Ideology and Falsification in Macroeconomics

                This is a response to two posts, one by Stephen Williamson and another two by Noah Smith. Both are linked to a Paul Krugman post, which commented on, and had the same broad message, as one of my own. See also Mark Thoma here.

                Both Paul Krugman and I argued that the reason for the apparent disputative nature of macro lay in politics and ideology. To paraphrase my own take, the antagonism to a Keynesian reading of events since to financial crisis has ideological roots, based on a distrust of government intervention. This distrust is most apparent in the austerity versus stimulus debate on fiscal policy.

                Underneath Stephen Williamson’s obvious personal dislike for what Krugman is doing, there is a serious challenge to this view.  He writes

“Modern macroeconomics has been much more concerned with science than with politics. Robert Solow, David Cass, Tjalling Koopmans, Len Mirman, and Buzz Brock were not thinking about politics when they developed the theory that Kydland and Prescott used in their early work. I don't think Kydland and Prescott had politics on their mind in 1982, nor was Mike Woodford thinking about politics when he adapted Kydland and Prescott's work to come up with New Keynesian theory.”

Details aside, I think this will strike a chord with many academic macroeconomists. They are just trying to advance the discipline, and are certainly not trying to defend some ideological viewpoint. There are lots of interesting new ideas being explored in modern macro, producing high quality work with important implications. Most importantly, this work can be appreciated by most mainstream fellow researchers. Unlike the days of old, where members of different schools of thought talked across each other, we now have a shared language as a result of the microfoundation of macro.

I agree with everything in the previous paragraph, which is perhaps where I differ from some other Keynesians.[1] But I also obviously agree with what I wrote on ideology and macro. So how can I square this circle? The first, and probably critical, point to make is that when I and most others talk about antagonistic macroeconomic debates, we are referring to debates over current macroeconomic policy rather than the details of some macroeconomic research. The second point is that New Keynesian theory builds on Real Business Cycle foundations, and is therefore in theoretical terms not an alternative to it.

So, for example, I have no problem appreciating a seminar where the presenter explores a flex price DSGE model where fluctuations are only caused by productivity shocks, but where some relevant feature of the real world (some ‘friction’) is being added to earlier models. I might learn something about how to model this new feature, and what its macroeconomic implications might be. It could be the case that these techniques and results are completely negated once you added sticky prices into the model, but normally this is not the case. However, when it comes to looking at the impact of contractionary fiscal policy on the macroeconomy today, I will select a quite different model: sticky prices are essential, because we need to work in a world where we have demand deficiency.

The current reversion of macro back into schools of thought relates to policy advice. It’s about which models we select, and which we reject, when telling governments what to do. So the interesting question that arises is how this selection process takes place. Why do I insist we need to focus on aggregate demand to understand what is happening today, while others take a different view?

In the idealised Popperian description of scientific progress, it is evidence that provides this selection process. The moment that a piece of evidence is found that contradicts a theory or model, that theory will be rejected, and a new theory will emerge that is consistent with all known evidence. What is missing in macro, says Noah Smith, is this falsification process. I think the late and great Mark Blaug would wholeheartedly agree.

Now I could at this stage talk about the limits to falsificationism, and how it particularly fails to apply to economics. But I think Noah is essentially right. For a number of reasons I’ve talked about elsewhere, the microfoundation of macro and DSGE modelling downplays the role of evidence. More specifically, it allows modellers to be selective about which evidence they focus on (the ‘puzzle’). This may be fine for writing papers, but when it comes to model selection to tackle policy problems it is weak. And this weakness lets in the ideological factors I talked about.

So that is how I can be both supportive of current academic macro, and believe that macroeconomic policy advice is contaminated by ideology. I want to add one additional thought. Noah talked about this problem as one involving broken institutions, and I found that strange at first. But let’s go back to my fictional seminar involving a model where cycles are generated by productivity shocks. Even though the model is missing what I believe causes most business cycles, I can still learn something from the seminar, so it would be quite inappropriate for me to denounce the paper and storm out in disgust. Equally, academics should be free to choose what they think are interesting avenues to explore. The problem comes when the policy maker has to choose between models. But how and where exactly should evidence be exerting a greater influence? Is the problem in the selection processes of journals? Should there be more econometric analysis of structural macro relationships in journals, or do VARs tell us all we need to know? If nothing is missing from the academic journals, should policy making institutions employ more staff to do this kind of work? If you think that ideology plays too large a role in macro policy, but refuse to believe that this must always be so, these are interesting questions.        

