Microfoundations and the Speed of Model Development

                In a recent post I suggested one microfoundations based argument for what Blanchard and Fischer call useful models, and I call aggregate models. Both Mark Thoma and Paul Krugman picked up on it, and I want to respond to both. While this will mostly be of interest to economists, I have not tagged this ‘for economists’ because I know from comments that some non-economists who think about the philosophy of (social) science find this interesting. If you are not in either category, this post is probably not for you.

                Paul Krugman first. He makes a number of relevant points, but the bit I like best in his post is where he says “Wren-Lewis is on my side, sort of”. I really like the ‘sort of’. Let me say why.

                In one sense I am on his side. I do not believe that the one and only way to think about macroeconomics is to analyse microfounded macromodels. I think too many macroeconomists today think this is the only proper way to do analysis, and this leads to a certain microfoundations fetishism which can be unhelpful. Aggregate models without microfoundations attached can be useful. On the other hand I really do not want to take sides on this issue. Most of the work I have done in the last decade has involved building and analysing microfounded macromodels, and I’ve done this because I think it is a very useful thing to do. Taking sides could too easily degenerate into a ‘for and against’ microfoundations debate – in such a debate I would be on both sides. I certainly do not agree with this: “So as I see it, the whole microfoundations crusade is based on one predictive success some 35 years ago; there have been no significant payoffs since.” The justification for aggregate models that I gave in my previous post was deliberately four square within the microfoundations methodology because I wanted to convince, not antagonise. So ‘sort of’ suits me just fine.

                What I am against is what I have called elsewhere the ‘microfoundations purist’ position. This is the view that if some macroeconomic behaviour does not have clear microfoundations, then any respectable academic macroeconomist cannot include it as part of a macromodel. Why do I think this is wrong? This brings me to Mark Thoma, who linked my piece with one he had written earlier on New Old Keynesians. Part of that piece describes why economists might, at least temporarily, forsake microfounded models in favour of a ‘useful’ (to use Blanchard and Fischer’s terminology) model from the past. To quote

“The reason that many of us looked backward for a model to help us understand the present crisis is that none of the current models were capable of explaining what we were going through. The models were largely constructed to analyze policy is the context of a Great Moderation....”

and

“So, if nothing in the present is adequate, you begin to look to the past. The Keynesian model was constructed to look at exactly the kinds of questions we needed to answer, and as long as you are aware of the limitations of this framework - the ones that modern theory has discovered - it does provide you with a means of thinking about how economies operate when they are running at less than full employment. This model had already worried about fiscal policy at the zero interest rate bound, it had already thought about Says law, the paradox of thrift, monetary versus fiscal policy, changing interest and investment elasticities in a  crisis, etc., etc., etc. We were in the middle of a crisis and didn't have time to wait for new theory to be developed, we needed answers, answers that the elegant models that had been constructed over the last few decades simply could not provide.”

I think this identifies a second reason why an aggregate model – a model without explicit microfoundations – might be preferred to microfounded alternatives, which Paul Krugman also covers in his point (3). This has to do with the speed at which microfoundations macro develops.

                Developing new microfounded macromodels is hard. It is hard because these models need to be internally consistent. If we think that, say, consumption in the real world shows more inertia than in the baseline intertemporal model, we cannot just add some lags into the aggregate consumption function. Instead we need to think about what microeconomic phenomena might generate that inertia. We need to rework all relevant optimisation problems adding in this new ingredient. Many other aggregate relationships besides the consumption function could change as a result. When we do this, we might find that although our new idea does the trick for consumption, it leads to implausible behaviour elsewhere, and so we need to go back to the drawing board. This internal consistency criteria is partly what gives these models their strength.

                It is very important to do all this, but it takes time. It takes even longer to convince others that this innovation makes sense. As a result, the development of microfounded macromodels is a slow affair. The most obvious example to me is New Keynesian theory. It took many years for macroeconomists to develop theories of price rigidity in which all agents maximised and expectations were rational, and still longer for them to convince each other that some of these theories were strong enough to provide a plausible basis for Keynesian type business cycles.

                A more recent example, and one more directly relevant to Mark Thoma’s discussion, is the role of various financial market imperfections in generating the possibility of a financial crisis of the type we have recently experienced. There is a lot of important and fascinating work going on in this area: Stephen Williamson surveys some of it here. But it will take some time before we work out what matters and what does not. In the meantime, what do we do? How should policy respond today?

