It is always interesting to compare the Fed, ECB and Bank of England. For both the Fed and ECB it has been quite a year for innovation. At the Fed the most recent announcements in terms of forward guidance can be seen as just a development of how it began the year, by publishing its own forecasts for interest rates. Once you tell others how you expect policy to develop given one (central) projection of how the economy will go, it is natural to say how it might develop in other circumstances. Just as it seemed to me the first development was eminently sensible (but others disagreed), so I think recent moves are as well.
Do they mark a substantial shift in policy? Brad DeLong thinks so, but Paul Krugman is more downbeat. I think the answer depends on the timespan you are looking at. In terms of the very recent developments, they are perhaps not a huge shift, although I agree with Mark Thoma that raising the inflation target from an ‘apparent 2%’ to a ‘definitely at least 2.5%’ is significant. Seen over the year as a whole, and including the idea of continuing QE, I think it is an important change.
The ECB has also had an innovative year, but from a different starting point. OMT was a big deal not in terms of central bank practice - it just allows the ECB to do what others are doing already, but with a much more limited remit and under conditionality - but it was a big deal in terms of the mindset of the ECB. However, whereas I think the Fed has been consistently building one innovation on top of another, it seems as if OMT was such an effort for the ECB that they want a rest for at least a year or so. But the Eurozone is starting a new recession, while the US is at least growing. So in terms of what is needed, the ECB is looking at least as out of touch with reality as they did a year ago.
Which brings us to the UK. Now it was only a Christmas Party, but Stephanie Flanders’ account of Bank reactions to the Fed moves sound depressingly plausible. I remember hearing similar reactions to Fed policy as the financial crisis began (‘they will regret cutting rates so quickly’), and to their publication of interest rate forecasts (‘a rod for their backs’). Now if everything was hunky dory in the UK such conservatism might be forgiven, but its not. So it seems that if you want innovation at the Bank, it needs to be imposed from outside.
Which is why this recent speech from Mark Carney has attracted a lot of interest. It has been interpreted by some as arguing for NGDP targets, but I think it is more nuanced than that. Carney clearly argues that forward guidance is useful, but it is much more useful for a country like the US which does not have an overriding inflation mandate than it could ever be for the UK which does. The Bank of England, whoever is Governor, will never say that they will not think about raising interest rates until inflation goes beyond 2.5% because they would be clearly going outside their remit.
On NGDP targets, Carney is quite equivocal about their use in normal times, but sees clear advantages as a device for dealing with the Zero Lower Bound (ZLB). So one interpretation of his remarks is that, yes, they might have been useful back in 2008/9, but they are less useful today. However I think its also possible to take a more optimistic view. As long as we do not treat the survey evidence too seriously, acknowledging that there is a significant output gap (x% say) implies that any NGDP path has to start at a point x% above current NGDP. So even if the long term desired NGDP growth rate is 4% (2% real + 2% nominal), the target for NGDP growth for the year the policy begins will be 4%+x%, which implies a much more aggressive monetary expansion than we have at present.
To get this aggressive monetary stimulus for the UK, I still prefer my suggestion of moving temporarily to a 4% earnings growth target. (Latest number 1.3%.) There are two reasons. First, this puts no upper limit on GDP growth. If in fact the output gap is y% rather than x%, where y is much higher than x, a 4% earnings path will not stop us closing that gap quickly, whereas a NGDP path based on x% might. Second, I take a pessimistic view that x% will be chosen very conservatively, as a price for what will be seen by the indigenous Bank as a radical move. I can also see it taking time to come, because the new Governor will want to persuade, rather than impose his views. If, indeed, these are his views, which as I suggest above the speech leaves open.
I want to end by returning to the general theme of central bank innovation, and the lack of it in the UK. In the reaction on the Carney speech, one report suggested that the Chancellor was open to new ideas that might come from the new Governor. I think this tells you a lot about the current Chancellor. Even though he is in charge of the monetary policy framework and the target itself, he still waits for any suggestion of change to come from the Bank. I cannot imagine Gordon Brown, or indeed Alistair Darling or Nigel Lawson, waiting to hear from the Bank before thinking about changing macroeconomic policy. Perhaps the curtains of No.11 are closed while others do all the hard work?
Thursday, 13 December 2012
Sunday, 9 December 2012
Some Thoughts on Fiscal Rules
In one area macroeconomic policy in the UK is well ahead of the
US or the Eurozone: the use of fiscal rules. The US seems to
prefer cliffs to rules - yes, I know that is a cheap jibe, but you know what I
mean. In the Eurozone fiscal rules now come in packs, the individual parts of which are of
variable quality and may not be consistent with each other. By contrast, the
surviving UK fiscal rule (or ‘mandate’) makes some limited sense, as did Gordon
Brown’s predecessors. It says the government should
achieve structural (cyclically adjusted) balance, excluding investment
spending, within five years - where that five year period rolls forward.
What is good about this rule? Its main advantage is that, by
having a rolling target, nothing is adjusted too quickly. One thing that stands
out from the literature is that, as long as you are able to
sell debt, fiscal adjustments should be slow, and the government’s deficit
should act as a shock absorber. The analogy with consumption smoothing is
pretty close. Now it is true that a rolling target could allow a government to
keep delaying adjustment, but that is hardly a problem right now.
Two additional features of the UK rule are the use of the
cyclically adjusted deficit and the exclusion of investment. Although cyclical
adjustment gets talked about a lot, for this particular rule
it would in normal times be largely irrelevant, because we would expect to have
a zero output gap in five years time anyway. Right now it is not irrelevant,
but I will have more to say about the current conjuncture below. Whether it is
right to exclude spending on investment is a difficult question, which I will
leave for another post.
Where the rule is more problematic is the focus on the deficit,
and the idea that ‘balance’ for the current deficit is a meaningful target.
Ultimately we are concerned about government debt. We want to stop debt rising
relative to GDP, and then we want to get it down. The speed at which that is
done will imply a path for deficits, but these deficits will almost certainly
be varying over time, and there is no magic in zero (i.e. balance). The rule
that an economist would naturally think of (and which is commonly used in academic work) is to adjust instruments in
proportion to the difference between actual debt and its target level. However, a zero deficit over the medium run will imply a reduction in debt
(as the OBR shows), so at least its moving us in the right direction.
