Behaving like Luddites

The Luddites were 19th-century English textile artisans who protested against newly developed labour-saving machinery from 1811 to 1817. Activists smashed Heathcote's lacemaking machine in Loughborough in 1816. At the time, the BBC said that the increase in employment that would result from destroying the machinery “was of course good news”, but there was a concern that output might fall as a result. But some experts proclaimed that, thanks to the Luddites, we should celebrate that Britain was now leading the way in employment creation. A prominent politician that supported the Luddites accused the BBC of being hopelessly biased, and “peeing all over British workers”. The BBC Trust subsequently held a seminar on impartiality and economics reporting.

OK, the first two sentences come from Wikipedia, and the rest is nonsense. The idea that the BBC might describe additional employment that resulted from not using labour saving machinery as good news is surely unthinkable. If a journalist pointed out that these actions were problematic because productivity would fall, it must be inconceivable that any serious politician would accuse that journalist of bias. Unfortunately, if you follow the links, you will see that I made very little of that paragraph up, but just transposed things that happened a year ago back another 200 years.

There is one sense in which my transposition may be slightly unfair. In a recession, low productivity growth means that unemployment is lower. So I would have no problem with a line that went: “Of course the growth in UK employment, given flat output, is bad news. However, if this slowdown in productivity growth is temporary, and we catch up in terms of productivity levels later on, it may have a silver lining. Low productivity growth means that unemployment is lower, so that the pain of the recession is being more evenly spread by (nearly) everyone receiving lower real wages.” In a car crash, it is good when things like seat belts mean that people escape with minor injuries. But no one should describe the car crash itself as good news. [1]

At the seminar that the BBC Trust did hold in November 2012, there was disagreement over “whether BBC coverage should reflect a consensus view, in areas where there is one, or whether instead it must reflect the range of opinions even if parts of that range are minority views.” I would suggest that the overwhelming view today is that high productivity growth is beneficial, and that low productivity growth is a serious cause for concern, even if it might in the short term keep unemployment low. Do we really want the media to portray this as just ‘one perspective’, and then give equal time to the ‘opposing view’ that strong employment growth and low productivity growth is simply good news. In the case of the BBC and UK productivity, the BBC currently follows the 'opinions on shape of the earth differ' approach, and is then accused of bias for even mentioning that low productivity growth might be a concern.

It is vital that the media does not let politicians dictate how facts are interpreted. In George Osborne’s Orwellian nightmare, support for his handling of the economy is growing, and opposition to austerity is crumbling, whereas in the real world the case for austerity has never been weaker. It was always obvious that when the economy started recovering, this would be proclaimed as proof that the government’s policies are working, whereas what it really tells us is how used we have become to a no-growth economy.

Now if politicians want to be Luddites that is of course their choice. We trust in the system to quickly find them out, so that they do not get to hold positions of responsibility. Yet how is that supposed to happen, when the media insists on giving the Luddites equal space. As the opinion poll results presented by Professor Schifferes to the Trust showed, many people follow economics news closely, but remain confused by it. They rely on the media not just to present the news, but to put that news into context. Reporting that says one day ‘output growth low: bad’ and the next ‘employment growth high: good’, without putting the two together, is bad reporting.

Tim Harford has a recent post that pokes fun at some of the common misperceptions that the UK public has, such as crime is rising, a third of the population was born overseas, or that teenage pregnancy is widespread. What Tim does not ask is where these incorrect perceptions come from. He does note that they often do not come from direct experience: “people generally believe that their own area is closer to the way they like it with lower crime, lower unemployment, better policing, fewer immigrants. It’s the rest of the country they worry about.” So where do these perceptions about the rest of the country come from, if they do not come from the official statistics? The answer is pretty obvious - they come from the media.

There is a large part of the media, in the UK and elsewhere, that would regard the perceptions Tim quotes as indications of success rather than failure. It is not a coincidence that these misperceptions all tend to encourage a rather illiberal political agenda. However these perceptions should be a source of deep concern for organisations like the BBC, whose mission is “To enrich people's lives with programmes and services that inform, educate and entertain.”