                To answer those questions, we will have to fall back on models that contain elements that appear ad hoc, by which I mean that they do not as yet have clear and widely accepted microfoundations. Those models may contain elements discussed by past economists, like Keynes or Minsky, who worked at a time before the microfoundations project took hold. Now microfoundations purists would not (I would hope) go so far as to say that kind of ad hoc modelling should not be done. What they might well say is please keep it well away from the better economic journals. Do this ad hoc stuff in central banks, by all means, but keep it out of state of the art academic discourse. (I suspect this is why such models are sometimes called ‘policy models’.)

                This microfoundations purist view is a mistake. It is a mistake because it confuses ‘currently has no clear microfoundations’ with ‘cannot ever be microfounded’.  If you could prove the latter, then I would concede that – from a microfoundations perspective – you would not be interested in analysing this model. However our experience shows that postulated aggregate behaviour that does not have a generally accepted microeconomic explanation today may well have one tomorrow, when theoretical development has taken place. New Keynesian analysis is a case in point. Do the purists really want to suggest that, prior to 1990 say, no academic paper should have considered the implications of price stickiness?

                So here I would suggest is a second argument for using aggregate (or useful, or ad hoc) models. Unlike my first, it allows these models not to have any clear microfoundations at present. Such analysis should be respected if there is empirical evidence supporting the ad hoc aggregate relationship, and if the implications of that relationship could be important. In these circumstances, it would be a mistake for academic analysis to have to wait for the microfoundations work to be done. (This idea is discussed in more detail in “Internal consistency, price rigidity and the microfoundations of macroeconomics” Journal of Economic Methodology (2011) Vol. 18, 129-146 - earlier version here.).

Fiscal policy heroes

                Have you ever wondered why anyone becomes a football (soccer) referee? You are almost certain to be hated by one team and its fans because of the decisions you make. Any mistakes you make will be subject to detailed media scrutiny. Your financial rewards are dwarfed by those earned by the people you attempt to control, and to thank you for that they regularly abuse your attempts to do your job.

                One final thought from my trip to Paris is that we can ask the same question of those who run national fiscal councils. There is no glory and little power to their positions. At some time or other, they will almost certainly incur the wrath of some senior politician, who will publicly assert that the head of the fiscal council is either incompetent or politically motivated. They will have committed the sin of questioning the financial logic behind the minister’s pet project, or the assertion that certain tax breaks or spending projects can be afforded on a sustainable basis. While sections of the media can be the fiscal council’s friend, because they recognise unbiased analysis when they see it often enough, other – more partisan – sections of the media will have no scruples in doing the politician’s dirty work by slandering the fiscal council and its head.

                Who are the people who run fiscal councils, and why do they take on this thankless role? They are people like Alice Rivlin, the first director of the Congressional Budget Office in the US, who would not go along with Reagan’s optimism about self financing tax cuts. Or like Lars Calmfors, the first director of the Swedish Fiscal Council, about which the finance minister said “I have established the earned income tax credit and the Fiscal Policy Council. I am convinced that at least one of the two is very useful. I am very doubtful of the other” (Calmfors and Wren-Lewis, 2011). Like George Kopits, director of the Hungarian Fiscal Council which was abolished after only two years existence. Like Kevin Page, head of Canada’s Parliamentary Budget Office, whom the Finance Minister recently called “unbelievable, unreliable, incredible” after he questioned the rationale for pension reform.

                Having talked to them all, I can suggest one common motivation: a belief that economic decisions should be based on sound analysis rather than political calculation or whim.  A view that not only should a proper analysis be done, but that the public has a right to know about it.

                As I have suggested, this role can be thankless at the time. The silver lining is that in the longer term it may be more appreciated. It has been said that Alice Rivlin is now one of the most respected figures in Washington. Like the public finances themselves, short term unpopularity may be appreciated in the longer term. 

Microfounded and other Useful Models

                This title harks back to one of the books that have influenced me most: Blanchard and Fischer’s Lectures on Macroeconomics. That textbook was largely in the mould of modern microfounded macroeconomics, but chapter 10 was not, and it was entitled ‘Some Useful Models’. One of their useful models is IS-LM.

