A new mandate for monetary policy

John McDonnell wants to raise UK investment not by cutting corporation tax but by diverting funds from parts of the financial sector away from property to new investment by UK firms. That is a laudable aim. But giving the Bank of England that task with a 3% productivity target is not the best way to do that. However that is not because I think central banks cannot influence productivity.

The kind of toy model many people work with is that monetary policy is all about stabilising the business cycle, but that stabilisation has no impact on the medium term level of  output and productivity. That is because productivity is determined by the ‘supply side’ of the UK economy. And this toy model worked particularly well for the UK economy, which from the early 1950s until before the GFC seemed to always bounce back to an underlying trend rate of growth for GDP per capita of around two and a quarter per cent.

However over none of that period did we experience a recession where nominal interest rates hit their lower bound and fiscal policy turned from stimulus to austerity before the recovery had begun. In other words in none of these periods did we have a persistent period of deficient demand with growth never exceeding its long term average. I have argued that it is wrong to see the UK productivity puzzle as a period of uniform gloom since the recession, but rather there were periods of growth which were set back by uncertainty following two additional major policy shocks: austerity and the EU referendum.

Yet if you ask UK monetary policymakers whether they think they have done a good job over the last 10 years, they will say (in public at least) that they think they have. They do not say they have failed because of shocks they couldn’t control, which would be a reasonable position, but rather they have done reasonably well at controlling the economy. In the context of the slowest recovery for at least a century, with a consequent permanent hit to output (output is over 15% below previous trends), that degree of public self-satisfaction indicates a major problem. And if you ask them how they can possibly be satisfied they will talk to you about inflation.

This is a clear reason to question the inflation target. Although in toy models controlling inflation should also mean controlling output, the real world is much more confusing. By making the bottom line inflation, we are bound to make policymakers worry too much about inflation relative to output. The clearest case for me was 2011, when the ECB and almost the MPC raised rates when the recovery from recession was only just beginning.

For that reason I have long supported a more US style twin mandate. Yet although the US had a better recovery than the UK or Eurozone, the Fed still seems to be giving inflation much more weight than employment. But you cannot ignore inflation completely. The mandate I propose for monetary policy is this:

To maximise output growth subject to maintaining inflation within 1% of its target by the end of a (rolling) 5 year period.

Another thing we have learnt from the Great Recession is that policy has to change once nominal interest rates hit their lower bound. So I would, following Ben Bernanke, add to this mandate a ‘lower bound adaptation’ where the moment interest rates hit their lower bound the inflation target would be converted into an equivalent path for the price level. That would mean that if inflation undershot its target during the recession, it would have to overshoot it before rates could be lifted above their lower bound. I would also require central banks the moment they think rates will hit the lower bound to say publicly that fiscal stimulus is now required to meet its target.

This is a dual mandate, but one that puts the emphasis on output rather than inflation. [1] Why the 1% tolerance? Because it echos current UK arrangements (when the governor has to write letters) but in practice will raise average inflation. This is a feature rather than a bug: another lesson of the last recession is that there is a strong case for a higher inflation target, but in a situation where the Chancellor sets the target it is very difficult to formally raise the target because many people think higher inflation means lower real wages.

Tasking central banks to maximise output subject to an inflation constraint is certainly better than setting a probably unattainable target for productivity growth when we have no idea what the maximum productivity growth rate is. My suggestion is a dual mandate that puts the emphasis on output and makes clear inflation is a medium term concern, making it easier for central banks to see through temporary shocks to inflation like one-off depreciations. The nature of the target recognises that policy has to adapt when nominal interest rates hit their lower bound. Comments very welcome.

[1] What is the logic of giving inflation zero weight in the short run and total importance in the long run? The answer lies in asking what the costs of inflation are. Modern analysis looks at how when prices are sticky but set at different times, inflation distorts relative prices. But inflation due to changes in flexible prices is costless. Now it is not easy to distinguish between the two types of prices in price indices, but inflationary shocks that impact on flexible prices are likely to be short lived, while those that impact on sticky prices will be more prolonged. It therefore makes sense to ignore temporary changes in inflation (those that die out within five years), but because of the vertical long run Phillips curve have a medium term inflation target.     

Macroeconomic Policy Reform the IPPR way

Monetary and fiscal policy makers in the UK seem to think they had a good recession. You can tell that because neither group seem particularly interested in learning any lessons. This is despite the fact that we had the deepest recession since the 1930s, and the slowest recovery for centuries. It is also despite the fact that the level of UK GDP is almost 20% below the level it would be if it had followed pre-recessions trends, and all previous recessions have had the economy catch up with that trend.

