How a Greek drama became a global tragedy

Maybe that title is too strong, but there is an arguable case that what happened to Greece in 2010 was crucial in the move to austerity not just in the Eurozone, but in the UK and US too. As most reasonable people now recognise that the global move to austerity was a terrible mistake, understanding what went wrong in Greece is important. By this I do not mean how Greece came to behave fiscally in a total irresponsible way, interesting and important though that is. These things sometimes happen, but they do not usually have global consequences. What is more important is how the Eurozone and IMF subsequently handled events, which helped turn a Greek crisis into a Eurozone crisis and more.

These events have recently been analysed by the IMF. (Subsequent references are to paragraph numbers.) All credit to them for publicly and critically analysing their role in this affair. In terms of the substance, the facts of the case are not really in dispute. There were two feasible responses to the true fiscal numbers as they began to be revealed by the Greek government. [1] The first was forgiveness, in the form a large fiscal transfer from other Eurozone governments. These governments might have noted that the Greek people did not intend its previous governments to act in such a profligate and deceptive way, and that the Eurozone had failed to put in place effective institutions to stop it happening, and as a result they could have (one way or another) paid off a large part of Greek debt as a gift. That was never likely to happen, and it did not happen. [2]

So the other feasible option was default. As the report also notes (para 55), a number of Fund programs since 2000 had started with some ‘private sector involvement’. Yet initially the Eurozone ruled this out, as the report makes clear and which coverage of the report has widely noted. Why was it ruled out by the Eurozone? The charitable explanation was a concern that once the default possibility became reality, markets would turn on other vulnerable governments. Predictably, they did this anyway. A rather more base explanation was that with default the banks in other Eurozone countries might lose a lot of money, and become even more fragile. There may also have been a bit of pride.

So what we got was a transfer of ownership of a large part of the Greek debt from the private sector to other Eurozone governments, and crippling austerity for Greece. This was not feasible: default was just postponed, but only partial default on the remaining privately held debt. Additional austerity was imposed, and Eurozone governments swore there would be no default on the debt they now owned. And so it goes on.

So why did the IMF not point out that the original plan was not feasible, and refuse to participate? That would have been a hard political call to make, but the IMF is practiced in making such calls when the economics dictates. The report talks about failures in Greek implementation, but it also recognises that the subsequent turnaround in Greece’s underlying fiscal position has been dramatic, so its difficult to believe that plans to do any more should have been taken seriously. The real problem, as I note here, was that projections for the Greek economy were hopelessly optimistic.

Why were they too optimistic? As the IMF acknowledges (para 41) and has acknowledged before, it underestimated the impact on the economy of austerity. It got the multipliers wrong. [3] Yet while the report draws a number of lessons from the episode as a whole, I cannot see any analysis of how this fundamental, and arguably critical, mistake was made.[4] Talk to most people who know anything about the basic theory involved, and they will tell you that when nominal interest rates are fixed, the starting point for the government spending multiplier should be one. [5] In a financially crippled economy there are likely to be a lot of credit constrained individuals around, so the tax or transfer multiplier is also likely to be a lot larger than normal. So numbers based on looking at the past evidence which includes times when monetary policy was able to counteract the impact of the fiscal change were always going to be seriously wrong. You didn’t need to be a nobel prize winner to work this out, you just need to ask people who have worked through the theory of fiscal multipliers. [6] Knowing a little bit about the IMF, I would love to know how this mistake came to be made. [7] [8]

The IMF document is not just about deriving lessons looking back. It also speaks to a real issue that should be being debated in the Eurozone, and that is what are the best institutional arrangements for the lender of last resort to Eurozone sovereigns (hereafter SLOLR)? As Paul DeGrauwe has pointed out, the last few years tell you that you need a SLOLR to prevent a bad equiilibrium where debt crises are self fulfilling. But should the SLOLR be the central bank, other Eurozone governments or the IMF?

What the IMF report clearly shows is that it should not be other Eurozone governments. A good SLOLR needs to be effective (in having the fire power to prevent a bad equilibrium), but it also needs to be able to know when not to intervene, but instead allow default to happen. Eurozone governments failed on both tests: they were never willing to devote enough resources to ensure they were effective, but with Greece they failed to see that default was inevitable. They have the wrong incentives to make the right decision.

