I like teaching Ricardian Equivalence. Ricardian Equivalence is the idea that consumers will respond to a tax cut by saving the full amount, and not spending any of it. (Here we are concerned only with the impact of the tax cut on income, and we ignore any incentive effects.) It is counterintuitive, so it makes students think. It illustrates the importance of intertemporal budget constraints: that a tax cut financed by borrowing, and holding future spending fixed, must imply higher future taxes to either pay back the borrowing or pay the interest on that borrowing.[1] So a consumer that thinks ahead (and that faces the same interest rate as the government) will have to decide not just how they respond to the tax cut, but how they will pay for future tax increases. Finally it gets across the idea of consumption smoothing in the absence of credit constraints: if a consumer wanted to spend more today and spend less when taxes go up, they will have already done so by borrowing themselves.
Now macroeconomic textbooks will tell you many reasons why Ricardian Equivalence does not hold. Some of these are also interesting for students to explore. However one basic point often does not get the emphasis it deserves, and that is the assumption that the future path of government spending on goods and services remains unchanged. Only by making this assumption can we say that a tax cut today will mean tax increases tomorrow.
In reality consumers who receive tax cuts have very little information about what the implications will be for future taxes or spending. (Things are probably getting better, but as the IMF paper discussed in this post from Carlo Cottarelli makes clear, there is a long way to go.) Even if the current government did say that the tax cut was temporary, and would require higher future taxes to pay back the borrowing, and the consumer believed that government, it is quite possible that a different government might be in power when the time for higher taxes came. If that different government chose to cut its spending rather than raise taxes, then the consumer would be better off in terms of their income as a result of the tax cut.[2] A tax cut today paid for by lower government spending tomorrow will lead to higher consumption today.
The practical importance of this point for temporary tax cuts is probably not great. One of the points I try to get across when teaching is to distinguish between the implications of internalising the government’s budget constraint (which is ‘economics’ for thinking about how the government will eventually pay for a tax cut) and the implications of consumption smoothing. In the standard consumption model, a temporary tax cut, even if it is eventually paid for cutting government spending, will still lead to a quite small immediate increase in consumption, because the consumer will want to spread the benefits over time.[3] If you want to argue that temporary tax cuts will lead to significant changes to consumption, you need to focus on alternative models of consumer behaviour.[4]
The lack of information provided by governments about future fiscal plans, and their inability to commit to such plans in a democracy, is also relevant in trying to distinguish between temporary and permanent tax cuts. Governments often like to pretend tax cuts are permanent even when they cannot be. Those in the US do not need reminding that occasionally governments pretend tax cuts are temporary when they want them to be permanent. Tax cuts could be permanent if they are paid for at some later date by a permanent reduction in government spending. As a result, a tax cut could be a signal that government spending will at some stage be permanently reduced.[5] If that signal is correct, it makes sense to consume all of the tax cut.
So Ricardian Equivalence is a great thought experiment, but never a realistic possibility in a world where governments cannot commit on fiscal plans. Perhaps useful for the macroeconomist as scientist, but never the final answer for the macroeconomist as engineer. The macroeconomist as engineer needs to think about the possibility that a tax cut today implies a change in future plans for government spending, and that consumers might act on that possibility.
[1] We also assume no default or printing money.
[2] Whether the consumer’s overall welfare is higher is another matter, but that is beside the point here.
[3] Under certain conditions, a Barro type consumer who cares about their children will just consume the interest their receive on the amount of the tax cut.
[4] In particular, both the existence of credit constraints and precautionary saving really matter here.
[5] A further possibility is that the tax cut represents favourable news about future growth, which also implies that the consumer is permanently better off.
Monday, 18 February 2013
Friday, 8 February 2013
What is the attraction of helicopter money?
The reviews of the first episode of Mark Carney and the Treasury Select Committee seem generally favourable. Of course those wanting to see inflation targeting killed off right from the start were disappointed (as they were bound to be - you cannot kill an established star that quickly), but its demise has not been ruled out. From my point of view one of the real positives from the show was the evident desire of the new Governor to have a debate about the monetary policy framework, a debate which as I noted before has been largely missing in the UK. Martin Wolf, as ever, eloquently explains (£) the reasons why we need this debate, and I’m glad to see his suggestion that we might look at earnings growth as well as CPI inflation. To put the point strongly, one reason why monetary policy is currently so passive around the world is an unjustified obsession with just one particular measure of inflation.
Martin Wolf also says we need to talk about helicopter money, and the FT leader took a similar line the previous day. Here I admit I am conflicted. The macroeconomist in me wants to complain: as I have said in the past, helicopter money is either a plea for fiscal expansion - which is good, but why not call it that - or a policy for above target future inflation, which may also be good but why not call it that too? However perhaps I am being politically naive - maybe it is the only way we can get governments at the moment to undertake fiscal expansion.
Let me first summarise the macroeconomics as I see it. Suppose the government cuts taxes using new money created by the central bank (often called base money). This helicopter money seems formally equivalent to debt financed tax cuts, with the central bank buying the government debt through Quantitative Easing (QE), and then destroying the debt so it can never be sold. If so, helicopter money differs from tax cuts plus QE only in so far as the money creation with QE is temporary (the debt owned by the central bank is not destroyed), while with a helicopter drop it is permanent. With temporary money creation (QE) it is possible to claim that future inflation will not be allowed to exceed the target, because the central bank is free to reverse QE as much as it needs to. Standard macro would suggest that a permanent increase in base money will raise the price level eventually, so it may no longer be possible to prevent inflation exceeding its target at some point.
Is this standard macro right? I think many get confused by discussion flipping from prices to quantities or vice versa. They may think that the central bank can always raise interest rates to keep inflation in check. But just as in a free market the apple producer cannot flood the market with apples and keep the price of apples high, the central bank cannot flood the economy with money and keep interest rates high. It cannot independently control base money and short term interest rates.[1]
That is the macroeconomics as I see it. What about the naive part. First there is a standard point. A central bank could promise to raise inflation in the future, but will it keep that promise? There is a time inconsistency problem here, which I have talked about before. Perhaps we need some device to force the central bank to make good on raising future inflation, and printing money now might be just that device. In that sense, helicopter money may be a more effective means of increasing future inflation than raising the inflation target. However, if that is the argument, it is better to be honest and call for helicopter money as a means of raising future inflation. The FT leader I mentioned appeared to suggest the opposite.[2]
Second, perhaps this is all about fiscal policy after all. Governments have convinced themselves that we need austerity because government debt needs to come down, and helicopter money allows them to relax austerity without compromising on debt. Stop trying to convince governments they can be much more relaxed about debt in a recession, and let them use money creation as a way of getting fiscal stimulus. As long as there is not too much helicopter money, the increase in future inflation will probably be manageable and will help the recovery, so why quibble. But lets keep quiet about the future inflation bit - we do not want to put them off.
