How knowledge transmission should work

The tenth anniversary of the UK’s 2003 decision not to join the Eurozone has just passed. With all my complaints about how bad macroeconomic policymaking has been recently, I thought it was worth analysing an example of a good decision. Good not just because it was the right decision given the events of the last few years, but good also because of how it was done, and the way academic knowledge was used.

If you want detail on the background and process itself, I recommend viewing or reading a recent lecture by Dave Ramsden, who was the civil servant who masterminded the process. Here is just a short summary. The UK opted out of being one of the founding members of the Eurozone, but the possibility of us joining shortly afterwards was always taken seriously. The Chancellor Gordon Brown announced 5 tests that would need to be passed if this were to happen, and the Treasury spent a couple of years doing extensive work on these five tests. It eventually published 18 studies, which I recommend to any students who want to take a serious interest in Optimal Currency Area (OCA) theory. Although there is some original work there (of which more later), they were mainly very good summaries of the relevant academic literature, and various academics were consulted to help ensure this was the case.

I should declare an interest here. I wrote one of those studies, which tried to assess what exchange rate the UK should join at, if the decision was yes. However I do not think this has any influence on what I have to say below, because in an important sense my study was secondary to the question of whether we should join. [1] In contrast, much more critical was modelling work done by Peter Westaway, at the time a Bank of England economist who had previously built the Bank’s core macromodel.

Now some will argue that these 18 studies, and the years of work that went into them, were window dressing for a decision that had already been made. I think that is simply incorrect. Some of the reasons I think that are described by Dave Ramsden: if the politicians involved had already made up their mind, they went to quite elaborate lengths to conceal the fact from those that worked for them. (Compare this to the Iraq war, for example, where a dodgy dossier sufficed.) Furthermore, the studies themselves contain some very strong arguments (probably too strong) why joining the Eurozone could be very beneficial, which is not the kind of thing you do if you want the analysis to back up a foregone conclusion.

As a result, I think the exercise was what it purported to be: an attempt by civil servants to give the best advice they could to politicians. What marks it out for me was the extent to which those civil servants involved academics, and placed academic work at the centre of their analysis. The merits or otherwise of the Euro did divide macroeconomists, but there was no attempt to just consult those who agreed with some predefined view. (See, for example, the space given to Andrew Rose’s empirical work of the benefits of OCAs.)

So why was this process close to what I consider an ideal of how academic knowledge should be used, when I have just written a post which is far more pessimistic about how these things are generally done? I should think about this some more, but here are three ideas. The first is that the decision, although it generated strong opinions on either side, was not fundamentally ideological. There was no existing political apparatus that was clearly aligned with potential winners and losers. The second is that you had a Chancellor who had a very strong respect for economic ideas, whatever else you may think of him as a politician. Third, the Chancellor had to convince the Prime Minister Tony Blair, and so whatever decision he came to needed to be backed up as strongly as possible.

Most people would now agree that the 2003 decision (only one the five tests were passed) was the correct one. [2] While the analysis, and particularly the work by Westaway, contained some of the elements that came to the fore in the Eurozone crisis, I think Ramsden in his 10 year retrospective is clear that the 18 studies also failed to foresee other elements of the crisis, perhaps not surprisingly as most macroeconomists missed these too. Yet the deeper point is this. The decision was based on the best analysis that macroeconomics at the time could provide. It is a shame that this way of making economic decisions now looks like the exception rather than the rule.  

[1] If anyone ever asks whether I can keep a secret, I always give this as evidence that I can. The original work I did for the study was done and written up in 2002. At the time the Euro/Sterling rate was at or near 1.6 E/£, and my analysis suggested something closer to £1.4 E/£ was sustainable. So for nearly a year I sat on information that was extremely market sensitive, and I received plenty of phone calls trying to extract any hint at what my analysis would be, and I’m glad to say no one got anything out of those calls. Alas I also felt it would be improper for me to bet on my own analysis, which had been funded by the Treasury - perhaps that just makes me an honest fool. (The morning my study was published - by which time the rate had fallen to much nearer my numbers, naturally - it did move the market by about one percent, but that is another story.)

