Monetary and fiscal cooperation: the case for a state dependent assignment

In December last year Mark Carney said

“In a global liquidity trap, central banks cannot be the only policy makers who do “whatever it takes.” There are clear gains from coordination, with other policies – particularly fiscal policy”

I of course agree, as would most academic macroeconomists. So would any sensible informed fiscal policy maker. But of course this didn’t happen in the Global Financial Crisis from 2010 onwards in some key major economies, including the UK.

Carney’s statement, which follows similar statements by the central bank governors of the Fed and ECB, goes against what I have called the ‘consensus assignment’. The consensus assignment has monetary policy looking after the stability of aggregate demand and inflation, while the fiscal authority looks after government debt. In the UK at least this consensus assignment is deeply embedded in the way the media thinks about policy.

In 2009 George Osborne gave a speech in which he said

“[New Keynesian] Models of this kind underpin our whole macroeconomic policy framework – in particular the idea that by using monetary policy to manage demand and control inflation you can keep unemployment low and stable. And they underpinned the argument David Cameron and I advanced last autumn – that monetary policy should bear the strain of stimulating demand….”

This is a statement of the consensus assignment. The irony of it was that shortly before the speech was given UK interest rates hit their lower bound.

Is the consensus assignment still the best way to run policy after short interest rates hit their lower bound? In 2010, in Europe and the UK at least, central banks acted as if it was. Indeed they went as far as to advise fiscal policymakers to embark on austerity. Carney’s statement is an implicit acknowledgement that central banks had been wrong to do that.

The trouble with unconventional monetary policy is not that it does not work, but it does not work reliably. The scandal in 2010 was that while the Bank of England was suggesting in public that unconventional monetary policy could replace conventional interest rate policy, in reality they had little clue how much effect any change in unconventional monetary policy would have. An unpredictable and unreliable instrument is not a good basis for a policy regime when a better instrument is available, and that better instrument is fiscal policy. I think negative interest rates fit into this category of unreliable instruments, simply because we cannot for obvious reasons assume linearity.

So how do we ensure as far as we can that fiscal policy makers will not repeat the mistakes of 2010 in the next recession? The first best would be to have better fiscal policy makers, but alas that is not always possible. There are three widely discussed possibilities.

1. The first is MMT. This in effect reverses the conventional assignment, with fiscal policy doing the demand and inflation stabilisation in all states of the world. If that happens debt looks after itself. I am not in favour of MMT, because I think independent central banks have been very successful at controlling inflation, and a government using fiscal policy would be less successful.
   
   
2. The second is Helicopter Money. If you are prepared to call Helicopter Money (HM) monetary policy, this preserves the consensus assignment by giving the central bank a new tool. HM is more reliable than unconventional monetary policy, because HM is just like a tax cut, and we have a lot of data on the impact of tax cuts on consumers. Like tax cuts, HM will not work if all consumers are Ricardian, but they are not.
   
   

HM is only possible with the agreement of the government, preferably well before it is actually needed. Two key things have to be agreed. The first is the distribution mechanism, where I suspect some governments would prefer something other than a reverse poll tax. The second is an agreement to back the central bank, by which I mean supply it with the assets it requires to claw back at least some of the HM when the economy recovers. The only difference between HM and a bond financed fiscal expansion is that probably some or all of the bond issuance is delayed until after the economy recovers.

Central banks worry that governments will renege on their commitment to back the central bank. My response is that any government that would not back their central bank so it can fight inflation is also a government that would be prepared to abolish its independent central bank, so the concern is of no interest. I suspect also central banks think HM looks like fiscal policy to most people, and they shouldn’t be doing fiscal policy.

I would add a further point on HM. It will not stop a government using what I call ‘deficit deceit’ in a recession: pretending the deficit is too high and requires spending cuts, because the government wants to scare people into accepting a smaller state than would be popular otherwise. HM would avoid this fiscal consolidation influencing output because its demand effects would be offset by the central bank. But a shrinking of the state beyond anything that is popular in normal times is also almost certainly sub-optimal, and can have devastating political as well as economic implications, like those we have seen in the UK, and you could argue HM encourages this.

3. The third, and most likely, is central bank advice. If the central bank thinks that a recession is coming where rates will hit the lower bound, it advises the fiscal authority that some fiscal expansion is required. This is fine if we are trying to combat a fiscal authority that is just ignorant on these matters. The central bank could also convince a fiscal authority that was worried about financing its debt, by for example agreeing to monetise the expansion needed by doing the corresponding amount of QE, or more simply to neutralise any failure by private agents to buy debt.
   
   

My concern here is with a government that said thanks for the advice, but we prefer to focus on reducing the deficit using spending cuts. Would the central bank be prepared to make its advice public? It might not do so if it was concerned that the government would reciprocate by starting to tell the central bank what do so. You could therefore argue that this strategy could be either ineffective, or may threaten central bank independence.

So how can you stop a government that is determined to use the rising deficit in a recession to shrink the state? Of course you cannot, but you can try and create the conditions that will put maximum political pressure on it not to. I suggest above that HM fails to do this, and central bank advice is unlikely to either.

