Correcting Eurozone Imbalances

I have been thinking about the extent to which real exchange rate misalignment within the Eurozone (essentially most countries have lost competitiveness with Germany) requires austerity outside Germany. I have argued that a much tighter fiscal policy (austerity) outside Germany would have been a good idea before 2007 to prevent these imbalances occurring in the first place. However that does not necessarily imply it is required now, for two reasons. First, misalignment is eventually self-correcting, as less competitive countries sell less goods etc. Second, perceived debt risk which is driving up long term interest rates provides an additional deflationary force in many of these uncompetitive countries.

                This question is essentially a forecasting issue, so I looked at the OECD Economic Outlook forecasts. The table below comes from there. It contains a bit of a puzzle. If you look at unemployment rates, you see just the kind of pattern you would expect if correction was underway (except perhaps for Italy). German unemployment is way below the Eurozone average,  and the German average level in the decade before the recession, whereas the opposite is true for Ireland and Spain. The OECD’s calculation of the output gap tells the same relative story: everyone is below the non-inflationary level of output, but Germany by not that much, and Ireland and Spain by much more.

                If we look at inflation, however, we get a much more depressing story. Take the GDP deflator (the price of domestically produced output) for example. Inflation in Ireland is less than 1% below Germany, and that is the most favourable comparison. The signs of real exchange rate correction are weak.  

                There are two possibilities here. One possibility is that these inflation forecasts are way too conservative. In particular, low unemployment in Germany will lead to more rapid inflation than is forecast here. The alternative story is that the inflation forecasts are broadly correct, and they illustrate both the difficulty in getting inflation down outside Germany when it is so close to zero, and the difficulty in getting inflation up in Germany when its economy remains depressed. In particular, if the output gap number is right, then it is hard to see German inflation rising much above 2%. 

	Unemployment (%)				Output Gap	Ave Forecast Inflation % 2011-13
	1998-2007	2011	2012	2013	2011-13	Compensation	GDP	Consumer prices
Eurozone	8.6	10.1	10.4	10.1	-3.2%	2.1	1.3	1.8
Germany	8.8	5.7	5.7	5.4	-1.2%	2.4	1.1	1.8
Ireland	4.8	14.2	14.0	13.4	-7.1%	1.7	0.4	0.9
Spain	10.6	22.5	23.0	22.4	-5.7%	1.9	0.8	1.8
Italy	8.7	8.1	8.4	8.7	-2.3%	2.1	1.4	1.8
France	8.8	9.4	9.9	9.8	-4.2%	2.6	1.3	1.5

Mistakes and Ideology in Macroeconomics

Imagine a Nobel Prize winner in physics, who in public debate makes elementary errors that would embarrass a good undergraduate. Now imagine other academic colleagues, from one of the best faculties in the world, making the same errors. It could not happen. However that is exactly what has happened in macro over the last few years.

                Where is my evidence for such an outlandish claim? Well here is Nobel prize winner Robert Lucas

But, if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder -- the guys who work on the bridge -- then it's just a wash.  It has no first-starter effect.  There's no reason to expect any stimulation.  And, in some sense, there's nothing to apply a multiplier to.  (Laughs.)  You apply a multiplier to the bridge builders, then you've got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. 

And here  is John Cochrane, also a professor at Chicago, and someone who has made important academic contributions to macroeconomic thinking.

Before we spend a trillion dollars or so, it’s important to understand how it’s supposed to work.  Spending supported by taxes pretty obviously won’t work:  If the government taxes A by $1 and gives the money to B, B can spend $1 more. But A spends $1 less and we are not collectively any better off.

Both make the same simple error. If you spend X at time t to build a bridge, aggregate demand increases by X at time t. If you raise taxes by X at time t, consumers will smooth this effect over time, so their spending at time t will fall by much less than X. Put the two together and aggregate demand rises.

                But surely very clever people cannot make simple errors of this kind? Perhaps there is some way to re-interpret such statements so that they make sense. They would make sense, for example, if the extra government spending was permanent. The only trouble is that both statements were made about a temporary fiscal stimulus package. Brad DeLong tries very hard along these lines (see here for example), but just throws up inconsistencies.

                I prefer to just note that if any undergraduate or graduate student in the UK wrote this in an exam, they would lose marks. The more interesting question for me is why the errors were made. Of course everyone is human, including the best economists. (And if they were not among the very best economists, I would not be talking about these errors in a blog.) You get to be a brilliant economist or physicist by having great ideas, not by never making mistakes. But I think it is still the case that we cannot imagine members of a physics department making such errors. What is different about macro?