                The role of such models in an age where journal papers in macro theory are nearly always microfounded DSGE models is problematic. Paul Krugman has brought this issue to the forefront of debate, starting with his ‘How Did Economists Get It So Wrong?’ piece in 2009. His view has been recently stated as follows: “That doesn’t mean that you have to use Mike’s [Woodford] model or something like it every time you think about policy; by and large, ad hoc models like IS-LM are actually more useful, in my judgment. But you probably do want to double-check your logic using fancier optimization models.”

                This view appears controversial. If the accepted way of doing macroeconomics in academic journals is to almost always use a ‘fancier optimisation’ model, how can something more ad hoc be more useful? Coupled with remarks like ‘the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth’ (from the 2009 piece) this has got a lot of others, like Stephen Williamson, upset. I think there are a lot of strands here, many of which are interesting.

The issue I want to discuss now is very specific. What is the role of the ‘useful models’ that Blanchard and Fischer discuss in chapter 10? Can Krugman’s claim that they can be more useful than microfounded models ever be true? I will try to suggest that it could be, even if we accept the proposition (which I would not) that the microfoundations approach is the only valid way of doing macroeconomics. If you think this sounds like a contradiction in terms, read on. The justification I propose for useful models is not the only (and may not be the best) justification for them, but it is perhaps the one that is most easily seen from a microfoundations perspective.

First we must find a new name for these ‘useful’ models. They are sometimes described as ‘policy models’, but that is not a very good name because microfounded models are also used to analyse policy. Let me call them ‘aggregate models’. I think this term is useful, because the defining characteristic of the models I want to talk about is that they start with aggregate macro relationships. Like an IS curve. Microfounded models start with microeconomics, like an optimising representative consumer. I do not want to call aggregate models ‘ad hoc’, because the meaning of ad hoc is not well defined.

The typical structure of a microfounded model involves two stages. In the first stage the microfoundations are set out, individual optimisation problems solved, and aggregation assumptions made. We set out a particular world, perhaps a unique world, in all the detail required for the task in hand. This first stage may also include deriving an aggregate welfare function from individual utility. This leads to a set of aggregate relationships. The second stage involves using these aggregate relationships in some way – to find an optimum policy for example. In aggregate models we only have the second stage. A good paper of either type will often go further, and attempt to suggest (perhaps even show) what it is about the aggregate model that gives us the key results of the paper. Let us call this the critical features of the aggregate model.

Put this way, it looks as if microfounded models must be the superior tool – we get more information in the form of the model’s microfoundations. In particular, we establish that at least one microfounded support exists for the aggregate model we use in the second stage. If we start with an aggregate model, it is possible that no such microfounded support exists for that model. If that could be proved, the usefulness of that aggregate model is completely diminished from a microfoundations perspective. A more realistic case is if we cannot for the moment find any potential microfoundation for such an aggregate model (this is what some people mean by ad hoc), or the only microfoundation we can find is a little odd. In that case the usefulness of the aggregate model is highly questionable.

But suppose there is in fact more than one valid microfoundation for a particular aggregate model. In other words, there is not just one, but perhaps a variety of particular worlds which would lead to this set of aggregate macro relationships. (We could use an analogy, and say that these microfoundations were observationally equivalent in aggregate terms.) Furthermore, suppose that more than one of these particular worlds was a reasonable representation of reality. (Among this set of worlds, we cannot claim that one particular model represents the real world and the others do not.) It would seem to me that in this case the aggregate model derived from these different worlds has some utility beyond just one of these microfounded models. It is robust to alternative microfoundations.

                In these circumstances, it would seem sensible to go straight to the aggregate model, and ignore microfoundations. Well, not quite – it would be good to have a sentence referring to the paper that shows at least one of these microfoundations. A classic example of what I have in mind here is Clarida, Gali and Gertler (1999) Journal of Economic Literature. If an aggregate model can be derived from a number of different microfoundations, then we actually appear to restrict the generality of what we are doing by choosing one derivation and then working with this particular microfounded model. I think this possibility is stronger still if we think about the critical features of an aggregate model – the things that generate the results we focus on.

                I suspect it is this robustness aspect of aggregate models that makes them attractive to some macroeconomists. Why restrict yourself to one particular microfoundation – and let’s be honest, waste time going through yet another derivation of Euler equations and the like? Why not go straight to the set of aggregate relationships that contain the critical features we need for the problem at hand?