While for the macroeconomist as scientist there is plenty of
scope for exploring these issues, I think they miss the two major problems that
the macroeconomist as engineer has to deal with. The first is whether we are
designing rules for a (roughly) benevolent government, or for a government that
departs from benevolence in particular ways. Second, good rules will inevitably
involve making guesses about the future, and many people find it difficult to
get their head around this.
As an example, we only need to look at the reaction to the
Autumn Statement in the UK. Whether the measures taken by the Chancellor are
sufficient to meet his rule depends on where you think the economy will be in
five years time. Given the current uncertainty about the output gap, the
Chancellor could be being too optimistic or embarking on unnecessary austerity.
(See Ian Mulheirn on the implications of
alternative assumptions.) Commentators, particularly those political
commentators for whom the long run is after the next election, but also in my
experience some macroeconomists, yearn for rules or targets that are not
conditional in this way. Why cannot we have something straightforward like an
inflation target? I mention all this not because I think these concerns are
legitimate (I have argued against unconditional inflation
targets), but because if fiscal rules are to command public confidence, they
may need to take this into account. Perhaps concerns like these explain
why most rules focus on deficits rather than debt.
However, there is one point that has to be made if we are
discussing fiscal rules in relation to current events, and that is that all the
discussion above presumes that monetary policy is unconstrained, and in
particular that interest rates are not at the Zero Lower Bound (ZLB). This is a
very familiar point, that Paul Krugman has made again and again: at the ZLB things are very different. Monetary policy has lost much of its
power, and it has certainly lost its claim to predictability and superiority.
We need fiscal policy to help in eliminating excess supply. In this situation, if we need a fiscal rule at all it is more likely to look like a Taylor rule than a rule involving a debt or deficit target. However, when
there is no danger of hitting the ZLB, there is no need for fiscal policy to be
concerned about the output gap or inflation at all - if we are talking about an
economy with a floating exchange rate. The conventional assignment can apply.
Some fiscal rules attempt to address this point by having terms
in both debt stabilisation and output gap stabilisation. Now while this might
make sense under fixed exchange rates, it is a
pointless compromise under flexible rates. If the effectiveness of monetary
policy is quite different at the ZLB, then optimal fiscal policy is also bound to be very different at the ZLB. So the main problem with the UK
government’s fiscal mandate has nothing to do with cyclical adjustment or any
of the other things discussed above. It is just inappropriate for the
situation we are now in.
Friday, 7 December 2012
Delegating to the wrong people: the strange case of interviewing undergraduate candidates at Oxford
This post starts off talking about something rather parochial, but it then moves to a wider point about decision making in a particular type of large organisation.
This is a strange time of year at Oxford University. Very few UK universities interview prospective undergraduates to help select who should be admitted, but both Oxford and Cambridge do. As a result, all but the most senior academics will generally spend at least two solid days interviewing something like 3 times as many undergraduate candidates as there are places. The personal and social cost of this is pretty high - quite a few research papers will not get written as a result, and maybe the odd important discovery will be delayed by years. Yet Oxford and Cambridge are also relatively unusual among UK universities in still allowing academics considerable control over the way the institution is run. Is this a paradox?
Now all this might make sense from a social point of view if interviewing meant we clearly got much better students at Oxford than we would otherwise. However all the evidence I have ever seen on interviews is that they are pretty unreliable as a selection procedure. In this particular case, there are well known biases: those from certain schools or families will be practiced at giving a good impression in such situations, whereas others will not. We (and I think I’m justified in using that collective pronoun) do our very best to get round those biases, but it is hard. We can fail to compensate, or over compensate. We all think we can judge someone by talking to them for 30 minutes, but in reality our ability to assess academic potential that way is pretty small. Indeed, even if information gleaned from interviews contains some useful information, I strongly suspect those making decisions give this information far more weight than it deserves. My suspicions receive some local support from Bhattacharya et al (2012)[1].
So, if there is no clear evidence that students are much better selected as a result of interviews, why do we continue with them? One familiar idea is that this is a form of concealed class bias, but I suspect this is not the general case. The evidence from Bhattacharya et al suggest that for PPE at Oxford, the marginal student from an independent (private) school faces significantly higher admission thresholds than those from state schools. A slightly less politically charged version of this argument is that we want to select students who are easy and interesting to teach, and as the interviews are like mini tutorials they achieve this goal. This would also explain why interviewing is largely confined to the two universities that still have a traditional tutorial system (teaching in small groups of two to four).
Even if there is some truth in this, there still seems to be a puzzle. From the self-interested point of view of the research oriented and highly competitive academic, the effort involved in interviewing seems out of proportion to any gain in getting more congenial students. I spend the equivalent of 12 full days a year teaching in tutorials, so spending 2+ days each year in a process that might make those 12 days slightly easier is just not worth it.
One of the other unusual aspects of Oxford and Cambridge is that they remain - in theory at least - self-governing. The individual colleges that make the admission decisions certainly are run by the academics.[2] So why are Oxford academics so attached to interviewing, when it just does not seem to be in their interests?
But maybe this is not the right question. Perhaps the majority of Oxbridge academics would happily give up interviewing, but for some reason this preference is not getting realised. I could at this point talk about the peculiarities of decision making at Oxford (and peculiar is the right word), but I think there may be a more general issue here.
Decision making in large organisations like universities is often run through committees, or through delegation to ‘volunteers’. Most academics, even though they may enjoy teaching students, are primarily interested in research (either intrinsically, or because it determines future career prospects). As a result, they will tend to avoid taking positions where they have to think about non-research related issues (like being on department or university teaching committees), and try and avoid administrative duties more generally. However a minority will have different priorities, and so they will take those positions. They may as a result take decisions which divert academics away from research, given their own interests and responsibilities. It may be these people who are taking decisions about interviewing, and not your more typical research focused academic.
Some of my former (non-Oxford) colleagues wrote a paper about this general issue some time ago [3], and although they did not apply it to universities, I suspect it may have been their inspiration. In many organisations this problem is dealt with by a strong central authority, but universities often do not have that, and Oxford and Cambridge certainly do not. So even if the majority of academics did want to stop interviewing, they cannot exercise this preferences, because they have delegated decision making to others who have different interests and priorities. Who knows if this is right, but maybe I have just thought up a good interview question!