Which brings me back to Dr. Carney. Just imagine that the Chancellor told him over the next few months that he had decided to embark on a limited programme of helicopter money. The aim was to stimulate the economy, and the fact that the money was being used for tax cuts before an election was just one of those coincidences. As the Chancellor knew that Dr. Carney was in favour of additional stimulus, he was sure that he would be happy to go along with this. What would Dr. Carney say? Well we already know from episode one:
“with respect to so-called helicopter money, which was referred to there, I will be absolutely clear, I cannot envisage a circumstance where I would support that as a strategy”
Do I think these are the words of a seasoned central banker who is afraid to break a taboo? I suspect instead they are the words of a good macroeconomist who wants to call a spade a spade. If the Chancellor announced bond financed tax cuts, we know Dr. Carney would not object. If he announced a higher inflation target - well that is also a decision for the Chancellor and not the Governor. But announcing a policy that could severely compromise the future Governor’s ability to do what he is mandated to do, while pretending it does not - I think he has every right to object to that.[3]
[1] Perhaps the hope is that tax cuts financed by printing money will increase demand - because the government has not issued any debt which will require future tax increases to pay back or service (Ricardian Equivalence will not apply) - yet the central bank can still sell what assets it has to mop up the money created by the tax cut. But as this leaves the private sector holding the same amount of government debt as they would if the tax cut was debt financed, it is difficult to see how this trick could work.
[2] As I explained here, if helicopter money was expected to raise prices, consumers would need to save all the tax cut to preserve the real value of their money balances. However savings would still fall because higher prices at the zero lower bound would reduce real interest rates. So the policy is more expansionary because future inflation increases. Here is a closely related post.
[3] I cannot help noting, however, that to the extent that austerity involves price increases of some form, you could legitimately argue that the Chancellor is already making life rather difficult for the MPC. Here is a chart from a recent speech by MPC member Ian McCafferty [HT uneconomical]. The FT suggests the government’s increase in university tuition fees may add 0.3% to inflation both this year, and in the following two years.
Martin Wolf also says we need to talk about helicopter money, and the FT leader took a similar line the previous day. Here I admit I am conflicted. The macroeconomist in me wants to complain: as I have said in the past, helicopter money is either a plea for fiscal expansion - which is good, but why not call it that - or a policy for above target future inflation, which may also be good but why not call it that too? However perhaps I am being politically naive - maybe it is the only way we can get governments at the moment to undertake fiscal expansion.
Let me first summarise the macroeconomics as I see it. Suppose the government cuts taxes using new money created by the central bank (often called base money). This helicopter money seems formally equivalent to debt financed tax cuts, with the central bank buying the government debt through Quantitative Easing (QE), and then destroying the debt so it can never be sold. If so, helicopter money differs from tax cuts plus QE only in so far as the money creation with QE is temporary (the debt owned by the central bank is not destroyed), while with a helicopter drop it is permanent. With temporary money creation (QE) it is possible to claim that future inflation will not be allowed to exceed the target, because the central bank is free to reverse QE as much as it needs to. Standard macro would suggest that a permanent increase in base money will raise the price level eventually, so it may no longer be possible to prevent inflation exceeding its target at some point.
Is this standard macro right? I think many get confused by discussion flipping from prices to quantities or vice versa. They may think that the central bank can always raise interest rates to keep inflation in check. But just as in a free market the apple producer cannot flood the market with apples and keep the price of apples high, the central bank cannot flood the economy with money and keep interest rates high. It cannot independently control base money and short term interest rates.[1]
That is the macroeconomics as I see it. What about the naive part. First there is a standard point. A central bank could promise to raise inflation in the future, but will it keep that promise? There is a time inconsistency problem here, which I have talked about before. Perhaps we need some device to force the central bank to make good on raising future inflation, and printing money now might be just that device. In that sense, helicopter money may be a more effective means of increasing future inflation than raising the inflation target. However, if that is the argument, it is better to be honest and call for helicopter money as a means of raising future inflation. The FT leader I mentioned appeared to suggest the opposite.[2]
Second, perhaps this is all about fiscal policy after all. Governments have convinced themselves that we need austerity because government debt needs to come down, and helicopter money allows them to relax austerity without compromising on debt. Stop trying to convince governments they can be much more relaxed about debt in a recession, and let them use money creation as a way of getting fiscal stimulus. As long as there is not too much helicopter money, the increase in future inflation will probably be manageable and will help the recovery, so why quibble. But lets keep quiet about the future inflation bit - we do not want to put them off.
Which brings me back to Dr. Carney. Just imagine that the Chancellor told him over the next few months that he had decided to embark on a limited programme of helicopter money. The aim was to stimulate the economy, and the fact that the money was being used for tax cuts before an election was just one of those coincidences. As the Chancellor knew that Dr. Carney was in favour of additional stimulus, he was sure that he would be happy to go along with this. What would Dr. Carney say? Well we already know from episode one:
“with respect to so-called helicopter money, which was referred to there, I will be absolutely clear, I cannot envisage a circumstance where I would support that as a strategy”
Do I think these are the words of a seasoned central banker who is afraid to break a taboo? I suspect instead they are the words of a good macroeconomist who wants to call a spade a spade. If the Chancellor announced bond financed tax cuts, we know Dr. Carney would not object. If he announced a higher inflation target - well that is also a decision for the Chancellor and not the Governor. But announcing a policy that could severely compromise the future Governor’s ability to do what he is mandated to do, while pretending it does not - I think he has every right to object to that.[3]
[1] Perhaps the hope is that tax cuts financed by printing money will increase demand - because the government has not issued any debt which will require future tax increases to pay back or service (Ricardian Equivalence will not apply) - yet the central bank can still sell what assets it has to mop up the money created by the tax cut. But as this leaves the private sector holding the same amount of government debt as they would if the tax cut was debt financed, it is difficult to see how this trick could work.
[2] As I explained here, if helicopter money was expected to raise prices, consumers would need to save all the tax cut to preserve the real value of their money balances. However savings would still fall because higher prices at the zero lower bound would reduce real interest rates. So the policy is more expansionary because future inflation increases. Here is a closely related post.
[3] I cannot help noting, however, that to the extent that austerity involves price increases of some form, you could legitimately argue that the Chancellor is already making life rather difficult for the MPC. Here is a chart from a recent speech by MPC member Ian McCafferty [HT uneconomical]. The FT suggests the government’s increase in university tuition fees may add 0.3% to inflation both this year, and in the following two years.
Wednesday, 6 February 2013
Carney and the Treasury Select Committee: Episode One Preview
The new Governor of the Bank of England, Mark Carney, will appear before the Treasury Select Committee for the first time tomorrow. The Committee asked for evidence that could help them with their questioning, and I obliged with the short note reproduced below, which also provides a useful summary of my current views on UK monetary policy which have otherwise been scattered around various posts. However the new Governor’s first appearance might also be an appropriate point to say something about central bank communication in the era of the Zero Lower Bound (ZLB).
Consider the following alternative things Dr Carney might say:
1) At the ZLB there is really nothing more we can do. We have tried QE, which may have helped at the margins, but decreasing returns have clearly set in, and basically monetary policy is now a spent force.
2) The ZLB means we have to do things differently, but we are still able to achieve the goals set for us using a variety of unconventional policies. The instruments have changed, and everything is more uncertain, but otherwise its business as usual.
I’m sure the first statement will never be made, but I think there is a clear danger that something like the second message will be the one conveyed. I know there are some who think, perhaps with the right choice of target, that the second statement is true, but I do not think it is. The following would I believe be the right thing to say:
3) At the ZLB there are still actions that the monetary authorities can take to try and stimulate demand. However there may be limits to this ability, which means that monetary policy can no longer ensure that the output gap falls to zero and that we hit our inflation target. This needs to be understood when other policy decisions are taken.