Now there is a danger in this approach. That sentence referencing the paper where the aggregate model is derived from microfoundations may not be written, and then further along the line it turns out that the aggregate model being used misses out something important because microfoundations were being ignored. Krugman acknowledges that danger in the last sentence of the quote I started with. However, it seems a little strong to suggest that to avoid such mistakes we should always do the full microfoundations thing.

                So my claim is in many ways quite a weak one. Some aggregate models contain critical features that can be derived from a number of different microfoundations. In that situation, it is natural to want to work with these aggregate models, and to describe them as useful. We could even say that they are more useful, because they have a generality that would be missing if we focused on one particular microfoundation. 

Why introductory macroeconomics should ditch the LM curve

For teachers and students of economics

                For the next two years I will be taking a break from teaching tutorials in first year undergraduate macro. That will be a relief for just one reason. I have become more and more embarrassed at having to teach the IS-LM model. The IS curve is fine, but the LM curve is not. The reason is obvious enough: central banks do not operate a fixed money supply policy. It would be nice to tell students that the fiction that the monetary authorities fix money is a harmless fairy story, but I do not believe this. Here are just three mistakes or confusions caused by using the LM curve.

1) Is that real or nominal rates on the vertical axis? It does not matter if expected inflation is constant, but we use the apparatus to look at price changes.

2) IS-LM leads to AS/AD. If your goal is controlling inflation, the AS curve suggests that all you need to do is to return to somewhere on the vertical AS curve. If you use a traditional Phillips curve with backward looking expectations then returning to the natural rate will not be enough. Which is the student supposed to believe?

3) IS-LM leads to textbook Mundell Fleming, which in its simplest form has domestic interest rates stuck at world levels. Everyone then learns that fiscal policy is ineffective under floating rates, which is unfortunate, because this is a special consequence of assuming fixed money. The IS curve plus UIP is a much better way to think about this, and gives a more relevant answer: a temporary demand shift is not crowded out by an appreciating real exchange rate if domestic interest rates are unchanged.

                I’m currently lecturing on Oxford’s second year undergraduate macro course. There I largely ignore the LM curve, and (following the textbook by Carlin & Soskice) instead teach a three equation model involving an IS curve, a Phillips curve, and a monetary rule. The monetary rule captures the idea that the monetary authority has preferences over excess inflation and the output gap, and combining this with the IS curve and Phillips curve we can derive a Taylor rule. While the monetary rule curve is far from ideal, representing the result of a static rather than dynamic optimisation exercise, it at least captures the spirit of what central banks try and do today.

The introductory course in macro at Oxford starts with IS-LM, but it also includes the Phillips curve and the Taylor rule, presumably because they are more relevant than the AS curve and the LM curve. So first year students learn about the AS curve and the Phillips curve, the LM curve and a Taylor rule. Perhaps not surprisingly, many get very confused. It would seem to make much more sense to switch things around. Use only the IS curve, Phillips curve and monetary/Taylor rule in a first year introductory course, and only introduce the LM curve in subsequent years. (I would introduce the LM curve in stages. First, think about replacing an inflation target with a price level target for monetary policy. Maybe think about nominal GDP targets, using the current situation as clear motivation. Then go to money supply targets, with of course some discussion of money demand.)

                This sequencing seems clearly preferable, so I find it puzzling that most Principles textbooks do not take this approach, but instead continue to start with IS-LM. Why are they so devoted to the LM curve? Is learning about the LM curve meant to impart some deep wisdom to students? Is there a feeling that because money is important in understanding how business cycles and inflation work, it should be introduced as part of the core model come what may? This seems strange, and is probably counterproductive. Perhaps the explanation is more mundane: that the economics of high volume textbook publishing is such that innovation is difficult to do. 

I sometimes say to master’s students just starting the core macro course that they will spend some time learning about the same stuff as they did when they were undergraduates: inflation, unemployment, business cycles. The key difference is that what they learn will only be 5 or 10 years out of date, compared to material that is 30 years out of date for undergraduates. Strange, but unfortunately true.

Government debt in Europe: some good and bad news.

