The UK economy in three charts

It is a measure of the state we are in that the latest quarterly growth number for the UK, at 0.3% (1.2% annual rate) for 2013Q1, should be regarded as a political plus for the Chancellor. [See postscript at end.] So here is the first chart:

This extremely weak growth from a starting point of a deep recession should spell disaster for employment. But it has not, as this second chart from the Bank of England’s February Inflation report shows.

The upside of this incredibly poor productivity performance is that employment has been much more buoyant than the GDP numbers would normally imply. However a moment's thought reveals that this could be really bad news, because it might imply that the recession has led to a permanent reduction in what the UK economy can produce. I say ‘could’ and ‘might’ advisedly, because the reasons for this productivity disaster are almost totally mysterious, as I discuss here. Yet it helps explain why inflation has remained above target, and gives us a reason (although not in my view a justifiable one) why monetary policy has not been more expansionary.

Is this a reason for thinking that in fact policy in the UK has not been too bad, and that really we are suffering from some unexplained malady that the usual medicine (continuous monetary expansion and fiscal stimulus) could do nothing to cure?  So we come to my third chart, which is UK unemployment (source ONS).

Despite strong growth in private sector employment, which with stagnant GDP gives us our second chart, unemployment remains high. Low earnings growth suggests that this level of unemployment is keeping real wages low, so there is no suggestion that this increase since the recession is in any way structural. (The wages Phillips curve in the UK continues to work as normal, with a natural rate way below 8%.) It reflects in part a significant increase in labour force participation (again quite different from the US), but that is no excuse to allow it to remain high.

So policy clearly has not and is not doing enough to expand demand. If it did do much more, with any luck productivity would start growing again and catch up some of the ground it has lost, but even if it does not this third chart shows us that expansion is the right policy. What has been happening instead is that fiscal policy has been working in the opposite direction, contracting demand, and monetary policy has been unwilling or unable to offset this. It is indeed one of the major UK macroeconomic policy errors since the second world war.

Postscript

As an illustration of this sad state, the normally excellent Stephanie Flanders describes 0.3% as "good news". A better description would be pathetic. How can an annualised growth rate of 1.2%, in an economy that pre-crisis had a trend growth rate above 2%, and at the bottom of a deep depression, be described as good news! If you think I'm biased, read John Van Reenen.

Scotland's future exchange rate regime

I have not, until now, written anything about prospective Scottish independence. In part I admit this is because the vote is a long way off (18th September 2014), and the polls have consistently suggested that the Scottish people will reject independence. However if television keeps showing reruns of Braveheart who knows what might happen. What is clear is that macroeconomics, rather than distorted historical facts, is crucial to any informed decision.

Today the UK Treasury has published a detailed analysis of the choices an independent Scotland would face in deciding on an exchange rate regime. Partly because of pre-publication spin, but also because the document itself is very negative in tone, its arguments may be dismissed as propaganda. This would be unfortunate, because there are some real and serious problems that the paper identifies. So let’s not ask here whether independence is a good idea, but instead if the vote for independence is yes, what next? Throughout I will refer to the remaining UK after independence as rUK, rather than as the ‘continuing UK’ which the Treasury document uses.

The policy of the Scottish National Party is to retain the use of sterling (although previously it had talked about joining the Euro), rather than have its own currency. The debate about fixed versus floating rates, or the cost and benefits of currency union, are as old as macroeconomics itself. Yet what is happening in the Eurozone clearly puts a fresh perspective on this debate. It illustrates that the key issues are as much fiscal as monetary.

In terms of setting interest rates, existing arrangements could carry on almost as if nothing had happened. The MPC could continue to set monetary policy under a flexible inflation targeting regime, where the inflation target continued to be for the whole sterling union. There would be some changes in detail (external members could no longer be appointed just be the rUK Chancellor), but the MPC could remain as accountable to both governments as it is to the single UK government. This is one advantage of having a currency union of 2 rather than 17. The costs and benefits of this for Scotland would be the standard Optimal Currency Area issues, noting that the scope for migration between the two parts of the sterling union is quite high.

