Annoying Anti-Stimulus Arguments: Numbers 1 and 2

Unfortunately this may be the beginning of a series. I will try and keep it short and to the point. I will also avoid mentioning anyone in particular who has made these arguments – you know who you are! These arguments are annoying because they keep being made, despite the fact that they have shown to be inadequate over and over again.

No. 1   Arguments that ignore the zero lower bound for interest rates.

                There are good arguments for saying that if monetary policy is free to do its job, then countercyclical fiscal policy is both unnecessary and welfare reducing. I have written on the subject. But having written those papers, I could see immediately the importance of that proviso about monetary policy. At the zero lower bound for interest rates (in a liquidity trap), monetary policy is clearly not free to do its job, and so different conclusions apply. See Eggertson and Woodford (2004). If the argument assumes that, despite the zero bound, monetary policy can do all that is required, then this should be said so explicitly, because it is somewhat counterfactual.

                For exactly the same reasons, these arguments against countercyclical fiscal policy do not apply to individual countries in a monetary union. If monetary policy is set by the ECB, it cannot ensure output is at its natural level (‘full employment’) in each individual Eurozone country. There is a large literature on this, which I have contributed to, but a standard reference would be Gali and Monacelli (2008). There, as in most of this literature, countercyclical fiscal policy in the face of country specific shocks is welfare improving.

No.2    Arguments that say stimulus is just Econ 101, and the profession has moved on.

                I have in the past been very critical of the gap between undergraduate teaching in macro and teaching at masters/PhD level. I think it is quite wrong to teach things to undergraduates that we then tell graduate students are incorrect. But the analysis of fiscal stimulus is not one of these. I know this because my work on fiscal policy uses microfounded New Keynesian models of the type Woodford and others analyse. It is not the same as old fashioned Keynesian analysis, but it can give similar answers for similar reasons. I gave an example here.

                So when I teach Keynesian theory to undergraduates, I am not thinking ‘this is nonsense, as they may find out when they are older’. I’m teaching them simple, non-microfounded models that are a rough approximation to many more advanced, microfounded models. If the argument is that these approximations do not hold in the case of fiscal stimulus, then the argument should be explicit about why. It is just not good enough to say we have better models now, without saying what those models are, and why they make a difference. 

If the argument is that New Keynesian models are wrong, say so, and say why. If the argument is that New Keynesian models would give different answers to Econ 101 reasoning, be specific about which models, and say why they give different answers. If the argument is that state of the art New Keynesian analysis does not support fiscal stimulus at a zero lower bound, then it is simply false: again, see Eggertson and Woodford (2004).

It is time the Bank of England started publishing interest rate forecasts

                In an earlier post I celebrated the announcement that the US Federal Reserve intended to publish interest rate forecasts. It has now done so. Here is the key chart.

The vertical axis in the level of expected interest rates. On the horizontal axis we have four points in time: the end of 2012, 2013, 2014 and the long run. Each dot represents the expectation of one of the FOMC members (roughly the equivalent of members of the Monetary Policy Committee in the UK).

                This tells us some important information that could only be guessed at beforehand. The majority of FOMC members expect interest rates to stay at almost zero for the next two years. Every member of the FOMC expects interest rates to be below their long run level (i.e. they expect monetary policy to be expansionary) in three years time. (We know it is expansionary because we also have FOMC inflation forecasts, so we can work out what real interest rates will be.) Now these forecasts are not necessarily better than others, but that is not the point. What they tell us is what these individuals are likely to decide to do if events (inflation, growth etc) turn out as they expect, and if they are being consistent. (More formally, this makes it easier for a central bank to demonstrate its credibility in the face of potential time inconsistency: see my earlier post for an example of what this means.)

                The Federal Reserve example also weakens two of the standard arguments against the Bank of England doing the same. The first argument is how you get all the MPC members to agree a forecast. As the above shows, you do not. Each member of the MPC says what they think. The second argument is that the public will confuse conditional forecasts with commitments. However, unless every MPC member has the same forecast (which seems unlikely), what you get is alternative opinions, so clearly this is not some kind of unconditional target for interest rates.

                The central bank of New Zealand has been doing this for years, and those of Sweden and Norway for some time now. Those central banks have not decided it was a horrible mistake because the public did not understand what it was doing. However, these were relatively small economies, so the Bank of England could brush their experience to one side. Now that the US has followed in their footsteps, I believe the Bank has to move in the same direction.