What would be more effective is for macroeconomists and central banks to start being honest about the consensus assignment. As a near optimal policy regime that assignment is dead. Instead macroeconomics suggests what could be called a ‘state dependent assignment’. In most states of the world, central banks stabilise the macroeconomy just as they do now. However in an economic downturn of sufficient size (where ‘sufficient’ is to be defined) the assignment flips, and fiscal policy makers are in charge of stabilisation. In non-technical language, fighting recessions becomes the government’s job.

I think this is something that most academic macroeconomists and some central bankers have accepted implicitly but not explicitly. One reason is I think pedantic. Of course in the state dependent assignment the central bank does not stop trying to stimulate demand in a recession by at least keeping rates low, but there are compelling political economy reasons to highlight the responsibility of governments in this respect.

Those familiar with Jonathan and my paper on fiscal rules will recognise our knockout when rates hit their lower bound as one operationalisation of a state dependent consensus assignment. But it is not an ideal mechanism because switching the assignment should depend on forecast events. Others, like the IPPR and Resolution Foundation, have suggested alternative schemes that come under the umbrella of a state dependent assignment. There is a great deal of work required to figure out the best mechanisms, and also to think about who has control over when switches (both on and off) happen, and whether there is a role for the central bank and/or fiscal council in advising the government on effective stimulus packages.

To conclude, central banks are now recognising that fiscal stimulus is required in significant economic downturns. This is in contrast to the GFC, when many fiscal policy makers enacted austerity. One of the reasons they were able to enact austerity was the dominance of the traditional consensus assignment in the mind of the public. Our most effective way of preventing this happening again is to make a state dependent assignment the new consensus assignment.

A New Macropolicy Assignment

With central bankers rightly pessimistic about fighting recessions, maybe it is time to give that responsibility to politicians, while keeping central banks in charge of keeping inflation at target.

At the recent Jackson Hole conference of central bankers there seemed to be a general acceptance that central bankers just do not have the tools to effectively fight a new recession. I discussed some of the reasons here. The most familiar is the lower bound for nominal interest rates, but Anna Stansbury and Larry Summers argue that even before we get to the lower bound interest rates may be an ineffective stabilisation tool when they are very low. [1]

This is not a problem specific to this period of time. Most people agree that the natural real interest rate (the real rate at which inflation is stable) has fallen with little sign that this fall will be reversed. That means nominal interest rates are likely to remain low for decades. So its not just this recession where monetary policy is impotent, but every recession in the foreseeable future.

One response is that, as I argued in my earlier piece, central bankers should aim to develop new tools that are effective in recessions. This includes differential interest rates for borrowers and savers, and helicopter money. But for whatever reason central bankers are in no hurry to do this. Instead their current view is that fiscal policy needs to take some of the burden of fighting recessions.

Unfortunately for a variety of reasons many politicians in government have not got the message. In the Eurozone they are stuck with primitive fiscal rules that assume monetary policy can always control demand. In the US and perhaps the UK they think a fiscal stimulus is giving the rich tax breaks, which is perhaps the most ineffective way of stimulating demand.

More generally we have had decades were central banks were responsible for controlling inflation and avoiding downturns, and both politicians and the media (and to some extent economists) will require something more than one Jackson hole conference to shift this expectation. Maybe another recession might do it, but the largest recession since WWII failed to do the job. Part of the problem is that central bankers will try to fight the next recession with ineffective measures like Quantitative Easing, and this appearance of activity will fool too many into thinking they have the problem in hand.

As we saw in the last recession, the danger is not just that politicians will fail to fight a recession, but they may actually do the wrong thing. In their minds and also the minds of most media commentators, the central bank is responsible for controlling demand (and therefore fighting a recession) but politicians are responsible for controlling the deficit. This leads to a perverse response in an economic downturn if monetary policy is ineffective.

Macroeconomists call a simple division of labour between monetary and fiscal policy an assignment. What I call the conventional assignment is that interest rates control demand (and therefore inflation) and politicians control the deficit. I called this assignment conventional because it had become ingrained in the minds of economists, the media and politicians. Right now the conventional assignment is not working in terms of fighting recessions.

If central banks remain conservative in developing new tools, what we need to do is give back to politicians the responsibility for fighting economic downturns. One way of doing that is to take monetary policy away from independent central banks, and give it back to politicians. This would make politicians responsible for avoiding recessions as well as controlling inflation, and they will realise that a fiscal stimulus is a more effective means of doing this than any kind of monetary policy stimulus.

I do not want to rehearse the arguments for or against central bank independence (CBI), but simply note that the popularity of CBI comes from a suspicion that politicians are unreliable when it comes to fighting inflation. And unlike supporters of MMT I see no reason to believe that interest rates chosen by independent central bankers are not effective at moderating periods of excessive inflation.

My suggestion is instead a modified assignment. Central bankers remain responsible for controlling inflation, but politicians become responsible for fighting recessions. That is two different bodies managing the same variable - aggregate demand - but at different parts of the business cycle. Think of it like a car, with independent central bankers as the brake and politicians as the accelerator.