[1] Bhattacharya, Kanaya and Stevens (2012), Are University Admissions Academically Fair? Oxford University Discussion Paper No. 608. Note (Table 2) that interview scores are very significant in deciding who is admitted, but have a weaker correlation with first year exam results compared to other pre-admission evidence.
[2] For UK universities, research performance is the key incentive, because of the UK’s research assessment exercise. So I suspect a strong, top down central authority would quickly decide that interviewing was a non productive distraction.
[3] Bulkley, G., Myles, G.D. and Pearson, B.R. (2001), On the Membership of Decision-Making Committees, Public Choice, 106, 1-22.
This is a strange time of year at Oxford University. Very few UK universities interview prospective undergraduates to help select who should be admitted, but both Oxford and Cambridge do. As a result, all but the most senior academics will generally spend at least two solid days interviewing something like 3 times as many undergraduate candidates as there are places. The personal and social cost of this is pretty high - quite a few research papers will not get written as a result, and maybe the odd important discovery will be delayed by years. Yet Oxford and Cambridge are also relatively unusual among UK universities in still allowing academics considerable control over the way the institution is run. Is this a paradox?
Now all this might make sense from a social point of view if interviewing meant we clearly got much better students at Oxford than we would otherwise. However all the evidence I have ever seen on interviews is that they are pretty unreliable as a selection procedure. In this particular case, there are well known biases: those from certain schools or families will be practiced at giving a good impression in such situations, whereas others will not. We (and I think I’m justified in using that collective pronoun) do our very best to get round those biases, but it is hard. We can fail to compensate, or over compensate. We all think we can judge someone by talking to them for 30 minutes, but in reality our ability to assess academic potential that way is pretty small. Indeed, even if information gleaned from interviews contains some useful information, I strongly suspect those making decisions give this information far more weight than it deserves. My suspicions receive some local support from Bhattacharya et al (2012)[1].
So, if there is no clear evidence that students are much better selected as a result of interviews, why do we continue with them? One familiar idea is that this is a form of concealed class bias, but I suspect this is not the general case. The evidence from Bhattacharya et al suggest that for PPE at Oxford, the marginal student from an independent (private) school faces significantly higher admission thresholds than those from state schools. A slightly less politically charged version of this argument is that we want to select students who are easy and interesting to teach, and as the interviews are like mini tutorials they achieve this goal. This would also explain why interviewing is largely confined to the two universities that still have a traditional tutorial system (teaching in small groups of two to four).
Even if there is some truth in this, there still seems to be a puzzle. From the self-interested point of view of the research oriented and highly competitive academic, the effort involved in interviewing seems out of proportion to any gain in getting more congenial students. I spend the equivalent of 12 full days a year teaching in tutorials, so spending 2+ days each year in a process that might make those 12 days slightly easier is just not worth it.
One of the other unusual aspects of Oxford and Cambridge is that they remain - in theory at least - self-governing. The individual colleges that make the admission decisions certainly are run by the academics.[2] So why are Oxford academics so attached to interviewing, when it just does not seem to be in their interests?
But maybe this is not the right question. Perhaps the majority of Oxbridge academics would happily give up interviewing, but for some reason this preference is not getting realised. I could at this point talk about the peculiarities of decision making at Oxford (and peculiar is the right word), but I think there may be a more general issue here.
Decision making in large organisations like universities is often run through committees, or through delegation to ‘volunteers’. Most academics, even though they may enjoy teaching students, are primarily interested in research (either intrinsically, or because it determines future career prospects). As a result, they will tend to avoid taking positions where they have to think about non-research related issues (like being on department or university teaching committees), and try and avoid administrative duties more generally. However a minority will have different priorities, and so they will take those positions. They may as a result take decisions which divert academics away from research, given their own interests and responsibilities. It may be these people who are taking decisions about interviewing, and not your more typical research focused academic.
Some of my former (non-Oxford) colleagues wrote a paper about this general issue some time ago [3], and although they did not apply it to universities, I suspect it may have been their inspiration. In many organisations this problem is dealt with by a strong central authority, but universities often do not have that, and Oxford and Cambridge certainly do not. So even if the majority of academics did want to stop interviewing, they cannot exercise this preferences, because they have delegated decision making to others who have different interests and priorities. Who knows if this is right, but maybe I have just thought up a good interview question!
[1] Bhattacharya, Kanaya and Stevens (2012), Are University Admissions Academically Fair? Oxford University Discussion Paper No. 608. Note (Table 2) that interview scores are very significant in deciding who is admitted, but have a weaker correlation with first year exam results compared to other pre-admission evidence.
[2] For UK universities, research performance is the key incentive, because of the UK’s research assessment exercise. So I suspect a strong, top down central authority would quickly decide that interviewing was a non productive distraction.
[3] Bulkley, G., Myles, G.D. and Pearson, B.R. (2001), On the Membership of Decision-Making Committees, Public Choice, 106, 1-22.
Wednesday, 5 December 2012
Some thoughts on the Autumn Statement
1) As the snow that I can see outside my window as I write this testifies, the Chancellor’s Autumn statement is misnamed - but it does have a winter’s feel about it. Yet again we have low growth that from the survey evidence looks structural. To quote from the OBR:
Now on this occasion the OBR has balked at following this evidence, and instead it has assumed that most of the slow growth has been cyclical rather than structural. Nevertheless their estimate of trend output has fallen, so as a result prospective UK austerity has now been increased and extended one more year (see Gavin Davies here). But you have to ask, if the survey information is not credible this year, has it been credible in previous years?
2) The Chancellor’s headline grab was to cancel the proposed increase in petrol duty. This cements his reputation as being decidedly anti-green. When the history books are being written in a hundred years time as the world struggles with average temperatures 4 degrees centigrade higher, George Osborne’s name will be on the list of people who helped that happen.
3) The statement included £5 billion extra in public investment, mainly paid for by reducing government consumption elsewhere. When I talked about rearranging the deck chairs, I thought I was using a metaphor and not a simile. Now it is probably true that the net effect of this on demand will be positive, when it happens. But if building a 100 new schools is such a great idea now, cancelling the project to repair existing schools two and a half years ago was clearly a very bad idea. As they say in the media nowadays, I think we deserve an apology.
