From measures of inflation to the failure of European governance

To some it all seems very strange. The Eurozone is in recession, and no one is doing anything about it. The ECB are keeping interest rates at 0.75%, and there are no plans for Quantitative Easing. It is possible to speculate on possible factors here, but there is one obvious answer. Consumer price inflation is expected to be pretty close to 2% this year and next in the Eurozone as a whole. So with inflation on target, what is there to do?

Now I think there are strong grounds, familiar to anyone who has studied economics, for saying that monetary policy is not just about current inflation, but should be about closing the output gap as well. The OECD in June estimated that the Euro area output gap will be between -3.5% and -4% in 2012 and 2013. However monetary policy makers in the UK as well as the Euro area (and, until recently, the US) appear to be just looking at inflation. Textbooks will have to be rewritten.  

Euro Area Inflation Forecasts

Consumer Prices		2012	2013
	IMF October	2.3%	1.6%
	OECD June	2.4%	1.9%
GDP deflator
	IMF October	1.5%	1.4%
	OECD June	1.2%	1.6%
Compensation per employee	OECD June	1.7%	1.7%

But which inflation measure should they focus on? The standard answer is consumer prices. However there is nothing in economic theory which suggests that this should be the only inflation measure that matters. Indeed, a convincing case can be made that a better indicator of the costs of inflation is a measure of output prices, such as the GDP deflator. As the Table shows, output price inflation is expected to be well below 2% both this year and next. (The change in the GDP deflator is not on average significantly less than CPI inflation.) Furthermore, wage inflation, which is normally significantly greater than either measure of price inflation, is also expected to be below 2%.

A major reason why CPI inflation is above these other measures of inflation is commodity prices. Of course commodity price inflation is largely outside the control of the ECB. But what the ECB is effectively doing, by focusing on the CPI, is saying that non-commodity price inflation has to be below 2% to compensate for rises in commodity prices. Once again, there is no obvious theoretical reason why that is a sensible thing to try and do.  In some Eurozone countries CPI inflation is high because of VAT increases – again it makes little sense for monetary policy to react to this.

So the ECB is not only ignoring the output gap, but it is also ignoring any inflation measure except the CPI. Is this just an unfortunate consequence of the public focus on this measure of inflation? I wonder what would happen if the reverse was the case. Imagine if CPI inflation was at 2%, but other inflation measures were well above, and there was a large positive output gap. Would the ECB be doing nothing in that case?

The news on fiscal policy is equally depressing, and even more predictable (see the final section of this). The public discussion is not about whether further austerity is appropriate. Instead it is whether countries are undertaking enough fiscal contraction to avoid the sanctions that are part of the Eurozone’s excessive deficit procedures (see Bruegel here). The problem is not only the actions of politicians but also the views of those who advise them. It is as if officials have spent the last ten years in a losing battle to restrain public deficits, and they are not going to give up now just when things are going their way. Spiegel (HT MT) reports that Angela Merkel’s government has proposed some very minor fiscal easing, but this has been met by stern disapproval from the country’s Council of Economic Experts.[1]

What we seem to have here is a collective failure of the European governing class. It is a governing class that is much less accountable than in, for example, the United States. While there has been understandable discussion, and some progress, on further economic integration (banking and fiscal union) in the Eurozone, I worry about the wisdom of moves that give further power to a governing elite that has failed, and continues to fail, in such a spectacular manner. (Acemoglu and Robinson, Amartya Sen and Niamh Hardiman express similar concerns.) Is there a danger that economists, with the best of intentions, are helping to dig a deeper hole for the Eurozone because they are failing to see the bigger political picture?

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[1] There is no mention of this in the English summary of their report, and I have no German, so I’m taking Spiegel’s report on trust.

Multipliers, inflation and another response to Tyler Cowen on UK austerity

Tyler Cowen points us to a nice paper by Emmanuel Farhi and Ivan Werning on multipliers. The authors had been good enough to send me a copy earlier, so I can respond quickly. The paper contains some neat analysis, but I just want to focus on one point that Tyler mentions, which may appear counterintuitive at first, but is in fact quite a simple idea. I then want to argue against the implications for the UK that Tyler draws.