Of course the ‘two sides’ approach has its place. It is not clear, for example, how much of the productivity slowdown in the UK is the government’s fault. However given what we know about output, the strong growth in UK employment is self-evidently bad news. As the coincident slow growth in UK wages shows, we are (nearly) all significantly worse off as a result. It is time the UK media recognised that the Luddites were wrong, and update its reporting accordingly.

[1] In the US in particular, monthly employment numbers are used as an indicator of what is happening to output, which is something completely different. Here I am talking about commentary that at least has the potential to compare what is happening to employment and output.

The two arguments why the Zero Lower Bound matters

I think it is important to distinguish between two arguments why the Zero Lower Bound (ZLB) for nominal interest rates matters. I will label these the first and second, and economists and statisticians will soon [1] see why these labels have some significance. The first argument is debatable, but the second is I believe very difficult to argue against.

The first argument why the ZLB matters is that unconventional monetary policy either does not work, or hits limits on what it can do, and these constraints bite. In short, monetary policy at the ZLB cannot fully achieve monetary policy goals. The second argument about why the ZLB matters is that the impact of monetary policy becomes more uncertain. Under the second argument, it is possible for some particular dose of unconventional monetary policy to duplicate what interest rate policy might otherwise achieve, but there is more uncertainty about what that appropriate dose is. The impact of any unconventional monetary policy action is therefore more unpredictable than the impact of conventional policy.

Much of the discussion of unconventional monetary policy involves the first argument. An important feature of Quantitative Easing (QE) is that its size is potentially unbounded - the central bank can create as many reserves as it likes. So if the impact of each unit of QE on the economy is constant, even if this constant is small, if we knew what that constant was we just scale up the programme so it has the desired effect. However, it seems to be much more likely that the policy involves diminishing returns, but to be honest I have no idea whether that means there are limits to what the policy can currently do. There are also some who worry that unconventional monetary policy has dangerous side effects on financial stability if it becomes too large. As I said, the first argument is debatable.

What seems clear to me is that we know much less about the impact of QE, or other kinds of unconventional monetary policy, than we do about conventional monetary policy. This almost follows by definition: we have well established models for conventional policy, and much more data to check these models against. What data we have also suggests the impact of unconventional monetary policy is more uncertain. (This is the conclusion drawn by John Williams, who has done a good deal of work on their impact, and I have never heard anyone argue against this view.) That is why I think it is very difficult to deny that the impact of monetary policy at the ZLB is much more uncertain compared to monetary policy outside the ZLB. [2]

Why do I make this distinction? Good policy tries not only to achieve the best outcome for the economy, but it also tries to reduce the uncertainty associated with that outcome. Indeed, we might well be prepared to sacrifice some of the former for some of the latter: uncertainty is in general undesirable. A standard way to judge the merits of a particular rule for macro policy, for example, is to ask whether it reduces the variance of output or inflation when the economy is hit by a standard set of shocks.

Let me return to an old friend. Suppose you are a doctor, and you have two medicines to treat a disease. One is reliable, but the other requires trial and error to get the correct dose, and occasionally has nasty side effects. In these circumstances, you would rather not run out of the reliable medicine. Indeed, you would want to go out of your way to avoid running out of the reliable medicine.

Seen from this perspective, it becomes almost undeniable that fiscal austerity at or near the ZLB is a dangerous policy. By making us more reliant on unconventional monetary policy it increases macroeconomic uncertainty. It makes it more likely that we will have to resort to the unreliable medicine. I think too much of the argument over whether monetary policy is all you need focuses on the first reason why the ZLB may be important, and ignores the second. [3]

[1] I was tempted to write ‘in a moment’ rather than ‘soon’, but decided a bad pun might detract from the main text.

[2] The Williams paper also elaborates on a well known idea that uncertainty about the impact of policy instruments should make policy makers cautious in using those instruments. I think this is an additional consideration, which would reinforce the point I’m making here. I also agree that good policy should take into account the characteristics of uncertainties arising from the economy, and have used this to argue - for example - that policymakers should over rather than under estimate the size of the output gap at the ZLB.

