No spring in the UK air

I was not going to write anything about the non-event of Hammond’s Spring statement, in part because I confess I am tired of writing about the Conservative party’s hopeless macroeconomic policy. It is like being forced to second mark all the fails from a first year economics exam. There is a danger that if you keep on writing things like ‘the government is not like a household’ and ‘pro-cyclical policy is a mistake’ your writing becomes illegible or you start writing everything in capital letters. I can sense Chris Dillow is also running out of patience, 

So this time I will ignore macroeconomics and write instead about political economy and distribution. The political economy of modern Conservatism is extreme laissez faire in the following sense. The belief is that if you let businessmen (they are usually men) get on with things, and take away red tape, regulations, and reduce taxes, all will be well. There is no need to help with public sector investment and R&D initiatives, or worry about rent extraction: the private sector can always do things better itself. The public sector does not support the private sector, but just gets in the way. An obvious consequence is that the Chancellor is reduced to a glorified bookkeeper, and political success comes with balancing the books and shrinking the state

The results of this approach have been disastrous. This laissez faire experiment took place in the most favourable of circumstances: a recovery from a very deep recession which if history is any guide should have seen rapid growth. The result has been the slowest recovery for as long as anyone can remember. This chart from the Resolution Foundation shows this clearly.

The economic approach of those on the right of politics has therefore failed, and failed big. 

Perhaps it has been unlucky. Perhaps for some as yet unexplained reason the financial crisis has doomed the subsequent recovery. Perhaps the tepid recovery is a consequence of the particular mistakes of austerity and Brexit rather than a reflection of the overall laissez faire approach. That debate has begun in progressive circles, but in the mainstream media and among Conservative politicians we still hear talk of ‘strong and stable’. It is as if everyone is living in a postmodern world where the economy can be whatever government politicians wish it to be.

I have talked in the past about how this fiction of a strong economy can be sustained despite being obviously false. I argued that this deceit won the Conservatives the 2015 election. But I think there is another factor I have not mentioned before, and that is how the burden of austerity has been spread.

This chart from the IFS tells us all we need to know. On the horizontal axis are income deciles, with the richer to the right. On the vertical axis is the loss (or small gain) as a result of fiscal measures. The grey line shows what happened under the Coalition government. Austerity hit the poor most, but the richest also lost income. Austerity under a Conservative government, either already under way or (mostly) planned, hits the poor most and actually slightly benefits the ‘almost rich’.

We can say quite clearly, and without caveats, that the poor have born the brunt of austerity in terms of income gains or losses. In that sense we have not, and nor will we be, all in this together. Jonathan Portes estimates these changes will increase child poverty by 1.5 million over the next 5 years. Since Margaret Thatcher, Conservative governments have been and continue to be regressive (transferring money from the poor to the rich) and have increased poverty.

This chart also tells us how we can have political commentators talking about the end of austerity. Political commentators are secure in the upper half of the income distribution. For them, austerity has indeed come to an end. But for those who are working class, poor or left behind austerity is very far from over. No wonder they say “that’s your GDP, not ours” when real wages have been steadily falling yet political commentators let government politicians get away with talking about a strong economy.

Austerity has hit and will continue to hit those who can least bear it, but it has had very little impact on your average Conservative party member, or your average political commentator working for the BBC. This government has not just continued where Mrs Thatcher left off in dividing this country by class, but it has also divided it by age and divided it once again over Brexit. We may have just had the spring statement, but the country is still in the winter of its discontent.   

Confidence as a political device

Some technical references but the key point does not need them

This is a contribution to the discussion about models started by Krugman, DeLong and Summers, and in particular to the use of confidence. (Martin Sandbu has an excellent summary, although as you will see I think he is missing something.) The idea that confidence can on occasion be important, and that it can be modelled, is not (in my view) in dispute. For example the very existence of banks depends on confidence (that depositors can withdraw their money when they wish), and when that confidence disappears you get a bank run.

But the leap from the statement that ‘in some circumstances confidence matters’ to ‘we should worry about bond market confidence in an economy with its own central bank in the middle of a depression’ is a huge one, and I think Tony Yates and others are in danger of making that leap without justification. Yes, there are circumstances when it may be optimal for a country with its own central bank to default, and Corsetti and Dedola (in a paper I discussed here) show how that can lead to multiple equilibria.

But just as Krugman wanted to emulate Woody Allen, I want to as well but this time pull Dani Rodrik from behind the sign. In his excellent new book (which I have almost finished reading) Rodrik talks about the fact that in economics there are usually many models, and the key question is their applicability. So you have to ask, for the US and UK in 2009, was there the slightest chance that either government wanted to default? The question is not would they be forced to default, because with their own central bank they would not be, but would they choose to default. And the answer has to be a categorical no. Why would they, with interest rates so low and debt easy to sell.