[2] Will Hutton disagrees. In his counterfactual where we joined, the UK not only does better before the crisis because sterling stays at a competitive rate, but also the UK’s benign influence provides a counterweight to Germany. This alternative history deserves a proper analysis which I do not have space for here, but my initial take is that it involves a lot of wishful thinking. 

Government debt, Inflation and Money

Do budget deficits cause inflation? Let me be a little more specific: does raising the level of debt and keeping it there when the economy is at full employment raise the price level? The conventional answer is: not if the central bank controls inflation. Sometimes economists say the same thing in a different way: not if the debt is not monetised. High debt may be problematic for other reasons (e.g. crowding out of private capital, default risk, increasing distortionary taxation), but not because it must cause inflation.

This post is about explaining this conventional view. The two ways of giving the answer reflect two different ways to describe the conventional view, and I think that tells us something interesting - although perhaps controversial - about the role of money.

In the textbooks, the conventional view starts by talking about the demand for the medium of exchange, money. The amount of money in the economy, it is assumed, is related to the amount of money created by the central bank, but not the amount of debt issued by the government. The demand for nominal money is proportional to the price level, which is what economists mean when they say people demand ‘real balances’. So, if the stock of nominal money does not change, neither can the price level. When economists talk about not monetising the debt, they mean that the central bank keeps nominal money fixed.

There are two elements in this argument. The first has to do with the relationship between the amount of money created by the central bank (‘base’ or ‘high powered’ money), and what the financial institutions that create money (private banks) can do. The second has to do with money demand, which is what I want to focus on first. To do so, imagine an economy where the only money is cash printed by the government.

It is trivial to show why there can be this tight and simple link between cash and the price level. The economic system is all about real variables: not just consumption and output, but also relative prices like real wages. Furthermore people want money to buy some real quantity of goods, so the demand function can be written as M/p = f(...) where (...) includes real output. So, if the price level only appears on the left hand side of this equation and nowhere else in the system of equations describing the economy, and the central bank controls the supply of cash M, then this will lock down the price level. This is the famous neutrality of money. Furthermore, the mechanism by which this lock down works is intuitive: if the central bank creates more cash, we have ‘too much money chasing too few goods’, so prices rise.

Once we allow private banks to create money, the story can get much more complicated. The textbooks try and short circuit this by teaching the money multiplier, which I think does a lot more harm than good. But we could just assume there is some mechanism by which the central bank can control the amount of money created by banks, and continue to tell our neutrality story.

So according to this conventional view there is no worry about government debt, as long as the central bank ignores debt when ‘fixing the money supply’. Whether it always will ignore debt, or whether it always can, is a separate issue for another post. The critical assumption I make here that allows me to avoid this issue is that the fiscal authority does adjust its taxes or spending to make the higher level of debt sustainable.

This story is missing a key ingredient, and to see why consider the following. Let all government debt be nominal (not indexed). Suppose that, just as there is a demand for real money, there is also a demand for a real quantity of government debt: B/p = g(....). The government, by cutting taxes for a period, raises the supply of nominal debt by a fixed amount. Suppose it keeps nominal debt at this level. In that case, using an argument analogous to the earlier one involving money, will the price level not increase, until the supply of real debt matches the demand for real debt? If so, higher government debt has raised the price level.

One argument here is to say that, as the government increases the nominal quantity of debt, the demand for debt also rises in step, so there is no need for prices to rise. This will happen if consumers are completely Ricardian, because they believe tax cuts today mean tax increases tomorrow, and they save to pay for those future tax increases by buying government debt. In this sense, the supply of government debt creates its own demand, so we do not need anything else, including the price level, to change.

Suppose, however, that this process is incomplete, perhaps because some consumers are credit constrained, and so spend rather than save their tax cut. Does that not mean prices will still have to rise a bit to match the increase in the supply of nominal bonds? However, if we still have a fixed nominal amount of money, then higher prices will raise the demand for money, giving us a contradiction. What squares this circle is that interest rates rise, which makes people economise on money, and also raises the demand for government debt without the need for prices to increase. So higher debt might raise interest rates, but it will not raise the price level if it is not monetised.

