The Eurozone’s Founding Mistake

It really was predictable. Take away the ability to control national interest rates, and you create a potential for patterns of demand to diverge, leading to movements in competitiveness that would have to be painfully unwound later on. The good news was that you could use countercyclical fiscal policy to moderate these movements - an entirely conventional macroeconomic idea. But it was not what the architects of the Euro wanted to hear.

This is how my paper just published in Global Policy starts. So instead of countercyclical fiscal policy, we got an obsession with budget deficits and the possibility of fiscally profligate governments. Even with this obsession the Eurozone failed to spot its one member that was behaving in this way until it was too late. But in looking in the wrong direction, the Eurozone allowed just the kind of competitiveness imbalances to take place that fiscal policy might have been able to do something about.

This is not wisdom from hindsight. Before the Euro was established, I was among a large group of economists suggesting that fiscal policy should be used countercyclically by Eurozone members. That work continued after the Euro was established: here and here are just two examples. It had no impact on policy. There was a lot we did not foresee. It is particularly ironic that the first major asymmetric shock to hit the Euro area, that would cause these large competitiveness imbalances, was arguably a consequence of the creation of the Euro itself. But the point remains that a method of handling these things, which was entirely conventional in macroeconomic terms, existed and was ignored.

Now in saying this I find myself in the rather unusual position of disagreeing with Martin Wolf. He has argued (here for example) that a country like Spain could not have done more in terms of fiscal policy to counteract its housing boom. I have heard many others make the same point - you think Spain should have been running even larger surpluses? they ask incredulously. The answer is simply yes: by looking at fiscal surpluses you are looking at the wrong indicator. Here is what happened to consumer price inflation from 2000 to 2007.

	2000	2001	2002	2003	2004	2005	2006	2007
Ireland	5.3	4.0	4.7	4.0	2.3	2.2	2.7	2.9
Spain	3.5	2.8	3.6	3.1	3.1	3.4	3.6	2.8
Portugal	2.8	4.4	3.7	3.3	2.5	2.1	3.0	2.4
Euro area average	2.2	2.4	2.3	2.1	2.2	2.2	2.2	2.1

 

Inflation was significantly above the Euro area average year after year. If the average inflation rate had been 10%, or even 5%, this might not have been a big deal, but when the inflation target was 2% or less, that makes reversing these trends very painful. Looking at budget surpluses during a property led domestic boom can be very misleading, as Karl Whelan argues in the case of Ireland.

There may be many reasons why the Eurozone ignored this advice. One was probably a belief among some that countercyclical fiscal policy was either ineffective or dangerous. (The ordoliberal logic on this has never really been spelt out, and it seems more like an article of faith.) Another was an almost mystical belief that the creation of the Euro would diminish the importance of asymmetric shocks or the extent of asymmetric structures.[1] Yet another was a view that the far greater danger lay in the reduced fiscal discipline that being part of the Euro would bring, and any countercyclical role would only encourage this ill discipline. Yet we now know (and I do not think anyone really foresaw this) that this last argument is completely wrong. Not having your own central bank means that market discipline on Euro members’ fiscal policy will be much greater, once it is understood that national default can occur.

I do not think this point has sunk in yet among many macroeconomists. The standard line, backed by academic papers, was that joining a common currency would reduce market discipline on fiscal policy. Yet that analysis ignored default, and the possibility of a bad equilibria generating a self-fulfilling crisis. Countries will not forget the events of 2010-12 in a hurry, so the danger now is that we have too much, not too little, market discipline influencing fiscal policy. 

Ironically, the architecture of the Stability and Growth Pact sent all the wrong signals. By stressing the dangers that individual countries might free ride on the Eurozone, it suggested that such actions might be in the national interest for any country that could get away with it. That is why attempts to control national budgets at the Eurozone level can be counterproductive as well as unnecessary. It is far better to build national institutions that can make sure countries develop appropriate fiscal policy which is in their national interest. In an ideal world the Commission might play a coordinating role, but given its current mindset it would be best if it just stayed out of the picture.

So while the details of the Euro crisis were not foreseen, the palliative medicine that would have made that crisis much more manageable was available, but those in charge decided not to take it. What turns this serious policy error into a tragedy is that policy makers continue to make the same mistake. The Fiscal Compact is exactly the opposite of what the Eurozone requires right now. (I have cited the Netherlands as a clear example of this.)

This makes me both optimistic and pessimistic about macroeconomics as a discipline. Optimistic because the subject has so much potential to do good: basic ideas, long understood, yet clearly not obvious to some, can help prevent disaster. (Those who claim that macroeconomics is the weak point of the economics family should take note.) Pessimistic because even when those disasters occur, the macroeconomic wisdom continues to be ignored.  