You might think that the Greek episode also tars the IMF with the same brush. But as Karl Whelan points out, the ECB does not come out of this episode very well either. Which is a little worrying, because with OMT the ECB is now the SLOLR. It does have back-up, but from those very same governments that got it wrong in the case of Greece. So in a future crisis, does the ECB have the right mechanisms in place to know when it should pledge to buy government debt and when it should do nothing to prevent default? While the IMF deserves credit for being publically self-critical, I cannot help but ask how long will we have to wait for a similar self-analysis of the ECB’s role in this affair?  

[1] As the IMF notes, in October 2009 a new government revised up its estimate of the 2009 deficit from 4% to 12.5% of GDP, and even this was 3% below the final estimate.

[2] In technical terms, this would have amounted to there really being just one set of Eurozone fiscal accounts. If one government gets its people into trouble, the other governments will raise taxes or cut spending to prevent default. When I was writing this paper with Campbell Leith, we ruled out this possibility as unrealistic, but I never imagined that judgement would be tested so quickly.

[3] Assuming a multiplier of 0.5 rather than 1 does not account for all the forecast error. But what remains does sound a bit like ‘we expected the confidence fairy but she did not turn up’. For example, errors “reflected the absence of a pick-up in private sector growth due to the boost to productivity and improvements in the investment climate that the program hoped would result from structural reforms.”

[4] Am I overemphasising this point? Consider this hypothetical. Using the correct multipliers, the IMF just cannot show that the original no-default programme adds up. (As the report makes clear, the actual projections only just did so.) The IMF tells the rest of the Troika that it cannot participate without some initial default. Fearing the impact that such news would have, the Europeans recognise that some default is required. Rather than spending the next year or so putting off the inevitable, the Troika instead focuses on establishing that Greece is a special case, and ensuring there is adequate support for other periphery countries on beneficial terms without crippling austerity (using the right multipliers). The rest of the world increasingly sees Greece as an isolated incident and not the beginning of a worldwide debt crisis. The other possibility, explored by Barry Eichengreen (HT Brad DeLong), is that the Greek government could have insisted on default.  

[5] In a closed economy at the ZLB it is almost certainly above one. In a monetary union, even if the government spending is entirely on domestic goods, in a model with unconstrained consumers it will be below one, but with credit constrained consumers it can be above one (see this paper by Fahri and Werning, and a forthcoming post). Ideally, from a macro point of view, you would choose to cut government spending on goods produced overseas, where multipliers could be negative. The amount that Greece spends on arms, the extent to which it has been part of the fiscal consolidation programme, and the fact that many of these arms come from other European governments is highly controversial.   

[6] Doing the analysis is what is crucial here. In this particular case it just so happens you could have asked a well known nobel prize winner who had also done the analysis. However just asking an academic who has won a nobel prize for macroeconomics but who had not done the analysis could get you into trouble.

[7] Even though the report notes that the assumed multipliers were too low, it also comments (para 46) that “The adjustment mix seems revenue heavy given that the fiscal crisis was expenditure driven”. Yet if you want to protect demand, you should (in the short run) focus on tax increases rather than government consumption or investment. So even within this document, the basic macroeconomic theory behind fiscal consolidation has still not been fully appreciated.

[8] Of course you can say that the numbers were chosen to fit the politics, and the real lesson is that the head of the IMF should not be a past and/or prospective French politician. But those within an organisation like the Fund should try and make it as difficult as possible for politics to overrule economics in this way.

Must we live with a post-truth media?

Something odd but familiar was going on when I wrote this post on Labour’s economic record. The Labour leader and shadow chancellor both made speeches that had apparently been months in the making, and which were (I think intentionally) spun as trying to convince voters that they could trust a future Labour government with fiscal management.

Why odd? Because it presumes that there is some real problem to solve. It presumes that the last Labour government managed the nation’s fiscal affairs very badly, and so today’s politicians have to show they would be different. Yet the paper I wrote tells a very different story. The previous Labour government set up fiscal rules that were both responsible and better than rules subsequently adopted elsewhere. Until the financial crisis, they kept to those rules. Here is the basic data: the top line is the debt to GDP ratio, the bottom line a scaled up current balance to GDP ratio.