4) One of the policy changes is a huge increase in investment allowances for small businesses. I really do not understand why this was not done earlier, and why it is limited to small firms. When I gave a talk at the Treasury in the summer I said I thought there was lots of scope for introducing incentives of this kind to get firms to bring forward investment plans. But why direct this to smaller firms, who may not be able to get the loan from the bank, when it is larger firms that have all the cash? [Edited from original, which complained that the measure did not have an expiry date. It does - it only lasts for two years. The hazards of reacting quickly to partial information!]
5) No doubt a lot of political capital will be made from the fact that the Chancellor has had to delay for a year meeting one of his fiscal rules. The opposition can say that at least Gordon Brown’s rules lasted for 10 years, while one of George Osborne’s has not lasted beyond two. Yet this ‘supplementary target’ was always rather silly, as it was vulnerable to a negative demand shock of the kind the UK has suffered. The main fiscal mandate, which is to achieve cyclically adjusted balance on the budget excluding investment, involves a rolling five year period. Now the criticism of a rule of this type is that it allows a government to keep putting adjustment off, but its advantage is that it allows flexibility in response to shocks. Obviously in the current situation I think the latter is more important.
6) We got the usual nonsense about austerity not causing the second recession. Luckily Chris Dillow makes the points, so I do not have to go over this again. Paul Krugman gets exasperated by having to play the ‘fiscal policy can have a big impact on demand’ record once more, just as I did here. Perhaps denial of this kind is understandable from politicians who do not want to admit mistakes, but less understandable when coming from good macroeconomists.
7) The FT asked me to write 300 words. Unfortunately the style didn’t match the other pieces they had, so there was a rather hasty re-edit, but here is the original which I rather like:
In a parallel universe somewhere....
Mr. Speaker
I commend this statement to the House.
"Business and consumer surveys ... imply that the output gap had narrowed since the end of 2011 despite actual output being roughly flat over this period and much weaker than expected in March. This in turn would imply that the weakness in output over this period was structural and that trend total factor productivity (TFP) had contracted."
Now on this occasion the OBR has balked at following this evidence, and instead it has assumed that most of the slow growth has been cyclical rather than structural. Nevertheless their estimate of trend output has fallen, so as a result prospective UK austerity has now been increased and extended one more year (see Gavin Davies here). But you have to ask, if the survey information is not credible this year, has it been credible in previous years?
2) The Chancellor’s headline grab was to cancel the proposed increase in petrol duty. This cements his reputation as being decidedly anti-green. When the history books are being written in a hundred years time as the world struggles with average temperatures 4 degrees centigrade higher, George Osborne’s name will be on the list of people who helped that happen.
3) The statement included £5 billion extra in public investment, mainly paid for by reducing government consumption elsewhere. When I talked about rearranging the deck chairs, I thought I was using a metaphor and not a simile. Now it is probably true that the net effect of this on demand will be positive, when it happens. But if building a 100 new schools is such a great idea now, cancelling the project to repair existing schools two and a half years ago was clearly a very bad idea. As they say in the media nowadays, I think we deserve an apology.
4) One of the policy changes is a huge increase in investment allowances for small businesses. I really do not understand why this was not done earlier, and why it is limited to small firms. When I gave a talk at the Treasury in the summer I said I thought there was lots of scope for introducing incentives of this kind to get firms to bring forward investment plans. But why direct this to smaller firms, who may not be able to get the loan from the bank, when it is larger firms that have all the cash? [Edited from original, which complained that the measure did not have an expiry date. It does - it only lasts for two years. The hazards of reacting quickly to partial information!]
5) No doubt a lot of political capital will be made from the fact that the Chancellor has had to delay for a year meeting one of his fiscal rules. The opposition can say that at least Gordon Brown’s rules lasted for 10 years, while one of George Osborne’s has not lasted beyond two. Yet this ‘supplementary target’ was always rather silly, as it was vulnerable to a negative demand shock of the kind the UK has suffered. The main fiscal mandate, which is to achieve cyclically adjusted balance on the budget excluding investment, involves a rolling five year period. Now the criticism of a rule of this type is that it allows a government to keep putting adjustment off, but its advantage is that it allows flexibility in response to shocks. Obviously in the current situation I think the latter is more important.
6) We got the usual nonsense about austerity not causing the second recession. Luckily Chris Dillow makes the points, so I do not have to go over this again. Paul Krugman gets exasperated by having to play the ‘fiscal policy can have a big impact on demand’ record once more, just as I did here. Perhaps denial of this kind is understandable from politicians who do not want to admit mistakes, but less understandable when coming from good macroeconomists.
7) The FT asked me to write 300 words. Unfortunately the style didn’t match the other pieces they had, so there was a rather hasty re-edit, but here is the original which I rather like:
In a parallel universe somewhere....
Mr. Speaker
The OBR, using tried and tested methods, tell me that there is very little spare capacity. Apparently the UK has suffered an unprecedented decade of low productivity growth, for no obvious reason. We therefore need yet more fiscal consolidation.
But there is another possibility. Firms may be underreporting their capacity. Inflation is not falling because of commodity price shocks and rigidities when inflation is low.
But there is another possibility. Firms may be underreporting their capacity. Inflation is not falling because of commodity price shocks and rigidities when inflation is low.
I have no idea which explanation is correct. But a good Chancellor considers the consequences of mistakes they might make. I failed to do that in 2010, and I will not do so again.
The danger in following the OBR’s path is self-fulfilling pessimism. By tightening policy today, demand falls, and supply appears to fall with it. It may be years before we realise that the economy could have safely produced much more, and we will never get that output back.
That is why I am announcing today that there will be no further austerity. Instead, to test what the economy can sustain, I’ve agreed a £25 billion increase in public investment, funded by a combination of borrowing and higher taxes. Furthermore, I have told the Bank of England for the next three years to replace their current target with a nominal earnings growth target of 4%, and I’ve sanctioned unlimited Quantitative Easing in order to achieve it. I have asked the Treasury Select Committee to investigate possible longer term changes to MPC objectives, like a nominal GDP target.
Perhaps my policy will fail to produce extra growth and just give us higher inflation. But I know the MPC will act quickly to counteract this. At least I would have tried. The far greater danger is that by continuing down my previous course each UK citizen would end up losing thousands of pounds forever.