Scotland would inherit a significant proportion of UK government debt. So a key question is, would the Bank of England act as a Lender of Last Resort (LOLR) for that debt? As Brian Ashcroft notes, there is no way the UK government will allow the Bank of England to become sufficiently independent that it could refuse to act as a LOLR for the rUK government. So the Scottish government cannot be equal to the rUK government in this respect. If the Scottish government wants the Bank of England to act as a LOLR for Scotland, it has to persuade the rUK to allow it to do so.

Would it matter if it did not? Without such a provision, it is quite possible that Scotland might find itself in the type of bad equilibrium that the Eurozone periphery experienced in 2010/2012. They may find themselves paying a significantly higher interest rate on any new debt they issued compared to rUK, and this - or the threat of it - might restrict what they felt able to do in terms of fiscal deficits. (For a detailed discussion on this point, see Brian Ashcroft here.)

If the new Scottish government asked the Bank of England to act as a LOLR for its government debt, what price would the UK government ask in return? If the Eurozone experience is anything to go by, they might impose tough restrictions on Scottish fiscal policy - their own version of the Eurozone’s fiscal compact. This might reduce the risk of a market crisis, but the Scottish government cannot relish having rUK constantly monitoring and prescribing its fiscal decisions in the way the Troika currently does for some periphery countries. rUK might want to impose such conditions just to act as a LOLR for Scottish financial institutions, even if it did not do so for the government, on the basis that otherwise it could not be sure the Scottish government would be willing or able to pay for such support.

Would tight fiscal restrictions on Scottish government borrowing matter? In the longer term you could argue that, with exhaustible oil money playing a large role for a newly independent Scotland, it should be building up a sovereign wealth fund along Norwegian lines, in which case large budget surpluses would be the norm. In other words it should be choosing a tight fiscal policy in any case. The problem is one of transition. The UK economy is almost certain to still be very depressed at the end of 2014, and Scotland’s macroeconomic position in this respect is similar to the UK average, so it will clearly not be the moment for a sharp tightening of Scottish fiscal policy relative to rUK.

Is it inevitable that any sterling currency union would involve imposing a more restrictive fiscal policy on Scotland than it would experience without independence? In a previous post I outlined how the ECB could set conditionality for its LOLR role (OMT) in such a way as to avoid imposing an unnecessarily tight fiscal regime. I argued that they just need to be reasonably sure that the government will remain solvent, and suggested a way this could be done. The Scottish government could ask for a similar arrangement from the Bank of England. The arrangement I suggest requires that default would happen if the central bank believes the government is not solvent, so a significant default premium on Scottish debt would remain. (In contrast, LOLR would in practice be unconditional for rUK, so rUK would have a smaller default premium.) However the sterling equivalent of a fiscal compact, or worse the equivalent of Troika control, would not be imposed on Scotland.

The Scottish government might propose such an arrangement as an alternative to Eurozone type controls. It could argue, with some justification, that this arrangement was in rUK’s own interests, because the alternative policy of squeezing Scottish fiscal policy would damage rUK. It could note the harm that the current fiscal restrictions on the Eurozone periphery were doing to exports from the core, and overall political stability.

The problem is that when it comes to fiscal policy, the UK is an awfully long way from being enlightened. Just as it thinks the current UK recession has nothing to do with its own fiscal regime, it is unlikely to be sympathetic to concerns from Scotland about imposing tight fiscal policy there. It would recognise the harm that 

a Scottish default could do to

rUK, but its response will be to impose tough fiscal restrictions to avoid that happening, even if it does not agree to act as a LOLR.  