The authors focus on the ‘consumption multiplier’, which is the impact of government spending on consumption. So in a closed economy a consumption multiplier of zero is a government spending multiplier of one (there is no capital). This point is not clear from Tyler’s post.

As I have discussed before, and various papers by Eggertsson and Woodford (among others) have explored in detail, at the zero lower bound the consumption multiplier can be positive because higher output raises inflation which reduces real interest rates. The point the authors make is that the further into the future the increases in government spending are, the more powerful is this effect (as long as the zero lower bound constraint is still there). This may seem odd, but it follows simply from the properties of the New Keynesian Phillips curve.

Suppose I can increase output today or tomorrow. The New Keynesian Phillips curve basically says inflation today depends on expected inflation tomorrow and the output gap today[1]. Additional output tomorrow will raise inflation tomorrow. However it also raises inflation today because it raises expected inflation. Higher output today only raises inflation today. So for given nominal interest rates, higher output tomorrow gives me two periods of lower real interest rates, while higher output today just gives me one. A one-off addition to government spending tomorrow, because it raises output tomorrow, gives me a greater impact on real interest rates and therefore consumption than the same one-off increase in government spending today.

Does this have any new implications for the debate of UK austerity? I see things very differently from Tyler. Let’s take his initial points in turn.

1. This is where the confusion over the output and consumption multiplier comes in. Suppose we are highly uncertain about the impact fiscal or monetary policy has on inflation right now. That makes monetary policy’s impact very uncertain, but with government spending on domestic goods you get an output multiplier of one for sure.
2. Again, this is the inflation effect, where fiscal tightening reduces inflation, which at the zero lower bound raises real interest rates, leading to an appreciation. However, as Tyler notes, at the same time as 2010 austerity we also had positive inflation shocks. Furthermore, we have little idea of what caused the 2008 depreciation. So movements in the real exchange rate are not a very reliable indicator of anything.
3. I’m not quite sure what advice is being referred to here. What I would take from the timing point discussed in the paper is that you cannot ignore the impact that announcements of future austerity can have on output today. Expectations matter in macro. Those who say most of the cuts have not happened yet so they cannot explain weak UK output ignore this point. What opponents of austerity like me have been arguing for is postponing cuts until a recovery eliminates the zero lower bound constraint. Without that constraint, monetary policy can in principle completely offset the impact of any cuts on output.
4. Not guilty – indeed I have stressed how price stickiness is not the issue at the zero lower bound.
5. Again not guilty – indeed this cannot apply to anyone who uses New Keynesian theory, as the New Keynesian model is an elaboration of the RBC model.

I’ll stop there, except to make two comments. First, the conclusion that Tyler draws just does not stand up. The paper by Farhi and Werning, like much of the literature that this paper refers to, some of which I have talked about before, uses fairly standard New Keynesian models. New Keynesian models imply cuts in government spending reduce output at the zero lower bound. My discussion of this has been as transparent as I can make it. I also take great exception to the implication in (5) that I pick and choose which theory I use in order to support a particular policy position.

Second, there is a lot more that is interesting and important in the Farhi and Werning paper, particularly concerning policy in a monetary union, and I hope to talk about that in a later post.

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[1] It is not exactly the output gap in most models, but this complication is not crucial here.

Disengagement at the Bank of England?

The Bank of England has just published three reviews of aspects of its performance over the last few years. These reviews were controversial before they were published: Andrew Tyrie, chair of parliament’s Treasury Select Committee, says that “the Bank of England has yet to produce a comprehensive review of the Bank's role in, and response to, the crisis. The decision to commission these reviews fell well short of what was required."

One of the reviews, by Dave Stockton (former Director of Research and Statistics at the US Fed), looks at the MPC’s forecasting capability. I want to discuss just one small part of that review, which I think illustrates how macroeconomic discussion of policy has appeared to degenerate in the UK over the last twenty years. (There is a lot else of interest in the reviews: see here for example.) The Bank’s current forecasting model, a DSGE model, is called Compass. Stockton notes that (para 92): “Compass has now been in active use by the staff as input into the forecast for nearly a year.  However, interested parties outside the Bank have little to no understanding of the model and its key features.”