I commend this statement to the House.
Sunday, 2 December 2012
How to try and get more inflation quickly
The following is written in the UK context, but the proposal I make would work in the US and the Eurozone as well.
Wednesday will be Autumn Statement day in the UK: one of the two times a year the Chancellor makes big fiscal announcements. Yet this post will not be about fiscal policy: current policy looks too much like rearranging the deck chairs, and so I will just be repeating myself in saying that the strategy is all wrong. Instead this post is about monetary policy. How come - that is the MPC at the Bank of England surely? I think not - they are just rearranging the deck chairs too. The big picture on UK monetary policy is down to the Chancellor.
The MPC’s mandate, set by the Chancellor, is to hit 2% for CPI inflation ‘within a reasonable time period’. In the past I and others thought the phrase reasonable time period would allow the MPC in practice to minimise a combination of excess inflation and the output gap, which is what most macroeconomists assume monetary policy is all about. I think this was true, within limits. In the UK these limits were surpassed following the Great Recession, where we had a large negative output gap but above target inflation. We are at the ZLB, and have had Quantitative Easing (QE), because the MPC looked at the output gap as well as inflation, and thought that a large output gap would mean inflation would come tumbling down. It did not, so now they are just targeting CPI inflation (and rather conservatively at that).
What we need is for UK monetary policy to be as expansionary as it can be, and we are not going to get that under the current system, even with a new man running the Bank. I have talked to enough MPC members to know that they take the mandate they are given very seriously. They certainly believe they do not have the discretion to follow a different strategy while still paying lip service to the current set up. The system can only be changed by the Chancellor. Now some would like him to move to nominal GDP targets, and I’d be happy with that. However I cannot see him doing that overnight: the move to include output and go from changes to levels is probably too much for something that is not widely discussed in the UK . The best we can hope for (and hope is the word) is for him to launch some kind of inquiry into this (and other) possibilities - I have suggested in the past that the Treasury Select Committee could do this.
So for the next year or two we are almost certainly stuck with inflation targeting. He could announce an increase in the inflation target, which he has the discretion to do as part of the current system. But he will not, because it plays terribly in terms of politics. As Noah Smith laments, what we as economists understand as inflation is not what everyone else understands by inflation. The number of people in the UK who would be prepared to defend raising the current CPI inflation target to 4% (which I would) is probably less than the number of economics departments in the UK.
However, why not change the measure of inflation being targeted? The GDP deflator is the obvious alternative, but there is a better candidate if the aim is produce a significant but temporary rise UK inflation (and thereby to start a proper recovery in UK output). My suggestion is that 2% CPI inflation is replaced by a target for 4% growth in average earnings. In normal times 4% earnings growth and 2% CPI inflation would be quite compatible (because real wages grow with productivity), but currently average weekly earnings inflation is below 2%.[1] So moving wage inflation from 2% to 4% is a real challenge for monetary policy. To help with this challenge, the Chancellor could at the same time sanction unlimited QE, and could suggest this goes beyond just buying gilts.
If monetary policy still has some power despite the ZLB, then this move would have a significant effect in reducing real interest rates. It would also play well politically. “In the last few years hard working families have seen the real value of their earnings fall, as wage growth has been held back while the Bank of England has failed to keep consumer price inflation on target. It is time that we changed things so that the rewards from working increased rather than decreased over time. That is why I am announcing today ….” Rhetoric that is nonsense in terms of economics, but no worse than much of the rhetoric the government currently uses.
Now of course plenty of people will complain that this is returning us to the 1970s, losing all the gains in inflation credibility that we have carefully built up etc etc. But their arguments can be easily countered. If CPI inflation does rise, this helps get round the ZLB, and so should stimulate a recovery. Yet it cannot ‘open the floodgates’, because all that has happened is that the definition of the inflation target has been changed. There is no further change in definition that can lead to yet higher inflation. In the longer term 4% wage inflation is pretty compatible with 2% price inflation, unless you believe that UK productivity growth can never grow again at levels that were thought normal before the recession. Finally I do not think there is anything in the academic literature which says that the CPI index is a significantly better measure to target than an earnings index.
In an ideal world, would I be suggesting this change? Almost certainly not. Do I think it is better than nominal GDP targeting? Probably not. However, we are not in an ideal world, and we need some action right now. Otherwise there is a great danger that we continue down a road of self-fulfilling pessimism, with all the misery and loss of resources that this entails.
[1] That wage inflation is currently well behind price inflation plus underlying productivity growth is not just a UK phenomenon - it applies in the US and Eurozone as well. To that extent this proposal is not just of relevance to the UK, although elsewhere central banks have the power to make this change, whereas in the UK they do not.
Wednesday will be Autumn Statement day in the UK: one of the two times a year the Chancellor makes big fiscal announcements. Yet this post will not be about fiscal policy: current policy looks too much like rearranging the deck chairs, and so I will just be repeating myself in saying that the strategy is all wrong. Instead this post is about monetary policy. How come - that is the MPC at the Bank of England surely? I think not - they are just rearranging the deck chairs too. The big picture on UK monetary policy is down to the Chancellor.
The MPC’s mandate, set by the Chancellor, is to hit 2% for CPI inflation ‘within a reasonable time period’. In the past I and others thought the phrase reasonable time period would allow the MPC in practice to minimise a combination of excess inflation and the output gap, which is what most macroeconomists assume monetary policy is all about. I think this was true, within limits. In the UK these limits were surpassed following the Great Recession, where we had a large negative output gap but above target inflation. We are at the ZLB, and have had Quantitative Easing (QE), because the MPC looked at the output gap as well as inflation, and thought that a large output gap would mean inflation would come tumbling down. It did not, so now they are just targeting CPI inflation (and rather conservatively at that).
What we need is for UK monetary policy to be as expansionary as it can be, and we are not going to get that under the current system, even with a new man running the Bank. I have talked to enough MPC members to know that they take the mandate they are given very seriously. They certainly believe they do not have the discretion to follow a different strategy while still paying lip service to the current set up. The system can only be changed by the Chancellor. Now some would like him to move to nominal GDP targets, and I’d be happy with that. However I cannot see him doing that overnight: the move to include output and go from changes to levels is probably too much for something that is not widely discussed in the UK . The best we can hope for (and hope is the word) is for him to launch some kind of inquiry into this (and other) possibilities - I have suggested in the past that the Treasury Select Committee could do this.