The real problem for Scotland is that, in forming a sterling currency union, it will be dealing with a government that thinks like Germany. What is worse, although Germany can sometimes be persuaded to go against its austerity instincts for the sake of European unity, after an independence vote rUK is unlikely to let its heart strings be pulled in a similar way! The problem for Scotland is that the rUK can provide something that in fact costs it very little, but the absence of which would cost Scotland a great deal, so rUK will be able to ask for a high price. Unless the new Scottish government is prepared to pay for a Bank of England LOLR role with some of its oil revenues, it may find it has nothing to bargain with. If no agreement can be found, the Treasury paper is quite right to conclude that using sterling unilaterally would not be attractive for Scotland. So rather than accept damaging fiscal restrictions, the new Scottish government may end up with its own currency after all.

The Stupid Cruelty of the Creditor

In the middle ages those who could not afford to pay their debts were sent to prison by their creditors. An efficient solution to the moral hazard problem? Hardly, because the chances that the debtor could earn some money to repay something to the creditor from a prison cell were not high. So countries gradually developed rather more civilised bankruptcy laws, like Chapter 11 in the US.

Yet we are seeing the equivalent of these medieval practices in Europe at the moment. Arguably the harm being inflicted on the people of Greece by its creditors is even more cruel, and more stupid. More cruel, because the harm is being done to those totally innocent of the original contract - children indeed, as Karl Smith notes. More stupid, because those doing the damage cannot see what they are doing, either by refusing to open an economics textbook, or believing that they somehow know better.

Just look at these numbers, from the latest OECD economic outlook.

The Greek Macroeconomic Disaster

	2010	2011	2012	2013	2014
Government Consumption Growth %	-8.7	-5.2	-5.9	-7.1	-4.0
Underlying Primary Surplus (% GDP)	-3.6	1.3	4.2	6.5	7.6
Output Growth %	-4.9	-7.1	-6.3	-4.5	-1.3
Unemployment %	12.5	17.7	23.6	26.7	27.2

Why is this happening? Because the Eurozone governments that foolishly bailed out Greece after the crisis first developed in 2010/11 want all their money back. (I discuss this in more detail here.)

But surely, you may say, those who lent money to the Greek government are entitled to have their money back (with interest). No one was forcing the Greek government to accept these loans, and the conditions that go with them. The creditors are justified in doing everything they can to pressure the Greeks to repay their debts, including threatening Greece with expulsion from the Eurozone. The fact that this is causing great human suffering and misery is just one of those unfortunate things, and perhaps a necessary lesson to make others think more carefully before electing governments that secretly run up unsustainable debts.

If that is what you think, then I would suggest this view is the moral equivalent of locking debtors up in prison. It is also as stupid, because the damage being done to the Greek economy and its politics is making the scale of the eventual default greater than if some debt relief was allowed now. A fiscal contraction of this scale, in a country with no independent monetary policy, was bound to do this much damage. Any macro textbook tells you that. Those who believe that reducing one component of demand just changes its mix rather than its overall level display an ignorance which in this case is close to criminal.

But, you may say, the Greek economy has become uncompetitive, and wages need to fall if the economy wants to stay part of the Eurozone. There is no escaping macroeconomic pain. True some deflation was necessary, but deflation on this scale is totally wasteful, and the immense harm it is doing is therefore avoidable. Once again, very simple macroeconomics tells you this. And, as Ryan Avent is the most recent to point out, the core of the Eurozone is making this competitiveness correction as difficult to achieve as possible. You might say that this chaos is required to achieve necessary structural reform. I seem to remember someone else once had a similar idea, which they called perpetual revolution.

Unfortunately this would not be the first time creditors have laid waste cities in an effort to recover debts, as Peter Frankopan has reminded us. But it need not be like this. Let me end by quoting Robert Kuttner, from a review of David Graeber’s book ‘Debt: the First 5000 years’.

[The Allies] wrote off 93 percent of the Nazi-era debt and postponed collection of other debts for nearly half a century. So Germany, whose debt-to-GDP ratio in 1939 was 675 percent, had a debt load of about 12 percent in the early 1950s—far less than that of the victorious Allies—helping to produce postwar Germany’s economic miracle.