You can tell from this paragraph that I do think serious changes are required to how monetary and fiscal policy are done. So does the IPPR, and their detailed analysis and proposals are set out in a new report by Alfie Stirling. The analysis is not too technical, well presented, well researched and I agree with a great deal of what is said. I will look a monetary policy first, and then fiscal policy.

What the Great Recession showed us (although many macroeconomists already knew) is that once nominal interest rates hit their effective lower bound (ELB) [1], monetary policy makers lose their reliable means of combating a recession. The report is dubious about Quantitative Easing (QE) for much the same reason that I have been for anything other than a last resort instrument. In brief, the impact of QE is very uncertain because it is not routinely used, and in addition there may be important non-linearities. It is not a reliable alternative to interest rates.

The report makes much the same point about negative nominal interest rates: partially or perhaps fully removing the lower bound. To quote:

“Like QE, the impacts of negative rates are uncertain and, depending on the behavioural response from banks and savers, could actually reduce spending in the economy, or else increase the number of risky loans (see for example Eggertsson, Juelsrud and Wold 2017).”

I know some macroeconomists will disagree with that assessment, but I think the point is valid.

The report also rejects helicopter money as a solution to the ELB problem. Here I found their discussion less convincing, but they do recognise that a form of helicopter money has already been undertaken by some central banks through creating money to change the relationship between borrowing and lending rates, a point that Eric Lonergan has stressed.

The two reforms to monetary policy that have been suggested and which the report does support are adopting unemployment or nominal GDP as either a second target or as an intermediate target, and raising the inflation target by one or two percent. I have argued strongly for a dual mandate and also for using nominal GDP as an intermediate target, so I have no objections here.

The report recognises, however, that none of their proposed reforms to monetary policy eliminates the ELB problem completely. We have, inevitably, to think about the other reliable and effective instrument that we have to stimulate aggregate demand: fiscal policy. Their proposed fiscal rule is very similar to Labour’s fiscal credibility rule. It includes (a) a ‘knockout’ to switch to fiscal expansion if interest rates reach their ELB, (b) 5 year rolling target for a zero current balance (c) a 5 year rolling target for public investment (d) a similar target for debt to GDP. The last in this list you will not find in Portes and Wren-Lewis, in essence because it involves double counting, and debt targets are less robust to shocks than deficit targets.

If governments followed this fiscal rule, then the ELB would not be the serious problem that it is, because reliable fiscal stimulus would replace reliable monetary stimulus at the ELB. But the IPPR worry that governments might not do what the fiscal rule, and with the knockout what the Bank of England, tells them to do. They are concerned that what they call ‘surplus bias’ might be so strong that the government would not run the deficits that the Bank asks them to run.

To overcome this concern, they suggest an alternative to QE at the ELB: the Bank should create reserves to fund projects that are part of a National Investment Bank (NIB). The NIB would be independent of government in terms of the projects it funded (but not its high level mandate), and it would normally raise funds in the open market. (This makes it different from proposals that the NIB be entirely funded by the Bank: see here.) In an ELB recession, the Bank of England would ask the NIB to fund additional projects, with the Bank providing the finance.

As public investment is particularly effective as a countercyclical tool if undertaken immediately, and as it is usually possible to some degree to bring forward investment projects, this proposal seems a superior alternative to QE, as long as the link between additional purchases of NIB debt and additional investment by the NIB was reasonably clear. The key point here is that although conventional QE might try to stimulate private investment by reducing firm borrowing costs, in a situation where there is chronic lack of demand that can be like trying to push on a string. The same problem should not arise with an NIB. In that sense it just seems like a good idea.

Whether it would be enough alone to circumvent the problem of a rabid surplus bias government during a recession I doubt. The kind of public investment that is easy to ramp up quickly in a recession are things like flood defences or filling holes in the road, rather than the kind of things an NIB would fund. A government suffering strong surplus bias could cut these things quicker than an NIB could fund additional projects. Some form of QE would be more powerful in this respect. The danger in either case is that you just encourage the government to try and get down debt even faster: if QE gives money directly to people, the government just raises VAT.

How seriously should we worry about (design policy for) a government offsetting everything the Bank is able to do to stimulate demand in a recession? The answer may be given by imagining the following scenario. The government operates a fiscal rule that has an explicit ELB knockout. The Bank of England, when rates hit the ELB, requests the government undertake fiscal stimulus. If Cameron/Osborne had been faced with both those things, would they have still cut back public investment? I suspect the answer is no. That of course by implication means that central bankers in Europe played a large part in facilitating (or encouraging) austerity, which in the UK stemmed from a failure to admit the problems of the ELB because of a naive faith in QE.

Which brings us to central bank independence and what I call the conventional assignment (outwith the ELB, monetary policy deals with macroeconomic stabilisation). The IPPR stay with the mainstream macroeconomic consensus in wanting to keep both. People with a more MMT type view, like Richard Murphy, would reverse [2] the conventional assignment, and have fiscal policy doing the macroeconomic stabilisation. I have written a great deal on the distinction and will not repeat that here. However it is worth making one point on independence.