[3] This is not an argument about whether fiscal stimulus is more or less reliable than monetary stimulus, interesting though that question is. All I require is that an austerity policy reduces short run aggregate demand, which it clearly does. It also does not say that there are no circumstances in which we should undertake austerity at or near the ZLB - in theory the benefits of austerity could be so great that they outweigh the costs of putting us in a dangerous place. In the absence of a significant and rising default premium on debt, I do not think those benefits exist, but that is a separate argument.

An argument for forward guidance in the UK

What is the Monetary Policy Committee (MPC) of the Bank of England (BoE) trying to achieve? I think there are two leading candidate answers.

1) Flexible inflation targeting, as understood by academics. This means trying to reduce both deviations of inflation from target, and the output gap, at all periods in time. Call this FIT for short.

2) Strict inflation forecast targeting (SIFT), or more specifically trying to minimise deviations of inflation from target in two years time. Under this policy, the outlook for the output gap in two years time is irrelevant.

In most circumstances FIT and SIFT will produce very similar interest rate decisions, because normally to achieve the inflation target within two years means aiming to eliminate the output gap by then too. However one time that the two objectives could give different decisions is if the economy is being hit by a persistent cost-push shock. Under FIT, that could lead in two years time to inflation being above target, and a negative output gap. Under SIFT, we might expect a tighter policy, trying to reduce inflation to target within two years, at the cost of a larger output gap. [1]

So which better describes MPC policy? The Bank of England publishes a forecast for inflation two years out, and the chart below shows this since independence. This is their forecast based on market expectations of interest rates: we unfortunately have no information about what MPC members expect future interest rates to be.

Bank of England forecasts for inflation two years ahead, by date of inflation report

The inflation target was 2.5% until 2004, but has been 2% since. You can see why many might think that SIFT is the policy. The financial crisis was such a big shock that the Bank did not think it could achieve this target for a year to two, but otherwise the two year ahead forecasts have been pretty close to target.

Unfortunately while this is consistent with SIFT, it could also be consistent with FIT. The Bank does not publish any estimates of the current output gap, let alone the expected output gap in two years time. In addition, the output gap before the recession was generally thought at the time to be fairly small, so it is quite possible that the inflation forecast above is also consistent with FIT. However, the last few years look much less like FIT than SIFT. Actual inflation has been above target, and we have a significant output gap, and this combination is at least partly down to some significant cost-push shocks (like increases in VAT). Yet expected inflation two years out is close to target. Can the Bank really be expecting the output gap to close in two years as well?

We have one additional piece of information, which are the Bank’s forecasts for GDP growth over the next two years. Even if the current output gap is large, if the Bank was forecasting growth well above potential in the next two years, it could be closing that gap in two years time i.e. doing FIT. As we get closer to the present, this looks less plausible. In particular, in 2012 the Bank’s growth forecasts were pretty low. Even if they were assuming growth in potential of just 1% p.a., that would imply that their estimate of the current output gap was between -1% and -1.5% if they expected to close the output gap in two years time. That seems implausibly low: the OBR has an estimate closer to -3%. I would therefore conclude that it is quite likely that the Bank has been pursuing SIFT, and not FIT. (The February 2013 inflation report is a possible exception.)

Why does this matter? With continuing cost-push shocks (such as an increase in student fees), SIFT is going to mean tighter policy than FIT. In addition, my own interpretation of the Treasury’s March 2013 review of the MPC’s remit is that they do not want SIFT, but instead favoured something closer to FIT.

Suppose I am wrong, and the MPC is pursuing FIT, but I am not alone in incorrectly thinking it is doing SIFT. Or alternatively, suppose it has been doing SIFT, but now - following the Treasury review and a new governor - it wants to do FIT. How can it clarify this? Well one possibility is just the kind of forward guidance that the Fed has given. If the MPC state that if - say - unemployment looks like remaining above 6% over the next two years, they would aim to have inflation significantly above 2% in two years time, then it becomes clear they are not doing SIFT.

So one argument for forward guidance is that it could avoid damaging ambiguity in what the MPC is trying to do. There are of course other arguments for and against forward guidance, and here I want to plug a new blog by ex-BoE, and now Bristol University, economist Tony Yates. His first post considers some of these issues, and his most recent post deals with the Treasury March review.