Now an interesting feature of this story is that we could cut out the stuff about money altogether. We could just talk about the supply and demand for nominal government debt, and how the demand for debt is positively related to interest rates and prices. If the government wants to borrow more, the demand for nominal bonds needs to rise, and this can happen either because interest rates rise or because the price level rises. If interest rates rise sufficiently there is no need for higher prices. Loanable funds vs liquidity preference and all that. [1]

It is a small additional step to just talk about the central bank controlling interest rates to fix the price level. Nowadays this is how many macroeconomists would explain why higher government debt does not raise prices: the central bank changes interest rates to make sure it does not. This explanation not only has the advantage of simplicity (we do not need to talk about the demand for money, or how the central bank controls its supply), but it also seems to match how central banks think.

Of course something about money is there in the background. When we talk about interest rates being varied to control inflation, and why therefore we can ignore the size of the stock of government debt as an influence on inflation, we are assuming that the central bank has the ability to control interest rates. This depends on the fact that the government can issue money, or more specifically that the central bank’s “liabilities happen to be used to define the unit of account”, to quote from the bible Michael Woodford’s Interest and Prices (p 37). So money is there, but like the impresario of a play, it does not need to appear on stage.

In terms of the question posed by the title, both ways of describing the conventional view (with or without money) end up with the same answer to the question about government debt and inflation, which is good. However I remain puzzled about one thing. Do those who still tell the story using money think that telling the story just with interest rates is equally valid, or in some way misleading? When, with Campbell Leith, I first started using ‘cashless’ models of the Woodford type, a frequent complaint was ‘where was money?’. To appease potential referees we occasionally put money in, even though this added nothing to the main points of the paper. Yet I think those asking the question thought we might be missing something more fundamental, but I never discovered what it was. I remain genuinely curious.     

[1] Recall that I am assuming full employment in all this. In a recession caused by people saving more, higher saving will raise the demand for bonds, so even if the supply of bonds also rises following budget deficits, interest rates or the price level could fall rather than rise.

The knowledge transmission mechanism

In a comment on my last post, Joseph Grossman asks “If the vast majority grasp and support the basic shape of the [fiscal] stimulus solution, and if we live in democracies, isn't it time to shift the analysis to expose the exact and precise mechanisms by which our electoral systems are failing miserably?” This is the question which, since 2010, I have asked myself almost every day. The question becomes even more relevant as the intellectual case for austerity crumbles, but the policy continues, and in some cases even appears to gain ground. There may be some answers that are specific to austerity: see Paul Krugman here or myself here. But in this post I want to use this example to look at the question of the transmission of economic ideas more generally. So let’s break the question down.

First, do the vast majority of economists agree? In the case of fiscal policy, I think the honest answer here is: majority, probably yes, vast, almost certainly no. For example, in this survey the vast majority did agree that the 2009 US stimulus did reduce unemployment. It would be very surprising if this were not the case - after all this is what we teach first year economics students, and it would be a very strange discipline indeed that taught its students something it also thought was wrong. (For this reason, I would love to know the results of a similar survey of German economists.)

Yet on the question of whether it was a good policy (benefits exceeded costs), only 46% agreed, and a large 40% were uncertain or did not answer. That is not a vast majority. I don’t think there is a single reason why so many economists are equivocal. Some worry about government debt levels, others have a deep distrust of government, still others have faith that this is better done by monetary policy, despite the ZLB. I suspect those numbers would be more favourable if the survey was restricted to macroeconomists, but there would still be a significant number who would be unsure.

However, what the majority - vast or not - of economists think would be irrelevant if no one listened to them. The transmission mechanism from economists to economic policy works along many channels. It may be direct. It may be mediated through the civil service. It may work through economists influencing popular opinion, which then influences policymakers. I think the last of these is the least important. In part this is because most people do not have the time and inclination to interest themselves in what economists think: I was going to say regrettably, and I am heartened and encouraged by those who do take an interest, but I doubt if it is reasonable to expect most people to try and find out directly what the arguments are on economic issues.