The lesson from the 1920s had been learnt. Whether this was done out of self interest, because a vibrant post-war Germany benefited everyone, or compassion, I do not know. But whichever it was, the creditors of the Eurozone could use some of that wisdom right now.

An Understandable Mistake

No, I’m not talking about coding in excel - as someone who has in the past done plenty of empirical work, my overriding reaction is empathy with the researchers concerned. There - not so much by the grace of god but because no one bothered to check what we did - go us. What I’m talking about is the weak global recovery and a primary reason for it. But there is a link, which I will come to at the end.

To be honest, this post is really just to encourage you to read this Vox piece by Kose, Loungani and Terrones, which comes from the recent IMF WEO report (pdf). It tells a story in pictures (particularly comprehensive and clear pictures) that I and others - most notably Paul Krugman - have been telling for some time. In the past I have often used cyclically adjusted primary deficits as a summary measure of fiscal stance, because they are readily available and comprehensive. However as an indication of fiscal demand impact they are not ideal - just think of the standard Ricardian Equivalence experiment. So occasionally I have looked at just government spending, which is what Kose et al do in their analysis. The key chart is below.

What the chart shows is that government spending in the advanced economies has grown at a much slower rate in this recovery than in previous recoveries, and of course this recovery has been significantly slower as a result. In contrast, government spending in the emerging economies has been as rapid during the recovery as before the recession, and they have recovered rapidly from recession. Go into detail within the advanced economies group, and the pattern is clear: the greater the contraction in government spending relative to previous recoveries, the slower the recovery has been.

Their analysis also shows us one of the reasons why this happened. The advanced economies started the recovery with debt to GDP almost twice its average level in previous recoveries. At the start of the recession this was not the predominant concern, and we saw some attempt at countercyclical policy in the US, the UK and Japan, as the chart shows. But this was short lived in the UK, and was also reversed in the US and Japan, as debt concerns took over.

Kose et al also illustrate why this was a mistake. Interest rates hit the zero lower bound, so monetary policy could not offset what fiscal policy was doing. Yes, we have had Quantitative Easing (QE), but I think Jonathan Portes puts it rather nicely here. “It seems to me the idea that you risk the government’s credibility by borrowing an extra couple of percent of GDP for investment but there would be no risk to credibility by doing something [QE] which nobody in modern times in an advanced developed country has ever tried and that is generally considered to be last ditch strategy is an odd conclusion.” (The link is to a nice site by the way - on it you will also find Andrew Scott saying: “the right response for those governments wanting to hold on to AAA, whether it be Japan, US, Germany or the UK, is for government debt to show huge increases into triple digits versus GDP.”)

So we have one clear reason why the recovery from the Great Recession has been weak, and it also explains why it has been weaker in some countries than others. I’m sure its not the only reason, but is anyone seriously arguing anymore that it is not an important factor explaining our weak recovery? So the real mistake that Reinhart and Rogoff made was to push the high debt issue at the wrong time. It was I believe an honest mistake: high government debt is a concern, if only (but not only) because it makes politicians do the wrong thing in a serious recession. And of course the mistake would have happened anyway (in part because of Greece, and partly because of those who see reducing the size of the state as the overriding priority) - academics probably overestimate the importance of the research that politicians use as cover.  But when history tells the story of why the Great Recession was so prolonged, charts like the one here will be what is shown.

Reduced form macro

Mark Thoma has a reflective post on the ability of evidence to move us forward in macro. Noah Smith also has interesting things to say. I just want to add the following thought.

If you think about some of the recent disputed empirical results (the 90% debt to GDP, expansionary austerity, cutting spending rather than taxes, multiplier sizes), they all involve relating policy variables directly to outcomes. And if we think about some of the reasons these apparent relationships turned out not to be empirically robust, it was because they failed to think about other things that might matter for outcomes.