Cars are designed so it is difficult to push the accelerator and brake at the same time. We need something similar for this assignment: some way of coordinating between politicians and central banks so they don’t try to manage demand at the same time. The obvious coordination device is the adoption of a common belief about what the NAIRU is (or something similar to the NAIRU) and a common forecast (as actions will depend on expectations of future states of the economy).

The advantage of this asymmetric assignment is that it makes politicians responsible for tackling recessions, which in turn avoids a mistaken view that in a recession they should be controlling the deficit. In other words it is an assignment that rules out austerity. Any assignment that prevents austerity has to be worth considering.

[1] I will wait to see the paper before commenting on this idea, but there is no theoretical reason why the IS curve should be linear. What we need is some empirical evidence, but unfortunately the microfoundations hegemony means that is thin on the ground.

The Interest Rate Lower Bound Trap and the ideas that keep us there

Japan’s short term interest rate set by its central bank has been near zero since the mid-1990s. The UK’s equivalent short interest rate has been near zero since 2009, and the Eurozone’s since 2014. This in turn reflects core inflation being well below its target rate in Japan and the Eurozone over the same period. [1] This is not how it is meant to be. And because the short term interest rate in the US is above zero, it is not getting the attention from a US-centric macroeconomic community that it should.

We all know about interest rates hitting the lower bound after the GFC. But macroeconomic theory is quite clear. Governments can always, just always spend their way out of such a trap. The reasoning is simple. If the government cutting taxes and spending more on public services was not at some point inflationary, then why are we not having both? There must be a point at which demand exceeds supply by enough to make inflation meet its target.

I’ve often heard an objection that fiscal stimulus is not appropriate because these countries no longer have an output gap. But the output gap is difficult to measure. If these countries really did have a zero output gap, then why is inflation below target? Inflation, not the output gap, is the ultimate constraint on whether fiscal stimulus is needed. [2] If inflation is stuck below target and your measure of the output gap says that gap is zero, you should ignore the output gap measure and enact a fiscal stimulus.

So why has this not happened in Japan, or the UK, or the Eurozone? The answer has to be that for some reason governments in those countries have not done what they should have done, and therefore wasted a lot of resources that could have gone to their citizens. It takes quite a lot to convince governments not to spend when they should and to tax when they need not. So what is this force that stops these governments spending their way out of the interest rate lower bound trap?

There are three candidates I can think of.

The first is what I call the consensus assignment. The idea that monetary policy, and only monetary policy, can be used to stabilise the economy to hit the inflation target. It was the macroeconomic policy consensus until the GFC. It left governments unused to dealing with stabilisation themselves, because they had contracted out the problem to the central bank.

But this cannot explain it all. After all, all three countries/zones have used fiscal policy to expand the economy after the GFC, and Japan on many occasions. So something else must be inhibiting these countries from using fiscal policies by enough.

The second candidate is something that came with the consensus, and that is ‘deficit bias’. When interest rates controlled the level of inflation (and, contrary to MMT thinking, they were pretty effective at doing this job) many governments tended to allow government debt to gradually rise, for reasons that are hardly complicated. Rules were created and then institutions set up to prevent this happening. It may be that too many governments have internalised the idea that deficit bias is bad and therefore it is good to run down debt.

Of course that idea only makes sense when the consensus assignment is operating, and it does not apply when interest rates are stuck at their lower bound. When rates are stuck at around zero we need to reverse the assignment and use fiscal policy to stabilise the economy until rates are well clear of their floor. But perhaps some governments fail to see that and still think it is good for them to be reducing debt. 

To be honest I think this might apply to officials working for governments (including central bank governors), but not to politicians themselves. Officials who had learnt their economics when the consensus assignment was dominant and never read the footnotes (if they were there) about the interest rate lower bound. But that still matters, because officials play a big part in advising politicians. In particular, officials helped design a currency union which has no contingency for situations where monetary policy is ineffective.

The third and final reason is a phobia about government debt. Now there are good economic reasons why building up a large stock of government debt relative to GDP may have unfortunate side effects, but they all operate when the interest rate on government debt exceeds the growth rate (r > g for short). High government debt can crowd out private investment by raising interest rates, but inadequate demand is much more effective at suppressing investment and rates cannot be crowding out investment when they are at their floor! In short, the economic reasons for worrying about government debt fall aside at the lower bound. [3]

Now perhaps public officials and some others are influenced by the economic case against high debt to GDP and fail to see that it does not apply when interest rates are at their lower bound. But I think there are two more important reason for deficit phobia. The first comes from watching countries get into serious difficulties, and often resorting to the IMF, because they could no longer finance their debts. But this concern does not apply to a currency issuer whose debts are in their own currency, as Japan, the Eurozone and UK all are. However I suspect officials can be a little economical with the truth about this when it suits them (see the UK 2010 Coalition negotiations for example).

The second reason for debt phobia is ideological. Debt phobia is a means of keeping a lid on the size of the state. We see this in its most blatant form in the US from the Republican Party, but I think it is powerful everywhere. This is particularly the case under neoliberalism, where a key goal is reduce many activities of the state so taxes can be cut for the already well off.

