept. You would not dream of asking your doctor to forecast the number of times you would catch a cold over the next year (an unconditional forecast), but if you gave them all your relevant data they could probably make a better guess than your own. Their forecast would be probabilistic, but if you took the mean as ‘the forecast’ then in any particular year your doctor would generally be wrong. It would be absurd for you to then say that, having ‘discredited the profession with this inaccuracy’ you were now going to ignore their advice about how to avoid catching colds (advice based on conditional forecasts). But this is the logic of these two paragraphs.

As for a tendency to exaggerate, the simplest response involves a black kettle. But on this particular occasion I think there is a more honest response. In the Brexit campaign I felt the temptation to exaggerate (I don’t think I ever succumbed), because the media was failing to get the message from economists across. Our collective knowledge about the impact of trade restrictions was treated as just one more opinion, or described as Project Fear. When you are effectively being ignored you tend to shout louder.

But this is all defensive. Trying to explain yet again some basic economic ideas, and to be honest about what you can or cannot do and any failings you have. I’m just tired of doing this stuff over and over again, so it is time not just to defend. There are many good journalists out there, who when they write about macroeconomics do try to check with academics that what they are writing makes sense. (It was one of those journalists who drew my attention to the article I quote above.) It simply lets them down when others think they can write this sort of stuff without any of the kind of basic fact checking that journalists are supposed to do. It brings the profession of journalism into disrepute.

And they can only get away with it because academic economists only get a media voice by the grace and favour of journalists. If anyone should be doing some serious introspection after the Brexit result it should be journalists and the media. Warning of the dangers of trade restrictions was not a ‘tactical mistake’. What was a mistake was for journalists to allow those warnings, that knowledge, to be characterised as Project Fear, all in the name of ‘balance’ or cheap copy. But this was not a temporary lapse in an otherwise good record, but just another example of a growing tendency for the media to allow politicians to define economic facts and truths, a record I described in my lecture.

To have the nerve to blame economists for the Brexit result, to suggest that using their knowledge was a ‘tactical mistake’, to imply that the OBR should pretend they know nothing about Brexit, all that is itself amazing malevolent chutzpah. But it goes beyond audacity to criticise a profession and subject matter you appear not to understand when it is this lack of understanding that has contributed so much to the damage over the last few years.

The ECB as a Lender of Last Resort to Governments

John McHale rightly points out that in my earlier post on the European Commission’s justification for austerity, I said little about the Lender of Last Resort to governments (LOLR) issue. What I did say is that OMT should have been established much earlier, and that this might have allowed Ireland and Portugal to continue to sell government debt to the markets at tolerable interest rates, which in turn might have allowed them to implement budget consolidation at a less damaging pace. (Whether they would have taken that opportunity is another matter.)

However this begs an obvious question, which is how OMT conditionality should operate. One possibility is that the ECB imposes as least as harsh conditions as the current Troika. Alternatively the ECB passes responsibility for imposing conditions to the Troika, and the Troika continues to do what it has already done. It would be wrong to say nothing would be gained as a result. If OMT works and the governments continue to borrow from the market, then we avoid some of the toxic intergovernmental lending that is in danger of tearing the Eurozone apart. However we will still have excessive fiscal deflation.

Do we need any conditionality at all? Unfortunately we do. To offer OMT unconditionally would take us back to the pre-2007 situation, where default was not thought possible. It revitalises the arguments that gave rise to the disastrous Stability and Growth Pact and the more recent Fiscal Compact. As Charles Wyplosz and others have emphasised, it is very difficult to run any kind of system where component parts have autonomy to borrow without having the discipline of default, unless you resort to a degree of central control that is not feasible for the Eurozone.

Conditionality should not come naturally to any independent central bank. There is no significant example of a country delegating fiscal decision making to an unelected body, and even if it did so there are reasons not to use a central bank for that task. But before addressing this dilemma, we should establish what the nature of conditionality should be.

The remit of the central bank should be short run macroeconomic stabilisation and long run price stability. OMT can be justified under this remit, as I argued here, because if a country finds itself in a bad market equilibrium, this will have a negative impact on the monetary transmission mechanism and short run macroeconomic stability. Conditionality can also be justified under this remit, because a complete failure of fiscal control in one country in a union when default is not allowed will compromise monetary policy for the union as a whole. (One of my own papers with Campbell Leith looks at this in a two country case. [1]) By complete lack of fiscal control, I essentially mean that a government is insolvent at a level of interest rates consistent with normal monetary policy. [2]

In other words, all the ECB needs to worry about is whether fiscal policy is sustainable in the long run. It should have no concern about which of the many possible sustainable fiscal paths a government chooses - that is up to the national government. There is a analogy with the well established rules for central bank support of private banks. If the bank is solvent but suffering from liquidity problems, support should be unequivocal and unlimited. If the bank is insolvent, no support should be forthcoming. [3]

The problem with this analogy is that solvency for a government involves a political as well as a technical judgement. Suppose a government submits fiscal projections that are sustainable. This could involve government debt initially rising but stabilising at some high level. If it then starts falling again so much the better. There could be two things wrong with this projection. The first is technical: for example growth assumptions may be too optimistic or tax receipts given growth are too optimistic. The second is political: the plan may involve cuts in spending, or increases in taxes, that are unlikely to be realised because the political costs are too high.