I want to suggest two answers. The first is familiarity with models. I cannot imagine anyone who teaches New Keynesian economics, or who talked to people who teach New Keynesian economics, making this mistake. This is because, in these models, we do have to worry about aggregate demand. We focus on consumption smoothing, and Ricardian Equivalence, and teach it from the start. I often tell my first year undergraduate students that if they write anything like ‘Ricardian Equivalence says fiscal stimulus will never work’, they are in danger of failing.

Lack of familiarity does not necessarily imply believing something is wrong. In a separate piece, Cochrane writes 

“New-Keynesian” thought is devoted to defending the importance of monetary policy, and incorporating specific frictions in the equilibrium tradition, not to rescuing the ancient view that fiscal stimulus is important and abandoning that tradition.  

This is broadly true for New Keynesian theory when monetary policy is unconstrained (see Kirsanova, T, Leith, C and Wren-Lewis, S (2009), Monetary and Fiscal Policy Interaction: The current consensus assignment in the light of recent developments, Economic Journal, Vol 119) but not when interest rates are stuck at a lower bound. Cochrane is not saying New-Keynesian theory is wrong, but implies incorrectly that it suggests fiscal stimulus will not work.

                Lack of familiarity with New Keynesian economics may be partly explained by the history of macroeconomic thought that I briefly noted in an earlier post. As New Keynesian theory is an ‘add-on’ to the basic Ramsey/RBC model, it is possible to teach macro without getting round to teaching New Keynesian theory. However, what many people find difficult to understand is how monetary policy (or at least monetary policy as seen by pretty much every central bank) could be regarded as an optional add-on in macroeconomics.

                The second difference between physics and macro that could lead to more mistakes in the latter is ideology. When you are arguing out of ideological conviction, there is a danger that rhetoric will trump rigour. In the next paragraph Cochrane writes

These ideas changed because Keynesian economics was a failure in practice, and not just in theory. Keynes left Britain 30 years of miserable growth. Richard Nixon said, “We are all Keynesians now,” just as Keynesian policy led to the inflation and economic dislocation of the 1970s--unexpected by Keynesians but dramatically foretold by Milton Friedman’s 1968 AEA address. Keynes disdained investment, where we now all realize that saving and investment are vital to long-run growth. Keynes did not think at all about the incentives effects of taxes. He favored planning, and wrote before Hayek reminded us how modern economies cannot function without price signals.   Fiscal stimulus advocates are hanging on to a last little timber from a sunken boat of ideas, ideas that everyone including they abandoned, and from hard experience.  If we forget all that, we could repeat the economics of postwar Britain, of spend-and-inflate Latin America, and of bureaucratic, planned India.

Let’s not worry about where the idea that Keynes disdained investment comes from, or any of the other questionable statements here. This is just polemic: Keynes=fiscal expansion=planning=macroeconomic failure.  It is guilt by association. What on earth does fiscal expansion have to do with planning? Well, they are both undertaken by the state.

I have argued elsewhere that the problem too many macroeconomists have with fiscal stimulus lies not in opposing schools of thought, or the validity of particular theories, or the size of particular parameters, but instead with the fact that it represents intervention by the state designed to improve the working of the market economy. They have an ideological problem with countercyclical fiscal policy. But the central bank is part of the state, and it intervenes to improve how the economy works, so this ideological view would also mean that you played down the role of monetary policy in macroeconomics. So ideology may also help explain a lack of familiarity with the models central banks use to think about monetary policy. In short, an ideological view that distorts economic thinking can lead to mistakes. 

Executive Pay: acknowledging market failure

David Cameron was on the BBC this morning talking about the excesses of executive pay. What I liked about what he said was his clear identification of the problem as market failure. We do not hear this phrase enough in public discourse – indeed the BBC in the linked report puts market failure in quotes! It was good to hear a Conservative Prime Minister saying it too. (Perhaps having a PPE degree helped!)

                I remember naively saying after the credit crunch that at least it would put an end to the idea that markets always work, and that regulation was always unnecessary. We would instead, I hoped, have a more intelligent discussion that acknowledged market failures and focused on the best ways of dealing with them. That did not seem to happen. In part that is because the right wing think tanks that are paid to spin the ‘markets always know best/state intervention is always bad’ line carried on getting their funding. But what should have happened is that this line lost credibility because someone would immediately reply with the knock out ‘you mean like financial markets’. I’m not quite sure why this didn’t happen.