Labour Government's Fiscal Record: source OBR

Of course it is possible to find fault, and I do. In hindsight it would have been better if the debt to GDP ratio had been kept nearer 30% of GDP, or even reduced further. But debt to GDP was lower before the recession than when Labour took office, and the current balance was almost zero. Hardly a profligate government. Indeed one of the faults I find, over optimism in Treasury forecasts, has been fixed, to the Conservative party’s credit, with the creation of the OBR.

With the financial crisis everything changed, because this produced the Great Recession. Deficits go up in recessions. There was a small contribution from the government’s attempt to reduce the impact of the recession, an attempt which analysis suggests was successful, so they should take credit for that. It is pretty obvious that you cannot use the fact that the deficit rose in the recession to argue that Labour cannot be trusted with the public finances. Again, the data speaks - look at when the deficit rose in the past.

Of course you could say that the Great Recession was the government’s fault. It should have foreseen the financial crisis coming. It should have known that levels of GDP in 2007 were going to be interpreted, five years later, as a massive economic boom rather than as they appeared at the time as something close to trend. It should have known this, despite the advice it was getting to the contrary from the Bank of England, the IMF, OECD, most economists …. and Her Majesty’s opposition! You can take that idealist view - but not if you were agreeing with all this advice at the time.

So the idea that the last Labour government seriously mismanaged the nation’s finances is a myth. What is more, unlike older myths like the earth is flat, as these charts show it is not something that is generated by perception and which requires expertise to unravel. Unless you are completely naive about the impact of recessions on deficits, a quick look at the data tells the true story. So it is a manufactured myth that distorts what the numbers appear to show. The problem with myths is that after a time, even otherwise good journalists at good places like the Financial Times start believing them.

Now we all know who manufactured the myth. Yet I think most people believe that if a political party started telling a story that was clearly at variance with the facts, it would be found out. In short, people expect journalists and economic commentators to confront politicians who attempt to create and perpetuate myths. In this case they did not. Its also pretty obvious why they did not. The incentive for organisations like the BBC is to stay out of trouble. And who has been making most noise about bias in economic reporting - the government. As any economist will tell you, its all about incentives.

So it really is the duty of academics to speak to truth, as loudly as they can, when it is being ignored by the media. On this topic, the media in general and the BBC in particular have been hopelessly biased in allowing the government to get away with this myth. They have some serious explaining to do.   

Does the Dutch central bank employ any macroeconomists?

Did you think that the policy of fighting recession by increasing austerity was now intellectually bankrupt? No one seems to have told the Dutch central bank. (Hence the deliberately provocative title of this post.) The latest forecast by the Bank says

• The economy will shrink by 0.8% this year, followed by growth of 0.5% next, “accelerating” to 1.1% in 2015
• The unemployment rate will rise sharply, reaching a peak point at 7.2% of the labour force midway through 2014.
• The budget deficit will increase from 3.5% this year to 3.9% next.

What should the government do about this? The central bank says “"The forecast course of the factual and structural deficit in 2014 does not meet the recommendations given in May by the European Commission to correct the excessive budget deficit in the Netherlands. Extra consolidation measures are therefore necessary."

Unfortunately the central bank is being entirely predictable in continuing to urge austerity as the economy weakens. In earlier posts (here and here), I noted how the central bank’s advice was rather different from the Dutch CPB (Bureau for Economic Policy Analysis), which clearly does employ macroeconomists. What is just so depressing is that the central bank seems oblivious to the increasingly overwhelming evidence that austerity during a recession is the complete opposite of what you should be doing in a country without its own monetary policy. Unlike some other Eurozone countries, there is no market pressure forcing policymakers’ hands in the Netherlands.

If you think this is excessively rude, please read my own checklist on the subject. I am not disdainful of those in 2010 who thought austerity was necessary because either a debt crisis was around the corner, or economic recovery had been assured, and have subsequently done what Keynes suggested should be done when the evidence becomes clearer. I think they were wrong back then, and said so, but it was an understandable mistake, and even the best economists make mistakes. But I’m afraid to continue in 2013 to advocate a course of action which anyone can see is doing immense harm to so many people is just inexcusable. If you understand this, and are a macroeconomist working for this or another European central bank with similar views, then you have my sympathy. If you work for one of these banks and think I’m being too harsh, please tell me why in comments. But more importantly, let’s hope that Dutch politicians treat this advice, along with the recommendations of the Commission, with the contempt it deserves.