The argument goes that if the market suddenly gets spooked and stops buying debt, printing money will cause inflation, and in those circumstances the government might choose to default. But we were in the midst of the biggest recession since the 1930s. Any money creation would have had no immediate impact on inflation. Of course their central banks had just begun printing lots of money as part of Quantitative Easing, and even 5 years later where is the inflation! So once again there would be no chance that the government would choose to default: the Corsetti and Dedola paper is not applicable. (Robert makes a similar point about the Blanchard paper. I will not deal with the exchange rate collapse idea because Paul already has. A technical aside: Martin raises a point about UK banks overseas currency activity, which I will try to get back to in a later post.)

Ah, but what if the market remains spooked for so long that eventually inflation rises. The markets stop buying US or UK debt because they think that the government will choose to default, and even after 5 or 10 years and still no default the markets continue to think that, even though they are desperate for safe assets!? In Corsetti and Dedola agents are rational, so we have left that paper way behind. We have entered, I’m afraid, the land of pure make believe.

So there is no applicable model that could justify the confidence effects that might have made us cautious in 2009 about issuing more debt. There are models about an acute shortage of safe assets on the other hand, which seem to be ignored by those arguing against fiscal stimulus. Nor is there the slightest bit of evidence that the markets were ever even thinking about being spooked in this way.

Martin makes the point that just because something has not yet been formally modelled does not mean it does not happen. Of course, and indeed if he means by model a fully microfounded DSGE model I have made this point many times myself. But you can also use the term model in a much more general sense, as a set of mutually consistent arguments. It is in that sense that I mean no applicable model.

Now to the additional point I really wanted to make. When people invoke the idea of confidence, other people (particularly economists) should be automatically suspicious. The reason is that it frequently allows those who represent the group whose confidence is being invoked to further their own self interest. The financial markets are represented by City or Wall Street economists, and you invariably see market confidence being invoked to support a policy position they have some economic or political interest in. Bond market economists never saw a fiscal consolidation they did not like, so the saying goes, so of course market confidence is used to argue against fiscal expansion. Employers drum up the importance of maintaining their confidence whenever taxes on profits (or high incomes) are involved. As I argue in this paper, there is a generic reason why financial market economists play up the importance of market confidence, so they can act as high priests. (Did these same economists go on about the dangers of rising leverage when confidence really mattered, before the global financial crisis?)

The general lesson I would draw is this. If the economics point towards a conclusion, and people argue against it based on ‘confidence’, you should be very, very suspicious. You should ask where is the model (or at least a mutually consistent set of arguments), and where is the evidence that this model or set of arguments is applicable to this case? Policy makers who go with confidence based arguments that fail these tests because it accords with their instincts are, perhaps knowingly, following the political agenda of someone else.     

Political economy assignments

Suppose you have two objectives for monetary policy: financial sector stability and real economy stability. You have two main instruments: interest rates and macroprudential policy (things like changing the capital requirements of banks, or making it less easy to get a mortgage; often called macropru for short). Should you assign one instrument to one objective (often called an assignment), or try and achieve both goals with both instruments?

As Tony Yates points out, assignments are rarely optimal from a purely macro point of view. Even if, say, interest rates are less effective at achieving financial stability than macropru, you would still want interest rates to contribute something to that objective. An exception is when one instrument completely dominates the other: then assignment is optimal. An example of this exception in a certain class of model is monetary over fiscal policy as means to achieve real stabilisation, as discussed here and here (less technical discussion here). But this type of result is unusual, and even when you get a result like this for a certain class of models it is not hard to add real world complications that remove the result.

If assignment in the case of real and financial stabilisation is not optimal, does this imply that those setting interest rates should take financial stability into account? It is important to understand what we are talking about here. We are not talking about how financial conditions might influence what interest rates need to be to achieve real stabilisation, which is the kind of issue discussed in this post by Bianca De Paoli for example. Nor is it talking about allowing for risk as I discussed here. Instead it would be saying that institutions like the US Fed should have a triple mandate when setting interest rates, where the third mandate was financial stability. Interest rates could be changed if financial stability was a concern, even if this had no implications for inflation or output. Equivalently, interest rates could move to help financial stability even if this took output and inflation away from target.

However we already have assignments that are clearly suboptimal from a purely macro perspective. Fiscal policy is assigned to the control of government debt, and reducing debt is certainly not a monetary policy objective. But in standard models this assignment is clearly suboptimal: when debt is high, reducing interest rates can be quite effective in reducing debt (particularly if government debt is mostly short term), and undesirable knock on effects on output and inflation can be countered by fiscal policy. Yet the mainstream consensus is that monetary policy should not be used to reduce debt.