So for the next year or two we are almost certainly stuck with inflation targeting. He could announce an increase in the inflation target, which he has the discretion to do as part of the current system. But he will not, because it plays terribly in terms of politics. As Noah Smith laments, what we as economists understand as inflation is not what everyone else understands by inflation. The number of people in the UK who would be prepared to defend raising the current CPI inflation target to 4% (which I would) is probably less than the number of economics departments in the UK.
However, why not change the measure of inflation being targeted? The GDP deflator is the obvious alternative, but there is a better candidate if the aim is produce a significant but temporary rise UK inflation (and thereby to start a proper recovery in UK output). My suggestion is that 2% CPI inflation is replaced by a target for 4% growth in average earnings. In normal times 4% earnings growth and 2% CPI inflation would be quite compatible (because real wages grow with productivity), but currently average weekly earnings inflation is below 2%.[1] So moving wage inflation from 2% to 4% is a real challenge for monetary policy. To help with this challenge, the Chancellor could at the same time sanction unlimited QE, and could suggest this goes beyond just buying gilts.
If monetary policy still has some power despite the ZLB, then this move would have a significant effect in reducing real interest rates. It would also play well politically. “In the last few years hard working families have seen the real value of their earnings fall, as wage growth has been held back while the Bank of England has failed to keep consumer price inflation on target. It is time that we changed things so that the rewards from working increased rather than decreased over time. That is why I am announcing today ….” Rhetoric that is nonsense in terms of economics, but no worse than much of the rhetoric the government currently uses.
Now of course plenty of people will complain that this is returning us to the 1970s, losing all the gains in inflation credibility that we have carefully built up etc etc. But their arguments can be easily countered. If CPI inflation does rise, this helps get round the ZLB, and so should stimulate a recovery. Yet it cannot ‘open the floodgates’, because all that has happened is that the definition of the inflation target has been changed. There is no further change in definition that can lead to yet higher inflation. In the longer term 4% wage inflation is pretty compatible with 2% price inflation, unless you believe that UK productivity growth can never grow again at levels that were thought normal before the recession. Finally I do not think there is anything in the academic literature which says that the CPI index is a significantly better measure to target than an earnings index.
In an ideal world, would I be suggesting this change? Almost certainly not. Do I think it is better than nominal GDP targeting? Probably not. However, we are not in an ideal world, and we need some action right now. Otherwise there is a great danger that we continue down a road of self-fulfilling pessimism, with all the misery and loss of resources that this entails.
[1] That wage inflation is currently well behind price inflation plus underlying productivity growth is not just a UK phenomenon - it applies in the US and Eurozone as well. To that extent this proposal is not just of relevance to the UK, although elsewhere central banks have the power to make this change, whereas in the UK they do not.
Thursday, 29 November 2012
Is it a sin for the central bank to help reduce debt?
There is a great deal of discussion about the appropriate goals for monetary policy. Should it just be targeting inflation, or should central banks also include the output gap in their objective function? Perhaps they should target nominal GDP. However, hardly anyone would dream of suggesting that monetary policy should help reduce government debt, by lowering interest rates or raising inflation. It is just accepted that we should only use costly (in welfare terms) increases in taxes, or costly cuts in government spending, to achieve debt reduction.
What I have called the consensus assignment for economies with their own currency is that the central bank stabilises demand and inflation, and the government through fiscal policy manages government debt. The first part of that assignment does not work at the zero lower bound (ZLB), although some economists find it difficult to admit this. But equally there are circumstances where the second part of the assignment is far from optimal, and where it is useful to have the central bank help reduced debt. Circumstances like when debt is much too high.
If we just think about the macroeconomics, where a benevolent policy maker operates both monetary and fiscal policy, then the reason is straightforward and pretty obvious. When debt is high, reducing real interest rates is a pretty effective means of getting debt down. If government debt is about the same size as annual GDP, then a reduction in the real interest rate on government debt of 1% is equivalent to raising taxes by 1% of GDP. If debt is only half the size of GDP, the same reduction in real interest rates is only equivalent to increasing taxes by half as much. The larger the stock of debt, the more effective interest rates are compared to fiscal instruments in reducing debt.
Will reducing interest rates to cut debt not allow inflation to rise? Of course we are compromising our control of inflation. Fiscal instruments can be used to reduce this cost: if we cut government spending as well as cutting interest rates, the net effect on inflation may be small. But the key point is that inflation is not the only thing that matters. Raising taxes or cutting spending to reduce debt is costly too. So it may be better, in terms of social welfare, to let inflation rise for a time to get debt down than to have taxes rise to do the same.
At this point you are probably thinking isn’t the whole point about the consensus assignment that monetary policy is much better at controlling inflation than fiscal policy? Yes it is in our benchmark models, but only when debt is not a problem. If we had some fairly painless way to control debt (i.e. lump sum taxes),[1] then outwith the ZLB, monetary policy is indeed the best way to control inflation.[2] But suppose instead that debt is much too high, and we need to bring it down (and there are no lump sum taxes). Suppose, as suggested above, that monetary policy is also the best way of getting debt down. In that case we are in a different world where comparative advantage applies.
If you are still having difficulties with this - and because the consensus assignment has become such a consensus you might well be - imagine if debt was ten times GDP. In that case it is so much easier to get debt down by reducing real interest rates, it would be crazy not to. Any advantage monetary policy had in controlling inflation would pale into insignificance. If monetary policy is only a bit better at controlling inflation and much better at controlling debt, the latter should have priority.
So if I’ve convinced you this is possible, what about in more realistic situations. Here I can say two things. First, in quite a lot of the DSGE work I have done with my co-author Campbell Leith, we found situations in which monetary policy was useful in reducing debt when debt was high. Here high meant something like 50% of GDP, which is pretty standard today. Second, in the real world there have been occasions when monetary policy was linked quite closely with getting debt down, such as after the second world war. (See, for example, Charles Goodhart here.)
The reason why the idea of adding debt reduction to monetary policy’s tasks seems so taboo today is that we are concerned about the non-benevolent government. A government that spends too much and taxes too little can create ‘fiscal dominance’, and an inflation rate that is permanently too high. In extreme cases it can lead to hyperinflation. As is so often the case with fiscal policy (like the specification of fiscal rules), it is the non-benevolent policy maker which determines how we think about things.