                Readers of this blog will know that I am an evangelist for fiscal councils. Fiscal councils are publicly funded independent bodies that provide analysis of national fiscal policy. (They are sometimes called ‘watchdogs’, but some – such as the CBO in the US or PBO in Canada – see themselves as serving the legislature rather than the public directly, so they flinch from that term. As some are not councils as such, but institutions with a standard hierarchical structure, then the term Independent Fiscal Institutions (IFI) may be better, but I use the term fiscal council on my webpage and elsewhere so I’ll stick to that.)

                The good news is that in amongst the various directives/regulations/treaties that have recently been agreed by the European Union, there are clauses that encourage the formation of fiscal councils, together with the need for independent fiscal forecasting. (In some countries, like the UK, the fiscal council (OBR) is all about independent forecasting, while in others, like Sweden, forecasting was already reasonably independent before the council was formed.) This is a case of better late than never. Some EU countries have recently established fiscal councils through their own initiative as a response to the debt crisis (such as Ireland, Portugal and Slovakia), so this EU initiative is playing catch-up in their case.

                The bad news is that the rest of the EU’s response to the debt crisis makes life difficult for these new fiscal councils, and may in effect hinder the formation of new ones. In essence this is because the broad thrust of the EU’s crisis management has been to take away national autonomy in making fiscal decisions. I complained about this in the context of the new treaty here. What I had not fully appreciated until recently is that you now almost need a fiscal council just to try and work out what the huge number of sometimes conflicting EU directives actually mean in terms of what a country is allowed and not allowed to do.

                I think some economists view this development as benign, because they see it as part of an inevitable transition to a fiscal union. When others point out that so far it is no such thing, it is suggested that a fiscal union has to be done in stages for (largely German) political reasons, and that large scale European transfers will emerge once national fiscal responsibility is nailed down. Even if this was the planned pathway, I have severe doubts that it is a feasible path politically.

                I have even greater doubts that the new European regime will be able to deliver fiscal responsibility. As I have often argued, simple rules that produce severely suboptimal outcomes are not sustainable. (For a recent discussion of this sub-optimality, see Karl Whelan.) This was true with the original SGP, and it is just as true now. The idea that you can have effective legally binding rules based on something as difficult to measure as a structural budget deficit is bizarre.

                As Tyler Cowen suggests, a far better path would be one built on mutual trust. How can Germany begin to trust fiscal policymaking in other countries? Not, I would suggest, by placing monitors inside those countries – this is control, not trust. I far better way starts with recognition that it is in each country’s own interest to maintain fiscal discipline. The original Stability and Growth Pact was based on seeing fiscal policy as a free rider problem, where market discipline had been removed. We now know that this was a misreading, perhaps encouraged by a similar misreading by markets themselves. The pain caused by current austerity will linger long in the national memory. Once we recognise that debt responsibility is in the national interest, the aim should be to encourage the creation of national institutions that support that interest – national fiscal councils. These institutions can then be seen by other countries as their allies in maintaining fiscal discipline at the European level.

                I fear the major barrier preventing this happening may be the European Commission itself. I remember attending a Commission conference soon after the Euro was formed, where I presented a paper that, among other things, explored the possibility of new institutions involved in national fiscal policy. I had a discussion with a senior Commission official, who thought this was an excellent idea - because the Commission could be that institution! Like any bureaucracy, the Commission is all about super-national control, and not subsidiarity.

                One recent episode is a case in point. The Commission has recently suggested withholding funds from Hungary because it believes that country has not taken sufficient action to control its deficit.  Yet only a little over a year ago Hungary had a newly created and highly effective fiscal council under George Kopits. It was abolished by the Hungarian government largely because it was doing its job (for more information on this, see my earlier post). Where was the Commission then? 

Going beyond Quantitative Easing

                I’ve been away for a few days at the OECD, so have only just picked up Scott Sumner, fully endorsed by Tyler Cowen, asking why there are not more people advocating a higher inflation target, or a nominal GDP target, in the UK. (Being away did not in theory prevent me blogging, but I’m afraid in practice I prefer exploring Paris!) I think this is a good question. While there is a very active UK debate about fiscal austerity, most discussion on the monetary side tends to be within the parameters of current policy.  