The last Labour Government: has the influence of economists ever been greater?

The latest issue [1] of the Oxford Review of Economic Policy is devoted to an analysis of the record of the last Labour government (1997-2010). My own contribution is on fiscal policy, but I do not want to talk about that here, as I already have a post covering the main points. Instead I want to reflect just a little on Labour’s entire economic record. One way of characterising this period, which those outside the UK may not be fully aware of, is that it was a government in which the influence of mainstream economics has never been greater.

One of the government’s first acts was to give independence to the Bank of England, under a regime of inflation targeting. Not only was this straight out of the mainstream macro playbook, but its design included elements of transparency and accountability that led economists at the time to label it best practice. (1997 also saw the appointment as deputy governor of the Bank of England of Mervyn King, who in many ways is the central banker mainstream economics might wish for.) In my paper I argue that the fiscal rules that came shortly afterwards were much closer to mainstream academic views than either what had gone before, or what subsequently happened in Europe. Even when those rules broke down after the recession, the instinct to use fiscal policy in a countercyclical way was entirely mainstream. Not to be forgotten is the decision in 2003 not to become part of the Eurozone, which could well have gone the other way if political factors had played a larger role.  

In terms of microeconomic policy, the ethos was generally ‘light touch’ regulation, but with intervention where there was perceived to be a clear market imperfection. There was a particular interest in improving productivity (where the UK had traditionally performed badly in terms of international comparisons), but the interventions were of the kind economists would generally recommend (improving human capital, enhancing competition policies, subsidising R&D), rather than any attempt to pick winners. There was a clear aim to reduce poverty, but again this was done through the tax and benefit system, rather than trying to directly influence market outcomes. (An exception was the introduction of the minimum wage, but that had a lot of support among mainstream economists.) In the public sector there was a continuing trend towards introducing incentives and market processes. There was a deliberate lack of concern about inequality at the top. Now of course not all mainstream economists would endorse all these developments, but I don’t think a newly graduating student of economics would be puzzled by much of this. And of course the fact that these policies reflected mainstream economics did not make them right, as we all found out during the financial crisis.

Why was mainstream economics so powerful? I speculate a bit below, but for this particular administration it may have been in part a political accident - the deal struck between Gordon Brown and Tony Blair, where Blair got to be Prime Minister, but Brown’s Treasury became more powerful than it has perhaps ever been. Of course that does not tell us why Brown himself was so influenced by mainstream economics (his PhD was in history).

So how successful was this ‘government by economists’? As the editors (David Cobham, Christopher Adam, and Ken Mayhew) in their introduction note, if the government had ended in 2007 the verdict would have included many pluses. Over the previous decade the macroeconomy was remarkably stable. Unemployment continued to fall. Although fiscal policy had it failings, the rules had been kept, the budget deficit was not far from a sustainable level and debt to GDP was lower than a decade earlier. The health service clearly got better. As Van Reenan documents, UK productivity continued to improve relative to other countries, and he suggests this cannot be dismissed as just a hangover from the reforms of the previous Conservative government. (See also this CEP paper coauthored with Corry and Valero.) The achilles heel was of course the light touch regulation of the financial markets (discussed in a nice paper by Arup Daripa, Sandeep Kapur, and Stephen Wright). However this too can be seen as a failure of mainstream economics as much as a political error.

It is interesting to speculate whether any government could have avoided having its reputation defined by what happened in 2008. Perhaps it could have: given the recession, the election result in 2010 was surprisingly close. However, once a new government took over, we had the familiar story of the victor rewriting history. To quote from the introduction (but my emphasis), the new Coalition government claimed  

“… that the principal legacy of the 1997–2010 Labour government was an economic policy framework that was both in (large) measure responsible for the financial crisis of 2008 and also unable to address its consequences. As we hope the papers in this issue of the Oxford Review illustrate, this charge cannot be made to stick, and the period of the Labour government was much more interesting and more important for the long-run prospects of the UK economy than this simple ‘external’ narrative suggests.”

I completely agree, but then as an economist perhaps I’m biased.

