Executive Pay: acknowledging market failure

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

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

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

Conspiracy within conspiracy in Turkey?

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

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

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

Uncivil debate? Harsh words over fiscal policy

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

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

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

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

Uncertain times in Hungary

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

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

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

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

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

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

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

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

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

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

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

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

Keynesian Economics, Price Rigidity and Demand Denial

Something prompted from revising my second year undergrad lecture notes, and so mainly for economists.

In mainstream macro today, Keynesian economics is synonymous with the macroeconomics of price rigidity. Most of the time I have no problem with that. All the evidence suggests there is significant inertia in aggregate prices, and it is very difficult to tell realistic stories about how inflation moves without taking this into account. Price inertia and imperfect competition are probably essential in understanding why output tends to follow aggregate demand in the short term.

My problem with identifying Keynesian economics with the macroeconomics of price rigidity is that it allows those who would like to ignore Keynesian theory with too easy an opt out. They can argue that, despite appearances to the contrary, prices are in fact pretty flexible. They then conclude that Keynesian economics is irrelevant. Unfortunately far too many academic macroeconomists appear to implicitly or explicitly take this view.

                Is it logically the case that if prices are flexible Keynesian economics can always be ignored? The answer is simply no. Price flexibility alone does not ensure demand always moves quickly towards supply: it is the combination of price flexibility and monetary policy that does this. And when something goes wrong with monetary policy, price flexibility alone may not work.

We are living through exactly such a situation. It is not just the zero lower bound for nominal interest rates that is important here. It is also the fact that monetary policy has an inflation target rather than a price level target. After a large negative demand shock, demand can only be restored in the short term (for a given fiscal stance) by a large reduction in real interest rates. Real interest rates are nominal rates minus expected inflation. The zero lower bound stops nominal rates falling enough, and inflation targeting stops inflation expectations rising enough. No amount of price flexibility can change this. (For a more detailed discussion see here.)

                Students often think that price flexibility must imply that output is supply determined, because if any workers were unemployed, nominal wages would continue falling until they were employed. But just imagine an economy made up of monopolistic competitors where production was linear in labour. In that economy firms would ‘determine’ a constant real wage through their mark-up, and no amount of nominal wage cutting would reduce real wages or increase employment. 

Demand denial is the belief that we can always ignore aggregate demand when analysing short term movements in output and employment. It sometimes seems to be based on a view that price flexibility alone always ensures demand is sufficient for supply. It does not.

2011: The year the OBR came of age

2010 was a disastrous year: the year when global fiscal policy moved from (mild) stimulus to austerity. 2011 was the year of the Euro crisis. But I wanted to be a bit more positive, and original, so let’s highlight 2011 as being the year when the UK’s Office for Budget Responsibility (OBR) came of age. This is mainly of UK interest, but I think it says something more generally about how macro fiscal policy can be improved.

                The OBR is the UK’s fiscal council. Fiscal councils are independent fiscal institutions set up by governments to act as a watchdog over aggregate fiscal policy. They differ in shape and size around the world, but they are becoming increasingly popular. (See this webpage  or Calmfors and Wren-Lewis (2011) ‘What do fiscal councils do?’ Economic Policy.) The OBR is fairly limited in its scope, but what it does is important – it provides the forecast on which budget decisions are based.

                I first argued for a UK fiscal council many years ago, and have actively campaigned for one over the last few years. The OBR is not ideal from my point of view – in particular I think it is daft that it is not allowed to use its considerable expertise to look at alternative policies. However it is still a very important innovation that should certainly improve the fiscal policy debate in the UK, and might even at some stage improve policy.

                But why say this now, when the ‘interim’ OBR was first established in 2010 by the incoming coalition government? Well I think you can argue that November 2011 saw the first occasion when the OBR made the government do something that it did not like doing, and that might not have been done if the OBR had not been there. What the OBR did was revise down its estimate for the size of the UK’s output gap. As the output gap is the difference between actual output and the level output could be without any domestic inflationary pressure, then that is equivalent to saying that it revised down its estimate of what output will be once we have recovered from the recession. Less output means less taxes, so it also means the government can afford less spending. So the OBR said that if the Chancellor stuck to his current plans, he would have less than a 50% chance of meeting his fiscal rules.

As a result, the Chancellor announced budget plans that implied an additional squeeze on spending, which is now extended to beyond the next general election. Now I have mixed feelings about this, because I think fiscal policy in the UK at the moment is way too deflationary. I also do not know if the OBR’s analysis on the output gap is correct, although I do know it is evidence based. (I find the disappearance of so much potential output so quickly something of a puzzle.) But it remains the case that the OBR made the Chancellor do something that he would not have wanted to do.

The real counterfactual is whether the same thing would have happened without the OBR. Treasury officials will have looked at the same evidence, and might have come to the same conclusions. But then the Chancellor might have asked ‘how sure are you that the output gap is not as big as you thought last year’, and the officials would have correctly replied ‘well it is all very uncertain’. In those circumstances it is all too easy for them collectively to conclude ‘let stick with the old numbers until things become clearer’. This is not meant to be a comment on individuals: this is just how government works. A key argument behind the conservative party’s proposals for the OBR is that it prevented politicians influencing the forecast, and that is exactly what it may have done on this occasion.

So 2011 was the year in which the OBR began to make a real difference. Now bias in forecasting is not the only thing that can go wrong with aggregate fiscal policy. Once it is has been going for a few years, I would like to see the OBR’s remit extended so that it can look at the implications of alternative policies. It would also be an obvious body to filter academic research on trying to improve fiscal rules. Until it does these things, it cannot hope to improve the policy goals that governments set themselves. In short, it has a long way to go before it can convince a government not to embark on misguided austerity. But this year the OBR made a start on making fiscal policy respond to evidence rather than political convenience.