Lets be specific. Fiscal multipliers are bound to depend on what monetary policy is doing. In principle monetary policy can offset the impact of fiscal changes on output, but if monetary policy is constrained in some way, it cannot. So any empirical study of the impact of fiscal policy must control for what is happening to monetary policy. I have often written about why high debt may be damaging to growth, but these effects work through raising real interest rates, or discouraging labour supply. It just seems foolish to apply them to a situation where real interest rates are unusually low, and output is hardly constrained by a shortage of labour.

These are simple, obvious points, but its amazing how often they are ignored. It is if some in the profession are desperate to find universal (and perhaps convenient) simple truths, in the face of the obvious fact that the macroeconomy is complex. This is not a new phenomenon. I’m afraid what follows is a personal anecdote, but it is topical.

Monetarism was the centrepiece of Mrs Thatcher’s first government. Following Friedman, policy was based around the idea that there was a predictable causal relationship from the money supply to prices. Lags might be long and variable, but an x% change in the money supply would within a year or two lead to an x% change in prices. Parliament asked the new government to come up with evidence for this assertion. They agreed to, but for some reason I cannot remember, they promised to produce a working paper by a named Treasury economist, rather than some anonymous Treasury document.

At the time I was working in the Treasury, and my job was to help forecast prices. So they chose me to produce this paper. I was to report each week to Terry Burns on progress. Terry Burns had been recently appointed as Chief Economic Advisor and he was one of the architects of the government’s new macroeconomic strategy. The first meeting went fine: I reported that if you regressed prices on the government’s chosen monetary aggregate, you got exactly the relationship they were looking for. However I had remembered some of the econometrics I had been taught. I was worried about omitted variables, and the fact that the two time series were dominated by one particular episode. [1] To cut a long story short, the relationship fell apart if you either took that episode out, or added other explanatory variables like oil prices. Despite Terry and my best efforts, we could not rescue the relationship once you went beyond that first simple regression. To be honest I was not that surprised or unhappy about this, but for the government it was rather embarrassing.

I learnt two things from that episode. The first was to be always extremely distrustful of simple correlations between policy instruments and outcomes. The second occurred after my paper was published. As I was the named author, I was free to write what I thought was an unbiased but purely factual account of my findings, with (to Terry Burns’ credit) no pressure to spin the results to suit the government. Yet despite it being obvious to any objective reader that the results gave no support to the government’s policy, at least one well known city economist cherry picked the results to suggest it did. [2]

Pretty much all the econometric work I did subsequently involved more structural relationships rather than these simple reduced forms. I think we have learnt a great deal from estimating equations that at least try and get close to underlying behavioural relationships, whether its using cross section, time series or panel regressions. A carefully structured VAR may also tell us something. Perhaps an exhaustive robustness analysis running countless single equation regressions can reveal insights - as for example in Xavier Sala-i-Martin's AER paper 'I just ran two million regressions' trying to explain economic growth. But if the empirical evidence involves little more than a regression of outcome x on instrument y, be very very aware.

[1] Just in case anyone is interested, the expansion in M3 caused by the Competition and Credit Control reforms in 1973, and the increase in inflation associated with higher oil prices in 1975.

[2] What happened at that point is a story that I will tell publicly one day. It is probably of no interest except to those who were involved in UK policy at that time, but it reminds me of one of the nicest and most interesting acquaintances I made during my time at the Treasury who is greatly missed.

Framing: Taxpayers money and Fiscal Space at the IMF

Taxpayers Money

In writing this recent post, when I discussed the potential cost of a government scheme, I initial wrote ‘a cost that taxpayers will bear’. That is what everyone does when pointing out that the government’s finances are really our finances. But I changed what I wrote, because I realised this description is actually incorrect.

One possible reading of the similar phrase ‘taxpayers money’ is that this money in some sense belongs to the taxpayer. That is clearly wrong. This money belongs to the state, and the state is meant to reflect the people’s wishes. So if we want to remind ourselves that we live in a democracy, we could talk about the people’s money, or society’s money, or our money.