The Anti-Keynesian school

                Some comments on this recent post about Schools of Thought macro have raised interesting issues which I had not thought enough about, and which I want to come back to later if I can. Here I want to put forward an idea suggested by this from Jonathan Portes. We wrote these posts simultaneously and independently, and although I think Jonathan’s is consistent and complementary with what I had written, rereading it made me think a bit more about what I was really annoyed about.

Jonathan describes his puzzlement at being labelled a Keynesian when he thought he was just following mainstream macroeconomic theory and evidence. It discusses how misleading it can be to associate views about how the economy works with policy positions which may be rather specific in time, place and circumstance. Now I think these types of criticism, which I made in my original post, apply to at least some other schools of thought in macro. For example the label monetarist has many layers of meaning, from the very specific and policy related (money supply targeting) to the much more general and theoretical (money matters). These layers may be related, but they do not have to be.

Having said that, I think it is worth saying a bit more about the use of the specific term Keynesian, which both our posts focused on. It seems to me slightly unusual when used to denote a school of thought today, because it appears to be invoked more by those who disagree with it than those who agree. Jonathan’s post gave some clear examples of this. To caricature: we do not need to think too much about fiscal stimulus, because it’s a Keynesian policy. It is true that this kind of statement is more often made by politicians, journalists or bloggers than academics, but academics are not blameless here, and others often take their cue from them.

The source for dismissive statements of this kind probably goes back to the 1980s. At the academic level, it reflects the defeat of the Keynesians at the hands of New Classical economists, without noting that things have moved on rather a lot since then. At the level of policy in the UK, it may also reflect a perception on the right of past battles won.   

In contrast, those economists who use (New) Keynesian theory generally think they are just applying standard macroeconomic analysis. They are using the synthesis (e.g. the New Neoclassical Synthesis of Goodfriend and King) that I talked about in that earlier post. They do not think of themselves as members of a school of thought – they thought they were part of the mainstream.

                Is that just arrogance on their part? There are two reasons for thinking it is not. First, it is this synthesis model that is used by pretty well every central bank as the main tool for doing monetary policy. That does not make it right, but it does give it a pretty good claim to being mainstream macro. After all, it is mainly in central banks where macroeconomics is applied to the real world. Second, as the evidence that prices are sticky seems overwhelming (as Paul Krugman points out, the evidence from real exchange movements is clear), and it follows almost automatically that aggregate demand then matters, it is difficult to see how Keynesian analysis can either be controversial or ignored. (Furthermore, even if prices are pretty flexible, demand will still be important in determining output after a severe negative demand shock that takes us to the zero lower bound, as I argued here.)

                So I want to abolish the Keynesian school. Keynesian analysis should be part of the mainstream, and does not need to be embodied in a school of thought. However, for those that like schools of thought, I will replace it with a new one: the anti-Keynesian school of thought. It covers all those who attempt to dismiss Keynesian ideas like fiscal stimulus at the zero bound, or countercyclical fiscal policy in a monetary union, not through reasoned analysis, but by just labelling it Keynesian.

The Return of Schools of Thought Macro

When I first studied macro, it was all about ‘schools of thought’. Keynesians, Monetarists, New Classicals, and probably many more I cannot remember. Macroeconomists tended to take sides. Antagonists often talked across each other, and anyone not already on one side just got totally confused. I recall reading one textbook on international macro where each chapter represented an alternative ‘view’, with no clear idea of how each view or school was related to another. One thing that was pretty clear, however, was that most schools of thought could be identified with a particular ideological position.

                But then things began to change. The discipline appeared to become much more unified. It would be going much too far to suggest that there was a general consensus, but to use a tired cliché, most macroeconomists started talking the same language, even if they were not saying the same thing. I think there were two main reasons for this. The first was microfoundations: deriving the components of macro models from standard optimisation applied to representative agents. This gave macroeconomics the potential to achieve the same degree of unity as microeconomics. The second was the development of New Keynesian theory, which allowed an analysis of aggregate demand within a microfounded framework, and which integrated ideas like rational expectations and consumption smoothing into Keynesian analysis. To use the jargon, all models were now DSGE models.

                Goodfriend and King coined the term ‘New Neoclassical Synthesis’ (call it ‘synthesis’ for short), and other authors wrote along similar lines. So, even as recently as five years ago, I told masters students starting a macro course to forget anything they might have been told about alternative schools of thought: they were going to learn a unified framework that most macroeconomists – the mainstream – would sign up to. It was like the first half of David Romer’s popular textbook: start with Solow, but quickly replace a fixed savings propensity by an optimising intertemporal consumer to get the basic Ramsey model. Add endogenous labour supply to get RBC. Probably talk a bit about overlapping generations. Hopefully add to what was in Romer by doing some open economy stuff. Then add New Keynesian theory built around sticky prices. If the student went on to work in a central bank, they would probably encounter this framework as a central part of that institution’s forecasting and policy analysis.