The reasons for making central banks independent are not peculiar to monetary policy. They are that if the complex task of macroeconomic stabilisation is left in the hands of politicians who get secret advice, they can mess things up for political ends. [3] Messing things up can be minor (e.g. delaying necessary measures), structural (e.g. time inconsistency) or explosive (e.g. hyperinflation). Austerity shows that this fear is justified. MMT’s answer to the IPPRs concern about a surplus bias government is that this is just a cost of democracy or the good guys would always be in power, which I suspect many might not find reassuring. Yet that is also why European central bank’s encouragement of austerity was far from helpful to the case for the delegation of macroeconomic stabilisation.

[1] 'Effective' because in practice it is up to the central bank to decide at what point they cannot reduce nominal rates further. 

[2] Not strictly true. In the conventional assignment monetary policy does inflation/aggregate demand and government looks after its debt, while in MMT fiscal does inflation/aggregate demand and government debt looks after itself.

[3] I hope time inconsistency can be subsumed under this broad definition.

Revolutions in Economic Policy

The Commission on Economic Justice hosted by the Institute for Public Policy Research (IPPR) has just published a substantial and comprehensive report on the UK economy called ‘Time for Change’. I hope to write about aspects of that report later, but its basic premise is that we need a revolution in economic policy making, akin to the revolutions enacted by the post-war Attlee government and Mrs. Thatcher. The thinking behind the idea of economic policy revolutions is outlined by Alfie Stirling and Laurie Laybourne-Langton in a paper in The Political Quarterly.

The authors adapt the ideas of Thomas Kuhn’s The Structure of Scientific Revolutions to economic policy. I do not want to get hung up on the legitimacy or details of this. The basic idea that some periods involve profound changes in economic policy is not really contentious. Also the idea that the ‘failing paradigm’ will first try to adapt itself before being replaced by the revolutionary idea is straightforward. You only need to look at the state of current politics in the UK and US to take seriously the idea that what could be called the neoliberal era - the set of policies and world view associated with Thatcher and Reagan - is coming to an end.

There is a lot in the paper that I agree with, at least until the conclusions. [1] But I think my main critical comment would be that the paper focuses too much on macroeconomics, and as a result goes a little astray. It is if, having borrowed Kuhn’s idea and applied it to economic policy, the authors feel obliged to keep going back to an actual academic discipline, macroeconomic theory, rather than staying with economic policy as a whole. Let me set out first how I see the macroeconomic transformation that took place around the time of Thatcher and Reagan.

A key mistake that many people make is to say that conventional Keynesian macroeconomic theory was unable to explain stagflation, and that policymakers adopted monetarism or new classical ideas as a result. The basis for understanding stagflation and reducing inflation was known since at least Friedman’s famous address in 1968 giving his account of the expectations augmented Phillips curve. This Phillips curve was not used to guide monetary or fiscal policy before the end of the 1970s because most policy makers and some economists were reluctant to raise unemployment as a way of reducing inflation. [2]

In the UK this use of demand management to control inflation (or its counterpart, which was to abandon attempts at direct control like incomes policies) coincided with the election of Thatcher, but in the US it was initiated by Paul Volcker under Jimmy Carter. In both the UK and US it was associated with attempts to control monetary aggregates, but this lasted only a few years. You could argue that abandoning incomes policies was neoliberal, but to me it looks like the inevitable result of double digit inflation.

There was a revolution in macroeconomic theory, but I have argued elsewhere that it does not fit into the Kuhnian framework. The New Classical Counter Revolution (NCCR) did not come up with an alternative analysis of inflation: instead their concerns were more methodological. It is true that that many who promoted the NCCR also favoured neoliberalism, and you could relate reductionism to individualism (and hence neoliberalism), but I think the appeal of the NCCR owed much more to a collection of good ideas that the then mainstream resisted, like rational expectations.

Inflation targeting by central banks involves an attempt to manage the economy in much the same way as Keynesian fiscal activism had done before. The central bank is a part of the state. Central bank independence didn’t come to the UK until 1997, and existed in the US well before Reagan. What I call the Consensus Assignment (monetary to demand management, fiscal to debt control) was dealt a fatal blow by the GFC, but the popularity of this assignment owes little to neoliberalism. Attempts to link inflation targeting to neoliberalism, which are frequent, are in my view a mistake.