There is a very simple reason why those interested parties have little or no understanding. The Bank has not published any details of the model. In a speech by Spencer Dale in March, there is a footnote that says: “It is a DSGE model that explains the behaviour of 16 – a relatively small number – of macroeconomic variables in terms a set of underlying economic shocks.  In general, the structure of COMPASS is similar to models used in other central banks, although a few aspects have been tailored specifically to the UK economy.  Further details of COMPASS will be published in due course.” And that, as far as I can find out, is all anyone outside the Bank knows.

But is anyone too bothered by this lack of transparency? They used to be. Less than ten years ago, when the Bank published their previous model BEQM (which I have written about here), the model was launched at a one day conference which was attended – from my rather jet-lagged memory – by a large number of UK academics and macro analysts who showed great interest in the model, and who were rather frustrated at the lack of detail provided on that occasion. Going further back, there was continuous and active discussion of the properties of the main macromodels used in the UK mediated by the ESRC’s Macromodelling Bureau, which I have talked about here.

When monetary and fiscal policy was in the hands of the UK Treasury, the Treasury model was subject to detailed scrutiny. It was and still is available for outsiders to use (which a UK MP, Jeremy Bray, took full advantage of). Treasury macro analysis, including work on the model, was examined by their ‘Academic Panel’, which contained some of the leading UK macroeconomists at the time. Nothing like this exists at the Bank.

So what is behind this gradual disengagement of the tools of monetary policy from the UK academic community? Is it that, in the era of the Great Moderation, the issues became less controversial or interesting? Was the transition of monetary policy from the UK Treasury to a more insular Bank a factor? Did the transition from empirically based econometric models to DSGE analysis play a part? Whatever the reason, it does seem regrettable that the Bank has been using a model to produce its forecast for a whole year that no one knows anything about.

Being rude about austerity

How rude should I be about policymakers? Some may think this a strange question, but I personally have quite a high regard for them. Having spent some of my formative years working in government, I can certainly appreciate the difficulties they face. Sure, there are unspoken (in public) political imperatives that drive a lot of policy, but I don’t think politicians’ public concern with social welfare is entirely a facade, and it is certainly not among most of those who work for them – quite the opposite, in fact. So when I wrote this (see final paragraph) about belief in the confidence fairy, I did worry I was allowing rhetoric to get the better of me.

Now in mitigation, I have to say that the 2010 switch from fiscal expansion to austerity does make me very angry. I’d like to think that this is just because of the immense harm it is doing, but there is something else as well. It represents the abrogation of knowledge: knowledge which, largely through accident, I was particularly aware of. I think this is something that even economists who are not macroeconomists, and not just non-economists, do not fully appreciate. In the mid-2000s my main research was on monetary and fiscal policy interactions, and this was a field that appeared to be characterised by considerable common ground, and certainly not by alternative ‘schools of thought’. Some of this knowledge began to be applied in 2008/9, and even an institution like the IMF which was famed for its fiscal conservatism was quite happy applying that knowledge.

It is as if you are a doctor, treating a patient with proven but also state of the art medication. The patient is not well but the treatment you are applying is working. Then suddenly the hospital administrator tells you to stop, because the drugs are expensive and they would like to try some spiritual healing instead. And, in case you ask, the financial crisis did not suddenly render the sum of macroeconomic knowledge accumulated over the previous decades obsolete (whether embodied in textbooks or DSGE models).

But in a sense all this makes trying to be dispassionate about the reasons for the switch to austerity all the more important. So here is a list. I’ve talked about all of these before, but not in one place. These reasons for advocating austerity are not in order of their relevance (see Farrell and Quiggin (pdf) for the basis of such an assessment), but I am going to give them marks out of ten, where the lower the mark the more rudeness is justified.

“Our government cannot sell any debt.” Here I draw a sharp distinction between those in these countries, and those outside. For those inside, I think the choice between austerity and default (there was no other option) was very difficult, and I would only have minor criticisms: sometimes a failure to adopt the right fiscal mix, sometimes going further than was necessary, and sometimes being naive about the position and motivation of their creditors (perhaps through collective guilt). So 8/10: rudeness not appropriate. For those outside these countries (many in the ECB, Commission, Germany etc), a very different assessment – see below.