It is the right thing to say not only because it is nearer the truth, but also because it is the best way to protect central bank independence in the long run.
I was also going to say something on helicopter money, prompted by the following from a leader in the FT today:
“Demand stimulus by helicopter money need not be more inflationary than other types. It could be less so, since by definition it does not come with a built-in expectation of future reversal through tax rises (unlike public borrowing) or monetary tightening (unlike quantitative easing).”
However I realise it requires a whole post to cover all the reasons why this makes no sense, so here is my piece for the select committee, in which no helicopters appear.
1. Monetary policy has two objectives: to stabilise inflation at an acceptable level, and to try to eliminate any output gaps. As a result, academic work on monetary policy has two ultimate goals for monetary policy: to minimise excess inflation and to minimise the output gap. Views about the relative importance of these two objectives vary, and our knowledge here is very partial, but both objectives matter.
2. The current UK monetary policy regime places one of these objectives - targeting inflation - above the output stabilisation objective. This is in contrast to the regime in the United States, which has a ‘dual mandate’, which essentially corresponds to the two objectives outlined above. So why have in the past most macroeconomists, including myself, been relatively content with focusing on inflation as the primary policy objective?
3. The most important reason was that these inflation targets were interpreted in a flexible manner. (The regime is often called flexible inflation targeting.) Specifically the Bank of England has interpreted this flexibility as trying to hit the inflation target in two years time. The general view was that over this kind of time frame, hitting the inflation target would be consistent with closing the output gap. So although minimising the output gap was not a primary policy objective, that objective would be fulfilled under flexible inflation targeting. The theory behind this view is that inflation is ultimately determined by a Phillips curve, which implies inflation will only be stable in the long run if the output gap is zero.
4. Recent UK experience has unfortunately shown that view to be seriously incomplete. Inflation has been persistently above target, yet output is well below its sustainable level.[1] The MPC has currently set policy to achieve the inflation target in two years time, but it does not expect the output gap to come near to being closed in two years time. So the inflation objective is overriding the output gap objective.
5. There are probably two reasons why we now have a conflict between hitting the inflation target and closing the output gap. The first could be called bad luck. The UK economy has been hit by a series of positive inflation shocks: a large depreciation with lagged effects, increasing commodity prices, and increases in certain government charges and taxes. The second is more fundamental and also more a matter of conjecture. When inflation is low, high unemployment appears to have a smaller downward influence than when inflation is higher. One obvious reason for this is that workers are particularly resistant to nominal wage cuts.
6. Whatever the causes, there is now a clear conflict between what a sensible UK monetary policy would be doing and what is actually happening. Monetary policy is not providing enough stimulus to the UK economy, because it is focusing on the inflation target, and not the output gap. Inflation targeting in the UK is not working, and something needs to change.
7. Some commentators suggest that a change in personalities may be sufficient to deal with this problem. I think this is quite wrong. It is clear to me that the MPC takes the Bank’s interpretation of inflation targeting very seriously. It was put very well by Adam Posen in his recent (22nd Jan 2013) evidence to this Committee: “anyone who was on the [MPC] basically took the equivalent, in my opinion, of an oath of office. They were serving on the committee under the terms of the given inflation target.” Posen was generally a ‘dove’, not because he wanted inflation above the target, but because he thought inflation would come down more quickly than others.
8. For this reason, I do not think the MPC would be able to do what the US Fed is currently doing with monetary policy. The Fed has said that they are willing to see inflation go (a little) above their 2% target in order to get unemployment down. I believe the MPC would regard that as violating their remit. It would be useful if the Committee could see if the new Governor takes a different view.
9. If I am right, some change (or official reinterpretation) in the UK monetary regime has to take place. There appear to be three types of change that could be explored: moving to a dual mandate, looking at other measures of inflation, or getting rid of the inflation target completely.
10. Perhaps the most straightforward change would be to make monetary policy in the UK more like policy in the US, by adding an output gap or unemployment objective alongside the inflation target. It would not be necessary, and given current uncertainties it would not be desirable, to specify a particular number for unemployment or output. Instead the MPC could be charged with ensuring output was at a level consistent with long run inflation stability, or some similar phrase. The risk that this change would lead us back to the 1970s is zero. What this change would enable the MPC to do is allow inflation to be above target in 2 years time if they expected the output gap to persist.
11. Another possibility would be to stay with an inflation target, but to broaden the range of inflation measures that were looked at. There is no reason from economic theory why consumer price inflation is the ‘right’ inflation measure to target, and other measures (like output prices, or wage inflation) may be at least as relevant. Unfortunately the series of positive inflation shocks the UK has recently experienced have their maximum impact on consumer prices. Monetary policy in the UK would now be very different if the inflation target was for earnings growth - and there is no reason in terms of the macroeconomics why it should not be.
12. Both these suggestions have one apparent disadvantage: we lose the simplicity and clarity of a single target. By specifying more than one target, and not specifying the trade-off the MPC should use when the targets conflict, we are leaving more to the discretion of the MPC. However, such a regime would still give less discretion to the MPC than monetary policymakers in the US or Eurozone currently have. The targets would still be set by the Chancellor.
13. The third alternative is to replace a single inflation target by a single target for something else. Targets for nominal GDP have been widely canvassed. It is absolutely vital that here a clear distinction is made between targets for nominal GDP growth, and targets for the level or path of nominal GDP. It is the latter that many economists have recently suggested might offer some clear advantages over inflation targets, and which were discussed in a recent speech by the new Governor.
14. As some eminent macroeconomists, like Michael Woodford, have been arguing for the advantages of such ‘history dependent’ targets for some time (well before the recession), a debate on their merits is overdue. Although this issue is widely discussed in the US, we have very little discussion in the UK. This may be because the natural host for such a discussion would be the Bank, but the Bank has felt that it would be inappropriate for it to question its own remit. I hope the new Governor does not take that view, and it would be useful for the Committee to ask him about this. If the Bank, under its new Governor, still felt it inappropriate for it to lead a discussion on the merits or otherwise of NGDP targets, then the Committee itself should think about undertaking this role.
15. While I would welcome an extensive discussion of this type, it would be unfortunate if that debate put on hold any change in UK monetary policy. As I have argued above, policy is providing insufficient stimulus to the UK economy now, because of the form of the current monetary policy regime. Changes could and should be made to that regime now, without in any way prejudicing the results of a more extensive debate on NGDP targets. That is why I think it is important to address the possibility of moving to a dual mandate, or looking at alternative inflation measures.
[1] Macroeconomists use almost as many names for this sustainable level as there are estimates for its magnitude (natural rate, NAIRU, natural level, output potential...), but unless anyone wants to suggest that none of those currently unemployed are capable of working, there can be no doubt that UK output is currently below this level.
Consider the following alternative things Dr Carney might say:
1) At the ZLB there is really nothing more we can do. We have tried QE, which may have helped at the margins, but decreasing returns have clearly set in, and basically monetary policy is now a spent force.
2) The ZLB means we have to do things differently, but we are still able to achieve the goals set for us using a variety of unconventional policies. The instruments have changed, and everything is more uncertain, but otherwise its business as usual.
