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.

Negative rates, helicopter money and the Bank of England

Yesterday Mark Carney said he was against negative interest rates and helicopter money, but in reality he implemented a way of doing a version of both. Let me explain.

When negative interest rates are discussed, we normally think about savers, and the fact that they could avoid being charged to deposit money in a bank by hoarding cash. But borrowers would have no problem with negative rates: borrow £1000, and just pay back £990. The bank they borrowed from would have, unless there were negative rates on savings or they were getting a subsidy to lend.

Helicopter money is normally thought of as the central bank sending a cheque to every citizen. But the key point for economists is not the way the money is distributed, but the fact that it is created by the central bank and given away in return for nothing. (QE involves creating money to buy assets.) Who the money goes to is of course important, but it is not really the defining characteristic of the measure.

We normally think about monetary policy as changing the interest rate. If rates are cut, that benefits borrowers but is bad for savers. But suppose the central bank gave money to private banks, on condition that this money was passed on in the form of lower rates to borrowers. If it did this, but did not change the interest rate, that would be helping borrowers but not hitting savers. The Bank introduced such a scheme yesterday, called the Term Funding Scheme (TFS). What is more, this subsidy for borrowers is financed by creating money. Eric Lonergan argues that the ECB is doing something similar, and if there is any insight in this post I owe it to him (but if there isn’t it is my fault not his!).

So if you think the Bank has ruled out negative rates, you are half wrong. In principle the Bank can expand TFS to make borrowing as cheap as it likes, which could even mean negative interest rates for borrowers. If you think the Bank has ruled out helicopter money, you are half wrong. It is creating money to give away with nothing in return, but just giving the money to one particular group: borrowers.

Now if you are a saver you might say why cannot I rather than borrowers benefit from this money give away. But the Bank could argue that without TFS it would have to reduce the interest rate by even more than it has, which would make savers a lot worse off. So compared to that outcome, you are better off. Whether you find that convincing when you can always hold cash depends on the cost of holding cash.

So why did Mark Carney say that helicopter money was a flight of fancy, when he was in fact doing something quite similar? It is a good question to ask him. I suspect the real answer is that TFS looks like the kind of thing a central bank does, but giving money to every citizen looks like fiscal policy. But what it does mean is that in terms of the basic macroeconomics, the Bank of England is now doing helicopter money. But if you are neither a borrower or a saver and feel aggrieved you are not getting anything, you know who to complain to.

Its ideology, stupid

Wolfgang Münchau takes to task in today’s FT the latest example of German opposition, and in particular opposition from finance minister Schäuble, to ECB policies. However I think he ends up missing the obvious target. He discusses the particular problems negative rates pose for Germany’s financial sector, and in his last paragraph writes

“This episode is a reminder that the collective spirit that was so strongly present in the first years of the eurozone has gone. That — not the presence of imbalances or other technical problems — constitutes the single biggest danger to the long-term viability of Europe’s monetary union.”

I would suggest this has the causality wrong. Any collective spirit has gone because of these ‘technical problems’. The biggest technical problem is an obsession with inappropriate collective fiscal consolidation (austerity). In the Eurozone the ECB is being forced to try negative interest rates because it is having to undo the impact of fiscal consolidation. And the man most responsible for this obsession is Schäuble.  

Gavyn Davies nicely sums up my own view about negative interest rates. Without radical institutional and social changes (which may not be desirable), bank profitability puts a limit on how far central banks can go, and for that reason exploring these frontiers could be counterproductive. But the alternative of more QE, possibly directed at other assets besides government debt, is way down the list of effective and reliable instruments for managing aggregate demand right now. Helicopter money is a much better way of giving central banks more ammunition. But the focus right now should not be on any of this, if we are genuinely concerned about social welfare. As John Kay says, “we need less financial ingenuity and more common sense”.

What we should be talking about is why governments are not doing much more public investment. Yet in the US, Germany and the UK any dramatic increase in public investment seems out of the question. Barry Eichengreen, in an article entitled “Confronting the Fiscal Bogeyman”, writes of Germany:

“The ordoliberal emphasis on personal responsibility fostered an unreasoning hostility to the idea that actions that are individually responsible do not automatically produce desirable aggregate outcomes. In other words, it rendered Germans allergic to macroeconomics.”