Trying to fit macroeconomics into an account of the rise of neoliberalism is therefore problematic, and more importantly it detracts from the real economic policy revolution that neoliberalism represented, which was a change in the attitude of policymakers to state intervention of almost any kind. Out went government partnership with industry (described as ‘picking winners’), together with a regional and industrial policy serious enough to counteract the effects of globalisation and technical change. There was a corresponding shift from the collective (including attacking trade unions) to the individual, together with the idea that ‘wealth creators’ (aka high earners) had to be incentivised by cutting ‘punitive’ taxation. Public money became ‘taxpayers money’ and so on.

All this was a successful neoliberal revolution, where by success I mean it took hold for decades. It, together with subsequent overreach, has caused serious problems and is therefore ripe for review. But ironically the attempt at a truly neoliberal macro policy - hands-off monetary targeting with no demand management - failed within a few years of being tried.

[1] I should say why I think the conclusions do not follow from the rest of the paper. There are some simple mistakes, such as “the failure of these same models to predict accurately the effects of the UK vote to leave the EU threatens to renew the crisis of confidence in economic theory.” But there is also an implicit very misleading equation pair: neoliberal policy=mainstream economics, revolution=heterodoxy.

First, the two previous revolutions in macro theory came from within the mainstream, not from outside. Second, neither austerity or Brexit have anything to do with mainstream economics. More generally, mainstream economics is as much a critique of neoliberalism as a support. As a result, a revolution in economic policy making could quite easily originate from within mainstream economics (see here, for example).

[2] Today, that view has been revived by members of the MMT school, who call using the Phillips curve to control inflation amoral.

Raising the inflation target

The argument for a higher inflation target is straightforward, once you understand two things. First the most effective and reliable monetary policy instrument is to influence the real interest rate in the economy, which is the nominal interest rate less expected inflation. Second nominal short term interest rates have a floor near zero (the Zero Lower Bound, or ZLB). Combine the two and you have a severe problem in a recession, because to combat the recession real interest rates need to move into negative territory, and how far they can go into that territory is limited by the ZLB. That means monetary policy alone may be unable to get us out of a recession.

Raising the inflation target reduces the likelihood that interest rates will hit the ZLB. To see why, note first that the long run (economists often say ‘equilibrium’ or ‘natural’) real interest rate is positive. Let’s say it is 2%. If the inflation target is 2%, and the ZLB is 0%, that would mean that in normal times the average nominal interest rate is 4% (2% inflation target + 2% to get to a 2% real interest rate). That means nominal interest rates can be cut by a maximum of 4% if the economy falters. That may be enough for a mild downturn, but as we saw in 2008 it is not enough for a major recession. However if the inflation target was 4%, nominal rates would now be able to fall by a maximum of 6%. That is probably enough to combat all but the worst kind of recession.

Why are many economists currently arguing that we should raise the inflation target from 2% to 4%? One of the reasons is that we now believe the long run real interest rate is currently lower than it was when the 2% target was first chosen. (This is sometimes referred to as secular stagnation.) If you go through the arithmetic above, you can see why a lower long run real interest rate will make the ZLB problem worse. The argument is that we now need to raise the inflation target to make sure we hit the ZLB less often in the future.

This issue moved from an academic discussion to a real possibility in the US a few days ago. When Fed Chair Janet Yellen had been asked about raising the inflation target in the past, she has tended to dismiss the idea. However she now says that it is something that the Fed will review in the future, and that it is one of the most important questions facing central bankers today.

This will undoubtedly give new impetus to the debate over whether the inflation target should be raised. We are in standard trade-off territory here. Economists generally agree a higher inflation target will in itself inflict greater costs on the economy, but they bring the benefit that the ZLB problem will occur less often. But there is an alternative, and clearly much better way out of this dilemma.

Governments have another instrument that has a reasonably predictable impact on aggregate demand, and which can be used to combat a recession: fiscal policy (changes to taxes and government spending). In the UK at the moment interest rates are at the ZLB in part because fiscal policy is contractionary (austerity). It would be far better to use this instrument to stimulate the economy in a recession than to raise the inflation target. Yet the institution of independent central banks have discouraged governments from using fiscal policy in this way.

It is no good central banks pretending that this is something which is up to governments, and that there is some unwritten law which means that central banks should keep quiet on such things. In reality, in both the UK and the Eurozone, the central bank actively encouraged governments to do the wrong thing with fiscal policy in the last recession. In other words, they encouraged austerity. If there is something inherent in the institution of a central bank that makes them give inappropriate advice in this way, then we should be asking how central banks can be changed as a matter of urgency.

What should happen in a recession, as soon as the central bank thinks that interest rates will hit the ZLB, is that central banks should say, out loud in public, that fiscal policy should become more expansionary. In addition central banks should say, out loud in public, that governments need not worry about rising debt and deficits due to the recession and any fiscal stimulus they undertake spooking markets because the central bank has that covered. Both statements have the merit of being true. 