I’m sure the first statement will never be made, but I think there is a clear danger that something like the second message will be the one conveyed. I know there are some who think, perhaps with the right choice of target, that the second statement is true, but I do not think it is. The following would I believe be the right thing to say:
3) At the ZLB there are still actions that the monetary authorities can take to try and stimulate demand. However there may be limits to this ability, which means that monetary policy can no longer ensure that the output gap falls to zero and that we hit our inflation target. This needs to be understood when other policy decisions are taken.
It is the right thing to say not only because it is nearer the truth, but also because it is the best way to protect central bank independence in the long run.
I was also going to say something on helicopter money, prompted by the following from a leader in the FT today:
“Demand stimulus by helicopter money need not be more inflationary than other types. It could be less so, since by definition it does not come with a built-in expectation of future reversal through tax rises (unlike public borrowing) or monetary tightening (unlike quantitative easing).”
However I realise it requires a whole post to cover all the reasons why this makes no sense, so here is my piece for the select committee, in which no helicopters appear.
1. Monetary policy has two objectives: to stabilise inflation at an acceptable level, and to try to eliminate any output gaps. As a result, academic work on monetary policy has two ultimate goals for monetary policy: to minimise excess inflation and to minimise the output gap. Views about the relative importance of these two objectives vary, and our knowledge here is very partial, but both objectives matter.
2. The current UK monetary policy regime places one of these objectives - targeting inflation - above the output stabilisation objective. This is in contrast to the regime in the United States, which has a ‘dual mandate’, which essentially corresponds to the two objectives outlined above. So why have in the past most macroeconomists, including myself, been relatively content with focusing on inflation as the primary policy objective?
3. The most important reason was that these inflation targets were interpreted in a flexible manner. (The regime is often called flexible inflation targeting.) Specifically the Bank of England has interpreted this flexibility as trying to hit the inflation target in two years time. The general view was that over this kind of time frame, hitting the inflation target would be consistent with closing the output gap. So although minimising the output gap was not a primary policy objective, that objective would be fulfilled under flexible inflation targeting. The theory behind this view is that inflation is ultimately determined by a Phillips curve, which implies inflation will only be stable in the long run if the output gap is zero.
4. Recent UK experience has unfortunately shown that view to be seriously incomplete. Inflation has been persistently above target, yet output is well below its sustainable level.[1] The MPC has currently set policy to achieve the inflation target in two years time, but it does not expect the output gap to come near to being closed in two years time. So the inflation objective is overriding the output gap objective.
5. There are probably two reasons why we now have a conflict between hitting the inflation target and closing the output gap. The first could be called bad luck. The UK economy has been hit by a series of positive inflation shocks: a large depreciation with lagged effects, increasing commodity prices, and increases in certain government charges and taxes. The second is more fundamental and also more a matter of conjecture. When inflation is low, high unemployment appears to have a smaller downward influence than when inflation is higher. One obvious reason for this is that workers are particularly resistant to nominal wage cuts.
6. Whatever the causes, there is now a clear conflict between what a sensible UK monetary policy would be doing and what is actually happening. Monetary policy is not providing enough stimulus to the UK economy, because it is focusing on the inflation target, and not the output gap. Inflation targeting in the UK is not working, and something needs to change.
7. Some commentators suggest that a change in personalities may be sufficient to deal with this problem. I think this is quite wrong. It is clear to me that the MPC takes the Bank’s interpretation of inflation targeting very seriously. It was put very well by Adam Posen in his recent (22nd Jan 2013) evidence to this Committee: “anyone who was on the [MPC] basically took the equivalent, in my opinion, of an oath of office. They were serving on the committee under the terms of the given inflation target.” Posen was generally a ‘dove’, not because he wanted inflation above the target, but because he thought inflation would come down more quickly than others.
8. For this reason, I do not think the MPC would be able to do what the US Fed is currently doing with monetary policy. The Fed has said that they are willing to see inflation go (a little) above their 2% target in order to get unemployment down. I believe the MPC would regard that as violating their remit. It would be useful if the Committee could see if the new Governor takes a different view.
9. If I am right, some change (or official reinterpretation) in the UK monetary regime has to take place. There appear to be three types of change that could be explored: moving to a dual mandate, looking at other measures of inflation, or getting rid of the inflation target completely.
10. Perhaps the most straightforward change would be to make monetary policy in the UK more like policy in the US, by adding an output gap or unemployment objective alongside the inflation target. It would not be necessary, and given current uncertainties it would not be desirable, to specify a particular number for unemployment or output. Instead the MPC could be charged with ensuring output was at a level consistent with long run inflation stability, or some similar phrase. The risk that this change would lead us back to the 1970s is zero. What this change would enable the MPC to do is allow inflation to be above target in 2 years time if they expected the output gap to persist.
11. Another possibility would be to stay with an inflation target, but to broaden the range of inflation measures that were looked at. There is no reason from economic theory why consumer price inflation is the ‘right’ inflation measure to target, and other measures (like output prices, or wage inflation) may be at least as relevant. Unfortunately the series of positive inflation shocks the UK has recently experienced have their maximum impact on consumer prices. Monetary policy in the UK would now be very different if the inflation target was for earnings growth - and there is no reason in terms of the macroeconomics why it should not be.
12. Both these suggestions have one apparent disadvantage: we lose the simplicity and clarity of a single target. By specifying more than one target, and not specifying the trade-off the MPC should use when the targets conflict, we are leaving more to the discretion of the MPC. However, such a regime would still give less discretion to the MPC than monetary policymakers in the US or Eurozone currently have. The targets would still be set by the Chancellor.
13. The third alternative is to replace a single inflation target by a single target for something else. Targets for nominal GDP have been widely canvassed. It is absolutely vital that here a clear distinction is made between targets for nominal GDP growth, and targets for the level or path of nominal GDP. It is the latter that many economists have recently suggested might offer some clear advantages over inflation targets, and which were discussed in a recent speech by the new Governor.
14. As some eminent macroeconomists, like Michael Woodford, have been arguing for the advantages of such ‘history dependent’ targets for some time (well before the recession), a debate on their merits is overdue. Although this issue is widely discussed in the US, we have very little discussion in the UK. This may be because the natural host for such a discussion would be the Bank, but the Bank has felt that it would be inappropriate for it to question its own remit. I hope the new Governor does not take that view, and it would be useful for the Committee to ask him about this. If the Bank, under its new Governor, still felt it inappropriate for it to lead a discussion on the merits or otherwise of NGDP targets, then the Committee itself should think about undertaking this role.
15. While I would welcome an extensive discussion of this type, it would be unfortunate if that debate put on hold any change in UK monetary policy. As I have argued above, policy is providing insufficient stimulus to the UK economy now, because of the form of the current monetary policy regime. Changes could and should be made to that regime now, without in any way prejudicing the results of a more extensive debate on NGDP targets. That is why I think it is important to address the possibility of moving to a dual mandate, or looking at alternative inflation measures.
[1] Macroeconomists use almost as many names for this sustainable level as there are estimates for its magnitude (natural rate, NAIRU, natural level, output potential...), but unless anyone wants to suggest that none of those currently unemployed are capable of working, there can be no doubt that UK output is currently below this level.