That is not to say that people do not have opinions. What this does mean is that their opinions come not directly from what economists think, but from how the media discuss economic issues. One way this could work is that people in the media consult enough economists to find out what the key issues are and what the balance of opinion is, and report that to the public. While some of this goes on, to suggest this is how the media generally works would be naive. To see why it is naive, it is useful to look at direct links between policymakers and economists.

Again, a naive view here is that politicians do what the ‘ideal’ media would do. But nearly all economic issues involve winners and losers, either directly or indirectly. Most politicians support the interests of particular groups. So politicians will select to talk to those economists who support policies that favour those interests. They will have little regard to whether those economists are in the majority or not. A classic example is the Laffer curve. Hardly any economists believe that tax cuts increase tax revenues, yet the Republican Party looked to the few who did, and it became a party line. (Paul Krugman, in his first book, talked about the ‘policy entrepreneurs’ who intermediated this process. Nowadays we have think tanks: some good, some propaganda factories.)

Now if we had a media that faithfully reported what the majority of economists thought, and questioned politicians on this basis, then this kind of self selection by politicians would happen a lot less, because it would run the risk of being exposed. This clearly does not happen, as Stevenson and Wolfers lament here. There seem to me to be three main reasons.

1) Those in the media react to incentives and pressure, like anyone else. So when Stephanie Flanders made the obviously correct comment that growth in UK employment despite sluggish output might not be good news because it meant productivity growth was low, she was jumped on by Conservative politicians shouting bias. Did the BBC ignore these complaints and tell the politicians to get real - like hell they did. Yet if someone in the media writes something that does not make sense in terms of what academic economists understand, do the massed ranks of professors stand up and loudly complain? It was a rhetorical question. Occasionally groups of economists write letters, although these are pretty ineffective, either because they get ridiculed, or because it provokes an apparently equivalent letter from the ‘other side’. (See Alan Manning here.) Which brings us to ...

2) For sections of the media that do have an interest in truth rather than propaganda, the perception of being unbiased is terribly important. So when an economic issue that is politically divisive comes up, the natural response is to report ‘both sides’. This is the origin of the ‘opinions on shape of the earth differ’ jibe first suggested by Krugman and immortalised by DeLong (e.g. an early example here). It is much more difficult, and risky, for the media to report which side is in the majority among the experts. So the public just end up thinking that economists disagree all the time, even when they do not.

3) A large section of the media in most countries is politically controlled. Just as it is unnecessary to own the majority of shares to control a company, it is not necessary to control all the media to have a pervasive and defining influence. Of course obtaining ‘control of the means of information’ costs money, so it is not something that ‘both sides do’ in equal measure. The fact that this political influence works more through TV in the US and through newspapers in the UK is an interesting difference, but that it works through some means is not an accident, but an entirely predictable feature of our modern democracy. What I find interesting is that many people, including some academics, appear to deny its importance.

I have become a bit obsessed by all this as a result of the widespread adoption of austerity policies, and their remarkable persistence despite apparent failure. It is interesting to try and assess how important each element is: for example would it make much difference if the vast majority of economists thought fiscal stimulus was both effective and a good policy? One way to judge this is to look to other areas where science and politics clash, like climate change, or even badgers (on rereading, one of my better posts). It is an issue that scientists in general have become increasingly concerned about: the introduction to this collection of essays from the American Academy covers many of the points raised here, and more. However there is a tendency to revert to the old line that academics must communicate more and better, and glide over some of the structural weaknesses in the transmission mechanism that mean it would make little difference if they did.

My own current view is that these structural weaknesses are to a large extent inherent in liberal democratic societies, where restrictions on what money can do are very limited. That has led me to be much more favourably disposed to the delegation of economic decisions, even though this appears less democratic, and can be seen as representing arrogance and self-interest by the academic community. Yet the problem is real enough. And it is personal: when you study, teach and research in a subject where some of its most basic findings - understood for more than half a century- can be brushed aside so easily, and millions of people are worse off as a result, you have to ask yourself what the point is.