Of course governments will need to restore debt to desired levels at some point, but that point should be well after interest rates have left the ZLB because then debt correction can be painless. The immediate aim of fiscal policy in a recession should be to allow interest rates to rise above the ZLB as soon as possible. That gives you the best macroeconomic outcome, and one that is far superior to raising the inflation target. The most important question facing central bankers today is why they failed to do that from 2009.

Now it is possible that, if democracy is in a bad shape (as it currently is in the US for example), the government may ignore the advice it receives from the central bank. In that case it is worth considering giving central banks some additional power to mimic a fiscal expansion, such as helicopter money for example. Or it may be worth considering institutional changes that allow nominal interest rates to go negative. Or raising the inflation target. But before doing any of those things we need to ensure that central banks give the right advice to governments when the next recession comes along.

The last 7 years are an argument against inflation targeting

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

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

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

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

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

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

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

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

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

Haldane on alternatives to QE, and what he missed out

Andrew Haldane, Chief Economist at the Bank of England, gave a typically well researched and thoughtful talk recently. The main subject matter was the problem of the Zero Lower Bound (ZLB): why we may hit it much more often than we would like, and why QE is not a great instrument for dealing with it. To quote:

“QE’s effectiveness as a monetary instrument seems likely to be highly state-contingent, and hence uncertain, at least relative to interest rates. This uncertainty is not just the result of the more limited evidence base on QE than on interest rates. Rather, it is an intrinsic feature of the transmission mechanism of QE.”

In the past I have emphasised the point about lack of evidence simply because it is obvious. But as Haldane’s discussion shows, the problems are more basic than that. Some people argue that we can always get the result we want with enough QE. Yet if the central bank and the public never know how effective any amount of QE will be, then lags make it a poor instrument. It is refreshing to see a senior member of the Bank finally acknowledge its limitations.

Haldane considers two alternative ways of dealing with, or avoiding, the ZLB: a higher inflation target and getting rid of cash so that negative interest rates of whatever size become possible. The first is obviously welfare reducing, but as Eric Lonergan argues the second is likely to be as well. (See also Tony Yates.) But what is really strange about Haldane’s analysis is what is missing from his discussion.

One omission is a discussion of the possibility that targeting something other than inflation might help. The other omission is any discussion of helicopter money. There are some basic contradictions in the Bank of England’s views on helicopter money, but because central bankers tend to talk to each other I suspect they remain concealed. One argument is that helicopter money will somehow reduce confidence in the currency, but then the Bank seems happy to research getting rid of cash and imposing negative rates on money as if this is all about technicalities. [Postscript - meant to link to John Cochrane's discussion, and here is a reply by Miles Kimball.] I should have referenced  Another argument is that helicopter money will threaten the Bank’s independence because it will have to rely on government to (if necessary) recapitalise it, when at the same time the Bank has already obtained an underwriting guarantee for losses on QE. Also strange is the argument that independence will be threatened once the Bank does a 'helicopter drop' because governments will want the money for themselves, as if politicians had not noticed the amount of money being created under QE. After all Jeremy Corbyn's proposal was a response to the reality of QE, not the possibility of helicopter money.

The really ironic argument is that helicopter money is too like fiscal policy, and that there should be democratic control over fiscal policy. This is what central bankers mean when they talk about blurring the lines between monetary and fiscal policy. The argument is ironic because I am sure that if you actually asked most people which they would prefer - being charged to hold money, 4% average inflation, or occasionally getting a cheque from the Bank - the answer would be emphatic. So we rule out helicopter money because its undemocratic, but we rule out a discussion of helicopter money because ordinary people might like the idea.

There is also an element of hypocrisy. It is sometimes argued that helicopter money is unnecessary because it has a very similar impact to conventional fiscal policy. This is true, but it deliberately ignores the fact that governments around the world have gone for fiscal contraction because of worries about the immediate prospects for debt. It is not as if the possibility of helicopter money restricts the abilities of governments in any way. If governments undertake fiscal stimulus in a recession such that helicopter money is no longer necessary, it will not happen.

So it is good that some people at the Bank are thinking about alternatives to QE, which is a lousy instrument with unfortunate, and potentially permanent, distributional consequences. It is a shame that the Bank is not even acknowledging that there is a straightforward and cost free solution to this problem. My last two posts have involved defending central bank independence, but with independence comes a responsibility not to exclude discussion of particular policy options simply because they break some kind of taboo.      