[1] If anything, formation of a currency union should allows greater national specialisation, which of course has the opposite effect.  

What Recession?

Tony Yates thinks there should be no more [sic] fiscal stimulus in the UK, because inflation is above target. As inflation is above target, there is no need to stimulate demand. Tony accepts that in principle at the ZLB fiscal stimulus can be a useful expansionary instrument, but in the UK at the moment it is not required.

So here is a table of CPI inflation in a few countries.

CPI Inflation rates (source: OECD Economic Outlook)

	2007	2008	2009	2010	2011	2012	2013	2014
United Kingdom	2.3	3.6	2.2	3.3	4.5	2.8	2.8	2.4
United States	2.9	3.8	-0.3	1.6	3.1	2.1	1.6	1.9
Euro area	2.1	3.3	0.3	1.6	2.7	2.5	1.5	1.2

The inflation target in the UK is 2%. So not only is there no case for any stimulus going forward, it also looks like the UK managed to completely avoid any recession in 2008/9! The US also had a small boom in 2011, and who knows why people in the Eurozone feel so depressed?

OK, this is a cheap point, but a valid one nevertheless: CPI inflation is a pretty hopeless indicator of the output gap when inflation is low. Other inflation measures do a bit better: here is the GDP deflator at basic prices.

UK Inflation: source ONS

Some of the low growth in the GDP deflator is because of low inflation in the government consumption deflator, and we know this is difficult to measure. However I’m not trying to argue that one index is better than another. Instead I just want to make the point that at low levels of inflation, inflation itself becomes a very unreliable measure of the output gap. This is true not just in the UK, as the IMF recently pointed out. 

One reason why UK inflation has not fallen further is UK labour productivity, which I have discussed before. Now if the decline in UK productivity growth was an irreversible supply side phenomenon then you could indeed argue that the current UK output gap was small (but not zero - see below), but is this remotely plausible?

Here is a chart of (logged) UK GDP since 1950. [1] I’ve added a trend line not because I believe productivity growth is always constant, but just so the following point becomes clearer. GDP growth does sometimes fall sharply: in 1980, and in 1990. But both these occasions were demand induced recessions. To argue that 2008/9 is different means that something quite extraordinary and unprecedented has happened. Now maybe that is possible, but given the costs of being wrong about this, we have to be pretty certain of your story to base policy on it. 

UK GDP, logged. Source - see [1]

So let us look at something we can measure with reasonable accuracy: unemployment.

UK Unemployment Rate: ONS

The increase in unemployment since 2008/9 is modest given the output fall - productivity again - but it is not small. I have heard no one argue that this increase in unemployment represents an increase in the NAIRU or natural rate. To the extent that low real wage growth has encouraged substitution from capital to labour, unemployment underestimates the extent of the output gap. (If unemployment continues to fall at the same rate it has over the last year - a rate the Employment Minister describes as encouraging - we should see a return to pre-recession levels sometime after 2025.)

So it seems to me that we are sitting in a freezing house, but because the thermostat says it is still warm, its occupants are trying to convince themselves that they are not really feeling cold, and the last thing they want to do is turn up the heat. (I admit not the best of analogies for the UK right now.) Just because we build models in which inflation always responds in a predictable and linear way to the output gap, does not mean that the real world behaves in the same way.

[1] I’ve spliced the recent ONS data revision from 1998 on to a time series from Lawrence H. Officer and Samuel H. Williamson, 'What Was the U.K. GDP Then?' MeasuringWorth, 2012.

Fiscal backing

In an earlier post I went through the logic of why we do not think higher government debt necessarily causes inflation, even if that debt is denominated in nominal terms, as long as the central bank does not monetise that debt. As I argued there, talk of monetisation is largely unnecessary: we just need to say that the central bank uses interest rates to control inflation, and can therefore offset the impact of any increase in government debt.

However, as Mervyn King said, central banks are obsessed with budget deficits. This seems to contradict the previous paragraph. Are there some ways in which central banks would either lose the power to control interest rates, or be forced to abandon any inflation targets, as a result of fiscal policy? 

In the previous post the thought experiment I considered was a sustainable increase in the level of government debt. By sustainable I mean that the fiscal authorities raise taxes (or cut spending) to service this higher level of debt. But suppose they do not: suppose the budget deficit increases because spending is higher, but there is no sign that the government is prepared either to cut future spending or raise taxes to a sustainable level.

In 1981 Sargent and Wallace published a well known paper which said that, in this situation, the central bank could in the short term control inflation, but in the longer term inflation would have to rise to create the seignorage to make the government budget constraint balance. In other words, to keep the economy stable the central bank would eventually be forced to monetise. This was later generalised by the Fiscal Theory of the Price Level (FTPL). If the government did not act to stabilise debt itself (which Eric Leeper called – a little oddly - an active fiscal policy, and which others - including Woodford, Cochrane and Sims - have called even more confusingly a non-Ricardian policy [1]), then the price level would adjust to reduce the real value of government debt. Fiscal policy determines inflation.