The last few years have been a painful reminder that there is nothing inevitable about this rising influence of mainstream economics in the UK (or elsewhere? - I would be fascinated by the thoughts of others in other countries.) While it is tempting to link this influence to the colour of the party in power, I would hardly call policies adopted by the Labour governments of the 1970s as reflecting the mainstream economics of the time (e.g. attempts to control inflation through prices and incomes policies). Perhaps a better interpretation is that mainstream economics (which should be neither slavishly pro or anti market) has its greatest influence on less ideological governments of the center, and its just that since the 1980s the traditional political left has been out of the equation. Whatever the linkage, I wonder how long it will be before we again see a UK government so influenced by mainstream economics.

[1] If anyone is reading this late, its the Spring 2013 issue

Mystified on AS/AD

Peter Dorman asks why you don’t see AS/AD being used in the blogsphere, but it is still there at the beginning in textbooks (ht Mark Thoma). Various people have responded, and in most cases I am very puzzled. I think Paul Krugman, as ever, gets to the heart of the issue, but I still puzzled by what he says. My problem is not with any of the macroeconomics, but with what others think is easy or otherwise for students.

As Paul says, the diagram that fits more closely with how macroeconomists think has inflation and not prices on the vertical axis. The Phillips curve is one of the key relationships in Keynesian business cycle analysis. It relates the two variables that policymakers talk about. So it is just natural (and not at all the result of any fetishism) to start with a diagram relating inflation and output.

It is also very easy to give students an intuitive explanation about why there is a short run relationship between inflation and output, rather than prices and output. You just need to explain how, when output exceeds a natural rate, workers want higher real wages, but firms will not concede a lower mark-up, and may want higher profit margins. So we get a wage price spiral which in the short run gives us some particular level of inflation. The fact that the Phillips curve depends on inflation expectations, which could be endogenous in a dynamic way, is again not that difficult for students. In the long run the Phillips curve is vertical, because if output remains higher than the natural rate, expectations about inflation will rise etc etc.

The problem Paul seems to have is with the other curve, which he quite rightly explains tells us about how policy reacts. But why do we need another curve? We can think about monetary policy choosing some level for the output gap, and tell all the stories we want about the past on that basis. OK, maybe that is too much – economists are addicted to mimicking supply and demand. So if you want to derive a ‘demand curve’, just have policy choose the output gap to minimise a quadratic in excess inflation and that gap, subject to the Phillips curve. (Here is a textbook that takes this approach from the start.) This is much easier than deriving the conventional AD curve in output and prices space. [1]

Paul gives two reasons why he still likes AS/AD. First it provides a quick introduction to why demand and supply shocks are different. But can’t you do the same thing by talking about moving along the Phillips curve and shifts to the Phillips curve? Second, he says that one advantage of AS/AD is that it conveys how ultimately the economy is self-correcting through price adjustment. Now I agree it is vital to have the vertical long run Phillips curve there. But in terms of self-correction, I think the AS/AD is downright misleading. It encourages students to think that there is some kind of automatic adjustment of demand to inflation, rather than policy induced adjustment. For every good student who understands that inflation reduces demand because it leads policy makers to increase (real) interest rates, there are as many lazy students who take away from AS/AD that macro is just like the micro they have already learnt, which is a fatal mistake to make.

So I cannot see that AS/AD represents something that is easier for students to understand than the Phillips curve. Instead I would call it something that it is easy for students to misunderstand. Even if they do not misunderstand, starting off with AS/AD forces them to go through an awkward transition phase to get to a place where they can understand what is currently going on. The number of times I have been asked by students ‘do I use the Phillips curve or AS/AD?’  Let us go straight to the Phillips curve, and make our and their lives easier.

[1] Nick says quite rightly that the more conventional AD curve does tell us about other monetary policy regimes besides money targeting, but of course in the long list he gives inflation targets do not appear. So I’m mystified about why you start students off by telling them how things worked in the (maybe) past, or the (maybe) future, but not the present.

NGDP targets and UK Monetary Policy: Criticism and Reaction

In my presentation to the Bank of England advocating the adoption of NGDP as an intermediate target, I added at the last moment the following slide near the beginning of the talk:

Context

•     UK macroeconomic performance since 2010 has been disastrous, both in comparison to previous recoveries and to the US.
•     I have not seen any remotely persuasive ‘structural’ reasons why this has to be so, but there are some fairly obvious policy related explanations. (Austerity + ZLB + a string of cost-push shocks.)
•     For a policy mistake of this magnitude, it seems unlikely that either fiscal or monetary policy bears sole responsibility. It also seems sensible to ask to what extent the macropolicy regime caused or enabled this mistake.