               

               

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[1] This is a different question about whether modern macro has advanced our understanding of the current crisis. Here I agree that old fashioned tools (be they 1970s macro – see Robert Gordon for example - or the General Theory itself) have proved their worth, but I also suspect that in time a more complete understanding will include more modern (and as yet undeveloped) elements. 

Prolonging unemployment to demonstrate inflation credibility

                Why do central banks in the US, UK and EZ appear to focus on inflation, and ignore unemployment or the output gap? More specifically, why are they apparently not prepared to allow inflation to be above target by, say, 1% for a few years in order to generate a more rapid recovery? There are many potential answers (see, for example, Joe Gagnon), but one that is often mentioned is that excess (above target) inflation would destroy anti-inflation credibility. Here is Bernanke in April (via Felix Salmon, HT Brad DeLong):

“We, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation, which has proved extremely valuable in that we’ve been able to take strong accommodative actions in the last four or five years to support the economy without leading to an unanchoring of inflation expectations or a destabilization of inflation. To risk that asset for what I think would be quite tentative and perhaps doubtful gains on the real side would be, I think, an unwise thing to do.”

                What is exactly meant by this? In terms of a Phillips curve this statement seems odd. Over the last 4 years the recession has kept inflation and inflation expectations low. As long as unemployment remains above the natural rate, rising core inflation is not a danger. Is it plausible that QE might cause inflation without any impact on the real side?

The model that might make sense of such statements is the inflation bias literature. Those familiar with this can skip the next two paragraphs. This literature assumes that monetary policy makers are not content with unemployment at its natural rate. Although unemployment at this rate stabilises inflation, involuntary unemployment still exists at this rate because of market imperfections. As a result, with inflation and inflation expectations at target, policy makers will be tempted to raise inflation in order to reduce unemployment below the natural rate. For brevity, let’s call this the ‘overheating policy’.

                However, the private sector knows this when setting inflation expectations. If expectations are set at the inflation target, they will be too low, because policy makers will raise inflation to get lower unemployment. The only inflation guess that is rational (by which we mean that it will on average be correct) is an inflation level that is so high that policy makers are no longer tempted to pursue the overheating policy. We therefore get a rational expectations equilibrium where inflation is above target, but unemployment is at its natural rate. This excess inflation is called inflation bias.

                This idea was highly influential in persuading academics that independent central banks were a good idea. There are many versions of this argument, but one is that central bankers are less likely than politicians to be tempted to pursue the overheating policy (to reduce unemployment below the natural rate). However, ‘less likely’ is not the same as ‘never will’. So credibility in this context can simply mean the extent to which the private sector believes the monetary authority will not try the overheating policy.

                But what, you may ask, has this got to do with our current situation? Today unemployment is clearly above the natural rate. So a central bank that today traded a bit of excess inflation in order to get unemployment a bit closer to the natural rate need not be showing any signs of wanting to pursue overheating. They would simply be optimising the kind of social welfare function that macroeconomists assume all the time. There are no necessary implications for credibility as defined above.

                However, perhaps there is a more subtle point. Suppose there are two types of central bank: one that would like to try the overheating policy and one that would not. Credibility is about demonstrating that you are the second and not the first type. The private sector does not know which type the central bank is. In addition, the size of the output gap is uncertain, so evidence is messy. If the private sector is trying to guess which type its own central bank is, it might be more suspicious of a central bank that today raised inflation above target. As we noted above, this behaviour proves nothing, but it does not disprove anything either. However, a central bank that stuck with its inflation target even when unemployment is high is unlikely to also want to try the overheating policy, so this does prove something. Being indifferent to unemployment and strict on inflation demonstrates your credibility.

                If this is the argument, I have a suggestion. An even more effective way of establishing credibility, in my view, would be for monetary policymakers to agree to donate all their annual income to charity if inflation turned out to go above target at the same time that unemployment fell below the natural rate. (I am, of course, borrowing an idea from Carl Walsh.) Such a pledge would give a pretty clear indication that they would not intentionally pursue overheating.