One of the critiques of this theory is that the government budget constraint appears not to hold at disequilibrium prices. See, for example, Buiter here, and a response from Cochrane. I do not want to go into that now. Let’s also concede that if the monetary authority does either follow a rule that allows the price level to rise (by fixing the nominal interest rate for example), or tries to move interest rates to both stabilise debt and inflation (as in my recent paper with Tatiana Kirsanova), then the FTPL is correct.

The case I want to focus on here is where the central bank refuses to do either of those things, but carries on controlling inflation and ignoring debt. Suppose the government is running a deficit which is only sustainable if we have a burst of inflation which devalues the existing stock of government debt, but the central bank refuses to allow inflation to rise. You can say it does this by fixing the stock of money, or by raising the rate of interest - I do not think it matters which. This is an unstable situation: interest payments on the stock of debt at the low price level can only be paid for by issuing more debt, so debt explodes. In this situation, we have a game of chicken between the government and central bank.

Now the game of chicken would probably end when the markets refused to buy the government’s debt. That would be the crunch moment: either the central bank would bail the government out by printing money, or the government would default, which forces it to change fiscal policy. But in Buiter there is an elegant equilibrium outcome: the market just discounts the value of debt by an amount that allows the central bank to set the price level, but for the government’s budget constraint to hold at that price level. We get partial default. This discount factor becomes the extra variable that solves for the tension that both fiscal and monetary policy are trying to determine the price level.

You could quite reasonably suggest that such a central bank could not exist, because the government has ultimate power. It can always instruct the central bank to monetise the debt. However suppose the central bank actually managed the currency for a whole group of nations, and could only be instructed to do anything if they all agreed to do so. Furthermore that central bank was located in the one country in that group that would never contemplate monetisation, so it would be immune to pressure ‘from the street’. That central bank should be pretty confident it could win any game of chicken. [1]

Has any of this any relevance to today’s advanced economies? It seems to me pretty clear that these governments are not playing any game of chicken. Quite the opposite in fact: they are being far too enthusiastic in doing what they can to stabilise debt, despite there being a recession. So we certainly do not seem to be in a FTPL type world. Instead monetary policy right now retains fiscal backing.

Yet in a way we are having the wrong conversation here. Rather than trying to convince central banks that their fears are groundless, we should be asking whether monetary policy should – of its own free will – raise inflation to help reduce high levels of debt. I agree with Ken Rogoff that it should, and have argued the case here. Yet however optimal such a policy might be, the chances of it happening in today’s environment are nil. It looks like we may have to go through a lost decade before we are allowed to contemplate such things. 

[1] I guess a rationale for calling this fiscal policy ‘active’ is that stable regimes in Leeper require one partner to be active and the other passive. So in the normal regime monetary policy is active and fiscal passive, and this flips in a FTPL regime. In a FTPL regime, Ricardian Equivalence no longer holds (because taxes are not raised following a tax cut) – hence the label non-Ricardian.

[2] In this situation, would buying that government’s debt ‘show weakness’ in the game? If we follow Corsetti and Dedola and treat reserves as default free debt issued by the central bank rather than money, then not at all. Instead the central bank is giving the fiscal authority the best chance it can to put its house in order, by removing any bad equilibrium, but it retains the power to force default at any point. We no longer have Buiter’s method of resolving that game, but only because the central bank has the means which could force a win. As long as the government believes that the central bank would prefer the government to default rather than see inflation rise, the government should back down.

Behaving like Luddites

The Luddites were 19th-century English textile artisans who protested against newly developed labour-saving machinery from 1811 to 1817. Activists smashed Heathcote's lacemaking machine in Loughborough in 1816. At the time, the BBC said that the increase in employment that would result from destroying the machinery “was of course good news”, but there was a concern that output might fall as a result. But some experts proclaimed that, thanks to the Luddites, we should celebrate that Britain was now leading the way in employment creation. A prominent politician that supported the Luddites accused the BBC of being hopelessly biased, and “peeing all over British workers”. The BBC Trust subsequently held a seminar on impartiality and economics reporting.

OK, the first two sentences come from Wikipedia, and the rest is nonsense. The idea that the BBC might describe additional employment that resulted from not using labour saving machinery as good news is surely unthinkable. If a journalist pointed out that these actions were problematic because productivity would fall, it must be inconceivable that any serious politician would accuse that journalist of bias. Unfortunately, if you follow the links, you will see that I made very little of that paragraph up, but just transposed things that happened a year ago back another 200 years.