In the US, antagonism to the Federal government rooted in the past has meant Republican leaders are  

“antagonistic to all exercise of federal power except for the enforcement of contracts and competition – a hostility that notably included countercyclical macroeconomic policy. Welcome to ordoliberalism, Dixie-style. Wolfgang Schäuble, meet Ted Cruz.”

He ends

“Ideological and political prejudices deeply rooted in history will have to be overcome to end the current stagnation. If an extended period of depressed growth following a crisis isn’t the right moment to challenge them, then when is?”

He does not mention the UK, where the antagonism to public investment seems to lack any deep historical explanation, and may just reflect stupidity or an ideology imported from the US.

When I talk about public investment people normally think about big projects, like HS2 in the UK. I like to point out that simpler and perhaps more boring things, like repairing roads, are at least as important, and can be done immediately. But if there is one area above all else where much more needs to be done right now it is investment in renewable energy.

The recent news on climate change is not good. It is foolish to read too much into one or two months figures, but this chart is nevertheless quite scary. It is scary because we know of various possible ‘tipping points’ (like the melting of all Arctic ice or the mass release of methane from permafros) which could accelerate global warming. Most climate models assume we will control carbon emissions in time to stop that happening, but we cannot be sure of that, because we are in uncharted territory.

We know we need a massive expansion of renewable energy, but one problem that has so far stopped that being a complete solution to climate change has been that sometimes the wind neither blows nor the sun shines. We need to be able to cheaply store electricity, but our current battery technology is not good enough. Battery technology is also crucial in making electric cars as attractive as petrol based cars. But technology could come to the rescue. Existing batteries could be made much more efficient, or completely new battery technologies could be made viable. Much more efficient transmission could also help. And if you look at all three links, you may notice one common factor. These potential breakthroughs have all come from research undertaken in the public sector. As Mariana Mazucato has argued, the state is “better able to attract top talent and pursue radical innovation”.   

China put over $80 billion into the renewable energy sector in 2014. That is nearly 1% of its GDP. It has committed to spend 25 times that amount over the next 15 years on clean energy. Both the US and Europe spent much smaller amounts ($38 and $58 billion respectively), even though their economies are much larger (the US figure is around 0.07% of its GDP). In dollar terms, the Chinese government also spent more on Green R&D than Europe or the US. [1] The scope for US and European governments to spend more on researching and help with developing green technology is huge. Yet in the UK the government has recently cut back its support for renewable energy, even though the UK’s need for renewable energy is urgent.

Climate change may be the most important example, but it is not alone. It is absurd that when the potential for technological change leads people to write about robots taking over, actual productivity growth is slowing everywhere. As an IMF report says, "innovation [is] highly dependent on government policies." I think Brad DeLong, in commenting on Eichengreen’s article, has it exactly right when he writes “it is long past time for a frontal intellectual assault on the[se] dangerous and destructive ideologies”.   

 

[1] If we include corporate R&D, Europe moves ahead of China in $ spend, but China is still ahead of the US.       

The 'strong case' critically examined

Perhaps it was too unconventional setting out an argument (against independent central banks, ICBs) that I did not agree with, even though I made it abundantly clear that was what I was doing. It was too much for one blogger, who reacted by deciding that I did agree with the argument, and sent a series of tweets that are best forgotten. But my reason for doing it was also clear enough from the final paragraph. The problem it addresses is real enough, and the problem appears to be linked to the creation of ICBs.

The deficit obsession that governments have shown since 2010 has helped produce a recovery that has been far too slow, even in the US. It would be nice if we could treat that obsession as some kind of aberration, never to be repeated, but unfortunately that looks way too optimistic. The Zero Lower Bound (ZLB) raises an acute problem for what I call the consensus assignment (leaving macroeconomic stabilisation to an independent, inflation targeting central bank), but add in austerity and you get major macroeconomic costs. ICBs appear to rule out the one policy (money financed fiscal expansion) that could combat both the ZLB and deficit obsession. I wanted to put that point as strongly as I could. Miles Kimball does something similar here, although without the fiscal policy perspective

Of course many macroeconomists do see the problem, but the solutions they propose are often just workarounds. Things like Quantitative Easing, or NGDP targets, or a higher inflation target. [1] None completely remove the basic difficulty created by the ZLB. (One proposal that does is negative interest rates coupled with eliminating paper money, which I will come back to.) As a result, these workarounds mean that in response to a sharp enough recession, we would still regret no longer having the possibility of undertaking a money financed fiscal stimulus.