The reason for this suboptimal assignment is most probably because of political economy concerns. Or to put it another way policy is mainly concerned about knowingly sub-optimal decisions. Reducing interest rates to reduce debt sounds too much like fiscal dominance. There is a fear that if there is no institutional assignment, politicians will depart from optimal policy and by keeping rates too low to reduce debt they will allow excessive inflation.

Can such political economy concerns be applied to financial stability and monetary policy, particularly as the same actor - an independent central bank - is in charge of both? My instinct is that it can, because central bankers are heavily influenced by pressures from the financial sector. As a result, there is a danger that if interest rates are set with both objectives in mind, central bankers will depart from optimal policy and, for example, needlessly raise interest rates before the real economy requires them to rise. The recent experience of Sweden is a clear example where this happened. For this reason I rather like the UK institutional set-up, with a separate MPC and FPC and a clear assignment for each.

Why helicopter money is a political economy issue

When we have a recession caused by demand deficiency such that interest rates hit their Zero Lower Bound (ZLB), the obvious response from a macroeconomic point of view is fiscal stimulus. Instead governments have become obsessed by their debt and deficits, and so we have austerity instead.

It is important to understand that this deficit obsession is not a worry about the long run sustainability of government finances. We know this for two reasons. First, if it was only a concern about long run sustainability, there would be little need to act on that concern now (when doing so is so costly), rather than waiting a few years for the ZLB problem to be safely behind us. Indeed, governments should be worried that austerity now could actually damage long run sustainability, because of the hysteresis effects examined by DeLong and Summers (pdf, and note that their arguments could equally be applied to the impact of cutting back public investment even if there was no hysteresis). Second, governments seem happy to cut current deficits using measures that actually detract from long run sustainability (because it worsens their intertemporal budget constraint). Privatisation at give-away prices is an obvious example.

This political economy point is important, because it means that ideas such as Miles Kimball’s alternative to tax cuts - which is to give everyone a fixed period loan - will not be considered because it still increases the current budget deficit, even though long run sustainability is potentially unaffected. The political economy problem is that governments are obsessed with the deficit over the next few years.

From a macroeconomic point of view, there is an obvious way around this deficit obsession, and that is to finance any fiscal stimulus using money rather than debt. In a recession creating money does not create an inflation problem, as we have all seen in the last few years with Quantitative Easing (QE). The problem with this textbook solution (often called money financed fiscal stimulus) is that we have ruled it out by creating independent central banks. Governments cannot create money to finance fiscal stimulus. Central banks are creating money - lots of it - but can only use that to buy assets. Whatever political economy problem independent central banks have helped to solve, they have restricted our policy options in what has turned out to be a very serious way.

Helicopter money is the obvious solution to this. But it raises a potential problem. Helicopter money describes a means by which central banks can put money into the system in an effective (reliably demand expanding) way, but that process is not reversible. No one is proposing that a central bank can take money away from every citizen. So what happens, once the recession is over, if the central bank wants to reduce the amount of money in the system?

This, as Eric Lonergan and Cecchetti & Schoenholtz explain, is the only reason why the central bank’s balance sheet matters. If it runs out of assets to sell, its ability to take the money out of the system that it put in with its helicopter is reduced. This problem is not new. It has already occurred with potential losses arising from QE. In the UK, the central bank has dealt with that problem by getting the Treasury to cover these losses, if they arise. There are many things that the central bank could do if it ever runs out of assets to sell as a result of implementing helicopter money, but the most straightforward is to generalise this arrangement. Governments should commit to providing central banks with the assets they need to control inflation.

Making ‘fiscal backing’ of central banks explicit also indicates a contingent liability for governments. Helicopter money creates a contingent liability, and in doing so worsens the expected value of their long run budgetary position. But as we have seen, this is not the major concern for governments. The UK government did not object to QE because it created a contingent liability for them. All that mattered is that it did not raise projected deficits over the next few years.

While Eric Lonergan says central banks need not worry about their balance sheets, Cecchetti & Schoenholtz say that they are right to do so, for political rather than economic reasons. A poor balance sheet, which might make the central bank dependent on the government, compromises its independence. I think this argument is very weak. It imagines that central bank independence is about protecting the public from a government of nightmares that actively wants high inflation. As I argued here, a government that wants high inflation will not let an independent central bank get in its way. It is also ironic that central banks still worry about profligate inflationary governments when our problem is governments that put current fiscal probity above everything else, including the health of the economy. The combination of a government that is obsessed with its current deficit and a central bank that is obsessed with hypothetical future inflation is a dangerous mix.