The importance of this cannot be overemphasised. Two major economies and one economic block are wasting resources that could have gone to their citizens because of some all all of these factors. And perhaps even more importantly, they and other countries like the US are wide open to a negative demand shock creating a recession without effective [4] tools being ready to combat it.

[1] The UK is complicated by two large currency depreciations, but once you take out their effect everything here applies equally to the UK.

[2] With a Phillips curve, the only reason inflation can remain below its target besides deficient demand is if people and firms think the real target is below the official target. But if that is the problem, then policy makers should increase demand and inflation to show this is not true.

[3] Some may worry that high deficits will be difficult to wind down once we are off the lower bound. But a good fiscal stimulus is temporary, so this should not be a problem.

[4] Quantitative Easing is not a reliable tool. 

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.

Labour’s fiscal rule is progressive

I have seen a lot of things said about Labour’s fiscal credibility rule in the last few days which are simply wrong. I think the heart of the problem is that many heterodox economists do not believe in what I call the conventional or consensus assignment outwith the lower bound for interest rates. That conventional or consensus assignment [1] is that interest rates should be used to stabilise the economy rather than fiscal policy. The whole idea of independent central banks setting interest rates is predicated on this assignment.

The assignment will not work when interest rates hit a lower bound where central banks feel they cannot cut rates any further (obviously!), so fiscal policy has to become the stabilisation instrument in that situation. The innovative feature of Labour’s rule is the knockout that allows exactly that. I do not think there is any controversy here, so I will confine myself to situations where interest rates are not at their lower bound and set at a level central banks believe will stabilise the economy.

Just as independent central banks are a (not necessary) consequence of the conventional assignment, so are fiscal rules. Without them history suggests you are likely to get deficit bias: a gradual increase in the government debt to GDP ratio over time. For a country with its own currency a rising debt to GDP ratio is never catastrophic, because the markets cannot force such a country to default. There is no magic number for the debt to GDP ratio over which disaster happens. All that stuff is austerity propaganda.

However deficit bias is not good for a variety of reasons. The most straightforward is that more taxes need to be raised to pay the interest on that debt, and taxes discourage labour supply (as well as being politically unpopular). You get deficit bias because it is too tempting for politicians to cut taxes or increase spending by increased borrowing, because to the electorate it looks like you are getting something for nothing. (Trump’s tax cuts for the rich would have been even more unpopular if he had cut spending or raised other taxes to avoid increasing the deficit). A fiscal rule is a device to discourage deficit bias.

It is not the case that fiscal rules are inherently neoliberal. A fiscal rule does not limit the size of the state in any way, as long as you are prepared to pay for higher government spending by raising taxes. Labour’s fiscal rule does not ‘enforce austerity’. Austerity in my book is cutting government spending in a way that is bound to reduce demand and therefore hurt the economy as a whole. In a fiscal credibility rule world monetary policy stabilises the economy, and if rates hit the lower bound the rule’s knock-out applies. That is the crucial difference between Labour’s fiscal rule and the one used by the Coalition government in 2010. Labour’s fiscal rule makes austerity impossible. Let me repeat that: you cannot have austerity with Labour’s fiscal credibility rule.

One false charge is that Labour’s rule would prevent a Job Guarantee scheme being introduced. The idea seems to be that, if a negative shock hit the economy, JG spending would rise and the fiscal rule would stop that happening. Note this is conceptually no different to unemployment benefits. This is not true because Labour’s rule targets the current deficit in 5 years time. In five years time monetary policy will have dealt with the negative shock, so there is no reason to adjust fiscal policy as a result of the negative shock. If by chance monetary policy fails once the 5 years are up, it gets another 5 years to try because the fiscal rule has a rolling target - it always looks five years ahead. That means government spending is never cut because there is a temporary economic downturn.

What this means is that fiscal planning under Labour will in effect always assume output is at the level that keeps inflation constant. Who decides what that long run sustainable level of output is? The OBR, much as they do now. Not the central bank, but the independent OBR. The OBR’s main job is to work out what the medium term steady inflation level of output is, and they put a lot of effort into getting it right.

At the heart of many of the objections to Labour’s fiscal rule is a wish not to follow the conventional assignment, but instead have fiscal policy rather than interest rates stabilise the economy. That alternative assignment means that fiscal policy would be whatever is required to stabilise inflation, and no rule for the deficit is required. That happened in the UK when we had fixed exchange rates and capital controls, so it is not a stupid idea. But to suggest, as so many seem prepared to do, that this choice over assignments is something more than a rather technical debate about transmission mechanisms, institutional constraints and delegation [2] is deceitful..

Which brings me to Richard Murphy’s post. Richard says so many false things about this rule it is difficult to know where to start. It is not ‘neoclassical’, it does not ‘have its roots in microeconomics’. It does not assume ‘markets allocate resources efficiently’. It does not make any assumptions about how money is created. To say that Labour’s rule is based on a microeconomics perspective but MMT has a macro perspective is complete and utter nonsense. You can justify Labour’s rule on the basis of pretty well any macroeconomics you like, as long as you accept that interest rates are stabilising the economy rather than fiscal policy.