The F story about the Great Inflation

Here F could stand for folk. The story that is often told by economists to their students goes as follows. After Phillips discovered his curve, which relates inflation to unemployment, Samuelson and Solow in 1960 suggested this implied a trade-off that policymakers could use. They could permanently have a bit less unemployment at the cost of a bit more inflation. Policymakers took up that option, but then could not understand why inflation didn’t just go up a bit, but kept on going up and up. Along came Milton Friedman to the rescue, who in a 1968 presidential address argued that inflation also depended on inflation expectations, which meant the long run Phillips curve was vertical and there was no permanent inflation unemployment trade-off. Policymakers then saw the light, and the steady rise in inflation seen in the 1960s and 1970s came to an end.

This is a neat little story, particularly if you like the idea that all great macroeconomic disasters stem from errors in mainstream macroeconomics. However even a half awake student should spot one small difficulty with this tale. Why did it take over 10 years for Friedman’s wisdom to be adopted by policymakers, while Samuelson and Solow’s alleged mistake seems to have been adopted quickly? Even if you think that the inflation problem only really started in the 1970s that imparts a 10 year lag into the knowledge transmission mechanism, which is a little strange.

However none of that matters, because this folk story is simply untrue. There has been some discussion of this in blogs (by Robert Waldmann in particular - see Mark Thoma here), and the best source on this is another F: James Forder. There are papers (e.g. here), but the most comprehensive source is now his book, which presents an exhaustive study of this folk story. It is, he argues, untrue in every respect. Not only did Samuelson and Solow not argue that there was a permanent inflation unemployment trade-off that policymakers could exploit, policymakers never believed there was such a trade-off. So how did this folk story arise? Quite simply from another F: Friedman himself, in his Nobel Prize lecture in 1977.

Forder discusses much else in his book, including the extent to which Friedman’s 1968 emphasis on the importance of expectations was particularly original (it wasn’t). He also describes how and why he thinks Friedman’s story became so embedded that it became folklore. The reason I write about this now is that I’m in the process of finishing a paper on the knowledge transmission mechanism and the 2010 switch to austerity, and I wanted to look back at previous macroeconomic crises.

If it wasn’t a belief in a long run inflation unemployment trade-off, what was it that allowed inflation to gradually rise during those two decades? Forder has a lot to say on this, but the following is my own take. I think two things were critical: the idea that demand management was primarily designed to achieve full employment, and that full employment had primacy over the objective of price stability. Although more and more economists over that period began to see the policy problem within a Phillips curve framework, many still hoped that other measures like prices and incomes policies (in the UK in particular but also in the US) could override the Phillips curve logic. The primacy of the full employment objective meant the problem was often described as ‘cost-push inflation’ rather than a rise in the natural rate of unemployment.

If you find this hard to imagine, think about historians discussing the current period in a possible future in 2050. By then nonlinearities in the Phillips curve and the power the inflation target had in anchoring inflation expectations were firmly entrenched in mainstream thinking. Imagine that partly as a result in 2050 the inflation target has been replaced by a level of nominal income target. With the benefit of hindsight these historians were amazed to calculate the extent to which resources were lost decades earlier because policy had become fixated by a 2% inflation target and budget deficits. They will recount with amusement at the number of economists and policymakers who thought that the way to deal with deficient demand was by ‘structural reform’. Rather than construct folk tales, they will observe that even when most economists realised what was required to avoid being misled again policymakers were extremely reluctant to change the inflation target.

Radical macro lessons from the Great Recession

The relationship between NGDP targets, a higher inflation target and helicopter money

Just suppose that lower oil prices help generate a period of significantly above average growth in the OECD economies over the next five years. We avoid deflation, but despite more rapid growth modest increases in interest rates keep inflation at or below target. Even if this happens, the story of the Great Recession will not have been a happy one. If you compare where we are now to where we might have been without a financial crisis, there remains a huge gap. Even if we go a good way to closing that gap over the next five years, this very gradual recovery will have cost us dear. In some countries (most of the Eurozone) that cost is currently reflected in high levels of unemployment, while in others (the US) it manifests itself in real wage stagnation or decline. (The UK is now in the latter group: if you are bored with hearing this from me, see this from John Van Reenen.)

Are there lessons to learn from this? You can probably divide economists into two camps at this point. One group, the ‘supply group’ - which would include most of those setting monetary policy - tend to think that we have largely done the best we could under the circumstances. By circumstances, I mean two related things: a rather surprising increase in inflation during 2011, and an apparent decline in the ability of the ‘supply side’ of the economy to grow at the kind of rates we might have expected before the crisis. While the former is undeniable, the second is conjecture, because we cannot observe the key driver of long term growth, which is technical progress.

The second group of economists attribute more of the slow recovery since the financial crisis to deficiency in aggregate demand. I am in that second ‘demand’ group, and have argued that fiscal austerity is responsible for a great deal of the slow recovery. Implicit in such arguments is the idea that had demand been strong, any further increase in inflation around 2011 would have been modest and temporary, which with wise monetary policy need not have led to any increase in interest rates.