                Those familiar with the case for raising the inflation target can skip the next couple of paragraphs. For those who are not, the idea is that the central bank/government could moderate the impact of the zero lower bound constraint on interest rates by announcing that it would allow inflation to go above 2% for a significant period after the recession was over. This would help stimulate the economy today through various channels. One is that expected lower future short interest rates should reduce long term interest rates today, which would in turn stimulate borrowing by firms and consumers. Another is that, according to the New Keynesian Phillips curve, expected inflation today depends on expected inflation tomorrow, so if the central bank allowed above 2% inflation in the future, this would raise actual and expected inflation today, lowering real short term interest rates today. One of the interesting things about this policy proposal is that it is very New Keynesian rather than Old Keynesian.

                This policy was first suggested as a way out of Japan’s lost decade (when nominal rates were also stuck at the zero bound) by Paul Krugman, and subsequently formalised by Eggertsson and Woodford (Gauti B. Eggertsson & Michael Woodford, 2003. "Optimal Monetary Policy in a Liquidity Trap," NBER Working Papers 9968) among others. This paper suggests that the optimal policy can be approximated by replacing an inflation target with a price level target, because a price level target implies a period of excess inflation would automatically follow a period of insufficient inflation. Scott Sumner in particular has championed nominal GDP targeting, which would have similar effects, and this policy has gained a lot of support in the US and elsewhere.

                So why relatively little debate on this issue in the UK? At the political level, simple politics combined with recent experience may be important. Price inflation has been, and still is, high in the UK, and this is highly unpopular because it has been associated with large falls in real wages. An argument by any political party that the Bank should target higher inflation, rather than be admonished for its inability to prevent it, would be a hard sell. Nominal GDP (NGDP) targeting may be much more palatable to a non-macro audience, as Krugman points out. However a problem here for the government may be the accusation that such a change reflects a failure of their austerity programme, for reasons discussed below. Whether this issue might be on the Labour Party’s agenda I have no idea, although I cannot see any reason in principle why it should not be.

                What is perhaps more puzzling is a lack of discussion by the Bank itself. As far as I am aware, the Bank has not discussed these various alternatives to its current 2% mandate. I am also not aware of any members of the current MPC discussing them in public. Of course any decision to change the mandate would not be for the Bank or MPC to make – it’s a decision for the Chancellor - but that does not rule out discussion of options. I think this lack of ‘official’ discussion may also discourage debate elsewhere. (I know I thought of writing something myself on this a few weeks back, looked for something from the Bank as a ‘hook’ to argue with, and on finding nothing let it slide.) In contrast to the US, macroeconomic blogs in the UK are not developed or influential enough to initiate a debate themselves.

                The lack of public analysis from the Bank, or MPC members, could perhaps be another example of ‘groupthink’ that Laurence Ball suggests in his analysis of Bernanke’s views on the zero lower bound. My first experience of this came at a conference organised by the Centre for Central Banking Studies in 2009. Chris Sims and Mike Woodford were the other guest speakers, and both my and Mike’s paper provoked discussion of this policy issue. I have often been in meetings where an option may be politely discussed, but you just know it has no chance of serious consideration, and this seemed like one of those. To be honest, I think this represents central bank conservatism more than anything else.

                One of the main arguments against this policy option is time inconsistency. Even if a promise to raise future inflation was effective today, when the recession ended and it was time to implement the policy, the temptation would be to renege on this commitment and return to the 2% inflation target. A smart private sector would realise this, so the promise to raise future inflation would not be believed, and so it would not be effective. A price level or NGDP target is partly designed to help overcome this problem. However, in the case of the UK, where a change in policy would almost certainly have to be decided by the Chancellor rather than the Bank, this should be seen as less of a problem for the Bank or MPC. Its credibility would not be on the line, and the government rather than the Bank would come under pressure to renege.

                Exactly the same could be said of another objection to raising the inflation target, which is that it might be perceived as a way of helping the government reduce the ratio of debt to GDP. This charge could be a more serious concern for the Chancellor, if it was perceived that his austerity program was not delivering the fiscal target he had set himself. However, it should be less of a concern for the Bank, because they have always deferred to the Chancellor’s authority to set the inflation target. So for both reasons, I suspect the lack of discussion by the Bank and MPC may reflect a taboo about deliberately raising inflation above 2%.

                I should add that I think the advocates of NGDP targets sometimes go too far in suggesting that this is an obviously preferable way to speed economic recovery compared to fiscal stimulus. Promises to raise future inflation are costly, which is why there is a time inconsistency problem. However the current recession is, in my view, much more costly, so it needs both monetary and fiscal action to help bring it to a speedy end. Furthermore, the current recession may well indicate an endemic problem with low inflation targets, which is that we are in danger of hitting the zero bound quite frequently. (With this in mind, can anyone explain to me why the Bank of Japan has just announced an inflation target of only 1%?) This seems like an excellent time to be discussing alternatives to inflation targeting. 