The bottom line is that Richard tries to suggest that you could have more public spending under an MMT type assignment compared to Labour’s fiscal rule. That is also completely wrong, and if anything the opposite would be true. Suppose Labour comes to power in 2022, and nominal interest rates by then are at 2%, and inflation is steady at target. Labour are pledged to substantially increase public investment spending (which is outside the rule), which will put upward pressure on demand, at least initially. That would mean under a conventional assignment interest rates would rise to prevent inflation. But in an MMT world that wouldn’t happen. So in an MMT world how do you stop inflation rising? Either current spending would have to be cut, or taxes increased.

There is only one way that public spending for given taxes could be higher in an MMT world compared to Labour’s fiscal rule, and that is if inflation was not controlled at all. That is not what serious MMT economists would recommend. So when Richard says Labour’s rule means a Labour government would be committed to austerity policies, by which I think he means low public spending, while his MMT alternative would allow more public spending without raising taxes, he is, once again, just wrong.

[1] The term assignment comes from the idea that you have two instruments that can control inflation, fiscal policy or interest rates, and an assignment is where only one instrument is used to do the job. You could use both, of course, but if each instrument is controlled by different people with different views about the economy obvious problems could arise. Also in simple New Keynesian models it is optimal just to use monetary policy. I use the term conventional or consensus because it is the assignment that pretty well all advanced countries use, and the one most mainstream academic macroeconomists would recommend.

[2] transmission mechanism: how quickly and reliably each instrument impacts demand. institutional constraints: how quickly you can change the instrument (here monetary policy easily wins without significant institutional change). Delegation: again without major institutional change, you cannot delegate fiscal policy, so if you think delegating stabilisation policy is a good idea this favours monetary policy. As I argue here, delegation is as much about making advice public as it is about devolving power.

The lesson monetary policy needs to learn

It seemed obvious to write a post about the Peterson Institute’s recent conference on ‘Rethinking Macroeconomic Policy’, but nowadays I find it more efficient to let Martin Sandbu do the job. We agree most of the time, and he does these things better than I do. It allows me to write something only in the unlikely event that I disagree, or if I want to take the discussion further.

I only have one quibble with Martin’s column yesterday. I think Bernanke’s suggestion that following a large recession (where interest rates hit their lower bound) central banks revert to a temporary price level target is rather more than the tweak he suggests. In addition, as Tony Yates pointed out, level of NGDP targets do not resolve the asymmetry problem that Bernanke’s suggestion is designed to address.

I also thought I could illustrate Martin’s final point that “admitting one has got things badly wrong is a prerequisite for doing better” by looking at some numbers. If we look at consumer prices, average inflation between 2009 and 2016 was 1.1% in the Euro area, 1.4% in the US and 2.2% in the UK. The UK was a failure too: average consumer price inflation should have been higher than 2.2%, because we had a large VAT hike and depreciation that monetary policy rightly saw through. If we look at GDP deflators we get a clearer picture, with 1.0%, 1.5% and 1.6% for the EZ, US and UK respectively.

You might think errors of that size are not too bad, and anyway what is wrong with inflation being too low. You would be wrong because in a recovery period these errors represent lost resources that, as the Phillips curve appears to be currently so flat, could be considerable. Or in other words the recovery could have been a lot faster, and interest rates could now be well off the lower bound everywhere, if policy had been more expansionary.

What I really wanted to add to Martin’s discussion was to suggest the main problem with monetary policy over this period, particularly in the UK and the Eurozone. It is not, in my view, the failure to adopt a levels target, or even the ECB raising rates in 2011 (although that was a serious and costly mistake). In 2009, when central banks would have liked to stimulate further but felt that interest rates were at their lower bound, they should have issued a statement that went something like this:

“We have lost our main instrument for controlling the economy. There are other instruments we could use, but their impact is largely unknown, so they are completely unreliable. There is a much superior way of stimulating the economy in this situation, and that is fiscal policy, but of course it remains the government’s prerogative whether it wishes to use that instrument. Until we think the economy has recovered sufficiently to raise interest rates, the economy is no longer under our control.”

I am not suggesting QE did not have a significant positive impact on the economy. But its use allowed governments to imagine that ending the recession was not their responsibility, and that what I call the Consensus Assignment was still working. It was not: QE was one of the most unreliable policy instruments imaginable.

The criticism that this would involve the central bank exceeding its remit and telling politicians what to do is misplaced. Members of the ECB spent much of the time telling politicians the opposite, Mervyn King did the same in a more discreet way, while Ben Bernanke eventually said in essence something milder than the above. Under the Consensus Assignment we have invested central banks with the task of managing the economy because we think interest rates are a better tool than fiscal policy. As such it is beholden on them to tell us when they can no longer do the job better than government.

A better criticism is that a statement of that kind would not have made any difference, and we could spend hours discussing that. But this is about the future, and who knows what the political circumstances will be then. It is important that governments acknowledge that the Consensus Assignment no longer works if central banks believe there is a lower bound for interest rates, and this has to start by central banks admitting this. Economists like Paul Krugman, Brad DeLong and myself have been saying these things for so long and so often, but I think central banks still have problems fully accepting what this means for them.       