My own worry about forward guidance, which I expressed in the slides attached to this post, is that it is too incremental. I think a much clearer way of signalling the importance of the output gap is to adopt a path for nominal GDP as an intermediate target. I look forward to Tony’s future posts, which I suspect will include why he thinks this would be a bad idea!

[1] Two important caveats here. The first is obvious: if the output gap is given a trivial weight compared to inflation in the Bank’s objective, FIT morphs into SIFT. I have discussed why that is an unreasonable weighting here. Second, the optimal response to a cost-push shock if the central bank attempts to use future policy commitments to achieve the best outcome today will involve future periods in which inflation is below target, as I explain here. That would complicate discriminating between FIT and SIFT. However, as this policy is time inconsistent, the MPC would have to be quite open about this policy, and in the absence of such openness I think we can exclude that possibility.

Economic History and Krugman’s Crib Sheet

One of the positive things about reading blogs is that sometimes you see connections in apparently diverse offerings. So here are two seemingly unconnected posts: Paul Krugman’s discussion of how he came to do his path breaking research in international trade and economic geography, and Kevin O’Rourke’s post on why economics needs economic history.

I remember many years ago being in a large interdisciplinary forum, where Krugman’s research on economic geography came up. The economists in the room were of course very positive, but the geographer there could not hide his disdain. There is nothing in this work that geographers have not actively discussed for the past 50 years, he said. I have no reason to doubt that he was right, but it kind of missed the point. What Krugman and others did was manage to formalise these earlier thoughts in a particularly tractable and useful way.

What is so great about formalism, you might ask. The trouble with just talking and writing about the way the world works is that it is quite easy to become confused or to make mistakes. Macro, because it deals with a highly interconnected system, is full of these pitfalls. The example I use with undergrads when they first come to IS/LM is as follows. Cutting taxes may appear to boost the economy, but if it is financed by more government borrowing, to persuade people to lend more will probably push up interest rates. These higher interest rates reduce output, so as a result tax cuts could end up reducing output. Sounds reasonable, but the reasoning is incorrect. The worst that can happen with a tax cut is that people save it all, in which case output does not change, and neither do interest rates. IS/LM shows us that if interest rates rise it is because output has increased.

So it is good to be able to express ideas about how the world works in terms of simple models. But creating a new type of model for the first time is not an easy thing to do, which is why you get prizes for this kind of thing. Crucially, it may take a long time (decades or more) before someone comes up with that nice simple formalisation that captures those ideas. Yet those ideas are as important before the formalisation as they are afterwards - it is just the reasoning about them that has improved.

How is economics generally taught? In both macro and micro, most of the time we teach the formalisation. This is understandable (it is what has advanced the discipline and made it science like) and to a degree appropriate (understanding models is difficult). However there is a real danger that teaching this stuff crowds out all else. I used not to be concerned about this for macro, because I saw the discipline as inherently progressive, where the data would naturally push advances in the right direction. (My excuse for believing this in part comes from my background in building structural econometric models, where the data really did do that.)

If that is your view, you are likely to be a little dismissive about things like economic history, economic methodology or the history of economic thought. After all, most scientists do not worry too much about these things in their own discipline, and economics tries to be like a science. Even if we take a more realistic view, and think that economists are more like doctors (who fail to understand quite a lot), doctors do not spend too much time thinking about things like the methodology of medicine.

I changed my view in the last few years as a result of both the financial crisis and the subsequent domination of austerity policies. Teaching just what can be currently formalised in what now passes as a rigorous manner excludes too much of what is important. Of course we (hopefully) tell students that there are gaps in what economists can do this way, but perhaps these gaps need to be given a little more space than footnotes. There is a great deal of knowledge and insight in less formal economic reasoning, insight that can too easily be dismissed. Unfortunately it is natural for future academics or policy makers to believe that what is taught in undergraduate or graduate macro is what is important, rather than what has so far been formalised, or what the demands of this particular time and context require formalising, or worse still what political or ideological forces wish to formalise.

The analogy with doctors breaks down because, unlike doctors, an economist does not constantly have the full range of empirical problems thrown in their face. They are also unlikely to have politicians picking and choosing which treatments they like to promote based on the interests of those they serve. In particular, developments in macro over the last few decades have shielded economists from having to explain much of the data. (In my view the dismissal of single equation time series work as a vital component in model building because of identification problems was a crucial mistake.)