                Now one might object that the members of the committee could turn out to be unlucky. We might get the combination of excess inflation and below natural rate unemployment because forecasts went wrong. So this is the potential cost of this proposal. But what is the certain cost of the current policy of using unemployment to demonstrate credibility? Happiness research (see, for example, the references here) suggests that something like the salary of a monetary policy maker is required to compensate just one unemployed person for the unhappiness caused by becoming unemployed. So if the policy of using unemployment to reinforce credibility reduces social welfare by the equivalent of[1] just 20 or more extra unemployed, it is more costly than my suggestion. In reality, the current policy stance is reducing social welfare by the equivalent of thousands of additional unemployed.

                You may think this suggestion is frivolous, and it is certainly unrealistic. But it is meant to illustrate an important point. Credibility should not be immune from a cost benefit analysis. Economists appreciate that few things have infinite worth, and credibility is not one of them.

                Nor do I think credibility is as fragile as central bankers appear to imagine. The idea that a central bank that allowed above target inflation in a situation of high unemployment would suddenly loose all the credibility they had established over the previous 30 years makes no sense.

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[1] By the equivalent of, I mean after netting off the value of any consequent change in inflation. Happiness research also suggests (e.g. Di Tella, MacCulloch and Oswald, AER 2001) that, even if we ignore the unemployed themselves, a 1% fall in unemployment is worth at least as much as a 1% fall in inflation in terms of individual happiness. Add in the convexity we normally assume, and the current policy of (at best) hitting the inflation target but keeping unemployment high is clearly suboptimal. 

What microeconomists think about macroeconomics

                There is a lot that is interesting in Diane Coyle’s 2012 Tanner lectures. What I want to respond to here is an associated post, where she expresses some of the frustrations that I know many microeconomists have with macroeconomics. These can be summed up rather crudely as: why do we disagree all the time, and yet appear so sure we are right, and don’t we realise we are bringing the whole discipline into disrepute? Diane says that “macroeconomists simply do not realise how low their stock has sunk in the eyes of their microeconomist colleagues”. This may be an exaggeration, but who knows what is said when we are out of earshot. Because I (and pretty well all macroeconomists) do have great respect for our microeconomic colleagues, we have some explaining to do. (Jonathan Portes has an excellent post responding to some of the more specific comments Diane makes in this post.)

                What I want to say in summary is this. Microeconomists are right in many of their criticisms, but what they often fail to see is the root cause of the problem. This is that macroeconomic policy is highly political, with strong ideological implications. Ideology and politics distort macroeconomics as a science. Yet despite this, there is – and for many years has been – a substantial body of analysis that most macroeconomics would sign up to, and which has sound empirical backing.

                What is this substantial body of analysis? It is what used to be called the new neoclassical synthesis (Goodfriend and King (1997) – see here for more background and references). For a closed economy, its details are well represented in Romer’s graduate textbook, for example. This body of analysis has important gaps and omissions, of course, such as a naive and simplistic view of the financial sector. However, as I argued recently, the financial crisis itself showed up this incompleteness, but did not invalidate most of what was in the synthesis. Indeed, events since the crisis have provided significant empirical support for the Keynesian elements of that synthesis. (Of course, there are caveats, some of which I have discussed in earlier posts, and which I will return to below.)

                So why the appearance of constant disagreement among macroeconomists? The first point to make is that the disagreement tends to focus on one part of the synthesis, which is short term macroeconomic fluctuations: their causes and cures. This is not the only part of the synthesis which has the potential for political and ideological controversy, but it is where there is constant popular and media interest. The second point, however, is that politics alone is not sufficient to explain controversy within a scientific discipline. Here I might give climate change is an example: despite strong pecuniary temptations, climate change science is pretty united, and typically dissenting views come from outside the discipline.

                The reason, I would suggest, why many macroeconomists do not sign up to the new neoclassical synthesis is that its Keynesian component conflicts with an ideological view which uses economics as part of its intellectual foundation. That view is that markets generally work well when left free from political interference and that government intervention is almost always bad. Now most microeconomists will immediately point out that microeconomic theory as a whole does not support this ideological view. Much microeconomic analysis is all about market imperfections. But that misses the point. Those attracted to this ideological position use a very partial take on economics for support, and are naturally attracted to that part of the discipline.