Why is MMT so popular?

I think, as a result of earlier posts, that I can be pretty confident that I can answer this question. But first some background. Although MMT has been around for some time, it recently held its first international conference and has in the last few years attracted a devoted band of followers online. According to this article, it has ‘rock star appeal’. In this post I just want to concentrate on the core of MMT which involves fiscal policy, and not talk about other ideas like job guarantees.

There are short and simple explainers around (e.g. here), but what these and MMT followers are typically not so good at is in explaining exactly why and how they differ from mainstream macroeconomics. To understand this, we need to go back to the 1960s and 70s. Then there was a debate between two groups in macro over whether it was better to use monetary policy or fiscal policy as an instrument for stabilising the economy. I prefer to call these two groups Monetarists and Fiscalists, because both sides used the same theoretical framework, which was Keynesian.

To cut a long story short the monetarist won that argument, although not quite in the way they intended. Instead of central banks controlling the economy in a hands off way using the money supply, they instead actively used interest rate changes to control output and inflation. Fiscal policy was increasingly seen as about controlling the level of government debt. I have called this the Consensus Assignment, because it became a consensus and because I don’t think there is another name for it.

The one or two decades before the financial crisis were the golden years for the Consensus Assignment, in the sense that monetary policy did seem to be relatively successful at controlling inflation and dampening the business cycle. However many governments were less successful at controlling government debt, and this failure was termed ‘deficit bias’.

MMT is essentially different because it rejects the Consensus Assignment. It regards monetary policy as an unreliable instrument for controlling the economy, and MMT prefers to use fiscal policy instead. They are, to use my previous terminology, fiscalists.

If you are always using government spending or taxes to control the economy, you are right not to worry about the budget deficit: it is whatever it needs to be to get inflation to target. Whether you finance those deficits by creating money or selling bonds is also a secondary concern - it just influences what the interest rate is, which has an uncertain impact on activity. For this reason you do not need to worry about who will buy your debt, because you can create money instead.

The GFC exposed the Achilles Heel in the Consensus Assignment, because interest rates hit their lower bound and could no longer be moved to stimulate demand. Alternative measures like QE really were as unreliable as MMT thinks all monetary policy is. What governments started to do was use fiscal policy instead of monetary policy to support the economy, but then austerity happened in 2010 for all the reasons I explore at length here.

Now we can see why MMT is so popular. Austerity is about governments pretending the Consensus Assignment still works when it does not, because interest rates are at their lower bound. We are in an MMT world, where we should be using fiscal policy and not worrying about the deficit, but policymakers don’t understand that. I think most mainstream macroeconomists do understand this, but we are not often heard. The ground was therefore ripe for MMT.

Policymakers following austerity when they clearly should not annoys me a great deal, and I am very happy to join common cause with MMT on this. By comparison, the things that annoy me about MMT are trivial, like a failure to use equations and their wordplay. You will hear from MMTers that taxes do not finance government spending, or that spending comes first, but you will hardly ever see the government’s budget constraint which makes all such semantics seem silly.

MMT is particularly attractive because it does away with the perennial ‘where is the money going to come from’ question. Instead it replaces this question with another: ‘will this extra spending raise inflation above target’. As long as inflation is below target that does not appear to be a constraint. In the US right now interest rates are no longer at their lower bound, but inflation is below target, so it appears to MMTers that the government should not worry about how extra spending is paid for.

Of course having a fiscal authority following MMT and a central bank following the Consensus Assignment once rates are above their lower bound could be a recipe for confusion, unless you believe what happens to interest rates is unimportant. I personally think we have strong econometric evidence that changes in interest rates do matter, so once we are off the lower bound should we be fiscalists like MMT or should we return to the Consensus Assignment? That is a question for another day.

The OBR’s risk assessment lacks context

In its recent report on fiscal risks, the OBR talks a lot about all the shocks that could make the government debt to GDP ratio rise again. It then says the following:

“None of this should be taken as a recommendation to refrain from particular spending increases or tax cuts, or to avoid particular fiscal risks – that would lie beyond our remit. And there are those who believe fiscal policy is still too tight, given the pace of economic growth and the looseness of monetary policy. But ….”

Should I be grateful for the second sentence, being one of ‘those’ who think that way?

I think the reverse is true. The OBR has played the tune the government wanted, but it is the wrong tune, and this now mature and independent organisation is capable of much better than this. I will first deal with a particular issue to do with monetary policy, and then talk more generally about the concept of ‘fiscal risks’.

Our macroeconomic institutional architecture is based around what I have called the consensus view about macroeconomic policy. This consensus involves what economists call an assignment. The stabilisation of output and inflation is assigned to independent central banks operating monetary policy. Fiscal policy should be confined to managing the government’s deficit and debt, and to help it with that task there should be a combination of fiscal rules and independent fiscal institutions (aka fiscal councils, like the OBR).