Annoying Anti-Fiscal Stimulus Arguments Nos. 3 and 4

For numbers 1 and 2, see this post.

Number 3. We must reduce the size of the state.

This argument is often there but unstated, because to say it explicitly involves a deception. Instead it sometimes goes by the euphemism of ‘structural’ or ‘supply side’ reform. (No, I’m not saying there are no genuinely useful structural reforms out there, but just what some people mean when they use this term.) But as those making the case for austerity get more desperate, I have seen this argument a few times recently.

It involves a deception, because reducing the size of the state has nothing in principle to do with austerity and stimulus. I personally have no strong views about what the size of the state should be: some things are clearly done better by the private sector, while others are done better by the state, and how this eventually pans out for the aggregate I have no idea. But this has almost nothing to do with the need to increase demand when interest rates are at the zero lower bound. The deception comes when austerity mainly involves cutting spending (as in the UK), because it is anticipated that it will be very easy to cut taxes later on once austerity is over.

When I say it has almost nothing to do with stimulating demand, this is why I say almost. A long established and theoretically robust method of stimulating demand is a balanced budget fiscal expansion, where you temporarily increase government spending by temporarily raising taxes. However as it need involve nothing more than bringing investment projects forward in time (e.g. repairing roads and schools before they completely fall apart), it is not really increasing the size of the state. The idea that what is temporary is bound to become permanent does not stand up.

4. We must think of the children

This is annoying not because it is wrong in principle. Instead it is wrong because it either ignores who suffers the costs of austerity, or because it is not genuine. The argument that is right in principle is that, by increasing debt, we are ceteris paribus redistributing money from future generations to the current generation. There may be a complete offset if that increase in debt avoids hysteresis effects (or enables investment with beneficial supply side effects). Yet even leaving that aside, there are often very good reasons to redistribute income. When a country suffers a natural disaster, both governments and individuals freely give money to help those involved. We can think about the recession as a similar disaster.

If that does not convince you, ask who is bearing the brunt of this recession. All around the world, youth unemployment has risen by more than unemployment in general. If you asked those who cannot find a job after leaving school or college whether they would be willing to pay higher future taxes in order to get a job today, what do you think their answer would be?

Why do I suspect that this argument is sometimes not genuine? Because some of those who make this case also argue against measures to tackle climate change. Now even if you are sceptical about the science, the potential costs of you being wrong and 98% of scientists being right are so great that if you really cared about future generations you would support measures to reduce carbon emissions. (See Martin Wolf here or Martin Weitzman here.) So when, for example, a recent Wall Street Journal article argued that “we need an exclusive focus on supply-side reform [reducing the size of the state] to promote growth. Luxuries such as family-friendly employment legislation or green initiatives such as the carbon taxes are no longer affordable in the age of austerity” you know something is not right. The biggest risk to the well being of future generations right now is climate change, so what is the point of increasing future growth if the cost is doing nothing to reduce that risk. Of course that combination might make sense if you only care about what happens in the next few decades, but if that is your view then don’t tell me we should avoid a short run increase in debt for the sake of future generations. 

Money as Credit

The relationship between money and macroeconomics is very strange. At one time money was thought to be central to the discipline - advanced courses in macroeconomics were often called monetary economics. We had monetarism. Then gradually money slowly faded away. We had real business cycle models that were just real, and if we wanted to make them nominal you just added money as a ‘medium of exchange’. Then even Keynesian models with sticky prices began to dispense with money altogether, becoming cashless. Money seemed both essential - for example to the concept of inflation and to why Says Law did not hold - but also dispensable.

These thoughts followed from reading a book called ‘Money: The Unauthorised Biography’ by Felix Martin. 