So it is a pity that this policy option is not being debated more actively in the UK right now, with help from the Bank and MPC members. In the absence of a discussion based around the Bank, then this seems to be exactly the kind of issue that the Treasury Select Committee of the House of Commons should investigate. The committee has always taken a keen interest in all aspects of monetary policy, and such an investigation would be a good follow-up to their recent report on Bank accountability. 

The Balanced Budget Expansion Debate Begins?

                Less than a week ago, I wrote in a post on my blog: “So there is something we can do with fiscal policy, without increasing government debt. Why does hardly anyone talk about this?” Two days ago Ian Mulheirn from the Social Market Foundation published a detailed proposal exactly along these lines. (There is also a short piece in Monday’s Financial Times.) A coincidence of course, but very welcome.

                This proposal involves bringing forward by four years £15 billion of tax increases pencilled in for after 2015, and using that money for temporary infrastructure spending in those four years. This is a specific example of a more general idea, that you can stimulate demand through additional but temporary increases in government spending financed by temporary increases in taxes. The proposition that this will stimulate aggregate demand is a pretty robust bit of macroeconomic theory. In fact we can go further, and say that the benchmark multiplier for such a policy will be at least one. This suggests that this proposal, by using OBR figures, may be rather conservative in its estimate of the impact on UK growth.

The multiplier will be one if consumers are of the simple Keynesian type who consume some constant fraction of their current income. Higher taxes will reduce their income, but as long as their propensity to consume is less than one, there is a net positive effect on demand, which gets translated into higher output and higher income. But higher income leads to higher consumption, and we get the famous ‘balanced budget multiplier’ of one which every first year undergraduate learns how to prove. However, as Professor Michael Woodford has recently shown, we get exactly the same multiplier of one if consumers are much more sophisticated, and look at their entire lifetime income when planning their consumption. The basic intuition here is that any temporary tax increase gets smoothed over their lifetime, so the impact on current consumption is small. As the simple Keynesian case shows, any short term impact there is will be offset by higher incomes generated by higher government spending.

                This all assumes an unchanged level of real interest rates. Higher aggregate demand should lead to some increase in expected inflation. If the Bank of England keeps nominal interest rates unchanged (which, with inflation falling, they should), then real interest rates will fall, which will provide an additional stimulus to demand. That is why the benchmark multiplier will be at least one. If the government spending is in the form of useful infrastructure projects, this has the additional bonus of increasing future supply.

                Why have tax financed temporary increases in public investment not been part of the austerity versus stimulus debate so far? For those who oppose austerity, I think the problem is a (correct) belief that debt financed increases in spending would be even more effective at stimulating demand (because ‘Ricardian Equivalence’ does not hold), and that the short term dangers of increasing debt are vastly overblown. While I think this line is right in principle, I fear this debate is unwinnable so long as the Eurozone crisis continues, and the media obsesses about ratings agencies. We can argue till the cows come home that the Eurozone is different, because these countries do not have their own central bank, and that the market takes no notice of ratings agencies, but these arguments are drowned out by the daily news about Greece and other Eurozone economies.

                On the other side, among those who favour austerity, I think there is a reluctance to consider policies that increase the size of the state, even though this would only be for a few years. There is also the obvious unpopularity of tax increases. However there is now a real danger that by the time of the next election UK unemployment may still be rising and the recovery will be modest. It is going to be very hard to win an election with this record. (I do not think Argentina will distract attention again as it did in 1982!) The great advantage of tax financed increases in spending is that they stimulate the economy without going back on the austerity pledge. Indeed, because they stimulate growth, they reduce headline budget deficit figures and so increase the likelihood that austerity will be successful in bringing down the ratio of debt to GDP.

                So these proposals from the Social Market Foundation are very welcome indeed. They show that something can be done to stimulate the economy without increasing debt. Of course there is a great deal of discussion still to be had on what taxes to increase, and what investment to fund. However from a macroeconomic point of view most combinations will succeed in stimulating the economy. With unemployment continuing to rise, there is still time to act. It is imperative that we do.