To some it will seem obvious that this should be so. Politicians can be trusted to do the wrong thing, particularly if it is in their interests. There are plenty of examples where this has happened in the past. However, many of us have been arguing that governments today seem if anything too eager to use fiscal policy to get debt down. We seem to have a twisted sort of fiscal dominance, where governments are reducing debt too rapidly, the economy is suffering as a result, yet monetary policy cannot effectively counter because we are at the ZLB. It therefore seems a little odd to be arguing that monetary policy cannot help bring debt down, because that would let fiscal policy makers off the hook. In countries like the UK, USA or the Netherlands, there is no hook, but policymakers are taking unpopular measures to get debt down nevertheless. Would they really do a complete about face if monetary policy lent them a hand?
Now with short interest rates at the ZLB, and in the US and UK with Quantitative Easing directly reducing interest rates on government debt, it would appear as if there is no conflict at the moment between keeping inflation on target and reducing real interest rates. (Although this does not stop some getting very worked up when the central bank helps to reduce current borrowing.) However there are two parts to real interest rates. To the extent that monetary policy could be more expansionary today, but at the cost of higher inflation, it could be helping to reduce debt. If it is not, and the government is benevolent, monetary policy is probably behaving sub-optimally.
[1] These are taxes which have no impact on incentives, and so do not reduce output when raised. Although Miles Kimball has written what seems like a lament to their absence, when Mrs Thatcher tried to introduce them in the UK it led to her downfall.
[2] This is also true if we are quite happy to let debt permanently rise and fall in response to shocks, as Eser et al show.
What I have called the consensus assignment for economies with their own currency is that the central bank stabilises demand and inflation, and the government through fiscal policy manages government debt. The first part of that assignment does not work at the zero lower bound (ZLB), although some economists find it difficult to admit this. But equally there are circumstances where the second part of the assignment is far from optimal, and where it is useful to have the central bank help reduced debt. Circumstances like when debt is much too high.
If we just think about the macroeconomics, where a benevolent policy maker operates both monetary and fiscal policy, then the reason is straightforward and pretty obvious. When debt is high, reducing real interest rates is a pretty effective means of getting debt down. If government debt is about the same size as annual GDP, then a reduction in the real interest rate on government debt of 1% is equivalent to raising taxes by 1% of GDP. If debt is only half the size of GDP, the same reduction in real interest rates is only equivalent to increasing taxes by half as much. The larger the stock of debt, the more effective interest rates are compared to fiscal instruments in reducing debt.
Will reducing interest rates to cut debt not allow inflation to rise? Of course we are compromising our control of inflation. Fiscal instruments can be used to reduce this cost: if we cut government spending as well as cutting interest rates, the net effect on inflation may be small. But the key point is that inflation is not the only thing that matters. Raising taxes or cutting spending to reduce debt is costly too. So it may be better, in terms of social welfare, to let inflation rise for a time to get debt down than to have taxes rise to do the same.
At this point you are probably thinking isn’t the whole point about the consensus assignment that monetary policy is much better at controlling inflation than fiscal policy? Yes it is in our benchmark models, but only when debt is not a problem. If we had some fairly painless way to control debt (i.e. lump sum taxes),[1] then outwith the ZLB, monetary policy is indeed the best way to control inflation.[2] But suppose instead that debt is much too high, and we need to bring it down (and there are no lump sum taxes). Suppose, as suggested above, that monetary policy is also the best way of getting debt down. In that case we are in a different world where comparative advantage applies.
If you are still having difficulties with this - and because the consensus assignment has become such a consensus you might well be - imagine if debt was ten times GDP. In that case it is so much easier to get debt down by reducing real interest rates, it would be crazy not to. Any advantage monetary policy had in controlling inflation would pale into insignificance. If monetary policy is only a bit better at controlling inflation and much better at controlling debt, the latter should have priority.
So if I’ve convinced you this is possible, what about in more realistic situations. Here I can say two things. First, in quite a lot of the DSGE work I have done with my co-author Campbell Leith, we found situations in which monetary policy was useful in reducing debt when debt was high. Here high meant something like 50% of GDP, which is pretty standard today. Second, in the real world there have been occasions when monetary policy was linked quite closely with getting debt down, such as after the second world war. (See, for example, Charles Goodhart here.)
The reason why the idea of adding debt reduction to monetary policy’s tasks seems so taboo today is that we are concerned about the non-benevolent government. A government that spends too much and taxes too little can create ‘fiscal dominance’, and an inflation rate that is permanently too high. In extreme cases it can lead to hyperinflation. As is so often the case with fiscal policy (like the specification of fiscal rules), it is the non-benevolent policy maker which determines how we think about things.
To some it will seem obvious that this should be so. Politicians can be trusted to do the wrong thing, particularly if it is in their interests. There are plenty of examples where this has happened in the past. However, many of us have been arguing that governments today seem if anything too eager to use fiscal policy to get debt down. We seem to have a twisted sort of fiscal dominance, where governments are reducing debt too rapidly, the economy is suffering as a result, yet monetary policy cannot effectively counter because we are at the ZLB. It therefore seems a little odd to be arguing that monetary policy cannot help bring debt down, because that would let fiscal policy makers off the hook. In countries like the UK, USA or the Netherlands, there is no hook, but policymakers are taking unpopular measures to get debt down nevertheless. Would they really do a complete about face if monetary policy lent them a hand?
Now with short interest rates at the ZLB, and in the US and UK with Quantitative Easing directly reducing interest rates on government debt, it would appear as if there is no conflict at the moment between keeping inflation on target and reducing real interest rates. (Although this does not stop some getting very worked up when the central bank helps to reduce current borrowing.) However there are two parts to real interest rates. To the extent that monetary policy could be more expansionary today, but at the cost of higher inflation, it could be helping to reduce debt. If it is not, and the government is benevolent, monetary policy is probably behaving sub-optimally.
[1] These are taxes which have no impact on incentives, and so do not reduce output when raised. Although Miles Kimball has written what seems like a lament to their absence, when Mrs Thatcher tried to introduce them in the UK it led to her downfall.