In a consensus assignment world, the job of a fiscal council is to stop deficit bias: the tendency clearly observable in some countries before the global financial crisis for deficits to creep up over time. In particular, when all is going well and the deficit appears not to be an issue, it is their job to tell the government to 'fix the roof while the sun shines’.

As I and others have noted many times, this consensus assignment has an Achilles Heel, which is that nominal interest rates cannot go below a number close to zero, the so-called Zero Lower Bound (ZLB). In the absence of some mechanism to allow interest rates to become significantly negative, that ZLB problem means that sometimes fiscal policy makers have to help monetary policy in its stabilisation role. The simple consensus assignment breaks down.

Although most academic macroeconomists recognise that, our institutions find it hard to do so. Monetary policymakers in the UK and Eurozone find it very difficult to say that they have lost their main instrument, and that therefore they can no longer reliably do their job. It seems that our fiscal council, the OBR, has similar problems.

We are currently at the ZLB. The most immediate risk we therefore face is that we are hit by a negative shock and monetary policy is unable to respond effectively. Hence the quote from their document above. But as far as I can see that is it. In their section in the Executive Summary on the risk due to a recession I would have thought the ZLB problem was worth at least mentioning, but it does not appear. Indeed I’m not sure the term ZLB or liquidity trap appear anywhere in the document.

I’m sure the OBR would in defence say two things: assessments of fiscal risks generally look at risks to fiscal sustainability not macroeconomic stabilisation, and their remit precludes them from talking about alternative fiscal policy paths. This is all true. The Treasury wanted a report that would enable them to say we must continue with austerity because of all the risks identified by the OBR. The Treasury also wrote the OBR’s current remit. 

But the OBR is supposed to be independent. Just because the government tries to pretend that there is no Achilles Heel to the consensus assignment, that does not mean it has to go along with that act. In particular, it will (I hope) have noted that the main opposition - which came close to defeating the current government - has a fiscal rule that explicitly says that fiscal policy needs to switch from stabilising debt to stabilising the economy when interest rates are at their lower bound (like now). In this context, I think something beyond a single sentence alluding to the ZLB would have been appropriate.

Tony Yates said similar things yesterday. He also made another important point: a key role of government in many areas is to be a risk absorber. It assumes risks, because it is beneficial to take risks away from individuals or individual generations and spread them more widely, and often the state is the only institution that can do this. In addition, its deficit and debt should be a macroeconomic shock absorber. Given all that, why exactly should we be concerned if various shocks increase government debt? That is what is supposed to happen!

To put the term risk and attach it to some level of debt or deficit, giving us ‘fiscal risks’, is questionable. It is a bit like saying their is a risk that your central heating will come on if it gets cold: that is not a risk, but why it is there. The OBR would no doubt respond that the government has a mandate in terms of a deficit or debt target, and it has been asked to look at risks that this may not be met. But that should not stop an independent OBR from asking more fundamental questions.

Implicit in the idea of ‘fiscal risks’ is either a belief that there is an optimal level of debt which is below current levels, or a view that there is some level of debt so high that markets would start worrying about the government choosing to default. If we are worried about a debt burden on future generations, does it make sense to put all that burden on a current, already disadvantaged, younger working generation? Unless these key issues are addressed, all the risk assessment the report undertakes is meaningless, or worse still just provides support for the government’s misguided policy. It is time the OBR stopped being constrained by its remit, and started providing the public with a useful framework in which to think about ‘fiscal risks’.

MMT and mainstream macro

There were a lot of interesting and useful comments on my last post on MMT, plus helpful (for me) follow-up conversations. Many thanks to everyone concerned for taking the time. Before I say anything more let me make it clear where I am coming from. I’m on the same page as far as policy’s current obsession with debt is concerned. Where I seem to differ from some who comment on my blog, people who say they are following MMT, is whether you need to be concerned about debt when monetary policy is not constrained by the Zero Lower Bound. I say yes, they say no, but for reasons I could not easily understand.

This was the point of the ‘nothing new’ comment. It was not meant to be a put down. It was meant to suggest that a mainstream economist like myself could come to some of the same conclusions as MMT writers, and more to the point, just because I was a mainstream economist does not mean I misunderstood how government financing works. It was because I was getting comments from MMT followers that seemed nonsensical to me, but which should not have been nonsensical because the basics of MMT are understandable using mainstream theory.

One comment on that earlier post provided a link to a very useful Nick Rowe post, who as ever has been there before me. This suggested that MMT assumed a vertical IS curve (there is no impact of interest rates on aggregate demand). If the IS curve is vertical, then it explains the puzzle I have. In the thought experiment I outlined in my previous post, if the government started swapping debt for money the decline in interest rates that would follow [1] would have no impact on demand, so there would be no rise in inflation. Indeed what else could it be besides an assumption of a vertical IS curve, as MMT does not deny that excess demand would lead to inflation at full employment.