                Keynesian analysis is all about the consequences of one particular market imperfection. Conventionally this is seen as the externalities that arise from sticky prices. (I personally am increasing drawn to describe them as the consequences of the existence of money, but that is a different story.) It implies in general the need for constant involvement of one arm of the state – the central bank – in stabilising the economy, and in some circumstances the involvement of fiscal policy to do the same. I have argued that this analysis leaves those with the ideological view that free markets are good and government intervention bad feeling very uncomfortable, so they will try and find ways of avoiding and disputing this part of the synthesis.

                Now nothing I have said so far makes macroeconomics unique in attracting ideologically driven controversy. There are areas of microeconomics which are equally controversial for similar reasons. I would suggest the debate over minimum wages is an example. An outsider looking at this debate might well conclude that labour economists are as equally disputatious as macroeconomists on this issue. Another example from my youth I always like to use is the ‘Cambridge controversies’ over ‘reswitching’. This was a highly technical theoretical dispute, but its ideological implications were such that views on this technical debate were highly correlated with political beliefs.

                I think there is one factor that is peculiar to macroeconomics, and that is the role of ‘city’ economists. There are two elements here. One is that city economists work in an environment which has a strong vested interest in promoting the free market ideological view. The other is that part of the name of the game for these guys is to differentiate the product. These are of course tendencies: there are many excellent city economists who go with the evidence rather than with ideological conviction.

                Why is it important to say all this? First, because the influence of ideology on economics is not confined to macroeconomics. It is also not confined to the political right, so there is no simple bias, but recognition rather than denial is important. Second, the cure – if there is one – is evidence. As Jonathan points out, the recent evidence is clearly with those who accept Keynesian views, but I think there is an underlying problem. The way empirical evidence is marshalled in the microfoundations methodology associated with DSGE modelling makes it too easy for those who hold ideologically based priors to retain and defend those priors, which is one reason why I have tried to suggest that it should not be the only way serious macroeconomic analysis is done.

                 

But which inflation?

               In an earlier post, I used recent UK experience to suggest looking at other inflation measures besides consumer prices. The two widely published alternatives are the GDP deflator (the price of all that is produced rather than consumed in an economy) and average earnings/wages. The reason I gave for looking at these other inflation measures was purely pragmatic. Some shocks (like value added tax or commodity price changes) could have a significant impact on consumer prices, but it was difficult to know whether their impact is just temporary or whether they could initiate something worse. Looking at output prices and wages would give you a much better handle on that.

               But consumer prices are what ultimately matter, right? They are what we care about. Well no, not necessarily. Individuals as consumers do not like consumer prices going up, but wages going up are good for individuals as workers, unless they are someone else’s wages. The first thing we need to do is distinguish between inflation in an abstract sense and movements in real variables. (The two may be associated, of course, which may help explain public attitudes.)

 For economists, inflation is the phenomenon where, over some period, all nominal magnitudes are rising together, without any particular implications for real incomes. There are a number of reasons why inflation so defined may be costly. One is that holding money becomes more expensive, because its purchasing power decreases with inflation. In this case a focus on consumer prices is probably correct. But there is another cost of inflation where the source of inflation does matter.

It has been known for some time that inflation goes hand in hand with greater variability in relative prices. To the extent that inflation causes this relative price variability, it is costly, because relative price changes caused by inflation alone distort the market mechanism. One clear reason why this might happen is that many prices are changed infrequently at different times. If the price of good X is changed each April, and the price of good Y is changed each October, then inflation will cause good Y to be too cheap relative to good X in the summer and too expensive in the winter. There is no reason in terms of supply or demand for this pattern in the relative price of X in terms of Y, so if it leads to changes in consumption or production it misallocates resources. The higher the rate of inflation, the greater this misallocation cost.

               Is this cost of inflation important? Keynesians certainly believe that slow or 'sticky' price adjustment is pervasive, and is largely responsible for generating persistence in business cycles. The reasons why many prices are sticky appear diverse and complex, but imperfectly competitive markets do seem to be important. In recent years a number of Keynesian economists (following pioneering work by Michael Woodford in particular) have attempted to quantify the costs of the relative price movements generated by inflation and sticky prices, and these calculations suggest that changes in inflation generate significant changes in social welfare through this route. This means that the type and source of inflation is important. If inflation occurs in commodities where prices are changed frequently, then it is much less costly than if inflation occurs in prices that are sticky. In other words, some types of inflation are more costly than others.