 “After Greece, it could be anyone next” or more simply “Panic!”. Many policymakers convinced themselves that markets, in refusing to buy certain countries debt, were behaving irrationally – after all we had just had a financial crisis where they also seemed to behave in this way (either before, or during, or both). In these circumstances, ‘confidence’ becomes the word of the moment, and appeasement to a particular reading of market sentiment understandable (although wrong). Here I give (6-2x)/10, where x is the number of years after 2010. I can forgive policymakers being confused in the panic of 2010, but by 2011 we understood much better what was going on, and the evidence by 2012 that this was a particular Eurozone problem generated by ECB behaviour became so clear that even the ECB understood. (As you can see, 2/10 means I can be rude!)

“We want our money back.” Again a reason that is only relevant to those who lent to certain Eurozone economies. A common enough human motive, generally coupled with a belief that creditors bear no responsibility for properly assessing risk. Not a good way to lend money (see 2007/8 and earlier), and certainly not a good basis for macroeconomic policy. (“Oh, did we play a major part in designing this system?”) Also largely self defeating. What comes into my head as I write is Destroyer of Worlds, and I don’t think that is far wrong. Does not deserve a mark.

“The recovery is well underway, so now is the time to deal with debt.” What this argument has going for it is that at some point it becomes correct. In addition there are policy lags, and forecasting is difficult. But it is also true in macro that timing is everything. The argument was wrong in 2010, because it failed to take seriously the asymmetric nature of the consequences of forecast errors. So (6-3x)/10. By now those who advocated austerity on this basis should have changed their minds, which some have done to their credit (and I mean that – it is difficult to admit mistakes).

“Monetary policy can take care of demand.” What I have called Zero Lower Bound Denial. There is perhaps some evidence that this belief was part of the UK Conservative Party mindset (see end of this post), but I think it is more prevalent among some bloggers, or economists who are not macroeconomists or who ‘missed’ the lost decade in Japan and who thought the Great Depression was just history. There, I’ve revealed my mark by my language again: 2/10. A slight variant in the UK is “without austerity, interest rates would have been higher”, which owes a great deal to hindsight (and higher VAT).

“We need to reduce the size of the state” (apart, perhaps, from the bit that buys military hardware). 0/10, not for the belief itself (that is mostly politics, with very little macro), but for duplicity. Chris Dillow might add, follow Kalecki, a view that the working class needs to be controlled, but I think that was UK 1981, not world 2010. Less than 0/10 for the variant that says what the state does in another country is a waste of money, because even if it happens to be true it combines duplicity with imperialism.

“What aggregate demand problem” or more succinctly Demand denial. A strange belief that should have died when J.B. Say realised his error, but which resurfaces from time to time and place to place. 0/10.

“Reducing debt is virtuous.” I hesitate to include this, because I do not seriously think any policymakers actually believe it (they are often the same people who happily spend or cut taxes in a boom). The macroeconomics is obviously silly – not everyone can run a surplus (so 0/10). Unfortunately this kind of economics as morality does seem to influence some people. The argument that “we cannot waste any time tackling the problem of debt” faces similar problems, and is also not really believed by many who make it.

So there you have it, and yes, I do feel much better having written this all down. But will it stop me being rude in the future?

In partial defense of Cyclically Adjusted Deficits

Tyler Cowen and Nick Rowe both make some good points on the use (or misuse) of cyclically adjusted budget deficits. However there is a danger in moving from ‘we have to be careful in using this concept’ to ‘we should not use this concept’. I think we can ask two questions here. First, when is it better to look at the cyclically adjusted deficit (let’s call it the CAD) than the actual deficit, and second when is it better to look at something else.

The main reason for the focus on CADs is quite simple. It is to stop people writing “because of the recession there is a black hole in the government’s accounts, so they will have to raise taxes or cut spending”.[1] Very crudely, there is the idea here that good policy involves balancing the actual budget. I would claim it is better policy to balance the CAD. The first switches the automatic stabilisers off, which makes the recession worse. Of course what people write would not matter if policymakers were wise to this, but unfortunately they are often not.

Nick Rowe says lets imagine two countries facing the same recession. The first has automatic stabilisers, but the second does not, so there the deficit does not increase as a result of the recession. However the second government undertakes discretionary action that mimics what happens in the first country that does have automatic stabilisers. So both countries are in exactly the same position, with the same actual deficit, but the second has a positive CAD whereas the first does not. Looking at the actual deficit tells us correctly they are doing the same thing, but looking at the CAD implies the second country is doing something wrong.