Sunday, 3 February 2013
Labour productivity in the recession: why are the UK and US so different?
I’m afraid this post is
going to seem like an episode of House, except without finding out what the patient had at the end. Indeed it
is not even clear which patient, the UK or the US, has the unusual symptoms.
Here are two charts, taken from a new study
by the Institute for Fiscal Studies.[1] The first compares UK labour
productivity in this recession and two earlier large UK recessions.
The second chart compares labour productivity growth in this
recession across selected countries.
These are startling differences, so what can explain them? The
IFS study, which builds on earlier analysis by the Bank, MPC member Ben Broadbent, and others
[2], has some ideas about some things that may be going on and some things that
are not, but I think its fair to say that we are still in the conjecture phase
on this. So this post is mostly conjecture.
Let us start with the first chart. There are two classes of
explanation for such a dramatic change. One is that the structure of the UK
economy has radically changed. The other type of explanation is that the nature
of the recession is different, and so the outcomes are also different. This
recession has been generated by a financial crisis rather than by tight
monetary policy. However, the fall in productivity growth in the UK is pretty
widely spread across industries, so it is not a composition effect caused by a
decline in the financial services sector. We need more clues.
One clue may be the unusual behaviour of UK real wages, which
have fallen in this recession to a much greater extent than they did in earlier
downturns. Unfortunately there is a chicken and egg problem here: does real
wage growth reflect productivity growth (as it generally does in the long run),
or does it have a causal role? It helps here to look at investment. Investment
always falls in a recession, but UK investment has fallen by more in this
compared to earlier recessions.
This leads to one possible story: factor substitution. Firms
are replacing machines by workers, because real wages are low. Real wages are
low because the UK labour market has become more flexible, and workers are
cutting wages in response to unemployment by more than they used to. So this is a
structural change story. If true, this could be good news. If the economy
recovers and unemployment falls soon enough to avoid significant hysteresis
effects, real wages will increase again, factor substitution will go into reverse,
and labour productivity will make up lost ground.
I’m sure there is some of this going on. But it does not
account for why the same thing has not been happening in the US, the archetypal
flexible labour market. In addition, Ben Broadbent argues that a much larger fall in investment
would be required to explain observed productivity this way.[3] There are also
many other reasons why investment in this recession might be relatively low.
The size of the downturn is greater, as is probably its expected duration (or
at least the uncertainty associated with it’s duration). In addition, firms may
just not be able to invest because banks will not lend them the money.
Here is another interesting clue. Large firms appear not to
suffer from this problem: they have plenty of cash. There is some evidence that
small firms, who are both more reliant in the UK on bank finance and are a more
risky proposition, may have been subject to credit constraints. However we
should not forget a third category of firms: start-ups.
One final clue. As has been noted by the IFS study and others,
company liquidations in this recession have been lower than in previous
recessions. (Tim Harford looks at this from a European angle.) In a
recession where banks, as well as some firms, were in difficulties, banks may
be reluctant to acknowledge failed loans and so may increase forbearance.
Equally banks that are particularly concerned about their loan book are
unlikely to take on new risk, so it may be much more difficult for new
companies to get finance. (There is some support for this idea from the fact
that the variance of rates of return and productivity have increased during the
recession, but I have not seen evidence on whether this is unusual for a
typical recession.) This is a story told about Japan’s lost decade. [4]
So, to the extent that UK banks have become much more cautious,
they have stopped providing finance for new (potentially innovative) firms, but
are keeping low productivity firms in business. A similar process may be going
on within larger companies, where getting finance is not a problem. Innovation
often requires investment, and so a reduction in investment generated by
uncertainty (and perhaps greater risk aversion) will slow down productivity
growth. (The structural econometric model of the UK economy that I built twenty
years ago, COMPACT, has a vintage production structure,
so I have a fondness for this idea.)
This story puts the unusual nature of the recession - a
financial crisis and an associated reduction in risk taking - at the centre of
the explanation of the UK productivity puzzle. There is also a nice corollary,
which I have not seen emphasised elsewhere. To the extent that new entry has
become less likely because of a lack of finance, the extent of competition has
decreased. (Markets have become less ‘contestable’.) This will allow existing
firms to increase profit margins, which may also help explain why UK inflation
has been surprisingly persistent in this recession. So the story helps explain
two UK puzzles rather than just one.[5]
Yet this is a story that explains one of the charts - unusual
behaviour in UK productivity - but not why none of this is visible in the US.
Indeed, given that many European countries have similar profiles to the UK
(except just not so bad), and given the econometric evidence noted below, the
puzzle here may actually be the US. There are many people who know much more
than me on these issues, but at the moment I cannot see any obvious reason why
the US should be different.
The US banking industry appears much less concentrated than in the UK:
there are many more US banks than UK banks even after allowing for the
different size of each economy. I have seen it suggested that larger banks may find it more
difficult to use local knowledge about particular markets or industries, local
knowledge which could help offset the impact of higher risk aversion on
innovation. Perhaps US start-ups have access to a greater range of sources of
finance than those in the UK, but there seems to be the same concern in the US about small business lending
as there is in the UK.
So I do not think we even have a potential answer to the puzzle
posed by both charts, although I should also note an ever present danger in
macro of trying to explain too much with too little data (to overfit). A recent
very good study that tries to maximise the data by looking at financial crises
the world over has just been published
by Nicholas Oulton and MarÃa Sebastiá-Barriel. They find that financial crises
not only tend to lower productivity by more than other types of recession in
the short run, but also that there is a permanent productivity effect from
financial crises. However they also find that this long run effect is not
robust - it comes from the inclusion of developing countries in the data set,
particularly Latin American countries. Which suggests that nothing is
inevitable, and being fatalistic about potential output that we can never get
back may be a big mistake.
[1] The productivity puzzles, Richard Disney, Wenchao Jin and
Helen Miller, IFS
[2] Bruegel has some useful links here. This includes some who still believe a lot of labour
hoarding is going on, and I would not want to discount that possibility.
[3] In other words we are seeing very low UK TFP growth as well
as low labour productivity growth
[4] For example Caballero, R. J., Hoshi T and Kashyap A. (2007)
“Zombie Lending and Depressed Restructuring in Japan”, American Economic Review
98.
[5] In fact an increase in monopoly power in the UK following
the recession would produce on its own higher inflation, lower real wages and
lower labour productivity (via factor substitution). However it would also
imply a falling labour share, which as Chris Dillow points out does not appear to have happened.
So you need to add some additional productivity story as well.
Friday, 1 February 2013
Safe Assets and Sovereign Wealth Funds: Norway, the UK and Oil
Miles Kimball was ahead of me in thinking about the safe asset problem. It was interesting that we seem to have reached similar conclusions thinking about very different things. He focused here on the immediate problem of what the Fed was buying as part of QE, whereas I was in a fictional (and perhaps utopian) world centuries ahead when the government owned net assets rather than net debt. A sovereign wealth fund can be helpful in both cases: the monetary authority can ask the fund to make the decisions about what assets to buy, and the fund can provide the assets to either match against government debt or help reduce the need to raise taxes to pay for government spending. A short list of his posts on this issue can be found here. They are especially relevant for the UK if you are worried that all the Bank has been doing with QE is buying Gilts.