No central bank should like to be in a position where it has to make these political judgements. It would like to offload the problem on someone else. The obvious someone else is the market, but that will not work because all the market tells you is that there exists a bad equilibrium, and not whether a good equilibrium exists. To use Keynes’s famous analogy, the market is judging who the market thinks is beautiful, and not who is actually beautiful. The ratings agencies seem ‘market like’, but are in effect just a bunch of people with a (perhaps informed) opinion, and a not very good track record.

Who else could the ECB delegate conditionality to? Delegating to EU heads of state would be a bad idea, for reasons that I hope are obvious. [4] Delegating to the Commission seems too close to that. A better possibility would be the IMF. The IMF certainly knows all about this issue: see this research for example. However all of these agencies have a recent track record that does not inspire confidence. An acid test is how any arrangement would have worked in the case of Greece. What should have happened, as soon as the true extent of Greece’s fiscal problems had become clear, is that whatever body the ECB had delegated its conditionality assessment to should have concluded that default was more likely than not, and therefore OMT should not have been provided.[5]  

I have an alternative suggestion, which regular readers will not find surprising. A number of Eurozone countries now have fiscal councils, whose very job is to assess the sustainability of fiscal policy. They are the obvious people to ask. Putting such an important question to the relevant national fiscal council may be politically unwise - could that council survive a decision that led to default? It would be better, for this and other reasons, for fiscal councils to act as a group in advising the ECB on the sustainability of national fiscal plans. That way expertise could be pooled, and experience shared.

Let me be quite clear what I am suggesting here. As soon as a country specific default premium began to emerge on a Eurozone member’s government debt, the ECB would ask the collective of Eurozone fiscal councils whether they thought current fiscal plans would result in a sustainable level of debt. If they did, the ECB would announce that OMT would apply to that country i.e. it would buy whatever quantity of that debt that could not be sold to the market. That decision could be reviewed annually until the default premium faded away. If the fiscal councils collective did not think current fiscal plans were realistic and sustainable, OMT would not be forthcoming. In these circumstances, there would be no bailing out by the Eurozone or IMF, and default would almost certainly follow.

The Commission plays no part in this. However, I think the Commission still has a very important role to play. The ECB, as part of the role it should have in preventing deficient aggregate demand in the Eurozone as a whole, should publicly state that because of the zero lower bound they cannot use monetary policy to fulfill this function. They should ask the Commission to coordinate fiscal actions to provide additional support to demand. In doing this, the Commission would clearly not ask that much of countries on OMT, so most of the ‘burden’ would fall on others, like Germany or the Netherlands.

Which brings me back to my previous post, and why I think what I said there was quite compatible with LOLR issues. Now some commented on that earlier post that it was not politically feasible, by which they mean Germany would not countenance it. I am sure that is right, although what has disappointed me (and others - see Kevin O’Rourke) is that the election of Hollande did not emboldened countries like France and Italy to provide any kind of counterweight to German views.

One of the advantages of being an academic is that your advice does not have to be bound by what is politically feasible. It is important that someone sets out what is best as they see it, and others can then modify it to satisfy political constraints. However the problem in this case is not so much that fiscal stimulus rather than austerity, and the ECB acting as a LOLR, are not in the German national interest. I think you could make a case that they are in fact in Germany’s long term national interest, because a well functioning Eurozone is in their interests. The problem seems more that policy makers throughout Europe have two economic blindspots. [6] Those blindspots are the fallacy of austerity at the Zero Lower Bound, and the necessity of a LOLR. What I will not do is give advice which accepts that those blindspots cannot be removed.

 

[1] See also Canzoneri, M. B., R. E. Cumby and B. T. Diba (2001), “Fiscal Discipline and Exchange Rate Systems”, Economic Journal, No. 474, pp 667-690.

[2] Using Eric Leeper’s terminology, it means the fiscal authority is active: for a discussion of the active/passive idea and its application to the ECB and OMT see here.