The first thing to say is that this book is a great read, and one that I think non-economists will find completely accessible. Much of the book, as you would expect from the title, involves a historical discussion of how money evolved, was developed and was understood in particular societies at different times. Some of this I was familiar with - like the stones of Yap - but a great deal was new to me. But this is a biography with a message. Money is not fundamentally a commodity medium of exchange that made exchange more efficient compared to barter, but a particular form of credit, a system of clearing accounts (transferable credit). Yet, Martin argues, the dominant view since Adam Smith has been of money as a commodity medium of exchange, and this has enabled macroeconomics to largely ignore financial crises, until they actually happen. Here is a passage:

“From the moneyless economics of the classical school there evolved modern, orthodox macroeconomics: the science of monetary society taught in universities and deployed in central banks. From the practitioners’ economics of Bagehot, meanwhile, there evolved the academic discipline of finance - the tools of the trade taught in business schools, used by bankers and bond traders. One was an intellectual framework for understanding the economy without money, banks and finance. The other was a framework for understanding money, banks, and finance, without the rest of the economy. The result of this intellectual apartheid was that when in 2008 a crisis in the financial sector caused the biggest macroeconomic crash in history, and when the economy failed to recover afterwards because the banking sector was broken, neither modern macroeconomics nor modern finance could make head or tail of it.”

Some of this will be familiar, although what was new for me (but perhaps not to followers of Minsky or MMT) - and quite challenging - was the idea that this could all be traced back historically to a misconceived view of money itself. (According to Martin, the 17th century philosopher John Locke has a lot to answer for.) The threads developed from the historical account of the origins of money are numerous. For example money as credit is inevitably social, and so its value is bound to be politically determined. In a financial crisis, when the size of debts begin to encumber the economy, it is therefore quite logical and natural to adjust the value of money to redistribute between creditors and debtors.

So this is a big ideas, big picture kind of book. Inevitably, therefore, some of the brushstrokes may be a little too broad or bold for some. The story of macroeconomics as essentially classical and real with only a brief incursion by Keynes is I think too simple and easy, and I would have liked to know his take on the explosion of macro work on financial frictions since the crisis. But the historical detail is fascinating, and the ideas they are used to illustrate are clear and thought provoking, so I’m very glad I read it.

UK Growth has been even worse than we thought

That is one headline on the Office for National Statistics (ONS) latest data revisions. Output in the UK economy is now estimated to be currently almost 4% below its previous peak, compared to previous estimates of 2.5% below. Or alternatively, the headline could be that the UK never had a double dip recession: at the beginning of 2012 growth was flat rather than falling by 0.1% (not annualised), a 0.1% that has been reallocated to the subsequent quarter. The chart below shows the old and new data for GDP growth, quarter on quarter. So GDP went fall, flat, fall, which technically is not a recession. I’ll leave you to decide which the more informative headline is.*

As you can see the big revision is in how much GDP fell in the recession. GDP is now thought to have decreased by a little over 5% in 2009 as a whole, compared to the previous estimate of -4%. At this point I cannot resist telling a small story about this number, but for those who are fed up with my personal anecdotes there is a serious point about inflation to follow. I make a weak attempt to connect the two at the end.

Quarter on quarter changes to UK GDP (not annualised): ONS

At the beginning of 2009, I was asked to attend a breakfast meeting with the then Chancellor, Alistair Darling, along with some non-academic economists. I had never attended one of these before, so I did not know what to expect. I had not met Darling, but all the other economists invited appeared much more comfortable with the format and surroundings, so to be honest I was rather nervous. Academics in particular can appear out of touch because they do not have all the latest data at their fingertips.

Sure enough, one of the first questions Darling asked was just how bad we each thought things could get. I cannot remember what each person said, but the general view was that GDP could fall by as much as 3% in 2009. I was the last to give my opinion. I could have ducked out, but instead I remembered one thing from my earlier days as a forecaster. This was that forecasts typically underestimate the extent of large swings in GDP, particularly if they are globally synchronised. So I said that I thought things could be worse than that, and GDP could fall by 5%.

Impossible! was the immediate retort of one of the other economists: someone who is very well known and very sensible, although I will not say who it was here. This person then used their detailed knowledge of the data to say why it was inconceivable that GDP could fall by so much. One by one everyone else agreed that although things were bad, they could not get that bad, and 5% was an outlandish number. Just as I wished I had kept my mouth shut, or better still just not come, the senior economist from the Treasury who was there came to my defence: a fall that large could happen, and they described how it might happen. I of course take no pleasure in the fact that my forecast has been vindicated, and it was little more than luck, but it is one of those moments I will not forget.