Now perhaps you are thinking that the phrase ‘taxpayers money’ is simply designed to remind ourselves where the government’s money comes from. I guess some people need to be reminded that most of the government’s money once belonged to taxpayers. But of course everyone in society is a taxpayer, because we all buy things which the government levies indirect taxes on. Yet I suspect most people read taxpayer as someone who pays income tax, so I would argue that the phase is misleading compared to something like ‘society’s money’ or ‘citizens’ money’.

The actual phrase that I was going to use, and which is so often used, is that some item of government spending represents ‘a cost to the taxpayer’. Additional government spending could be financed by raising income taxes. But it might not be. It could be financed by cutting some type of government transfer. [1] In fact, in the UK at the moment, if you had to guess what was the most likely source of finance for the marginal item of government spending, it would be cuts in welfare benefits. So the probability is that the phrase ‘this is a cost that welfare recipients will bear’ will be more accurate than ‘this is a cost that taxpayers will bear’. Yet I have never seen the first phrase used.

Is this me being pedantic? I would argue this is an example of framing. A related phrase is ‘tax relief’. There is nothing incorrect about using the phrase, but it equates the idea of paying taxes with some kind of affliction. An alternative phrase might be ‘tax dodge’, which has completely the opposite connotation, invoking taxes as a duty which someone is unfairly not fulfilling. I think another example is ‘free market’. Those who favour market solutions often use ‘free market’ instead of just saying ‘market’. We all want to be free. But an alternative description might be ‘unregulated market’, which sounds (to most) less good. One final example might be intellectual property, but I am sure there are many more. [2]

Fiscal Space at the IMF

Unlike the phrases discussed above, ‘fiscal space’ is less widely used, but I want to argue that it too frames a debate in a biased way. There are many good things in the just issued ‘Rethinking Macro Policy II: Getting Granular’ by Blanchard, Dell'Ariccia and Mauro at the IMF. Their discussion of ‘Should Central Banks Explicitly Target Activity’ reflected many of the points I tried to make recently here, although of course they were not rude about the ECB. But the section on fiscal policy was strange, and it made me think about why I have always been reluctant to use the phrase ‘fiscal space’.

The section of the paper on fiscal policy goes as follows. (The letters in brackets refer to the subsections in the paper, and I will use them as references below.) Government debt is too high and needs to come down (A). For some countries where a default premium on government debt has emerged, then debt reduction has to be rapid. The idea that monetary policy could help in these circumstances raises the problem of fiscal dominance (B). In other countries there is ‘fiscal space’, so debt consolidation does not have to be so quick (C). Maybe these countries might think about redesigning their automatic stabilisers (D).

Fiscal space is like a breathing space. The debate is all about the speed of fiscal consolidation, and some countries can afford to take a small breather before getting back on the consolidation path. Taking a breather might be a good idea, because going too fast may have some unintended consequences when we are stuck at a zero lower bound. The idea of active fiscal stimulus becomes reduced to a slower speed of fiscal consolidation and tinkering with automatic stabilisers.

Take this sentence from the paper. “Underlying the debate about multipliers has been the question of the optimal speed of fiscal consolidation (with some in the United States actually arguing for further fiscal stimulus).” Well one or two people outside the US have been arguing for fiscal stimulus too, but the key message here is that there is just one primary role for fiscal policy (fiscal consolidation), and anything to do with multipliers and recovering from recessions just influences its speed.

This framing is wrong. Fiscal policy has two roles. In normal times outside of a monetary union the primary role should be debt stabilisation/reduction. At the zero lower bound the primary role should be fiscal stimulus. In a monetary union both roles are equally important all the time. Framing fiscal policy discussion around the idea of fiscal space negates the countercyclical role. This negation was a key factor behind the Eurozone crisis, and more generally it has intensified and prolonged the current recession.

One of the features of framing is that it is not literally wrong (it is not like the doublespeak of Orwell’s Ministry of Peace ). In the statements above, I agree with (A). But once you concede it is all about (A), then the discussion of (B) and (C) becomes distorted, and the policy endpoint (D) becomes quite inadequate. In fact, you suspect that part of the idea is to deliberately avoid the thought that governments could use fiscal policy in a discretionary manner to stimulate the economy. (The word countercyclical appears only once in the paper.) In that sense, I’m afraid to say, the IMF inhabit the same fiscal space as the European Commission!