I think this synthesis and the reasons behind it may have had one or two unintended and unfortunate consequences. Sometimes the emphasis on microfoundations became a bit of a fetish. (I have written about the shaky methodological grounds on which ‘microfoundations purists’ sometimes stand here.) Some have suggested that the emphasis on microfoundations meant too much time was devoted to elements that were easy to model within that framework rather than the things that really mattered. But I personally thought this synthesis had many more positive than negative consequences. I would not wish for every single macroeconomist to sign up to the synthesis: there is an important role for heterodox economists. However I liked the fact that the majority of macroeconomists used the same analytical framework.

                Just five years later and it seems rather different. I’ve encountered a much larger range of economics blogs in the last week or two (you can guess why), and it does feel like going back in time. Schools of thought in macro are definitely back. Since the recession it has become clear that the synthesis had not been adopted everywhere. In particular, in sections of the profession there remained a suspicion (to put it mildly) of New Keynesian theory, and partly as a consequence of this the amount of this theory that was taught to graduates differed widely.

                It is true that for some, schools of thought can be quite fun. Some students find the idea that academic macroeconomics consists of opposing forces locked in combat adds a degree of interest and motivation that might otherwise be lacking. However I am not persuaded that this spice was sufficient to offset misunderstanding. Personally when I was a student I found all the motivation I needed from socially destructive inflation, and widespread unemployment should do the same today. I do think that the schools of thought approach leads to an inexactness which can be misleading and annoying.

                Take the label Keynesian. Look up Wikipedia, and in the third paragraph you will find ‘Keynesian economics advocates a mixed economy — predominantly private sector, but with a significant role of government and public sector...’. Now I have a much more limited idea of what Keynesian economics is. For me, Keynesian macro is business cycle analysis based on aggregate demand and sticky prices. By this definition, the only ‘significant role for the public sector’ required is a central bank. Even in the rather unusual (I hope) times of a zero lower bound, Keynesian advocacy of fiscal stimulus implies is that the government brings forward its bridge building, and not that it permanently build more bridges. Does my preferred definition make me narrow-minded?

 Keynesian analysis as I define it implies that you need monetary policy, and occasionally countercyclical fiscal policy, to stabilise the economy, but that is not what is generally meant by a mixed economy! The extent of the public sector’s involvement in the economy will depend on microeconomics, not macro. Now it is true that those who tend to be antagonistic to state intervention may be uncomfortable with monetary and fiscal stabilisation policy, as I have suggested, but I am against ideology clouding economics, and I certainly do not want this connection hard wired as a school of thought.

                School of thought thinking also tends to bracket ways of looking at the economy with policy prescriptions, even when they are not inextricably linked. Take countercyclical fiscal policy, for example. Is that an intrinsic part of Keynesian thinking? For some time there has been general agreement among most macroeconomists that monetary policy was the stabilisation tool of choice, because of issues like implementation lags. This view has been strengthened by analysis over the last ten years that explicitly looks at welfare derived from a representative agent’s utility: the analysis of a simple basic case is contained in the Woodford paper I referenced here, and some of my own collaborative work has shown this result is surprisingly robust. So linking the routine use of countercyclical fiscal policy to what I think of as Keynesian theory is just misleading.

                  This sort of bundling together of ideas under one label at the very least causes confusion. (Here Jonathan Portes gives one recent example.) Worse still, it leads people to take sides on issues not because of the merits of the case, but because that case is associated with a school of thought whose other elements they do or do not like. I also miss the synthesis. I very much liked the idea that disagreements could be clearly located within a common framework. With the synthesis, I felt macroeconomics began to look more like a unified discipline - more like micro, and dare I say it, more like a science than a belief system. 

Optimism or Pessimism on the EuroZone Crisis?

On Monday Paul De Grauwe and others wrote a letter to the Financial Times in which they warned that the Eurozone was ‘on the road to macroeconomic disaster’.  They wrote:  “Today’s leaders, however, behave like cult followers who refuse to avail themselves of the treatment that will save their lives”. Yesterday Fred Bergsten and Jacob Kirkegaard at VoxEU sound a much more optimistic note about the ability of European leaders to see their way through the Eurozone crisis. They say “We therefore believe the Eurozone crisis – despite the superficial appearance of the opposite – is well on the way towards stabilisation and resolution.”