Now for something more consequential. The chart below compares two different measures of UK inflation: the CPI (green) and the GDP deflator (blue). CPI inflation has been significantly above the 2% target since 2010. In contrast over the last year growth in the GDP deflator has been well below 2%. This is the deflator at market prices, so it includes indirect taxes. The dashed line is the GDP deflator at basic prices, which excludes these. The press release only includes numbers going back to 2010 for this series, but you can see that growth has been below 2% for the last three years. The dotted line is growth in the US GDP deflator - this moved in a more immediately understandable way after the recession, but over the last two years the UK and US measures have not been that different.

Alternative measures of inflation

The fact that output price inflation (which is what the GDP deflator measures) has been below CPI inflation is neither surprising, nor unique to the UK. What is less appreciated is that there is no reason from an economic point of view to focus on one series (the CPI) rather than the other (the GDP deflator) when setting monetary policy. At an intuitive level looking at the output price measure makes more sense, because policy has more control over things produced in the same country. At a deeper level, inflation matters because some prices are sticky, and the GDP deflator generally excludes volatile commodity prices. It should be less influenced by volatility in the exchange rate, so it may be better for that reason too.

I cannot help but reflect on how different UK monetary policy might have been if it had focused on output prices rather than consumer prices. In 2011 interest rates were almost raised (3 out of 9 MPC members voted for doing so), despite the lack of a recovery. Would this have happened if the target inflation measure had been below 2%, as growth in GDP at basic prices was? Since then Quantitative Easing has largely stalled, which would have been very hard to justify if the focus had been on output prices.

One of the reasons often given for focusing on the CPI (which has come up again in discussion of nominal GDP targets) is that this data is available quickly and is not revised. [1] Which brings me back to the beginning, because the GDP deflator numbers for the first quarter of 2013 and earlier have been significantly revised (and are smoother as a result). I have never understood this argument. We should start with why inflation is costly, and then think about how best to measure these costs. If measurements change because information gets better, policy should respond to that. If that causes problems, improve the measurement. Perhaps policy needs to obsess a bit less about this bit of data or that, and think more about the fundamentals of what it is trying to do. 

* I changed the text here from the original version to make the nature of the adjustment clearer. As one economic journalist put it, reallocating 0.1% of GDP between quarters makes no difference in terms of the economics, but revising away the double dip recession will play well for George Osborne politically. I think that says a lot about the quality of political debate.

[1] Another argument is that the CPI is easily understood by the non-economist. If this impresses, why not use wages rather than the CPI, as I suggested here. As wages are clearly sticky, there are good theoretical reasons to focus on this as a measure of inflation.

Government default, reserves and QE

For macroeconomists. Paul Krugman needed more coffee to get his head round the latest paper by Corsetti and Dedola. I had a similar feeling, and I have written this post to try and get my thoughts in order. So this comes with a health warning, which is that I may have failed.

This post is all about the distinction between central banks and governments, but to make those distinctions clear, its helpful to consolidate their budget constraints. Initially assume that this consolidated entity can finance its deficit by either issuing bonds or printing cash. It is therefore true that this entity need never default: if no one buys its bonds, it just issues cash. However that does not mean that it will never default. Suppose, as Corsetti and Dedola do, there is a direct and simple link between cash and inflation, while issuing debt has no impact on inflation. Avoiding default by printing cash therefore creates inflation, which is costly. It may be so costly that the government/central bank entity chooses to default, rather than bear those costs.

I do not think this idea is controversial, but failure to distinguish between ‘need’ and ‘choose’ can cause confusion. What may be controversial in the above is the simple quantity theory link between cash and inflation, but in fact we do not need anything so sharp. As long as printing cash is more likely to raise inflation than issuing debt, the proposition still holds. What the exact nature of the inflation link will influence, of course, is the likelihood the government will choose to default rather than create higher inflation.