The discovery of a finite natural resource is an ideal experiment in teaching macro. It uses the intertemporal consumption model to illustrate why current account deficits (pre-extraction phase) and surpluses (extraction phase) can be optimal things for economies to have. I’m afraid I use the discovery of North Sea oil as my example, and luckily there is still enough there that no student will ever say to me ‘so there was once oil under the North Sea?’ [1] But my excuse for showing my age is that it also allows a very nice contrast between what happened in Norway and what happened in the UK, and a nice way to throw Ricardian Equivalence into the teaching mix.
For anyone who does not know, Norway invested (and continues to invest) most of its tax receipts from North Sea Oil into a Sovereign Wealth Fund (which used to be called the Petroleum Fund, but is now rather misleadingly called the Government Pension Fund.) It was not a token exercise - its assets are around $654 billion, which is larger than Norway’s GDP. The UK, mostly under the Thatcher government, decided instead that it was better to give this money to the people, so it cut taxes using its receipts from North Sea Oil. Under Ricardian Equivalence, where agents who care about their children as themselves also internalise the government’s accounts (which include any oil fund), what the UK and Norway did will have identical effects.
They will have identical effects, because those receiving the tax cuts will invest much of the proceeds so that when the oil runs out, they (or their children) will be able to carry on as if nothing had happened because they can consume the returns from those assets instead of revenues from the oil. It is a classic example of consumption smoothing: saving or borrowing to smooth out the impact of variations in income. We know people do sometimes try and consumption smooth, because most save for their retirement. Yet did UK consumers save the proceeds from oil to create their own personal equivalents of Norway’s oil fund?
The data is not very promising. While the UK ran some current account surpluses in the early 1980s, there were also deficits, and by the late 1980s there were only (large) deficits. We almost got back to current account balance in the late 1990s, but have had large deficits ever since. No obvious sign of saving the revenues from oil there. Looking at our net foreign asset position is initially a little more hopeful, as it’s positive value increased in the first half of the 1980s, but that disappeared for good by 1990, and the UK is now a net debtor. Perhaps a more detailed study might come to different conclusions, but I do not know of any that does.
Nor did the government set a very good example. It should at least have been running down its net debt position while North Sea oil revenues were at their peak, so that it could reduce the need to raise distortionary taxes once the money ran out. Net government debt did fall in the second half of the 1980s, but it went straight back up again in the early 1990s, suggesting this was just a cyclical effect.
What has this got to do with safe assets? Only this. One of the arguments against establishing a Sovereign Wealth Fund is that, even if the fund is nominally independent, governments cannot be trusted not to interfere, and so it is better to give the money to the people. Miles Kimball discusses this ‘libertarian’ view here, and I alluded to the ‘communism by the back door’ idea at the end of my earlier post. That, presumably, was part of the justification for not establishing an oil fund in the UK in the 1980s. I suspect if you asked most people who were born in the UK in the decade after North Sea oil started flowing whether the UK or Norway made the better decision, they would say Norway. In Norway, I suspect they would say Norway too.[2] The evidence seems to suggest they would be right. So in this case at least, not setting up a Sovereign Wealth Fund for ideological reasons was a mistake.
[1] How to use resource revenue is a critical issue for many developing countries, and is discussed in many places by my colleagues at the end of my corridor, including here.
[2] Of course many would not have a view, but I cannot help feeling that strengthens the case for a Fund. Interestingly it seems that it is the right in Norway that want to spend more of the Fund today, and the left that (financial crisis aside) want to stick to their 4% rule.
The discovery of a finite natural resource is an ideal experiment in teaching macro. It uses the intertemporal consumption model to illustrate why current account deficits (pre-extraction phase) and surpluses (extraction phase) can be optimal things for economies to have. I’m afraid I use the discovery of North Sea oil as my example, and luckily there is still enough there that no student will ever say to me ‘so there was once oil under the North Sea?’ [1] But my excuse for showing my age is that it also allows a very nice contrast between what happened in Norway and what happened in the UK, and a nice way to throw Ricardian Equivalence into the teaching mix.
For anyone who does not know, Norway invested (and continues to invest) most of its tax receipts from North Sea Oil into a Sovereign Wealth Fund (which used to be called the Petroleum Fund, but is now rather misleadingly called the Government Pension Fund.) It was not a token exercise - its assets are around $654 billion, which is larger than Norway’s GDP. The UK, mostly under the Thatcher government, decided instead that it was better to give this money to the people, so it cut taxes using its receipts from North Sea Oil. Under Ricardian Equivalence, where agents who care about their children as themselves also internalise the government’s accounts (which include any oil fund), what the UK and Norway did will have identical effects.
They will have identical effects, because those receiving the tax cuts will invest much of the proceeds so that when the oil runs out, they (or their children) will be able to carry on as if nothing had happened because they can consume the returns from those assets instead of revenues from the oil. It is a classic example of consumption smoothing: saving or borrowing to smooth out the impact of variations in income. We know people do sometimes try and consumption smooth, because most save for their retirement. Yet did UK consumers save the proceeds from oil to create their own personal equivalents of Norway’s oil fund?
The data is not very promising. While the UK ran some current account surpluses in the early 1980s, there were also deficits, and by the late 1980s there were only (large) deficits. We almost got back to current account balance in the late 1990s, but have had large deficits ever since. No obvious sign of saving the revenues from oil there. Looking at our net foreign asset position is initially a little more hopeful, as it’s positive value increased in the first half of the 1980s, but that disappeared for good by 1990, and the UK is now a net debtor. Perhaps a more detailed study might come to different conclusions, but I do not know of any that does.
Nor did the government set a very good example. It should at least have been running down its net debt position while North Sea oil revenues were at their peak, so that it could reduce the need to raise distortionary taxes once the money ran out. Net government debt did fall in the second half of the 1980s, but it went straight back up again in the early 1990s, suggesting this was just a cyclical effect.
What has this got to do with safe assets? Only this. One of the arguments against establishing a Sovereign Wealth Fund is that, even if the fund is nominally independent, governments cannot be trusted not to interfere, and so it is better to give the money to the people. Miles Kimball discusses this ‘libertarian’ view here, and I alluded to the ‘communism by the back door’ idea at the end of my earlier post. That, presumably, was part of the justification for not establishing an oil fund in the UK in the 1980s. I suspect if you asked most people who were born in the UK in the decade after North Sea oil started flowing whether the UK or Norway made the better decision, they would say Norway. In Norway, I suspect they would say Norway too.[2] The evidence seems to suggest they would be right. So in this case at least, not setting up a Sovereign Wealth Fund for ideological reasons was a mistake.
[1] How to use resource revenue is a critical issue for many developing countries, and is discussed in many places by my colleagues at the end of my corridor, including here.
[2] Of course many would not have a view, but I cannot help feeling that strengthens the case for a Fund. Interestingly it seems that it is the right in Norway that want to spend more of the Fund today, and the left that (financial crisis aside) want to stick to their 4% rule.
Tuesday, 29 January 2013
When formal monetary policy targets are useful
Stephanie Flanders makes a very perceptive point in a post today. She says:
“Does the chancellor want to set a new target for the Bank of England? The answer is no. But does he want have a debate about it? The answer is an emphatic yes - for political reasons as well as economic ones.”