[2] This is also true if we are quite happy to let debt permanently rise and fall in response to shocks, as Eser et al show.
Tuesday, 27 November 2012
Teaching graduate macro
For teachers and students of economics
Noah Smith has a depressing look at the reaction of some graduate students to the macro they are taught. He links this to the ‘war’ between freshwater and saltwater visions of macro, and any disconnect between what is taught and the real world is bound to be more acute with the former. Particularly today, courses that attach New Keynesian theory to the end of the programme - and in some cases (through accident or design) end up not teaching it at all - are just asking for trouble. Even in more normal times, isn’t it a good idea to give students some idea of what central banks think they are doing? - they might just want a job in one!
However, even if you put this ideological problem to one side, I think there is a difficulty for anyone teaching graduate macro, which is rather different from anything encountered teaching at the undergraduate level. At the masters level it is just logical to delay teaching New Keynesian economics until some way into the course. As is frequently said, New Keynesian theory is an elaboration of the RBC construct, so all that needs to be done first. To take the example of Oxford’s MPhil, we do the Ramsey model, RBC, OLG, growth theory, and the flex price open economy all before New Keynesian economics, and it makes sense to do it this way.
Now this would not be a problem if this other stuff was as obviously interesting and relevant as Keynesian economics is today. However I fear that it is often not presented as such. Take growth theory for example. Now in principle this is all about why some countries are rich and some poor, which should be attention grabbing. But if in practice it amounts to discussing whether the speed of catch up is consistent with the Solow model, it can appear rather irrelevant. With the Ramsey model, I suspect the question of whether the allocation is optimal was not quite what students really wanted to know when they started the course. And if you do not teach the RBC model as the way to explain the business cycle, there is not that much to get excited about.
The problem of lack of motivation is compounded by something that I think those teaching micro often fail to appreciate. Today graduate macro is intrinsically harder than micro. In terms of the techniques involved it is probably no more or less difficult, but what in my experience students find really hard is that everything we teach fits together. Yet until you have done everything it is difficult to understand why we choose to focus on some model features to discuss some issues, but on other aspects of the macroeconomy when talking about different issues. Motivation is useful when the subject is challenging.
Luckily I think recent events, and specifically the debates over how quickly to reduce government debt, have come to the rescue. I mentioned in a footnote to a recent post how this year I was experimenting with starting the macro course with the two-period OLG model, instead of first developing the Ramsey model. This has a straightforward advantage, which is that students are familiar with the two-period consumption model from their undergraduate training, so we do not have to hit them with Hamiltonians quite so soon. However I think the main plus is that it allows us to focus on government debt and intergenerational equity right at the beginning of the course. There is an obvious interest among students in debt and intergenerational equity, but the crowding out effects of government debt on capital and therefore output in the simple two-period OLG model (with no wage income in the second period) are also dramatic. Almost certainly overstated as well, but better to start here than with a model where government debt does not matter at all! I can even bring in recent blog debates.
We will see at the end of the year whether this turned out to be a good idea. Even if it is, I am still searching for the equivalent motivation when presenting the basic ideas behind flex price new open economy macro. What determines international competitiveness, its relationship to PPP, non-traded goods and home bias are all things students should know about, but I’m not sure it really grabs their attention. Any ideas will be gratefully received.
Noah Smith has a depressing look at the reaction of some graduate students to the macro they are taught. He links this to the ‘war’ between freshwater and saltwater visions of macro, and any disconnect between what is taught and the real world is bound to be more acute with the former. Particularly today, courses that attach New Keynesian theory to the end of the programme - and in some cases (through accident or design) end up not teaching it at all - are just asking for trouble. Even in more normal times, isn’t it a good idea to give students some idea of what central banks think they are doing? - they might just want a job in one!
However, even if you put this ideological problem to one side, I think there is a difficulty for anyone teaching graduate macro, which is rather different from anything encountered teaching at the undergraduate level. At the masters level it is just logical to delay teaching New Keynesian economics until some way into the course. As is frequently said, New Keynesian theory is an elaboration of the RBC construct, so all that needs to be done first. To take the example of Oxford’s MPhil, we do the Ramsey model, RBC, OLG, growth theory, and the flex price open economy all before New Keynesian economics, and it makes sense to do it this way.
Now this would not be a problem if this other stuff was as obviously interesting and relevant as Keynesian economics is today. However I fear that it is often not presented as such. Take growth theory for example. Now in principle this is all about why some countries are rich and some poor, which should be attention grabbing. But if in practice it amounts to discussing whether the speed of catch up is consistent with the Solow model, it can appear rather irrelevant. With the Ramsey model, I suspect the question of whether the allocation is optimal was not quite what students really wanted to know when they started the course. And if you do not teach the RBC model as the way to explain the business cycle, there is not that much to get excited about.
The problem of lack of motivation is compounded by something that I think those teaching micro often fail to appreciate. Today graduate macro is intrinsically harder than micro. In terms of the techniques involved it is probably no more or less difficult, but what in my experience students find really hard is that everything we teach fits together. Yet until you have done everything it is difficult to understand why we choose to focus on some model features to discuss some issues, but on other aspects of the macroeconomy when talking about different issues. Motivation is useful when the subject is challenging.
Luckily I think recent events, and specifically the debates over how quickly to reduce government debt, have come to the rescue. I mentioned in a footnote to a recent post how this year I was experimenting with starting the macro course with the two-period OLG model, instead of first developing the Ramsey model. This has a straightforward advantage, which is that students are familiar with the two-period consumption model from their undergraduate training, so we do not have to hit them with Hamiltonians quite so soon. However I think the main plus is that it allows us to focus on government debt and intergenerational equity right at the beginning of the course. There is an obvious interest among students in debt and intergenerational equity, but the crowding out effects of government debt on capital and therefore output in the simple two-period OLG model (with no wage income in the second period) are also dramatic. Almost certainly overstated as well, but better to start here than with a model where government debt does not matter at all! I can even bring in recent blog debates.
We will see at the end of the year whether this turned out to be a good idea. Even if it is, I am still searching for the equivalent motivation when presenting the basic ideas behind flex price new open economy macro. What determines international competitiveness, its relationship to PPP, non-traded goods and home bias are all things students should know about, but I’m not sure it really grabs their attention. Any ideas will be gratefully received.
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