                Whether the measures the government is due to announce will have any impact on executive pay is another matter. The Prime Minister talked about transparency, and shareholder power. I'm not sure strengthening either will have much impact. This is because it remains unclear exactly what the source of market failure is, and why it should have become so much more important in the last few decades. (Or perhaps the market failure was always there, and the other forces that used to restrain excessive executive pay have withered.) A key piece of evidence is that these trends have differed a lot among countries, as this wonderful database indicates. (Executive pay and the 0.1% share are not the same thing, but Atkinson, Anthony B., Thomas Piketty, and Emmanuel Saez. 2011. "Top Incomes in the Long Run of History." Journal of Economic Literature, 49(1): 3–71. suggest the former is a major cause of the recent increase in the latter.) Although this paper is full of ideas that could help explain the trends shown below, we are a long way from a comprehensive account.

Conspiracy within conspiracy in Turkey?

We have all seen films where some large network of conspirators plots to overthrow the state. We have also seen films where some arm of the state manufactures evidence against some individuals. There is probably at least one where a journalist uncovers the plot, and then falls victim to the same fabrication. One is a conspiracy against the state, the other is a conspiracy by part of the state.

                The Ergenekon conspiracy in Turkey has to be one of these two. So far hundreds have been arrested as part of this and associated plots, the latest being a former head of the army. Those arrested are not just army officers, but also journalists critical of the government, and academics. The analyst Gareth Jenkins suggests that “not only is the evidence ... deeply flawed, there are also increasing indications that much of it has been fabricated.” In more measured diplomatic language, the EU’s Turkey 2011 Progress Report says (p7)

concerns remain over the handling of investigations, judicial proceedings and the application of criminal procedures putting at risk the rights of the defence. The lack of any authoritative source of information on all these issues of wide public interest from either the prosecution offices or the courts raises similar concerns. All of this raised concerns in the public about the legitimacy of the cases.

Uncivil debate? Harsh words over fiscal policy

Over the last two years there has been a debate through blogs and elsewhere between those who support fiscal stimulus and those who do not. Take Brad deLong’s analysis of this note by John Cochrane for example. To say the debate has been intemperate would be an understatement.  People have complained that one or both sides have been too dismissive of the other (see, for example, Tyler Cowan here.)

                Now I’m the last person to argue that economists are never guilty of unnecessary and off putting aggression and point scoring. However it is quite easy to understand what has happened here. For those in certain freshwater departments like Chicago, for example, the idea of an effective fiscal stimulus was something they had thought had died with the rational expectations and New Classical revolutions of the 1970s. It was therefore something of a shock to see it being resurrected, and it is understandable that they might dismiss it as invoking long discredited ‘fairy tales’. It looked as if 30 years of progress in the discipline was being ignored. It is clear from Cochrane’s piece that he is not dismissing New Keynesian theory – he just thinks New Keynesian theory is all about monetary policy.

                 On the other hand those advocating the effectiveness of fiscal policy knew perfectly well that while New Keynesian analysis certainly did emphasise monetary policy as the stabilisation tool in normal times, in a liquidity trap (or a currency union for that matter) it also implied that certain types of fiscal policy would work as well. In these circumstances, you do not react kindly to having your analysis dismissed as out of date and a fairy tale. (In fact you find it shocking and slightly unbelievable, in my own case.)

                While this may help explain why the debate has been bitter, it does not excuse both sides. Those freshwater economists who suggested that fiscal stimulus at a zero bound was a fairy tale that was not supported by modern macroeconomic analysis were simply wrong. Why such innovative and clever people should make this mistake is interesting, and I’ll return to this later, but wrong they clearly were. If the likes of Krugman and DeLong are guilty of anything, it is that they tried too hard to make sense of what the other side was saying. Perhaps they should have simply said "go away and read the literature". 

Uncertain times in Hungary

Changes to the constitution in Hungary have provoked protests and critical comment. There have also been concerns about media control. I first became aware of the problem over a year ago, when the Hungarian government effectively abolished the newly established Hungarian Fiscal Council.

                As I suggested in a recent post, fiscal councils are a good thing. The webpage I set up for easy links and basic information on the various councils throughout the world was inspired by attending the first ever public conference of virtually all the fiscal councils, organised by George Kopits, then head of the Hungarian Fiscal Council.