[3] One problem with the Bagehot dictum is contagion: if an insolvent bank is allowed to fail, this may create a liquidity (or even solvency) crisis for others. These contagion arguments have much less weight when it comes to countries in the Eurozone, once OMT has been established and the conditionality involved is clear and non-political.

[4] See, for example, Cyprus. Colm McCarthy describes it well here (HT Kevin O’Rourke)

[5] This may be a little unfair on the IMF, who almost certainly came under intense political pressure from the Eurozone to provide funds before the inevitability of default was conceded. I do not know whether this assistance, which allowed default to be delayed, was provided against the better judgement of some of those in the Fund.

[6] See a shrill Kevin O’Rourke here.

Active and Passive at the ECB

I’ve been away and busy at the IMF, so did not respond immediately to this speech from ECB Executive Board member Benoît Cœuré on the new OMT policy. In econblog terms, the speech would be described as wonkish, but I think the ideas I want to focus on are reasonably intuitive. They are worth exploring, because they illuminate the key issue of conditionality.

In a classic paper, Eric Leeper distinguished between active and passive monetary and fiscal policies, within the context of simple policy rules. The concept of an active monetary policy is by now familiar: monetary policy should ensure that real interest rates rise following an increase in inflation, so that higher real interest rates deflate demand and put downward pressure on inflation. Leeper’s use of active and passive for fiscal policy is a little counterintuitive. A passive fiscal policy is where, following an increase in debt, taxes rise or spending falls by enough to bring debt back to some target level. If neither taxes nor spending respond to excess debt, debt would gradually explode as the government borrowed to pay the interest on the extra debt. This is the extreme case of what Leeper calls an active fiscal policy.

Now you might be forgiven in thinking that the only policy combination that would bring stability to the economy was an active monetary policy (to control inflation) and a passive fiscal policy (to control debt). This would correspond to what I have called the consensus assignment. However Leeper showed that there was another: an active fiscal policy combined with a passive monetary policy. A simplified way of thinking about this is that it represents the opposite of the consensus assignment: fiscal policy determines inflation and monetary policy controls debt, because debt becomes sustainable by being reduced through inflation. This idea, which became known as the Fiscal Theory of the Price Level (FTPL)[1], is very controversial. (For once, divisions cut across ‘party’ lines, with John Cochrane and Mike Woodford both contributing to the FTPL.) However for current purposes you can think of the FTPL policy combination as being a form of fiscal dominance. You can also think of this combination as being inferior to the consensus assignment from a social welfare perspective (see this post).

So why did Cœuré invoke Leeper’s definitions of active and passive in his speech? To quote:

“central bank independence and a clear focus on price stability are necessary but not sufficient to ensure that the central bank can provide a regime of low and stable inflation under all circumstances – in the economic jargon, ensuring “monetary dominance”. Maintaining price stability also requires appropriate fiscal policy. To borrow from Leeper’s terminology, this means that an “active” monetary policy – namely a monetary policy that actively engages in the setting of its policy interest rate instrument independently and in the exclusive pursuit of its objective of price stability – must be accompanied by “passive” fiscal policy.”

Now OMT involves the ECB being prepared to buy government debt in order to force down interest rates so that fiscal policy becomes sustainable. To some that seems like fiscal dominance: monetary policy is being used in a similar way to the FTPL, in order to make debt sustainable. Cœuré wants to argue that with OMT we can get back to the consensus assignment, because OMT will allow fiscal policy to become passive again.

Now current fiscal policy in the Eurozone can hardly be described as ignoring government debt, as in the polar case of active fiscal policy outlined above. However, for fiscal policy to be passive it has to counteract the tendency for debt to explode because of debt interest payments. If interest rates are very high, because of default risk, this may require destructive and perhaps politically impossible rates of fiscal correction. In other words, default risk forces fiscal policy to be active. Although this problem is just confined to one part of the Eurozone, as Campbell Leith and I showed here, this is sufficient to force monetary policy to become passive if it wants to preserve stability.

I think this is a very clever way of describing OMT to those who believe this policy goes beyond the ECB’s remit. OMT is necessary to allow fiscal policy to become passive in countries subject to significant default risk, and therefore for monetary policy to ensure price stability. The argument, like the FTPL, is controversial: many of those who dislike the FTPL would argue that an active monetary policy is sufficient to ensure price stability. This analysis also ignores the problem of the Zero Lower Bound (ZLB) for nominal rates, which one could reasonably argue forces monetary policy to become passive.  For both reasons I did not use this argument in my post on conditionality, but without length constraints I would have.