This focus on inflation in goods where prices are sticky bears some relation to the idea of focusing on 'core' inflation[1]. It is possible using similar reasoning to argue that the price inflation measure central banks should target is actually output prices (the GDP deflator) rather than consumer prices.[2]  (If there are trends in relative prices, then this idea also influences the optimal inflation target: see Alexander Wolman here, for example.) The same type of argument also suggests that central banks should be concerned with wage inflation as well as price inflation.[3] This is because wages are themselves 'sticky', and so wage inflation will generate costs by changing relative wages in a distortionary manner just as price inflation causes distortionary relative price changes. All this is explained clearly, in considerable technical detail, by Michael Woodford here.

To see why this is important, consider the recent impact of higher oil prices. This has a direct and fairly immediate impact on inflation. A hard-line inflation targeter would say that an inflation target is an inflation target, so the monetary authority should try and make non-oil price inflation fall to offset the impact of higher oil prices. However oil prices, and some things they influence like petrol prices, are pretty flexible. If inflation is costly because it induces unnecessary relative price distortions in prices that are sticky, then it makes sense to focus on inflation measures that give much less weight to oil prices than the consumer price index. In other words, core inflation is not just useful because it helps predict longer term trends in actual inflation, it is important because it actually matters more than actual inflation.

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[1] A seminal paper here is Aoki, K (2001), Optimal monetary policy responses to relative-price changes, Journal of Monetary Economics, vol. 48, pp 55-80. See this on the relationship between actual inflation, core inflation and commodity prices in the US.

[2]  For the rationale, and some additional and pretty technical complications, see Kirsanova, Leith and Wren-Lewis (2006) ‘Should Central Banks target consumer prices or the exchange rate?’ Economic Journal, 116, F208–F231.

[3] : The key paper here is Erceg, Christopher J., Dale W. Henderson, and Andrew T. Levin, “Optimal Monetary Policy with Staggered Wage and Price Contracts,” Journal of Monetary Economics 46: 281-313 (2000).

Teaching macroeconomics after the crisis

A slight variation on an old theme

                I was asked the other day how macroeconomics teaching at Oxford had changed as a result of the Great Recession of 2008-9. My answer, which was not much, seemed a little surprising at first. Does this reflect insularity or intellectual arrogance? Surely the failure to foresee the financial crisis must have led to some change in what was taught. Does this not confirm something rotten at the heart of economics?

                First I need to explain ‘not much’. [In what follows I only deal with core macro courses, and not options at either undergraduate or graduate level.] John Vickers, who gives the first year macro lectures, has added material on bank runs, leverage and banking reform, where for the latter he has of course played a major role in current UK policy. My own second year undergraduate lectures include a wealth of topical examples to illustrate basic theory. And perhaps most significantly, Martin Ellison now gives a couple of weeks of lectures on recent developments in modelling financial frictions as part of the core post-grad macro course.

                So why was my answer not much? Because although the crisis has added material, nothing has really been thrown away as a consequence of what has happened. We have not, either individually or collectively, decided that the Great Recession implies that some chunk of what we used to teach is clearly wrong and should be jettisoned as a result. Speaking for myself and my second year undergraduate lectures, quite the opposite is the case. As Paul Krugman has pointed out many times, recent developments have in many ways been a vindication of the basic Keynesian model that lies at the heart of any undergraduate macro course.

                Indeed, I would go even further. The mess we are currently in is due in part to policy makers ignoring this basic macroeconomic analysis. As a result, I teach this stuff with renewed vigour and determination. As many people know, both our current Prime Minister and the Leader of the Opposition will have attended a past version of the course I teach (although well before, I hasten to add, I started teaching it). Although George Osborne read Modern History at Oxford (and here ‘modern’ means from 1330, so the Great Depression was not necessarily covered in depth!), one of his principle advisors also read PPE (Politics, Philosophy and Economics). If any future Prime Minister or Chancellor follows a similar path, I want them to remember basic macro theory.

                Now I also teach the first part of the core macro for our MPhil (Oxford’s two year masters) course, and you might think that the basic Ramsey model which is covered there has less relevance to recent events. To some extent this is true: I’ve noted how the standard intertemporal consumption model is not going to explain trends in savings in the UK or US over the last few decades, and my colleague John Muellbauer has written extensively on this. On the other hand, I find the Ramsey model and its OLG variant very useful in discussing issues around the control of government debt.