As Kevin O’Rourke eloquently argues, teaching economic history provides a useful counterweight to these tendencies. We also need to make room for teaching some elements of methodology and the history of thought, for similar reasons. This is why I have actively supported Diane Coyle’s initiative in the UK (see here, here and here). I think having the occasional option in these subjects misses the point. It is much more about integrating these elements into core courses, although how best to do this remains an open question.

How knowledge transmission should work

The tenth anniversary of the UK’s 2003 decision not to join the Eurozone has just passed. With all my complaints about how bad macroeconomic policymaking has been recently, I thought it was worth analysing an example of a good decision. Good not just because it was the right decision given the events of the last few years, but good also because of how it was done, and the way academic knowledge was used.

If you want detail on the background and process itself, I recommend viewing or reading a recent lecture by Dave Ramsden, who was the civil servant who masterminded the process. Here is just a short summary. The UK opted out of being one of the founding members of the Eurozone, but the possibility of us joining shortly afterwards was always taken seriously. The Chancellor Gordon Brown announced 5 tests that would need to be passed if this were to happen, and the Treasury spent a couple of years doing extensive work on these five tests. It eventually published 18 studies, which I recommend to any students who want to take a serious interest in Optimal Currency Area (OCA) theory. Although there is some original work there (of which more later), they were mainly very good summaries of the relevant academic literature, and various academics were consulted to help ensure this was the case.

I should declare an interest here. I wrote one of those studies, which tried to assess what exchange rate the UK should join at, if the decision was yes. However I do not think this has any influence on what I have to say below, because in an important sense my study was secondary to the question of whether we should join. [1] In contrast, much more critical was modelling work done by Peter Westaway, at the time a Bank of England economist who had previously built the Bank’s core macromodel.

Now some will argue that these 18 studies, and the years of work that went into them, were window dressing for a decision that had already been made. I think that is simply incorrect. Some of the reasons I think that are described by Dave Ramsden: if the politicians involved had already made up their mind, they went to quite elaborate lengths to conceal the fact from those that worked for them. (Compare this to the Iraq war, for example, where a dodgy dossier sufficed.) Furthermore, the studies themselves contain some very strong arguments (probably too strong) why joining the Eurozone could be very beneficial, which is not the kind of thing you do if you want the analysis to back up a foregone conclusion.

As a result, I think the exercise was what it purported to be: an attempt by civil servants to give the best advice they could to politicians. What marks it out for me was the extent to which those civil servants involved academics, and placed academic work at the centre of their analysis. The merits or otherwise of the Euro did divide macroeconomists, but there was no attempt to just consult those who agreed with some predefined view. (See, for example, the space given to Andrew Rose’s empirical work of the benefits of OCAs.)

So why was this process close to what I consider an ideal of how academic knowledge should be used, when I have just written a post which is far more pessimistic about how these things are generally done? I should think about this some more, but here are three ideas. The first is that the decision, although it generated strong opinions on either side, was not fundamentally ideological. There was no existing political apparatus that was clearly aligned with potential winners and losers. The second is that you had a Chancellor who had a very strong respect for economic ideas, whatever else you may think of him as a politician. Third, the Chancellor had to convince the Prime Minister Tony Blair, and so whatever decision he came to needed to be backed up as strongly as possible.

Most people would now agree that the 2003 decision (only one the five tests were passed) was the correct one. [2] While the analysis, and particularly the work by Westaway, contained some of the elements that came to the fore in the Eurozone crisis, I think Ramsden in his 10 year retrospective is clear that the 18 studies also failed to foresee other elements of the crisis, perhaps not surprisingly as most macroeconomists missed these too. Yet the deeper point is this. The decision was based on the best analysis that macroeconomics at the time could provide. It is a shame that this way of making economic decisions now looks like the exception rather than the rule.  