Understandably this was just a little provocative to an audience of Bank of England economists and some MPC members.

Is this an example of the Rogoff-Krugman dilemma in how to confront policymakers? I suppose I could have said instead that it was mostly fiscal policy’s fault, and that the Bank had done a reasonable job in difficult circumstances, but I just thought they might tweak things a little bit. But if I had done so, this would have been an argument for something like forward guidance, not a more radical change like NGDP targets.

However Bank economists were right to be provoked, because the slide conflates two things: the weak recovery everywhere, and how the UK has performed relative to the US. I should have ignored the latter. As I have previously noted, the difference in productivity growth between the UK and US is substantial, and unlikely to be down to just labour hoarding. Although that post and others have speculated about what is behind that difference (see also below), in truth no one really knows. As a result, using relative UK/US GDP growth performance in a simplistic way to criticise policy is too easy.

That said, I do think that macropolicy has been better in the US than the UK. In terms of monetary policy, I would note the following:

1.        The US was quicker to recognise the severity of the crisis and reduce interest rates
2.        In spring 2011 the UK came close to raising interest rates, while the US did not.
3.        The US introduced forward guidance that countenanced exceeding the inflation target, whereas the UK has yet to do so. (The fact that actual UK inflation has generally exceeded 2% misses the point, because the idea should be to raise inflation expectations as long as unemployment remains high.)
4.        Bernanke has recently been explicit that US austerity means that monetary policy may not be able to meet its goals. Either UK policymakers do not believe that to be true, or they are keeping very quiet about it.

None of these are huge differences. I have argued that the lack of a dual mandate in the UK has been an important contributory factor behind the first three points above, which was the idea behind my last bullet point on the slide, but which rather got lost in debating the second. But perhaps the more basic point, which I should have focused on, is that in both countries the intended output inflation trade-off in this recovery has been wrong. In terms of decisions within the context of their respective mandates, I’m not sure either committee has done better than the other.

So that is one example where the Bank’s criticism would lead me to improve my argument. Another point that I perhaps should have tackled head on is the idea that the UK’s problems start and end with its banks (rather than the Bank).  The story goes something like this. UK banks, unlike US banks, remain undercapitalised, and undercapitalised banks are very reluctant to lend. In additional small and medium sized firms are more reliant on bank finance in the UK than in the US. This might help explain the UK’s poor productivity performance. So far this is believable, although the survey evidence on why firms fail to invest is not that supportive. The argument then goes that if banks are the problem, then changing bank behaviour (rather than raising inflation expectations) is also the solution, and policies like the UK’s FLS are unconventional but appropriate. To put the same point another way, it is the effective interest differential between short rates and bank lending rates that is the problem, and not the zero lower bound.

Unfortunately changing bank behaviour has proved rather difficult. In that situation, it is not the case that the only remedy is to tackle the cause. For example, although fiscal expansion is second best to lower nominal interest rates, when we are at the ZLB it can largely eliminate the impact of incorrect real rates on output with relatively low costs in terms of distortions. Equally expanding demand could offset the impact of risk averse banks on the economy as a whole. Indeed it might even encourage these banks to think rather more optimistically about their loan book.

Those are two specific issues. What about the general reaction to my proposal for establishing a path for NGDP as an intermediate target for policy? On the idea of raising inflation to raise output, this visit reinforced my impression that once you spend a lot of time in central banks, you become infected with the strange belief that while it is quite easy to get inflation expectations to increase, subsequently reducing these higher expectations is much more difficult. I would love to see the evidence or model on which that idea is based. But more generally I think the Bank’s reaction to NGDP targets goes back to where this post started.

My impression from this and other evidence is that the Bank has a form of what I have called ZLB denial: it thinks it can still do its job with unconventional monetary policy.  That in turn must imply that it bears responsibility for intended outcomes, and here I get mixed messages about the output inflation trade-off it is aiming for: maybe it is optimal because the UK output gap is pretty small (but what about all those unemployed and underemployed?), or maybe it is because the inflation target is primary. But either way I get the impression that the Bank thinks that it has done reasonably well in difficult circumstances. With these beliefs, the case for radical change seems underwhelming. 