This means we need to be careful when the degree of automatic stabilisation might vary. I think this is well understood. It might be foolish, for example, to look at the US and Germany, and make inferences about how much fiscal policy is supporting activity based on comparing CADs. But for a given tax and benefit structure, it does nothing to invalidate the key point that it is better to balance the CAD than the actual deficit.

Now of course calculating the CAD is difficult, particularly when there is great uncertainty about the size of the output gap. But this calls for sensitivity analysis, not abandoning the attempt. It is true that uncertainty over the output gap means in theory that balancing the CAD could be worse than balancing the deficit, if we get the cyclical adjustment completely wrong, but I think that is very unlikely in practice. Here the UK is a great example. Last year the OBR revised down its estimate of potential output, and because the government's main fiscal rule targets the CAD, it tightened its future fiscal plans as a result. Now there is a great deal of debate about whether the OBR was right, but imagine what would be happening instead if the government was targeting the actual deficit. 

But while balancing the cyclically adjusted deficit is better than balancing the actual deficit, it is hardly an optimal policy. Here Nick Rowe’s example yields a deeper point. Presumably there is an optimal response to a recession, and that optimal response will certainly depend on many factors (like whether we are in a liquidity trap). The chances that this response is exactly the one that would occur using just the automatic stabilisers must be very small (particularly as the automatic stabilisers are largely independent of these factors). What we should care about is getting this optimal response right, and the mix between it happening automatically and manually (through discretionary action) is a secondary concern.

I also 100% agree with the point that budget deficits (cyclical or otherwise) may be very crude measures of the aggregate demand impact of fiscal policy. I never miss the opportunity of saying that fiscal policy is not one instrument, but many instruments with quite different effects. The example I like to use is a pre-announced increase in sales taxes. This may reduce the deficit when it is implemented, but before that it stimulates aggregate demand. In contrast, a pre-announced increase in income taxes will reduce demand before it comes into effect. However, before they are implemented the direct effect on the budget deficit of both is zero!

To sum up. When the idea that we should raise taxes or cut spending just because there is a recession is regarded as uneducated lunacy, and when fiscal councils routinely provide assessments of the aggregate demand impact of budget measures, and when people stop saying that Greece is not doing enough because it’s not meeting its actual deficit targets, then I think we can dispense with the cyclically adjusted budget deficit. I really do look forward to that day.

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[1] I think the use of the analogy with a black hole in this context is a peculiarly British habit. It makes no sense as far as I can see, and for some reason irritates me immensely. 

The impact of austerity in the UK and Eurozone

When I wrote this recent post on the impact of austerity in the UK, I was slightly nervous about the numbers. I suggested that the 2011 and 2012 cuts in spending on goods and services alone would have reduced GDP in 2012 by between 1.25% and 2.5%, but this was a back of the envelope calculation using simple aggregates and static multipliers, and it left out the impact of important tax increases and transfer cuts. However luckily we today have a rather more systematic analysis from Dawn Holland and Jonathan Portes at NIESR. This adds in the impact of tax increases and transfer cuts, and comes to a figure of over 4% for the impact of 2011 and 2012 austerity on UK GDP in 2012. 

Now at this point I should declare an interest of sorts. Holland and Portes use the Institute’s global econometric model NIGEM. I built the first version of this model. However that was so long ago, and I’m sure that the improvements subsequently made by Ray Barrell, Dawn Holland and others mean that nothing is left of my original construct.

What is especially interesting about the NIESR study is that they also do the analysis for the Eurozone economies. If we extend the calculations to 2013, Greek GDP in 2013 is over 13% lower as a result of 2011-13 austerity, Portugal’s GDP nearly 10% lower and Spain’s 6.7% lower: UK GDP is ‘only’ 5% lower. Now a cut in average incomes of 5% or more is a big deal, and it is why I keep saying that the welfare costs of these measures dwarf other considerations. But we know that this pain is not evenly spread: many people are not much affected by austerity, while others are receiving much larger cuts in their incomes.