I now think that is putting it too strongly. The view that many MMT writers have is that interest rates have an unreliable impact on demand relative to fiscal instruments. In that case of course you would have to use fiscal policy to control demand and inflation. That would be the focus of the fiscal rule. It is a similar regime to one I suggest would be appropriate for individual Eurozone countries. Inflation would be a discipline on deficit bias. [2]

What about a world where monetary policy did successfully control demand and inflation, which is the world I’m writing about? Evidence suggests you then need a fiscal rule stopping deficit bias (a gradual rise in the debt to GDP ratio over successive cycles). In a country with its own central bank (so no concern about forced default) and where all debt is owned domestically, the standard reasons why you would be concerned about deficit bias are intergenerational equity, crowding out of capital, and having to raise distortionary taxes to pay the higher debt interest bill.

There is a lot you can say on all three, but the point I want to make is simple. Being in that world means you do not need to worry about other sector balances because of their impact on demand. By being in that world at no point am I misunderstanding how government financing works, or ignoring the role of money. It does not mean I read the government budget constraint from left to right or vice versa! Yet I still get comments like this one left on a more recent post.

“Your political yourself Simon. One thing more than anything really annoys me. Why do you never announce or go public and say that taxes do not fund government spending?”

Comments like the one above, taken without context from some MMT paper, just appear stupid. By all means criticise my view that monetary policy is effective, or that rising debt has costs, but in future comments like that will just be ignored.

Let me make the same point using another example. Alex Douglas in a post argues that MMT does make an original contribution to political economy. He looks at a Warren Mosler claim that the state creates unemployment, and this is the only reason unemployment exists. It seems to me (with some additional help from Alex) that this involves two elements. The first sounds like a combination of points that mainstream economists might make: deficient demand exists because we are in a monetary economy, and some combination of monetary and fiscal policy can always get rid of deficient demand. The second is that money exists because the state requires taxes to be paid with it. Now I’m less sure about that second argument, but the point is that I can unpick what I agree with and what I do not using perfectly standard economic ideas. Yet if he had simply sent me a comment which said “the state currency is fundamentally a device for coercing labour” I wouldn’t have had a clue what he was talking about.

Now you might ask at this point why is it so important to be able to put MMT arguments in the language of standard macro. MMT is a coherent school of thought, using a language that those who have read the important texts understand. [3] Someone like me should just take the time out to read those texts. Well I have read some MMT papers, but I can assure you I have read many more than pretty well every mainstream macroeconomist I know. So what you may say. But it is a fact, and you may think it is an unfortunate fact, that mainstream macroeconomics is pretty dominant in both academic and policy circles. And it will stay that way: heterodox economists have been predicting the downfall of mainstream economics for longer than I have been an economist. [4] So if MMT is to have any influence, it will be through changing how mainstream macroeconomists think.

You gain that influence by properly understanding the mainstream. Bill Mitchell, writing in 2013, lambasts economists like me who try to suggest that the fixation with debt since 2010 does not come from mainstream macro. He does not believe it, and writes

“Why is there mass unemployment if government officials understood all our claims? It would be the ultimate example of venal dysfunctional politics to hold that that everybody knows all this stuff but are deliberately disregarding it – for what?”

But that is the tragedy of what has happened since 2010. Politicians, either out of panic or with ulterior motives, decided in countries with their own currencies that we should start worrying about the market no longer buying government debt, and austerity was the result. In this they were supported by a media that thought the government was like a household, and economists from the financial sector who had their own reasons for promulgating this myth. True, they did find support from some mainstream academic macroeconomists, but that support was never based on mainstream theory.

What mainstream theory says is that some combination of monetary and fiscal policy can always end a recession caused by demand deficiency. Full stop: no ifs or buts. That is why we had fiscal expansion in 2009 in the US, UK, Germany, China and elsewhere. The contribution of some influential mainstream economists to this switch from fiscal stimulus to austerity in 2010 was minor at most, and to imagine otherwise does nobody any favours. The fact that policymakers went against basic macro theory tells us important things about the transmission mechanism of economic knowledge, which all economists have to address.

[1] Bill Mitchell appears to suggest that in this case the central bank could maintain its interest rate by selling its stock of government debt. However pretty soon it would run out of assets to sell. This is exactly why some central bankers are reluctant to undertake helicopter money. One solution with helicopter money is to get the government to recapitalise the central bank, but of course to do that would involve creating more government debt. The central bank could start creating its own debt, but if governments stopped creating their own debt and asked the central bank to do it for them, nothing has really changed. 

[2] It is not clear to me that in such a world debt would always be tied down. A government that used an effective (in multiplier terms) fiscal instrument in booms (e.g. government spending) but an ineffective one in depressions (tax breaks for the wealthy) might experience an upward drift in debt. But what is clear is that in such a regime, concern about the debt stock should never justify significant departures from demand and inflation stabilisation.

[3] Although, as the range of comments to my earlier posts showed, what people understand MMT to mean varies quite a lot.

[4] I personally would not welcome the disintegration of macro back into separate schools of thought. Economists should be like doctors, and I do not want to have to ask my doctor what medical school of thought they belong to. I have relied on doctors using the same language and being able to understand each other. However I also realise that the unwise fixation of the current mainstream with microfoundations methodology can act as an exclusion mechanism, which encourages the formation of alternative schools of thought. This is yet another reason to be very critical of this methodological hegemony.