I think most of the demand group also share a view that it would be a large mistake to shrug off this bad experience as a one-off, or as something that only occurs every century or so. The ‘one-off’ story could focus on an unfortunate misreading of the Eurozone crisis: however, while this might explain the change in attitudes is some important institutions like the IMF, it is less plausible in explaining why policy makers around the world switched to austerity. The ‘every century’ idea is wrong because it fails to note the changes that have been brought about by the widespread adoption of 2% inflation targets, coupled with a view that the ‘natural’ real interest rate is also likely to remain low for some time.

Different members of the demand group have proposed three different and radical innovations in macroeconomic policy to help avoid this kind of mistake happening again. These are targeting the level of nominal GDP (NGDP), raising the inflation target, and some form of helicopter money. Are these innovations alternatives or complementary to each other?

There are some (notably market monetarists) who seem to argue that changing monetary policy to NGDP targets is sufficient. My own view is less optimistic. A clear advantage of NGDP targets (and not its only advantage) is that they would create expectations of a more expansionary policy during and after the recovery phase from a recession, but in my view this would not be enough to prevent liquidity traps happening. This is because I see the problem of the liquidity trap (nominal interest rates being unable to fall below some lower bound around zero) as central to why the Great Recession was so prolonged, and episodes where we experience a liquidity trap as becoming more frequent because the inflation target (explicit, or implicit within the NGDP target) is low.

Raising the inflation target is an obvious way of reducing the frequency of liquidity traps. If the natural real interest rate is 2%, for example, then with a 4% inflation target, the nominal interest rate has much further to fall before the lower bound is reached than if the inflation target was 2%. It is important to note that this argument does not preclude adopting a NGDP target, because any target path for NGDP includes an implicit inflation target. For that reason, you can view NGDP targets and a higher inflation target as either complementary or alternatives, where the latter is true only if you think one device does the required job by itself.

Helicopter money is essentially giving the central bank an additional instrument - a form of fiscal stimulus. In that sense it is rather different from NGDP targets or a higher inflation target, because it involves instruments rather than the objectives of monetary policy. For that reason, in principle it could be a complement to both the other radical suggestions. In a way helicopter money is best seen as an alternative to Quantitative Easing, and there is no reason in principle why QE is not compatible with NGDP targets or a higher inflation target. It is possible of course that if helicopter money was shown to be effective in dealing with liquidity traps, then it would make the case for other radical changes less compelling.

If I’m being realistic, I think that if the first sentence of this post turns out to be true, the chances of any of these radical changes being adopted before the next liquidity trap episode are very small. A period of strong growth will be sufficient for policy makers to pretend that the slow recovery from the financial crisis was either a one-off or the best that could be done in the circumstances. Instead I suspect that as the economy moves ever closer to its pre-crisis trend, the demand group of economists will convince more of the supply group that they were wrong. This will give greater credibility to the idea that radical changes to policy are required, and each alternative will receive greater analysis and probably greater support amongst economists by the time the next liquidity trap episode occurs. 

The Divine Coincidence in a parallel universe

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

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

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

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

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

   

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

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

Asymmetries and Uncertainties

This post starts off talking about the UK, but goes on to make more general points about why we may have wasted resources on a huge scale over the last five years, and why this waste may be continuing.

I presented my new National Institute Economic Review paper on the macroeconomic record of the UK Coalition government yesterday, and reaction mainly focused on my conservative estimates of the cost of the move to austerity in 2010 and 2011: a cumulated loss of 5% of GDP or £1500 for each adult and child. The basis for those figures is outlined here, and their conservative nature comes from taking OBR estimates for the impact of fiscal contraction, and assuming (rather improbably) that the output lost through austerity was entirely recovered by 2013.

The key issue with numbers of this kind involves monetary policy. Some argue that without austerity monetary policy would have been more contractionary: the ‘offset’ argument. Of course some of the large increase in UK inflation in 2011 was the direct result of austerity: the VAT increase is the obvious example. In addition, the inflation of 2011 was not foreseen in 2010, so it does not alter the fact that austerity was a policy mistake, but just influences any calculation of the size of the mistake.

The paper addresses the offset argument. I use Bank of England forecasts to suggest that monetary policy was not able to hit its target for forecast inflation for much of this period, implying that the Zero Lower Bound (ZLB) constraint was biting. If the ZLB constraint bites, there will be no offset. Not surprisingly, when that target for expected inflation was not met, the Quantitative Easing programme was expanded. There was only a brief period in 2011 when this was not true, which was the period in which 3 out of 9 MPC members voted to increase rates. So if we had not had 2010 austerity, then at most interest rates might have begun rising in 2011, which given lags might have reduced GDP to some extent that year. But crucially the OBR numbers that I use already embody some monetary offset, because they are based on empirical estimates of average multipliers over the past. To use these OBR numbers and then do some monetary offset involves double counting.