Essentially the more it is debated what the Bank of England can do to get a recovery, the less it appears as if the Chancellor is responsible for the current state of the economy. I think in practical political terms this is correct. However it should not be so: the Chancellor and the Treasury set the MPC mandate. There are three key points here.
First, the inflation target matters. Some commentators suggest that the MPC in effect has the ability to set its own target, and that the formal inflation target is no constraint. I think this is completely wrong. As Adam Posen recently said (22nd January) to the Treasury Select Committee
“anyone who was on the committee basically took the equivalent, in my opinion, of an oath of office. They were serving on the committee under the terms of the given inflation target.”
My conversations with other MPC members are fully consistent with this view.
Second, because we have had a series of positive shocks to the Phillips curve, UK monetary policy has not been as expansionary as it should have been because it was, and is, constrained by the 2% target for consumer price inflation. That has become increasingly clear over the last few years. Interest rates were almost raised in early 2011.
Third, the Chancellor had, and has, both the formal power, and the political ability, to change this. He might have been cautious about moving to a nominal GDP levels target, but there were less radical options that would have helped the UK economy. The most obvious was to move to a dual mandate: following what the US Fed does can hardly be thought of as dangerously radical. He could, as I have suggested before, change the inflation measure being targeted from consumer price inflation at 2% to nominal earnings at 4%. Controversial, yes, but part of being a good Chancellor is to make bold moves when conventional policy is not working.
OK, rant over. What I really want to say concerns nominal GDP targets. In her post, Stephanie Flanders gives the following reason why she thinks a nominal GDP levels target will not be adopted by the Chancellor.
“will [voters] really ever believe that a government is going to withstand years of well above, or well below, target inflation, simply to get back to a particular, fairly arbitrary path for the cash value of the economy that was laid down by the folk who were in power before them? The general view in Number 11 is that the answer to that question is no.
Politicians are always going to let bygones be bygones - for the very good reason that voters expect them to think and talk about the future, not the past.”
This puts into ordinary language what macroeconomists call the problem of time inconsistency. Suppose, for example, we had before the recession a target for the path of consumer prices, and not its rate of change. As everyone knows, for most of the last few years UK inflation has been above 2%. With a price level target, the Bank would now be raising interest rates for sure, because it would have to achieve years where inflation was below 2% to get back to target. Bygones would not be bygones. Is it credible that policy makers would do that? More important, would voters allow them to do that?
Now a nominal GDP target would not suffer from that specific problem, because the recession goes the other way. But in other circumstances a similar problem could arise. Suppose we had an unexpected boom, where the central bank cannot prevent nominal GDP exceeding its target path. It then is required not just to get the growth rate of nominal GDP back to desired levels, but to reduce it further to get back to the target path. I think Stephanie Flanders is right that selling that policy would be difficult.
However that does not mean we should not do it. Committing to doing it may bring significant benefits, as Michael Woodford has consistently argued. What it does mean is that having a formal target could be very useful. Not, as macroeconomists typically put it, to stop central banks reneging on the policy. Instead, to protect central banks from politicians and voters when the bank sticks to the policy.
I think in this respect formal inflation targets are rather different from levels targets (whether its price level targets or nominal GDP levels targets). In a recent post I was skeptical of the arguments for why formal inflation targets might be useful, particularly if you had a credible central bank. I prefer the less formal dual mandate of the Fed to the formal inflation target of the MPC. As I noted at the start of this post, formal inflation targets can do considerable harm, whereas their benefits in preventing inflation bias are I think overrated. But the time consistency problem with levels targets is in my view much greater, and so the usefulness of formal targets also becomes greater as a result.
Let me put the point another way. Delegation works best when the objectives of the policy are clear. Keeping inflation and unemployment low are uncontentious, as is (nowadays) the idea that there are limits to how low unemployment can be pushed without compromising inflation. So delegating to a central bank that tries to keep inflation and unemployment low can work without hard wiring these objectives by using formal targets. Targeting the price level, when what you care about is inflation, is much less intuitive, and therefore potentially contentious. For that reason, it is a good idea to not leave this issue to the discretion of central bankers, but to formalise it as an instruction to central bankers - for their sake as much as ours.
So, if we are looking for the optimal monetary policy, I think the informal dual mandate of the Fed dominates a formal inflation target, but whether it dominates a formal price level or level of nominal GDP target remain open. Which means the new Bank of England governor should ask the Chancellor to change something. However, as I said at the start, the Chancellor really should have changed something already.
“Does the chancellor want to set a new target for the Bank of England? The answer is no. But does he want have a debate about it? The answer is an emphatic yes - for political reasons as well as economic ones.”
Essentially the more it is debated what the Bank of England can do to get a recovery, the less it appears as if the Chancellor is responsible for the current state of the economy. I think in practical political terms this is correct. However it should not be so: the Chancellor and the Treasury set the MPC mandate. There are three key points here.
First, the inflation target matters. Some commentators suggest that the MPC in effect has the ability to set its own target, and that the formal inflation target is no constraint. I think this is completely wrong. As Adam Posen recently said (22nd January) to the Treasury Select Committee
“anyone who was on the committee basically took the equivalent, in my opinion, of an oath of office. They were serving on the committee under the terms of the given inflation target.”
My conversations with other MPC members are fully consistent with this view.
Second, because we have had a series of positive shocks to the Phillips curve, UK monetary policy has not been as expansionary as it should have been because it was, and is, constrained by the 2% target for consumer price inflation. That has become increasingly clear over the last few years. Interest rates were almost raised in early 2011.
Third, the Chancellor had, and has, both the formal power, and the political ability, to change this. He might have been cautious about moving to a nominal GDP levels target, but there were less radical options that would have helped the UK economy. The most obvious was to move to a dual mandate: following what the US Fed does can hardly be thought of as dangerously radical. He could, as I have suggested before, change the inflation measure being targeted from consumer price inflation at 2% to nominal earnings at 4%. Controversial, yes, but part of being a good Chancellor is to make bold moves when conventional policy is not working.
OK, rant over. What I really want to say concerns nominal GDP targets. In her post, Stephanie Flanders gives the following reason why she thinks a nominal GDP levels target will not be adopted by the Chancellor.
“will [voters] really ever believe that a government is going to withstand years of well above, or well below, target inflation, simply to get back to a particular, fairly arbitrary path for the cash value of the economy that was laid down by the folk who were in power before them? The general view in Number 11 is that the answer to that question is no.
Politicians are always going to let bygones be bygones - for the very good reason that voters expect them to think and talk about the future, not the past.”
This puts into ordinary language what macroeconomists call the problem of time inconsistency. Suppose, for example, we had before the recession a target for the path of consumer prices, and not its rate of change. As everyone knows, for most of the last few years UK inflation has been above 2%. With a price level target, the Bank would now be raising interest rates for sure, because it would have to achieve years where inflation was below 2% to get back to target. Bygones would not be bygones. Is it credible that policy makers would do that? More important, would voters allow them to do that?
Now a nominal GDP target would not suffer from that specific problem, because the recession goes the other way. But in other circumstances a similar problem could arise. Suppose we had an unexpected boom, where the central bank cannot prevent nominal GDP exceeding its target path. It then is required not just to get the growth rate of nominal GDP back to desired levels, but to reduce it further to get back to the target path. I think Stephanie Flanders is right that selling that policy would be difficult.