[1] If anyone ever asks whether I can keep a secret, I always give this as evidence that I can. The original work I did for the study was done and written up in 2002. At the time the Euro/Sterling rate was at or near 1.6 E/£, and my analysis suggested something closer to £1.4 E/£ was sustainable. So for nearly a year I sat on information that was extremely market sensitive, and I received plenty of phone calls trying to extract any hint at what my analysis would be, and I’m glad to say no one got anything out of those calls. Alas I also felt it would be improper for me to bet on my own analysis, which had been funded by the Treasury - perhaps that just makes me an honest fool. (The morning my study was published - by which time the rate had fallen to much nearer my numbers, naturally - it did move the market by about one percent, but that is another story.)

[2] Will Hutton disagrees. In his counterfactual where we joined, the UK not only does better before the crisis because sterling stays at a competitive rate, but also the UK’s benign influence provides a counterweight to Germany. This alternative history deserves a proper analysis which I do not have space for here, but my initial take is that it involves a lot of wishful thinking. 

Government debt, Inflation and Money

Do budget deficits cause inflation? Let me be a little more specific: does raising the level of debt and keeping it there when the economy is at full employment raise the price level? The conventional answer is: not if the central bank controls inflation. Sometimes economists say the same thing in a different way: not if the debt is not monetised. High debt may be problematic for other reasons (e.g. crowding out of private capital, default risk, increasing distortionary taxation), but not because it must cause inflation.

This post is about explaining this conventional view. The two ways of giving the answer reflect two different ways to describe the conventional view, and I think that tells us something interesting - although perhaps controversial - about the role of money.

In the textbooks, the conventional view starts by talking about the demand for the medium of exchange, money. The amount of money in the economy, it is assumed, is related to the amount of money created by the central bank, but not the amount of debt issued by the government. The demand for nominal money is proportional to the price level, which is what economists mean when they say people demand ‘real balances’. So, if the stock of nominal money does not change, neither can the price level. When economists talk about not monetising the debt, they mean that the central bank keeps nominal money fixed.

There are two elements in this argument. The first has to do with the relationship between the amount of money created by the central bank (‘base’ or ‘high powered’ money), and what the financial institutions that create money (private banks) can do. The second has to do with money demand, which is what I want to focus on first. To do so, imagine an economy where the only money is cash printed by the government.

It is trivial to show why there can be this tight and simple link between cash and the price level. The economic system is all about real variables: not just consumption and output, but also relative prices like real wages. Furthermore people want money to buy some real quantity of goods, so the demand function can be written as M/p = f(...) where (...) includes real output. So, if the price level only appears on the left hand side of this equation and nowhere else in the system of equations describing the economy, and the central bank controls the supply of cash M, then this will lock down the price level. This is the famous neutrality of money. Furthermore, the mechanism by which this lock down works is intuitive: if the central bank creates more cash, we have ‘too much money chasing too few goods’, so prices rise.

Once we allow private banks to create money, the story can get much more complicated. The textbooks try and short circuit this by teaching the money multiplier, which I think does a lot more harm than good. But we could just assume there is some mechanism by which the central bank can control the amount of money created by banks, and continue to tell our neutrality story.

So according to this conventional view there is no worry about government debt, as long as the central bank ignores debt when ‘fixing the money supply’. Whether it always will ignore debt, or whether it always can, is a separate issue for another post. The critical assumption I make here that allows me to avoid this issue is that the fiscal authority does adjust its taxes or spending to make the higher level of debt sustainable.

This story is missing a key ingredient, and to see why consider the following. Let all government debt be nominal (not indexed). Suppose that, just as there is a demand for real money, there is also a demand for a real quantity of government debt: B/p = g(....). The government, by cutting taxes for a period, raises the supply of nominal debt by a fixed amount. Suppose it keeps nominal debt at this level. In that case, using an argument analogous to the earlier one involving money, will the price level not increase, until the supply of real debt matches the demand for real debt? If so, higher government debt has raised the price level.

One argument here is to say that, as the government increases the nominal quantity of debt, the demand for debt also rises in step, so there is no need for prices to rise. This will happen if consumers are completely Ricardian, because they believe tax cuts today mean tax increases tomorrow, and they save to pay for those future tax increases by buying government debt. In this sense, the supply of government debt creates its own demand, so we do not need anything else, including the price level, to change.