[1] Reaction functions relating policy to debt, for example, find no systematic tendency for taxes to respond by more than spending: some evidence is briefly reviewed here. Current austerity programs vary from spending based to tax based: see the IMF analysis reported here.

[2] An earlier version of this post, before I read the IMF paper, ended with a different link. Just as the phrase ‘taxpayers money’ presumed incorrectly that (income) taxes were the residual source of finance, too much macroeconomic analysis of temporary government spending changes uses income taxes as the residual source of finance. This allows opponents of fiscal stimulus too much scope: see for example John Taylor’s latest analysis of the impact of austerity, as discussed by Noah Smith here. The few theoretical cases of expansionary austerity that have been produced nearly all depend on these supply side effects of higher future income taxes outweighing the current impact of higher government spending: see also Campbell Leith here. It would be much better, as I have suggested before, if we instead focused in the first instance on what I have called ‘pure’ countercyclical policy: in this case higher government spending eventually paid for by lower government spending. This way we separate issues to do with intertemporal demand management (the business cycle) from issues to do with tax incentives. I couldn’t decide whether this link inspired or contrived.

Why a Dual Mandate is Essential

Monetary policy has two crucial roles. The first is to set the medium/long term inflation rate. Pretty well everyone understands this. The economy will not by itself settle down to an inflation rate of 2% or whatever - it needs monetary policy to set this rate and help achieve it.

The second is to ensure that aggregate demand matches aggregate supply. Now here there is sometimes confusion, even among the best economists. [1] The basic idea is that there is a ‘natural’ level of output determined by supply side factors, like how much people want to work, the degree of monopoly in the labour market, the state of technology etc. [2] There will be a real rate of interest associated with this level of output, which we can call the natural interest rate. On the other hand how much firms produce in the short run is largely determined by aggregate demand: firms tend to set prices, and do not ration demand. There is no reason why aggregate demand has to equal supply in the short run in a monetary economy. The difference between actual output and natural output is the output gap. If the output gap is not zero, problems will arise. For example with excess demand we get inflation, and with deficient demand we can have wasted resources and the misery of involuntary unemployment.

Aggregate demand depends on real interest rates. As monetary policy can influence real interest rates in the short run, then its job is to try and match aggregate supply and demand, by bringing the real interest rate as close as possible to the natural interest rate. [3]

These two roles for monetary policy map nicely into the two objectives macroeconomists typically ascribe to policy makers: minimising excess inflation and the output gap. With two goals there will also be conflicts, producing a trade-off between short run inflation stability and eliminating the output gap. Macroeconomics has extensively examined what to do when these conflicts arise.

A permanent non-zero output gap is not compatible with stable inflation in the long run. As a result, it is possible to reduce both roles to one single objective, the stabilisation of inflation, as long as that stabilisation is done ‘flexibly’. Hence the idea of a single, but flexible, inflation target. I now believe having only an inflation target, or making it 'primary', is an important mistake for two reasons. We can label each mistake as MPC and ECB for short.

The first (MPC) is due to persistent shocks to the relationship between the output gap and inflation (or equivalently to the Phillips curve). This sets up a potential conflict between the two goals. Although we know how to optimally deal with this conflict, the policy that results can appear inconsistent with inflation targeting, which puts a strain on an inflation targeting policy. The problem can be ‘solved’ by making inflation targeting even more ‘flexible’, but this in turn makes the policy less clear.

Of course macroeconomists have always acknowledged this possibility, but have thought that the impact of excess or deficient aggregate demand would always be strong enough for this not to matter in practice. However, as the recent IMF study I discuss here shows, either low inflation or credible inflation targets (or both) seem to have weakened the impact of the output gap on inflation, which makes the problem of persistent cost-push shocks more important. This has been the problem the MPC in the UK have been grappling with in recent years, and I believe the lack of a dual mandate has made their decisions less optimal. More generally, as Paul Krugman says here, thinking that stable low inflation must mean everything is OK could be very wrong.