                The story of the Hungarian Fiscal Council is told in Kopits, G (2011) “International Fiscal Institutions: Developing Good Practices,” OECD Journal on Budgeting, November (an early version of which can be found here.) It was doing its job effectively, which is to ask important but potentially tricky questions about the government’s fiscal plans. The whole idea of a fiscal council is that it should make life difficult for a government that gives insufficient attention to the longer term consequences of its overall fiscal plans. The Hungarian Fiscal Council did not go out of its way to pick fights with the government: it just did its job. Effective abolition came despite widespread protest by the heads of other fiscal councils and academics. Unfortunately that decision now seems part of a trend.

Some good news for the New Year! Fed to publish interest rate forecasts.

The US Federal Reserve has announced that it will in future publish its own forecasts for interest rates. (The FT report is here.) Among central banks, the pioneering Reserve Bank of New Zealand has published such forecasts for many years, and they were recently joined by the central banks of Sweden and Norway. However most central banks do not.

                Why is this good news? As any good undergraduate economics student will know, many important economic decisions depend not only on today’s interest rate, but also interest rates in the future. Indeed longer term interest rates are in effect a forecast of future short term interest rates. So when a central bank changes short term interest rates, they are only giving the public a part of the information they need. If interest rates are changed, everyone wants to know how long this change will last.

                Central banks often present forecasts for some key macroeconomic variables, such as inflation. They nearly all use forecasts in arriving at their interest rate decisions. These forecasts, by necessity, will contain some assumption about the path of future interest rates. It therefore seems sensible for the central bank to let people know what assumptions it is making in deriving its forecasts. However most central banks have been very reluctant to do this. There are a number of rather silly arguments that have been used to justify this reluctance, but the one that keeps being mentioned is that the public will mistake conditional forecasts for policy commitments. I always thought this insulted the public’s intelligence.

                On the other side, there is a compelling argument for publishing these forecasts. It has the potential to enhance the credibility of central banks. In technical terms this is to do with commitment under time inconsistency. It can perhaps best be explained by a topical example. A number of economists, and particularly the great Michael Woodford, have suggested that one way to reduce the impact of the liquidity trap (the fact that short term interest rates cannot go below zero) is for central banks to announce that once the recovery is underway, they will allow inflation to rise above target for some limited period. Let us call this the ‘excess future inflation policy’. This will mean that interest rates would stay low for longer. The excess inflation policy has an obvious future cost, but the benefit is that it keeps today's long term interest rates lower (because expected future short rates are lower), and it raises expectations about future inflation, which in turn reduces current short term real interest rates. As a result, the recovery should come sooner. (A variant on this idea is to have a nominal income target extrapolated from pre-recession levels: see here for example.)

                Now whether this is a good idea or not, it suffers from a serious implementation problem. Let us suppose it is announced, and that it works. The recovery is quicker as a result. Inflation then begins to rise above target. Now it is tempting for the central bank to reason as follows. The benefits of the excess future inflation policy have been achieved, but the costs are still to come (i.e. excess inflation). Why not change our minds, and say we will not after all allow inflation above target. We get the best of both worlds. Let us call this the temptation to renege on past commitments. Unfortunately smart agents would anticipate that the central bank will give in to the temptation, and so will not believe the excess future inflation policy will ever be implemented. If it is not believed, the benefits will not happen. So to work, the central bank has to have enough commitment credibility so that the public are sure it will not succumb to the temptation to renege.

                If this is too technical, think of a parent who offers sweets to induce good behaviour from a child. Even if the child does behave well, the parent does not give the reward, because sweets are bad for the child. If that happened, the child will no longer believe the parent’s promises. The parent will have lost an important tool to encourage good behaviour. The parent would be better off in the long run keeping their credibility for commitment by giving the child the reward.

                But how does a central bank get a reputation for commitment? Publishing interest rate forecasts could be a very useful tool. This is because a central bank that was avoiding the temptation to renege would follow its own interest rate predictions if no new information arose. More generally, by checking new information against how interest rate decisions changed compared to earlier forecasts, we could try and judge whether the bank was avoided the temptation to renege. But if the central bank does not publish its interest rate forecast, we have no idea whether it has changed its mind or not.

                It is partly for this reason that I have argued (see here, para 105 ) that the Bank of England should publish its own interest rate projections, at least when it makes interest rate changes. (At present its forecast is based on market expectations, which may or may not be what the Bank itself thinks it will do.) Up until now it has brushed such ideas aside. Now that the Fed will be publishing such forecasts, it will be interesting to see if the Bank decides, or is persuaded, to do the same.