Suppose, however, that this process is incomplete, perhaps because some consumers are credit constrained, and so spend rather than save their tax cut. Does that not mean prices will still have to rise a bit to match the increase in the supply of nominal bonds? However, if we still have a fixed nominal amount of money, then higher prices will raise the demand for money, giving us a contradiction. What squares this circle is that interest rates rise, which makes people economise on money, and also raises the demand for government debt without the need for prices to increase. So higher debt might raise interest rates, but it will not raise the price level if it is not monetised.

Now an interesting feature of this story is that we could cut out the stuff about money altogether. We could just talk about the supply and demand for nominal government debt, and how the demand for debt is positively related to interest rates and prices. If the government wants to borrow more, the demand for nominal bonds needs to rise, and this can happen either because interest rates rise or because the price level rises. If interest rates rise sufficiently there is no need for higher prices. Loanable funds vs liquidity preference and all that. [1]

It is a small additional step to just talk about the central bank controlling interest rates to fix the price level. Nowadays this is how many macroeconomists would explain why higher government debt does not raise prices: the central bank changes interest rates to make sure it does not. This explanation not only has the advantage of simplicity (we do not need to talk about the demand for money, or how the central bank controls its supply), but it also seems to match how central banks think.

Of course something about money is there in the background. When we talk about interest rates being varied to control inflation, and why therefore we can ignore the size of the stock of government debt as an influence on inflation, we are assuming that the central bank has the ability to control interest rates. This depends on the fact that the government can issue money, or more specifically that the central bank’s “liabilities happen to be used to define the unit of account”, to quote from the bible Michael Woodford’s Interest and Prices (p 37). So money is there, but like the impresario of a play, it does not need to appear on stage.

In terms of the question posed by the title, both ways of describing the conventional view (with or without money) end up with the same answer to the question about government debt and inflation, which is good. However I remain puzzled about one thing. Do those who still tell the story using money think that telling the story just with interest rates is equally valid, or in some way misleading? When, with Campbell Leith, I first started using ‘cashless’ models of the Woodford type, a frequent complaint was ‘where was money?’. To appease potential referees we occasionally put money in, even though this added nothing to the main points of the paper. Yet I think those asking the question thought we might be missing something more fundamental, but I never discovered what it was. I remain genuinely curious.     

[1] Recall that I am assuming full employment in all this. In a recession caused by people saving more, higher saving will raise the demand for bonds, so even if the supply of bonds also rises following budget deficits, interest rates or the price level could fall rather than rise.

The knowledge transmission mechanism

In a comment on my last post, Joseph Grossman asks “If the vast majority grasp and support the basic shape of the [fiscal] stimulus solution, and if we live in democracies, isn't it time to shift the analysis to expose the exact and precise mechanisms by which our electoral systems are failing miserably?” This is the question which, since 2010, I have asked myself almost every day. The question becomes even more relevant as the intellectual case for austerity crumbles, but the policy continues, and in some cases even appears to gain ground. There may be some answers that are specific to austerity: see Paul Krugman here or myself here. But in this post I want to use this example to look at the question of the transmission of economic ideas more generally. So let’s break the question down.

First, do the vast majority of economists agree? In the case of fiscal policy, I think the honest answer here is: majority, probably yes, vast, almost certainly no. For example, in this survey the vast majority did agree that the 2009 US stimulus did reduce unemployment. It would be very surprising if this were not the case - after all this is what we teach first year economics students, and it would be a very strange discipline indeed that taught its students something it also thought was wrong. (For this reason, I would love to know the results of a similar survey of German economists.)

Yet on the question of whether it was a good policy (benefits exceeded costs), only 46% agreed, and a large 40% were uncertain or did not answer. That is not a vast majority. I don’t think there is a single reason why so many economists are equivocal. Some worry about government debt levels, others have a deep distrust of government, still others have faith that this is better done by monetary policy, despite the ZLB. I suspect those numbers would be more favourable if the survey was restricted to macroeconomists, but there would still be a significant number who would be unsure.

However, what the majority - vast or not - of economists think would be irrelevant if no one listened to them. The transmission mechanism from economists to economic policy works along many channels. It may be direct. It may be mediated through the civil service. It may work through economists influencing popular opinion, which then influences policymakers. I think the last of these is the least important. In part this is because most people do not have the time and inclination to interest themselves in what economists think: I was going to say regrettably, and I am heartened and encouraged by those who do take an interest, but I doubt if it is reasonable to expect most people to try and find out directly what the arguments are on economic issues.