However that does not mean we should not do it. Committing to doing it may bring significant benefits, as Michael Woodford has consistently argued. What it does mean is that having a formal target could be very useful. Not, as macroeconomists typically put it, to stop central banks reneging on the policy. Instead, to protect central banks from politicians and voters when the bank sticks to the policy.
I think in this respect formal inflation targets are rather different from levels targets (whether its price level targets or nominal GDP levels targets). In a recent post I was skeptical of the arguments for why formal inflation targets might be useful, particularly if you had a credible central bank. I prefer the less formal dual mandate of the Fed to the formal inflation target of the MPC. As I noted at the start of this post, formal inflation targets can do considerable harm, whereas their benefits in preventing inflation bias are I think overrated. But the time consistency problem with levels targets is in my view much greater, and so the usefulness of formal targets also becomes greater as a result.
Let me put the point another way. Delegation works best when the objectives of the policy are clear. Keeping inflation and unemployment low are uncontentious, as is (nowadays) the idea that there are limits to how low unemployment can be pushed without compromising inflation. So delegating to a central bank that tries to keep inflation and unemployment low can work without hard wiring these objectives by using formal targets. Targeting the price level, when what you care about is inflation, is much less intuitive, and therefore potentially contentious. For that reason, it is a good idea to not leave this issue to the discretion of central bankers, but to formalise it as an instruction to central bankers - for their sake as much as ours.
So, if we are looking for the optimal monetary policy, I think the informal dual mandate of the Fed dominates a formal inflation target, but whether it dominates a formal price level or level of nominal GDP target remain open. Which means the new Bank of England governor should ask the Chancellor to change something. However, as I said at the start, the Chancellor really should have changed something already.
Thursday, 24 January 2013
Misinterpreting the history of macroeconomic thought
An attractive way to give a broad sweep over the history of macroeconomic ideas is to talk about a series of reactions to crises (see Matthew Klein and Noah Smith). However it is too simple, and misleads as a result. The Great Depression led to Keynesian economics. So far so good. The inflation of the 1970s led to ? Monetarism - well maybe in terms of a few brief policy experiments in the early 1980s, but Monetarist-Keynesian debates were going strong before the 1970s. The New Classical revolution? Well rational expectations can be helpful in adapting the Phillips curve to explain what happened in the 1970s, but I’m not sure that was the main reason why the idea was so rapidly adopted. The New Classical revolution was much more than rational expectations.
The attempt gets really off beam if we try and suggest that the rise of RBC models was a response to the inflation of the 1970s. I guess you could argue that the policy failures of the 1970s were an example of the Lucas critique, and that to avoid similar mistakes macroeconomists needed to develop microfounded models. But if explaining the last crisis really was the prime motivation, would you develop models in which there was no Phillips curve, and which made no attempt to explain the inflation of the 1970s (or indeed, the previous crisis - the Great Depression)?
What the ‘macroeconomic ideas develop as a response to crises’ story leaves out is the rest of economics, and ideology. The Keynesian revolution (by which I mean macroeconomics after the second world war) can be seen as a methodological revolution. Models were informed by theory, but their equations were built to explain the data. Time series econometrics played an essential role. However this appeared to be different from how other areas of the discipline worked. In these other areas of economics, explaining behaviour in terms of optimisation by individual agents was all important. This created a tension, and a major divide within economics as a whole. Macro appeared quite different from micro.
A particular manifestation of this was the constant question: where is the source of the market failure that gives rise to the business cycle. Most macroeconomists replied sticky prices, but this prompted the follow up question: why do rational firms or workers choose not to change their prices? The way most macroeconomists at the time chose to answer this was that expectations were slow to adjust. It was a disastrous choice, but I suspect one that had very little to do with the nature of Keynesian theory, and rather more to do with the analytical convenience of adaptive expectations. Anyhow, that is another story.
The New Classical revolution was in part a response to that tension. In methodological terms it was a counter revolution, trying to take macroeconomics away from the econometricians, and bring it back to something microeconomists could understand. Of course it could point to policy in the 1970s as justification, but I doubt that was the driving force. I also think it is difficult to fully understand the New Classical revolution, and the development of RBC models, without adding in some ideology.
Does this have anything to tell us about how macroeconomics will respond to the Great Recession? I think it does. If you bought the ‘responding to the last crisis’ narrative, you would expect to see some sea change, akin to Keynesian economics or the New Classical revolution. I suspect you would be disappointed. While I see plenty of financial frictions being added to DSGE models, I do not see any significant body of macroeconomists wanting to ply their trade in a radically different way. If this crisis is going to generate a new revolution in macroeconomics, where are the revolutionaries? However, if you read the history of macro thought the way I do, then macro crises are neither necessary nor sufficient for revolutions in macro thought. Perhaps there was only one real revolution, and we have been adjusting to the tensions that created ever since.
The attempt gets really off beam if we try and suggest that the rise of RBC models was a response to the inflation of the 1970s. I guess you could argue that the policy failures of the 1970s were an example of the Lucas critique, and that to avoid similar mistakes macroeconomists needed to develop microfounded models. But if explaining the last crisis really was the prime motivation, would you develop models in which there was no Phillips curve, and which made no attempt to explain the inflation of the 1970s (or indeed, the previous crisis - the Great Depression)?
What the ‘macroeconomic ideas develop as a response to crises’ story leaves out is the rest of economics, and ideology. The Keynesian revolution (by which I mean macroeconomics after the second world war) can be seen as a methodological revolution. Models were informed by theory, but their equations were built to explain the data. Time series econometrics played an essential role. However this appeared to be different from how other areas of the discipline worked. In these other areas of economics, explaining behaviour in terms of optimisation by individual agents was all important. This created a tension, and a major divide within economics as a whole. Macro appeared quite different from micro.
A particular manifestation of this was the constant question: where is the source of the market failure that gives rise to the business cycle. Most macroeconomists replied sticky prices, but this prompted the follow up question: why do rational firms or workers choose not to change their prices? The way most macroeconomists at the time chose to answer this was that expectations were slow to adjust. It was a disastrous choice, but I suspect one that had very little to do with the nature of Keynesian theory, and rather more to do with the analytical convenience of adaptive expectations. Anyhow, that is another story.
The New Classical revolution was in part a response to that tension. In methodological terms it was a counter revolution, trying to take macroeconomics away from the econometricians, and bring it back to something microeconomists could understand. Of course it could point to policy in the 1970s as justification, but I doubt that was the driving force. I also think it is difficult to fully understand the New Classical revolution, and the development of RBC models, without adding in some ideology.
Does this have anything to tell us about how macroeconomics will respond to the Great Recession? I think it does. If you bought the ‘responding to the last crisis’ narrative, you would expect to see some sea change, akin to Keynesian economics or the New Classical revolution. I suspect you would be disappointed. While I see plenty of financial frictions being added to DSGE models, I do not see any significant body of macroeconomists wanting to ply their trade in a radically different way. If this crisis is going to generate a new revolution in macroeconomics, where are the revolutionaries? However, if you read the history of macro thought the way I do, then macro crises are neither necessary nor sufficient for revolutions in macro thought. Perhaps there was only one real revolution, and we have been adjusting to the tensions that created ever since.
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