The second (ECB) is that, in the wrong hands, the flexible inflation targeting regime can become a severely non-optimal policy that pays too little (or asymmetric) attention to the output gap, even in the absence of supply side shocks. In academic language, we could express this in terms of Rogoff’s conservative central banker (giving less weight to the output gap than the public does), but it also allows bad policy enacted by an incompetent central bank (that does not understand the importance of the output gap) or a malevolent central bank (that wants to achieve its own objectives that may not just involve hitting an inflation target).

There is a nice quote by Duisenberg from February 2003 contained in this paper by Jörg Bibow (page 35) that a comment from an earlier post pointed me to. In discussing what price stability meant, he said it “implies that, in practice, we are more inclined to act when inflation falls below 1% and we are also inclined to act when inflation threatens to exceed 2% in the medium term.” [4] Now Andrew Watt and others would argue that this is not a good reading of the ECB’s actual mandate, but it seems to me a good reading of what they actually do, and it is one that a single rather than a dual mandate helps them to get away with.

So what is the objection to a dual mandate? As it reflects how an academic thinks about monetary policy, it should not lead to suboptimal policy in the hands of an informed and benevolent policy maker. So the fear must be that it will misdirect an uninformed policy maker, and encourage non-benevolent behaviour. The exemplar here is the 1970s, but for reasons I discussed here, I do not think that period should be used as evidence against the dual mandate. I discuss here why I think the standard inflation bias story is also overrated in this respect.

Is there any evidence that the US with its dual mandate has done better compared to inflation targeters? There has been some discussion of that recently (e.g. here and here), although the data analysis is not very sophisticated. [5] Until we see good evidence that having a dual mandate worsens outcomes, then I believe the presumption must be that the dual mandate is better because it reflects the two goals of monetary policy.

My argument here concerns higher level objectives. It is not about how best to achieve those objectives, which is where I would locate questions about the wisdom of nominal GDP targets. It does not address the relative weight that the two objectives should have, or the extent that the objectives should be vague or concrete. My own view is that the benefits of a publicly announced inflation target are overwhelming - indeed so much so that I recently forgot how new this ‘innovation’ was for the Fed. How best to express the goal of matching aggregate demand with supply is more difficult, because of the uncertainties involved in measuring the output gap. However output gap uncertainty is not so great that we should ignore the concept, and so this uncertainty cannot justify a single inflation mandate. There are lots of things in life that are difficult to define, but which are still worth striving for.

[1] See, for example, Brad DeLong here. The reasons for this confusion are interesting, but I have speculated on this elsewhere and do not want to get distracted. Of course none of this implies that the natural level of output and its associated interest rate need be in any sense optimal or efficient, but that should be a different and separable question.

[2] There is nothing mysterious about the natural level of output. It is the output which pretty much every macroeconomist not investigating problems of aggregate demand analyse. It could be called the level of output that comes out of an RBC model, for example. It is often described as the level of output that would occur if prices were completely flexible, and here I do have a quibble, because at a zero lower bound and with inflation targets I cannot see how increasing the flexibility of prices will ensure that output reaches the natural level.

[3]

If monetary policy cannot do this, then fiscal policy can help reduce the output gap. We could describe this as fiscal policy raising the natural interest rate, but an equivalent and more intuitive description is that fiscal policy just raises aggregate demand.

There are plenty of caveats to this econ 101 account, such as the possibility that actual output might have an influence on longer term aggregate supply.

[4] If the implied asymmetric differentiation between actual and possible future here was a slip, I’m tempted to suggest it was a Freudian one.

[5] For example, MPC decisions since the recession have tended to define flexibility as ‘seeing through’ actual inflation and focusing on expected inflation two years out. Inflation targets then become a constraint when the impact of cost-push shocks persist for two years or more.