However, I want to stay with my ‘no austerity’ counterfactual to make a more fundamental point. If interest rates had been raised in 2011, and this had reduced GDP in 2011 and 2012, we would now be talking about the MPC’s 2011 mistake, rather than the government’s 2010 mistake. I would be calculating how much GDP had been wasted in 2011 and 2012 as a result of premature monetary tightening. I would be right to do so, because the costs of delaying a recovery from a deep recession dwarf any benefits from reducing inflation a bit following a commodity price shock.

This indicates a fundamental problem, which policymakers have still not taken on board. For whatever reason (resistance to nominal wage cuts being the most obvious), inflation ceases to be a good indicator of underutilised resources when inflation starts off low and we have a major negative demand shock. Policymakers are continuing to make this mistake today: core inflation is not too far away from target, and growth is quite healthy, so it is OK to do nothing (or in the Eurozone, it is OK to wait for ages before doing anything). However it seems quite possible that GDP continues to be quite a few percentage points below where it could be without inflation exceeding its target, so we continue to waste resources on a huge scale. This is money down the drain that we will never get back. It is like taxing households thousands of pounds or dollars or euros a year and burning that money.

One way to put this point is to go back to the basic rationalisation behind flexible inflation targeting. It is OK to have a target based on inflation alone, with no mention of the output gap, because you cannot in the long run keep inflation at target without also keeping the output gap at zero. This is sometimes called the divine coincidence. However if, at low inflation rates, inflation becomes a noisy, weak and asymmetric indicator of the output gap, then focusing on inflation is going to perform badly. In these circumstances it could be many years before it becomes clear that we have been continually running the economy under capacity, and needlessly wasting resources. Unfortunately even when that point of realisation arrives, for obvious reasons monetary policymakers are going to be reluctant to acknowledge the mistake.

Why below target inflation is a big problem

Much of the coverage of deflation seems to miss the key point. Deflation is a sign that resources are being wasted. The lower inflation is, other things being equal, the more resources are being wasted. Wasted resources are probably a bit economics speak. What it means is that society as a whole - you and I - are worse off for no reason. There are also good grounds for thinking the sums involved could be very large, dwarfing the numbers the media normally frets about. [1]

Once you look at it this way, lots of rather silly debates become clear. First and most obviously, there is nothing magic about the number zero. Other things being equal, zero inflation suggests more resources are being wasted than if inflation is 1%, but resources are still being wasted when inflation is 1% and the target is 2%.  

Economists have worried about some of the knock on effects that deflation might have. In particular, because deflation means that the real value of debts fixed in nominal terms is rising, that may induce debtors to cut back spending, with no matching increase in spending by creditors. This will make the waste of resources worse. However this effect is not a non-linear one that kicks in when inflation is zero. If this effect is important, debtors will still be more inhibited by their debt if inflation is 1% compared to 2%. And, of course, even if this effect is unimportant resources are still being wasted if inflation is below target.

This is also why looking at some measure of core inflation is important. If below target inflation is just due to lower oil prices, say, which in turn are just lower because of increased supply, say, [2] then this is no reason to think resources are being wasted. Just as inflation targeting central banks should largely see through any inflation caused by higher oil prices, they should also do the opposite. However in the UK, US and Eurozone core inflation is significantly below target, suggesting resources are being wasted everywhere.

The really interesting thing about the current situation is that in all three places nominal wages seem to be going nowhere fast. This could be partly because plenty of domestic spare capacity exists, but partly also because workers are aware of the potential employers have to use overseas labour as an alternative. In either case, the really good news that this implies is that we can allow the economy to grow at an above average rate for some time. (It also suggests that current fiscal projections may be too pessimistic.)

This is only good news if we take the opportunity it presents. We should use the monetary and fiscal tools we have at our disposal (and invent some new ones if need be) to do so. There is no magic to raising demand - we have various tried and tested means of doing so. The basic barrier to raising demand has been and always will be inflation, so when that barrier is nowhere in sight (in fact appears to be moving further away) it is a criminal waste not to expand demand.

But what of those who advocate caution. We should raise interest rates now, so as to avoid rapid increases later? I am sure some people who argue this way are genuine, but just wrong because they have not realised the implications of the position we are now in, and in particular the balance of risks involved. But I cannot also help noticing that some on the right have been arguing for higher interest rates for some time, and refuse to admit they were wrong. They are confirming Kalecki’s idea that although what he called full employment was good for society, it may not be good for some particular parts of society. Those pursuing this line should not be dismissed: they should be laughed into obscurity.   

[1] This would be clearer if all central banks had a dual mandate.

[2] Which in the current situation is probably not true, so this is just to make the point.