That is not to say that people do not have opinions. What this does mean is that their opinions come not directly from what economists think, but from how the media discuss economic issues. One way this could work is that people in the media consult enough economists to find out what the key issues are and what the balance of opinion is, and report that to the public. While some of this goes on, to suggest this is how the media generally works would be naive. To see why it is naive, it is useful to look at direct links between policymakers and economists.

Again, a naive view here is that politicians do what the ‘ideal’ media would do. But nearly all economic issues involve winners and losers, either directly or indirectly. Most politicians support the interests of particular groups. So politicians will select to talk to those economists who support policies that favour those interests. They will have little regard to whether those economists are in the majority or not. A classic example is the Laffer curve. Hardly any economists believe that tax cuts increase tax revenues, yet the Republican Party looked to the few who did, and it became a party line. (Paul Krugman, in his first book, talked about the ‘policy entrepreneurs’ who intermediated this process. Nowadays we have think tanks: some good, some propaganda factories.)

Now if we had a media that faithfully reported what the majority of economists thought, and questioned politicians on this basis, then this kind of self selection by politicians would happen a lot less, because it would run the risk of being exposed. This clearly does not happen, as Stevenson and Wolfers lament here. There seem to me to be three main reasons.

1) Those in the media react to incentives and pressure, like anyone else. So when Stephanie Flanders made the obviously correct comment that growth in UK employment despite sluggish output might not be good news because it meant productivity growth was low, she was jumped on by Conservative politicians shouting bias. Did the BBC ignore these complaints and tell the politicians to get real - like hell they did. Yet if someone in the media writes something that does not make sense in terms of what academic economists understand, do the massed ranks of professors stand up and loudly complain? It was a rhetorical question. Occasionally groups of economists write letters, although these are pretty ineffective, either because they get ridiculed, or because it provokes an apparently equivalent letter from the ‘other side’. (See Alan Manning here.) Which brings us to ...

2) For sections of the media that do have an interest in truth rather than propaganda, the perception of being unbiased is terribly important. So when an economic issue that is politically divisive comes up, the natural response is to report ‘both sides’. This is the origin of the ‘opinions on shape of the earth differ’ jibe first suggested by Krugman and immortalised by DeLong (e.g. an early example here). It is much more difficult, and risky, for the media to report which side is in the majority among the experts. So the public just end up thinking that economists disagree all the time, even when they do not.

3) A large section of the media in most countries is politically controlled. Just as it is unnecessary to own the majority of shares to control a company, it is not necessary to control all the media to have a pervasive and defining influence. Of course obtaining ‘control of the means of information’ costs money, so it is not something that ‘both sides do’ in equal measure. The fact that this political influence works more through TV in the US and through newspapers in the UK is an interesting difference, but that it works through some means is not an accident, but an entirely predictable feature of our modern democracy. What I find interesting is that many people, including some academics, appear to deny its importance.

I have become a bit obsessed by all this as a result of the widespread adoption of austerity policies, and their remarkable persistence despite apparent failure. It is interesting to try and assess how important each element is: for example would it make much difference if the vast majority of economists thought fiscal stimulus was both effective and a good policy? One way to judge this is to look to other areas where science and politics clash, like climate change, or even badgers (on rereading, one of my better posts). It is an issue that scientists in general have become increasingly concerned about: the introduction to this collection of essays from the American Academy covers many of the points raised here, and more. However there is a tendency to revert to the old line that academics must communicate more and better, and glide over some of the structural weaknesses in the transmission mechanism that mean it would make little difference if they did.

My own current view is that these structural weaknesses are to a large extent inherent in liberal democratic societies, where restrictions on what money can do are very limited. That has led me to be much more favourably disposed to the delegation of economic decisions, even though this appears less democratic, and can be seen as representing arrogance and self-interest by the academic community. Yet the problem is real enough. And it is personal: when you study, teach and research in a subject where some of its most basic findings - understood for more than half a century- can be brushed aside so easily, and millions of people are worse off as a result, you have to ask yourself what the point is.