                So while the Great Recession has clearly shown that macroeconomics is incomplete in important respects, it has not shown that what we thought we knew is all wrong.  In many respects it has shown it is exactly right.

                However I think I should add one important rider to this. Anyone wanting to understand what has happened over the last five years would be better off reading an undergraduate macro textbook like Mankiw than a masters textbook like Romer. This is not because the former is less technical than the latter, but because the former is more old fashioned in academic terms. They might do even better still by reading The General Theory. Before I am misunderstood, I am not suggesting anything is wrong with what we currently teach. Rather that the inevitable focus at the masters level on the recent macroeconomic literature leaves no place for the history of macroeconomic thought, and that is a problem.

                Now I must confess two things here. First, I have not always held this view. Indeed until quite recently, when I thought most macroeconomists signed up to the New Neoclassical Synthesis, I imagined economics might be like a physical science, where knowledge of bygone theory added little to our understanding of the world today. The Great Recession changed that view, for me at least. Second, this argument to teach the history of macroeconomic thought is one that tends to be made by those of a certain age, and even though they might also be very eminent (for example), don’t we all want to pretend we are still young? Well maybe it’s time to admit my age.

Quantitative Easing and Fiscal dominance

Unfortunately I cannot find the written source (if any exists), but I am sure I have heard Mervyn King say, probably before he became Governor, that the one thing central bankers hate more than inflation are budget deficits. One rationale for this attitude is that central banks see themselves as playing a game with the fiscal authorities. Governments may be tempted, because they are not benevolent, to occasionally ignore debt when setting fiscal policy. If the monetary authority monetises that debt, this behaviour may be encouraged. This matters because an outcome where the fiscal authority always ignores debt is very bad.
 (It is very bad if the central bank gives in, because it will lead to inflation. If the central bank does not give in, it is very bad either because it leads to a debt explosion and default, or – if you follow the Fiscal Theory of the Price Level - because you get inflation anyway. I do not think it matters in this context which bad it is – see McCallum and Nelson for an example from this debate.)

If we want to prevent this very bad outcome, so the argument goes, it is important that the monetary authorities do nothing to encourage this fiscal policy behaviour. In purely macroeconomic terms, there may well be occasions when it is efficient to use interest rates to help reduce the debt stock – particularly when the debt stock is high. One half of what I call the consensus assignment – that monetary policy should have nothing to do with debt control – therefore needs to be justified by arguments with a more political economy flavour. This particular political economy argument is the one I helped put forward in more detail here.

This concern about not doing anything to encourage ‘fiscal indiscipline’ is likely to be particularly acute at the moment because of Quantitative Easing. Printing money at a time of large budget deficits can be interpreted as fiscal dominance, so it becomes all the more imperative that the monetary authority draw a line in the sand by insisting that QE is temporary, and reinforcing that by sticking rigidly to their inflation targets.

The trouble is that what the world economy needs right now is a bit of what looks like fiscal dominance. (Brad DeLong thinks along similar lines here.) We need a temporary increase in inflation above target. As I have argued before, by focusing on inflation, and ignoring the output gap, central banks are not maximising social welfare as we normally understand it. So how do you convince central banks that their concern about fiscal dominance needs to be set to one side?

One of the potential strengths of the UK monetary policy regime is that you do not have to. The inflation target is set by the government. As I have said before, I do not know why the UK government (and the opposition) is not even thinking about changing the 2% target. If the answer is that it would be politically too difficult to sell, that becomes a very strong argument against democratic control of macroeconomic policy!

 Where central banks do have control of the inflation target, one argument that could be used is that it is quite unusual for governments to persistently and completely ignore debt when setting fiscal policy (see this research for example). Unfortunately I do not think this line will be very persuasive. Quite unusual does not mean never: see Greece most recently. Even in the US, when a good part of one of the main political parties shows a similar disrespect for numbers and facts as some in the Greek government showed before 2007, anything is possible.

The argument I would use with central bankers is this. Fiscal dominance becomes a problem when the output gap is zero or positive, and not when we have demand deficiency. So allow inflation to rise conditional on the existence of a significant negative output gap (or high involuntary unemployment). This could be done through a nominal GDP target, but it does not have to be done this way.