I want to make two final points which Cœuré does not. First, a feature of passive fiscal policy at ‘normal’ (largely default risk free) levels of real interest rates is that debt correction does not have to be very rapid, and as Tanya Kirsanova and I show here, it should not be very rapid. Almost certainly the speed of debt correction currently being undertaken in periphery countries is more rapid than it needs to be to ensure a passive fiscal policy at normal interest rates. The current Eurozone fiscal rules also probably imply adjustment that is faster than necessary. As a result, no additional conditionality is required before the ECB invokes OMT. Second, this analysis ignores the problem of the ZLB, which is as acute for the Eurozone as it is elsewhere. Cœuré says that OMT is not Quantitative Easing (QE), but does not explain why the ECB is not pursuing QE. It has taken the ECB about two years too long to recognise the need for OMT – let’s hope that it does not take another two before it realises that for monetary policy to stay active in the sense described above, it also needs QE.  

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[1] The Wikipedia entry on the FTPL is poor.

ECB conditionality exceeds their mandate

To get a variety of views on this issue, read this post  from Bruegel . Here is my view.

We can think of the governments of Ireland or Spain facing a multiple equilibria problem when trying to sell their debt. There is a good equilibrium, where interest rates on this debt are low  and fiscal policy is sustainable. There is a bad equilibrium, where interest rates are high, and because of this default is possible at some stage. Because default is possible, a high interest rate makes sense – hence the term equilibrium.

Countries with their own central bank and sustainable fiscal policy can avoid the bad equilibria, because the central bank would buy sufficient government debt to move from the bad to the good. (See this pdf by Paul De Grauwe.) The threat that they would do this means they may not need to buy anything. Anyone who speculates that interest rates will rise will lose money, so the interest rate immediately drops to the low equilibrium.

How do markets know the central bank will do this, if that central bank is independent? They might reason that independence would be taken away by the government if the central bank refused. But suppose independence was somehow guaranteed. Well, they might look at what the central bank is doing. If it is already buying government debt as part of a Quantitative Easing (QE) programme, then as long as the same conditions remain the high interest outcome would not be an equilibrium.

Suppose instead that the central bank does not have a QE programme, and announces that it will only undertake one if the country concerned agrees to sell some of its debt to other countries under certain onerous conditions, and agreement is uncertain. We are of course talking about the ECB. Now the bad equilibrium becomes a possibility again. Perhaps the country will not agree to these onerous conditions. As Kevin O’Rourke points out, this possibility is quite conceivable for a country like Italy. Equally, based on past experience, the lenders may only agree if there is partial default. Neither of these things needs to be inevitable, just moderately possible – after all, interest rates are high only because there is a non-negligible chance of default. The ECB also says that even if the country and its potential creditors agree, it may still choose not to buy that country’s bonds. This throws another lifeline to the existence of a bad equilibrium.

So, we have moved from a situation where the bad equilibrium does not exist, to one where it can. As the good equilibrium is clearly better than the bad one, there must be some very good reason for the ECB to impose this kind of conditionality. What could it be?

The ECB’s mandate is price stability. So without conditionality, would there be an increased risk of inflation? One concern is that printing more money to buy government debt will raise inflation. But that does not appear to be a concern in the UK and US, for two very good reasons. First, the economy is in recession, or experiencing a pretty weak recovery. Second, central bank purchases of government debt are reversible, if inflation did look like it was becoming a serious problem.

What about the danger that by buying bonds now, when there is no inflation risk, governments will be encouraged to follow imprudent fiscal policies at other times when inflation is an issue. But why would the ECB buy government bonds in that situation? Buying bonds now does not commit the ECB to do so in the future. No one thinks the Fed will be doing QE in a boom. OK, what about all those ‘structural reforms’ that might not occur if the bad equilibria disappeared? Well, quite simply, that is none of the ECB’s business. It has nothing to do with price stability. If the ECB is worrying about structural reforms, it is exceeding its mandate.

Cannot the same argument – that an issue is not germane to price stability - be used about choosing between the good and bad equilibria? No. The bad equilibrium, because it forces countries like Ireland and Spain to undertake excessive austerity (and because it may influence the provision of private sector credit in those countries), is reducing output and will therefore eventually reduce inflation below target. The only ‘conditionality’ the ECB needs to avoid moral hazard is that intervention will take place only if the country in the bad equilibrium is suffering an unnecessarily severe recession. The ECB can decide itself whether this is the case by just looking at the data.

So, in my view, to embark on unconditional and selective QE in the current situation is within the price stability mandate of the ECB. To impose conditionality in the way it is doing is not within its mandate. Unfortunately, as Carl Whelan points out, this is not the first time the ECB has exceeded its mandate. As he also says, if the Fed or Bank of England made QE conditional on their governments undertaking certain ‘structural reforms’ or fiscal actions, there would be outrage. So why do so many people write as if it acceptable for the ECB to do this?