I also think there is a grain of truth in the argument that ICBs created an environment where deficit obsession became easier. Take the UK for example. In the 2000s the organisation that came to dominate budget analysis was the IFS. They are excellent on both the microeconomics of particular budget measures and their costing. Before the Great Recession that meant that all the IFS needed was a macro forecast (of which there are many) and they had all they required to provide excellent budget analysis. The IFS did not have strong macro policy expertise, and sometimes this shows, but as long as the consensus assignment worked that did not matter.

One of the those working at the IFS during this Labour government period was Rupert Harrison. In 2006 he became chief of staff to George Osborne. He helped introduce, perhaps reflecting his IFS experience, two important and positive policy innovations: setting up the OBR (with some minor assistance from a certain UK academic), and a form of fiscal rule (a five year deficit target) which allowed debt to be a shock absorber. But he also appeared to bring the received wisdom on the consensus assignment untroubled by the ZLB, which meant that Osborne could give a speech in 2009 outlining the macroeconomic basis of his strategy in which the ZLB was not mentioned.

This is an example of a more general point, which Robert in comments reminded me I could have made to strengthen the strong argument still further. With ICBs, macroeconomic expertise can move from finance ministries to central banks, leaving finance ministries unprepared for what they may need to do in a major recession.

But this grain of truth runs up against a real difficulty, which is the major flaw in the ‘strong argument’ I set out in the earlier post. To see the flaw ask the following question: in the absence of ICBs, would our deficit obsessed governments actually have undertaken a money financed fiscal stimulus? To answer that you have to ask why they are deficit obsessed. If it is out of ignorance (my Swabian syndrome), then another piece of macro nonsense that ranks alongside deficit obsession is the evil of printing money in any circumstances. I suspect a patient suffering Swabian syndrome would also be subject to this fallacy. If the reason is strategic (the desire for a smaller state) the answer is obviously no. We would simply be told it could not be done because it would open the inflation floodgates.

Following my grain of truth idea you might counter that without ICBs the knowledge within or outside government that these excuses were without foundation would be greater, and so governments could not get away with them so easily. But you would still have plenty of economists from the financial sector telling you that not only did you need to reduce debt rapidly to appease the markets, but also that any government printing money would scare the markets even more. Indeed, would governments alone have had the courage to undertake the scale of QE that we have seen ICBs undertake?

As for the argument that macroeconomic expertise gets concentrated in central banks, surely the answer here is to allow that expertise into the public domain by making central banks more open, and to directly combat the forces that make some central bank leaders routinely argue for austerity when they can no longer effectively combat deflation.

The basic flaw with my strong argument against ICBs is that the ultimate problem (in terms of not ending recessions quickly) lies with governments. There would be no problem if governments could only wait until the recession was over (and interest rates were safely above the ZLB) before tackling their deficit, but the recession was not over in 2010. Given this failure by governments, it seems odd to then suggest that the solution to this problem is to give governments back some of the power they have lost. Or to put the same point another way, imagine the Republican Congress in charge of US monetary policy.

But if abolishing ICBs is not the answer to the very real problem I set out, does that mean we have to be satisfied with the workarounds? One possibility that a few economists like Miles Kimball have argued for is to effectively abolish paper money as we know it, so central banks can set negative interest rates. Another possibility is that the government (in its saner moments) gives ICBs the power to undertake helicopter money. Both are complete solutions to the ZLB problem rather than workarounds. Both can be accused of endangering the value of money. But note also that both proposals gain strength from the existence of ICBs: governments are highly unlikely to ever have the courage to set negative rates, and ICBs stop the flight times of helicopters being linked to elections.

      

These are big (important and complex) issues. There should be no taboos that mean certain issues cannot be raised in polite company. I still think blog posts are the best medium we have to discuss these issues, hopefully free from distractions like partisan politics.  

   

[1] Please do not misunderstand what I mean by workarounds. The workaround may be still be useful in its own right (I have argued that monetary policy should be guided by the level of NGDP), but it does not completely remove the problem of the ZLB.