As regular readers of this blog will know, one of my persistent themes is that with fiscal policy we should separate short term issues of stabilisation from long term issues of debt control. Having a fiscal stimulus in a liquidity trap need not compromise long term fiscal discipline. When the long term problem gets mixed up with short term stabilisation, we get bad results. Exactly the same is true for monetary policy and long term fiscal policy: we should not let an obsession about fiscal discipline distort what we do on short term stabilisation. Central bankers understand that questions of moral hazard have to be put to one side in a banking crisis, so why is it so difficult to see that the same point applies in a macroeconomic crisis?

Mansion House Myths and Excuses

                In his speech yesterday, George Osborne said this:

“Of course, there are those who argue we should not be reducing the deficit – we should be spending and borrowing even more. But that argument ignores a crucial fact: inflation in the UK has been significantly above the Bank of England’s 2% target since the end of 2009. That is due to a combination of commodity price shocks, the lagged effects of a lower exchange rate and a worsening underlying productivity performance, and it has very important implications for fiscal policy. Looking backwards it means that over this period looser fiscal policy would almost certainly have been offset by tighter, or less loose, monetary policy.”

This is an argument I have already discussed, but it is the first time I have seen the government use it. It is an improvement on those based on bond markets, confidence fairies, or expansionary fiscal contraction. Yet even if you buy it (which I do not think you should), the key phrase here is ‘looking backwards’.

                In judging policy, we should not look backwards. Lots of things are true in hindsight, whereas policy has to be made under uncertainty. Good policy should be as robust as possible to this uncertainty. In 2010, when additional austerity was announced, the government did not know that inflation was going to be unexpectedly high in 2011. So it cannot have known that the MPC would have been debating whether to increase interest rates in the spring of that year. A more likely outcome was that inflation would be falling and interest rates would be firmly anchored at their lower bound. As a result, high inflation in 2011 is a poor excuse for a bad decision.

                It was a bad decision because the government should, at the very least, have considered the possibility that demand was going to be weaker than they expected, and that monetary policy would be unable to do much about it because interest rates were at the zero lower bound. If they did not think about this possibility, it was irresponsible. If they did and took a risk, we are now experiencing the consequences.

                The Chancellor in his speech also quoted Mervyn King as saying that current UK policy was a “textbook response” to the current situation. I do not know where that quote comes from (it is not in the text of the Governor’s speech at the same occasion), so I will focus on what the Chancellor thinks. He goes on to explain:  “Theory and evidence suggest that tight fiscal policy and loose monetary policy is the right macroeconomic mix to help rebalance an economy in the state [of high indebtedness].” To which I can only say – no, not when interest rates are stuck at zero.

                Central banks get a lot of criticism: some justified, some not. When it comes to what monetary policy can do in a liquidity trap, they do not want to appear too pessimistic. But there is a danger of giving the opposite impression, which is that nothing much has changed except the way policy is implemented. I would much prefer them to be quite explicit about how much more uncertain Quantitative Easing is as an instrument, and that fiscal policy will have a much greater impact on demand as a result.

                Regular readers may think I’m beginning to sound like a record on this. Indeed, Jonathan Portes argues that the proposed new programme discussed yesterday by the Chancellor of government guarantees to support new house-building and infrastructure investment concedes the intellectual and economic argument.  To quote:  “The economic difference between the government borrowing from the private sector to finance investment spending, and the government guaranteeing the borrowing of another entity - with the government guarantee meaning that the lender has no more or less risk of non-repayment than if the money was lent direct to government - is marginal.” If the new investment happens, I would agree.

I also suspect that Mervyn King would not describe such schemes as pure monetary policy. He says: “But the long term nature of the lending and its pricing mean that the Bank could conduct such an operation only with the approval of the Government, as offered by the Chancellor earlier. So such a scheme would be a joint effort between Bank and Treasury. It would complement the government’s existing schemes, and tackle the high level of funding costs directly.” That sounds like code for this is also fiscal policy.

But why quibble. If measures of this kind allow the government to carry on the fiction that they are sticking to Plan A, and if it produces a recovery which it is then claimed has nothing to do with fiscal policy, should we mind? I think we should, because today’s myths have a danger of becoming tomorrow’s received wisdom.