(A digression. It has just been announced that Fred Bergsten will retire from running the Peterson Institute this year. He established that Institute as a major voice in international macro. This is just a small personal anecdote. In 1998 I did some work with Rebecca Driver for the Institute on equilibrium exchange rates. At the time the Yen was around 160 140 per dollar, and our analysis suggested an equilibrium rate around 100. There was a small presentation of our work to some influential journalists at the Institute. One found the implications for the Yen incredible, and after grilling me, he turned to Fred and said ‘do you support this’? Many in his position would have been equivocal: something like ‘it’s an interesting view, but of course blah di dah’. After all, I was a relatively new academic hardly known in the US. Instead Fred replied ‘yes, I support it’.)

So two very different views, but one reason for this divergence may be that they are mainly looking at different crises. Although Bergsten and Kirkegaard note the competitiveness problem I discussed here, they focus on government debt. They note that, although the ECB has the capability of ending the crisis, to do so would create too much moral hazard. To quote: “Were the ECB to cap governments’ financing costs at no more than 5%, for instance, Eurozone politicians would probably never take the essential but painful decisions.” In other words, it is in the ECB’s perceived long term interests to allow a crisis to persist, because this will spur on institutional reforms that will avoid a similar debt crisis occurring in the future.

To some the idea of progress via crisis might seem far too chaotic. Why, for example, cannot the ECB systematically buy or sell government bonds in the market to achieve announced target interest rates for particular countries, and reduce interest rates for those countries that make progress in tackling debt problems, but raise rates for those that do not? In one sense this is what the market is doing, but while the market might have the general level of interest rates too high because of problems of multiple equilibria, the ECB could provide incentives in a more moderate and controlled way. Perhaps, but I doubt whether the ECB would want to play such an openly political role.   

 Under this view, the ECB’s policy is working just fine. European politicians are being forced to make changes (and in some cases are being forced from office when they do not), and institutional progress is under way. Because such changes are difficult politically they are bound to be slow and erratic, which is why the apparent crisis will continue for some time to come. But, so the argument goes, if at any stage the crisis appeared to be becoming critical, the ECB would step in to avoid this happening.

Paul De Grauwe and his colleagues are worried about a different crisis, a crisis of external imbalances. I think I’m right that as far as my discussion here is concerned, this is equivalent to a crisis of competitiveness. Eurozone countries running current account deficits have been losing competitiveness, and vice versa. To cure this crisis requires deficit countries to restrain demand, and surplus countries to expand demand. Now the first part of this cure is of course identical to the cure for excessive government debt – it requires fiscal austerity. The key difference is the second part, which involves expansion in surplus countries.

It is the absence of expansion in surplus Eurozone countries (which means Germany in particular) that leads De Grauwe et al to be so pessimistic. They see a “decade of economic stagnation entailed by current policies “. If European policy makers do not change course, they “will bear the responsibility for the implosion of the eurozone and, in the end, the failure of the whole European project”. Many others share this concern about a Eurozone recession: see Martin Feldstein for just one example.

We can put it this way. If the problem is simply one of government debt, and we have good reason to believe there is too much debt in most Eurozone countries (including Germany), then general austerity is the order of the day. Whereas the markets believe Germany will undertake austerity of their own free will, in other countries neither the markets nor the ECB believe this, so we need a continuing but controlled crisis to force these countries to act. However, if the problem is external imbalances and competitiveness, we have a danger of ‘competitive austerity’. We need more austerity outside Germany than within Germany to correct imbalances between the two. The more Germany adopts a contractionary fiscal policy the further countries outside Germany are forced to go. The end result is not only general stagnation within the Eurozone, but recession so acute in some countries that political turmoil may follow, possibly leading to the breakup of the Eurozone.

In other circumstances, competitive austerity might not be a problem, because the ECB could counteract any general stagnation by reducing interest rates. There are two reasons why this is not a way out today. First, by raising interest rates last year, the ECB appears to be too preoccupied by short term inflation, so they may not act when they should. Second, and more fundamentally, they are close to a zero lower bound, and so have lost the ability to prevent a second recession through monetary policy. So unlike the case where the problem is risk premia on government debt, the ECB cannot be sure to act effectively in a Eurozone recession.