The key point, which the NIESR study also puts numbers to, is that this pain is not in any way inevitable. It comes because austerity is being undertaken when monetary policy can do very little to counteract these effects. In more normal times, which means once the recovery is sufficiently underway such that interest rates begin to rise again, this scale of austerity will have a much smaller impact on GDP. In principle, its impact could be completely offset by monetary policy. So the argument that these large income cuts are inevitable because debt has to be brought down at some point is simply wrong.

However the NIESR study does miss one thing out of its calculations. Nowhere is there a confidence fairy that will magically persuade the private sector to spend because government debt is coming down. (As the NIESR study shows, the debt to GDP ratio actually rises because GDP falls by more than debt, but hey that’s a detail – GDP will recover one day, probably.)  Now to believe in fairies you need pretty good evidence, and that is just what we do not have. A few economists think they saw some in the data, but that is not enough - nothing like enough - to justify inflicting this scale of pain on so many. (Others, of course, saw nothing (e.g. pdf).) Unfortunately too many people just wanted to believe in the confidence fairy. Normally we find those who really do believe in 'real' fairies either rather amusing or rather strange. Unfortunately some of those who believed in the confidence fairy were put in charge of running our economies.  

More on climate change and budget deficits

When I wrote this, I was reminded of a rather different but clearly related argument that I have seen the Oxford philosopher (but also economist) John Broome make,[1] although its fullest exploration is probably by Duncan Foley (pdf)[2]. The Stern report clearly suggests that incurring the costs of mitigating climate change today will raise the utility of future generations by more than it reduces ours.[3] However the current generation appears unwilling to incur these costs.[4] Let us call the ‘status quo’ the situation where nothing much is done to prevent climate change, and so future generations suffer as a result.

Broome and Foley suggest that a Pareto improvement is possible compared to the status quo. (A Pareto improvement is a change where some people are better off, but no one is worse off.) This would involve taking measures today to mitigate climate change, but getting future generations to pay for it. How can this trick be pulled off? Following the logic of the arguments I discussed here and here - that government debt involves a transfer between generations - we could pay for climate change mitigation by issuing government debt, which would be redeemed by future generations. Reducing CO2 emissions would not cost us anything, because the money to pay for it would come from selling government debt to the young. The cost would fall on future generations, who would have to pay the higher taxes to either service the extra debt or pay it off. The Stern report suggests future generations would prefer this outcome to the status quo, because they would be prepared to pay to reduce climate change. It is therefore a Pareto improvement compared to the status quo. Let’s call this the ‘debt solution’.[5]

Now there is one immediate and powerful objection to the debt solution, which is that future generations have to pay for something that this generation is doing. It violates the polluter pays principle. This makes the debt solution unfair or unjust. It would be fairer if the current generation incurs the cost of mitigating climate change, just as it is right for a company that pollutes a river to pay to clear up the pollution. Let us call this the ‘just solution’.

The Stern review recommends that we move from the status quo to the just solution. Unfortunately so far most governments, individually or collectively, seem unwilling to do this. In these circumstances should we instead at least start by implementing the debt solution, and then work on achieving the just solution? Broome suggests “we should not encumber the process of controlling climate change with the quite different matter of transferring resources to future people.” That is a controversial suggestion: many will feel that giving governments that option will reduce the chances of achieving the just solution. But perhaps this is an example of where the best is the enemy of the good.

     

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[1] Broome’s paper is mainly about how we value the hopefully small chance of total catastrophe, but the argument discussed in this post is made early on in that paper.

[2] Foley, D. 2007. The Economic Fundamentals of Global Warming. Working paper 07-12-044. Santa Fe, New Mexico: Santa Fe Institute.

[3] Stern argued that it was ethically wrong to value the utility of future generations less than our own. He values their consumption less, because they will be better off and so require more consumption to achieve a certain level of utility. Stern’s report was controversial among many economists because they prefer to follow the supposed ‘revealed preference’ of the current generation to discount the utility of future generations.

[4] The qualifier ‘appears’ is important here. My own, relatively uninformed, view of the politics is that policy in this area is guided by particular vested interests, rather than the collective view of the current generation. If it was the case that the current generation was simply unwilling to make a present sacrifice for future benefit, why is so much money spent on trying to discredit the evidence about climate change?

[5] Government debt probably crowds out productive capital to some extent, but this could be offset if the money spent today involves increasing capital, in the form of renewable energy generation for example.