This choice may also be influenced by the existence of independent central banks. If governments give control over printing money and inflation to a conservative central banker in the Rogoff sense, then this could decrease the likelihood of using inflation to avoid default, and therefore makes default more likely for a given fiscal position. This may also, of course, influence fiscal policy. Whether independent central banks have that much independence is of course debatable.

Now let’s add the possibility of multiple equilibria. The ‘good’ equilibria is the one where the interest paid on government debt reflects the ‘true’ probability of default i.e. it reflects the circumstances in which the consolidated government chooses to default. The ‘bad’ equilibrium is one where the rate of interest reflects a much higher probability of default. As De Grauwe has recently emphasised, because the market can in effect force default by not buying debt, this bad equilibrium is possible.

However as our consolidated government/central bank can print cash, does this rule out the bad equilibrium? The answer, according to Corsetti and Dedola, is not necessarily. The reason is straightforward. Printing cash is still costly, because it raises inflation. The bad equilibrium could still exist, because to prevent it would require creating an undesirable amount of inflation, which the consolidated government will not at the end of the day do, whatever it may say it will do.

However Corsetti and Dedola note that in practice, central banks are buying government debt not by printing cash, but by creating reserves. So they extend their model to include a third asset, bank reserves. In terms of the consolidated government, what are these reserves? In Corsetti and Dedola I think reserves are default free debt. They pay a risk free interest rate, but there is no chance of default, because (by some means) the central bank always promises to pay back the interest and capital with money. However, like government debt and unlike money, there is no link between the quantity of reserves and inflation.

Now I find it intuitive that with this additional asset, it is now possible to remove the bad equilibrium, as the authors show. The government/central bank can simply choose to swap any normal debt that the market will not buy with reserves, which the market will buy, because reserves are default free. The government/central bank is essentially ruling out its option to default. Why does the government/central bank ever issue bonds?  In the absence of the possibility of a bad equilibrium, it might prefer issuing bonds because it wants to keep the default option.

I have traditionally thought about Quantitative Easing as being equivalent to swapping debt for cash. For exactly the reasons Corsetti and Dedola outline in a world without reserves, to do this permanently would raise the price level, so as a result QE is strictly temporary. But now add reserves of the Corsetti and Dedola type. QE then involves a swap between two types of debt: one default free and one not. The consolidated government/central bank is reducing its option to default on debt, in order either to remove a bad equilibria, change the term structure, increase the supply of completely safe assets, reduce its interest bill, or something else.

Now what is crucial in this analysis is that issuing reserves, unlike issuing cash, has no implications for inflation. You might object that while that clearly seems realistic at the moment, this reflects the peculiar circumstances of the zero lower bound (ZLB), and in the longer term additional reserves would be inflationary because they would allow private banks to create more loans and deposits etc etc. However in this context a recent post from Paul De Grauwe and Yuemei Ji is interesting.

De Grauwe and Ji, among many other things, consider the situation in a which the central bank buys government debt with reserves, and the government defaults. It is then often suggested that the central bank loses the ability to control interest rates and inflation. De Grauwe and Ji argue that this “does not hold water” for two reasons: the central bank can reduce the money stock by either raising reserve requirements, or by issuing interest bearing bonds. So would a permanently higher stock of reserves necessarily imply higher inflation once the ZLB was over? Following De Grauwe and Ji the answer is no, because either private banks can be forced to hold more reserves and not create more deposits, or the central bank could exchange reserves for some other kind of central bank asset that was still default free but which had no knock on implications for the banking sector.

So to the extent that reserves are just default free debt, or can be turned into default free debt, QE does not need to be temporary even with unchanging inflation targets. Whether this is of any consequence I’m not sure, particularly as central banks do not want to make QE permanent, as recent events illustrate. Seeing reserves as default free debt may also not be terribly interesting for the UK or US right now as the perceived default risk of each country’s debt is pretty low anyway, and so the chances of a bad equilibrium emerging are equally low. But the implications for the Eurozone are clearly much more interesting.