This suggests that the key problem for the Eurozone is similar to that faced by the US, the UK and others. Too much austerity in the short term is holding back or even killing the recovery from the last recession, because monetary policy has lost its power in a liquidity trap. In these other countries this excessive austerity will ‘only’ result in significantly higher unemployment for many years to come. In the Eurozone the consequences could be more dramatic.   

UK Growth reveals a major macroeconomic policy error

The first estimate of UK growth in the last quarter of 2011 was negative. As these updated NIESR charts show, no other UK recovery has stalled in this way. Of course very little is ever certain, but we can be pretty sure that growth would have been significantly better if the current government had not imposed severe additional austerity measures beginning in 2010. (This is the counterfactual that matters, and just looking at GDP components can be a misleading way at getting at this for reasons I discussed here.) Of course growth might have been better too if the Euro crisis had not happened, but this government had no control over the Euro crisis, while it does decide fiscal policy.

                I do not have anything very new to say about this, in part because many people predicted growth would be harmed before the policy was introduced. (See, for example, this letter from 80 economists published during the 2010 election campaign.) What was the reason for this major macroeconomic policy error? For some I think it was a political calculation that it would be advantageous to get as much of the cuts out of the way early, well before the next general election. However I think others in the coalition were genuinely spooked by events in Greece and elsewhere. Unfortunately the key difference between economies in the Eurozone and those with their own central bank was not appreciated. Today the claim that if these additional austerity measures had not been introduced UK interest rates on debt would have suffered the same fate as many Eurozone countries looks pretty implausible. In Denmark we even have an example of a country that has recently undertaken stimulus measures, and where interest rates have continued to fall in line with other countries outside the Eurozone (see David Blanchflower here).

                So I believe we must add 2010 to a list of major macroeconomic policy errors made in the UK since the war. Like the failed monetarist experiment in the early 1980s, it is the result of a government adopting a policy which relied on a mistaken macroeconomic analysis that was not supported by the majority of academic opinion.  And like that earlier failure, it will leave unemployment significantly higher than it need to have been for many years.  

Comments on Comments

                I number of people have asked me why I have not replied directly to Scott Sumner’s criticism of this and subsequent posts of mine, particularly as he keeps claiming that I made some mistake. Well, for the record, I do sometimes make mistakes, and when they are pointed out I acknowledge them. However on this occasion my writing on this issue seems pretty consistent to me and as far as I’m aware error free. So, why no reply?

                Well, I did in fact leave a comment on Scott’s second post. Scott then wrote another post (rather than comment on my comment). I stopped at this point, partly because the subject matter appeared to be moving away from what Cochrane and Lucas said to other issues which were not obviously relevant to my original point. I think Brad DeLong nails it here. This is one of the problems with the ‘you were inconsistent here, and you have forgotten this here, but you are a professor at Oxford so I’ll give you the benefit of doubt’ sort of exchange. I think it can muddle rather than clarify an issue.

                So instead I wrote a few self contained posts which tried to throw light on some of the issues, but which also made sense on their own. The original quotes I looked at appeared to suggest that if taxes went up, consumption would immediately fall by the same amount (“it’s just a wash”). I pointed out in my original post that this will not happen because of consumption smoothing. What I had not anticipated is that some people might think that lower saving would automatically lead to an equal fall in spending on capital goods without any change in income (another wash). That is why I wrote the savings equals investment post, which explained why this would not happen. Some of the comments to my original post said hey, these guys are just assuming full employment, so I wrote this on that general issue. There also seemed to be some confusion in the debate on the difference between behavioural responses and equilibrium relationships, which Paul Krugman and subsequently Brad DeLong discussed, and which Chris Dillow brilliantly anticipated. As the debate went on, I thought I could clarify a point about multipliers and consumption smoothing (or ‘Old Keynesian’ and New Keynesian models), so I wrote this. I’m glad to see that John Cochrane is now less dismissive of fiscal stimulus, which leads Noah Smith to make observations about politics and macro that have some similarities to those in my original post.

                While I’m on the subject of comments, I should say something about comments on my own posts. I had not anticipated so many people reading my stuff, and therefore so many comments, and if I tried to answer them all I would have to neglect the day job. However I do read them all, and if there is a common theme that I would like to say something on, I’ll write a new post on it (like ‘Demand Denial and Ideology’). One exception is where someone points out an error in what I wrote, or something where in retrospect I think I have been misleading or unclear, in which case I think it is sensible to recognise that immediately by replying to the comment. So thank you to those who have left comments, as I do find them useful.