My verdict on NGDP Targets

At the beginning of the year I decided I needed to firm up my views on nominal GDP (NGDP) targets, and when I thought it was interesting track that process through blog posts. I think I have now done enough to reach a tentative conclusion. I also gave a policy talk at the Bank of England yesterday, which was a useful incentive to get my thoughts in order.

Here is a link to the slides from my presentation. What I first do is compare targeting the level of NGDP to an ideal discretionary monetary policy. That is a demanding standard of comparison, but I argue that NGDP targets have the potential advantage over discretion that they may allow central banks to pursue a time inconsistent policy after inflation shocks that would otherwise be politically difficult (see this post). More speculatively, the uncertainty for borrowers of NGDP variation may be more costly than uncertainty over inflation, as Sheedy argues (see this post).

Against these advantages, I see two major negatives. First, following a shock to inflation, I think NGDP targets would hit output more than is optimal (see here and here). Second, if there is inflation inertia (inflation depends on past inflation rather than expected inflation), then targeting the level of NGDP is welfare reducing, because it is better in that case to let bygones be bygones. (There is a related point about ignoring welfare irrelevant movements in non-core inflation, but that probably needs an additional post to develop.)

So far, so typical two handed economist. But now let’s shift the comparison to actual monetary policy, rather than some ideal. Or in other words, how does actual policy as practiced in the UK, US and Eurozone compare to an ideal policy? While NGDP targets may well hit output too hard following inflation shocks (and more generally gets the short run output inflation trade off wrong), current policy seems even worse. One interpretation of this is that policymakers are obsessed with fighting what they see as the last war. Outside the US this is often institutionalised by having inflation targets (even if they are flexible) rather than a dual mandate, locking in the error Friedman complained of during the Great Depression.  As attitudes or institutional frameworks are unlikely to change soon, moving to NGDP targets represent a move towards optimality.

This bias in policy is particularly unfortunate when we are at the zero lower bound (ZLB), because unconventional monetary policy is far less predictable and efficient. Although fiscal stimulus is likely to be less costly as a way of raising output at the ZLB than committing to higher future inflation, monetary policy has to work with fiscal policy as it is. (However policymakers have a responsibility to let the public know when inappropriate fiscal policy is making it difficult for monetary policy to meet its objectives, as Bernanke is now doing, but the Bank of England has not. As for the actions of the ECB in encouraging austerity at the ZLB, I have described the gravest macroeconomic policy errors as those that are both wrong and contradict the textbooks.)

With perverse fiscal policy and uncertain unconventional monetary policy, we need to raise inflation expectations as a means of overcoming the ZLB and raising demand. Here I agree with Christina Romer: we need to indicate something rather more fundamental than the kind of marginal change implied by the forward guidance we currently have in the US and are likely to have soon in the UK. My proposal is therefore the adoption of a target path for the level of NGDP that monetary policy can use as a guide to efficiently achieving either the dual mandate, or the inflation target if we are stuck with that. NGDP would not replace the ultimate objectives of monetary policy, and policymakers would not be obliged to try and hit that reference path come what may, but this path for NGDP would become their starting point for judging policy, and if policy did not move in the way indicated by that path they would have to explain why.

To some supporters of NGDP targets this advocacy may seem a little wimpish. Why limit NGDP to an intermediate target that can be overridden? Given the problems with NGDP targets that I mention above, it would I believe be foolish to force monetary policymakers to follow them regardless. In general I think intermediate targets should never supplant ultimate objectives, and NGDP is an intermediate target. The analogy I would draw is with monetary targets as adopted by the Bundesbank, and as briefly adopted in the UK. As I wrote here, most readings of Bundesbank policy suggest that they treated money targets pretty flexibly. Following the oil price shocks of the mid 70s and early 80s, inflation did rise substantially, but the target ensured that inflation came back down again. In contrast the UK adoption of money targets was far less flexible, so we had inflation overkill in the early 80s, and these targets were quickly dropped.

How was this proposal received by my audience at the Bank? Did my reasoning stand up to their criticism? Well at least one of the slides I would change in hindsight, but perhaps all that is best left for a separate post tomorrow.