There is one sense in which my transposition may be slightly unfair. In a recession, low productivity growth means that unemployment is lower. So I would have no problem with a line that went: “Of course the growth in UK employment, given flat output, is bad news. However, if this slowdown in productivity growth is temporary, and we catch up in terms of productivity levels later on, it may have a silver lining. Low productivity growth means that unemployment is lower, so that the pain of the recession is being more evenly spread by (nearly) everyone receiving lower real wages.” In a car crash, it is good when things like seat belts mean that people escape with minor injuries. But no one should describe the car crash itself as good news. [1]

At the seminar that the BBC Trust did hold in November 2012, there was disagreement over “whether BBC coverage should reflect a consensus view, in areas where there is one, or whether instead it must reflect the range of opinions even if parts of that range are minority views.” I would suggest that the overwhelming view today is that high productivity growth is beneficial, and that low productivity growth is a serious cause for concern, even if it might in the short term keep unemployment low. Do we really want the media to portray this as just ‘one perspective’, and then give equal time to the ‘opposing view’ that strong employment growth and low productivity growth is simply good news. In the case of the BBC and UK productivity, the BBC currently follows the 'opinions on shape of the earth differ' approach, and is then accused of bias for even mentioning that low productivity growth might be a concern.

It is vital that the media does not let politicians dictate how facts are interpreted. In George Osborne’s Orwellian nightmare, support for his handling of the economy is growing, and opposition to austerity is crumbling, whereas in the real world the case for austerity has never been weaker. It was always obvious that when the economy started recovering, this would be proclaimed as proof that the government’s policies are working, whereas what it really tells us is how used we have become to a no-growth economy.

Now if politicians want to be Luddites that is of course their choice. We trust in the system to quickly find them out, so that they do not get to hold positions of responsibility. Yet how is that supposed to happen, when the media insists on giving the Luddites equal space. As the opinion poll results presented by Professor Schifferes to the Trust showed, many people follow economics news closely, but remain confused by it. They rely on the media not just to present the news, but to put that news into context. Reporting that says one day ‘output growth low: bad’ and the next ‘employment growth high: good’, without putting the two together, is bad reporting.

Tim Harford has a recent post that pokes fun at some of the common misperceptions that the UK public has, such as crime is rising, a third of the population was born overseas, or that teenage pregnancy is widespread. What Tim does not ask is where these incorrect perceptions come from. He does note that they often do not come from direct experience: “people generally believe that their own area is closer to the way they like it with lower crime, lower unemployment, better policing, fewer immigrants. It’s the rest of the country they worry about.” So where do these perceptions about the rest of the country come from, if they do not come from the official statistics? The answer is pretty obvious - they come from the media.

There is a large part of the media, in the UK and elsewhere, that would regard the perceptions Tim quotes as indications of success rather than failure. It is not a coincidence that these misperceptions all tend to encourage a rather illiberal political agenda. However these perceptions should be a source of deep concern for organisations like the BBC, whose mission is “To enrich people's lives with programmes and services that inform, educate and entertain.”

Of course the ‘two sides’ approach has its place. It is not clear, for example, how much of the productivity slowdown in the UK is the government’s fault. However given what we know about output, the strong growth in UK employment is self-evidently bad news. As the coincident slow growth in UK wages shows, we are (nearly) all significantly worse off as a result. It is time the UK media recognised that the Luddites were wrong, and update its reporting accordingly.

[1] In the US in particular, monthly employment numbers are used as an indicator of what is happening to output, which is something completely different. Here I am talking about commentary that at least has the potential to compare what is happening to employment and output.

The two arguments why the Zero Lower Bound matters

I think it is important to distinguish between two arguments why the Zero Lower Bound (ZLB) for nominal interest rates matters. I will label these the first and second, and economists and statisticians will soon [1] see why these labels have some significance. The first argument is debatable, but the second is I believe very difficult to argue against.

The first argument why the ZLB matters is that unconventional monetary policy either does not work, or hits limits on what it can do, and these constraints bite. In short, monetary policy at the ZLB cannot fully achieve monetary policy goals. The second argument about why the ZLB matters is that the impact of monetary policy becomes more uncertain. Under the second argument, it is possible for some particular dose of unconventional monetary policy to duplicate what interest rate policy might otherwise achieve, but there is more uncertainty about what that appropriate dose is. The impact of any unconventional monetary policy action is therefore more unpredictable than the impact of conventional policy.

Much of the discussion of unconventional monetary policy involves the first argument. An important feature of Quantitative Easing (QE) is that its size is potentially unbounded - the central bank can create as many reserves as it likes. So if the impact of each unit of QE on the economy is constant, even if this constant is small, if we knew what that constant was we just scale up the programme so it has the desired effect. However, it seems to be much more likely that the policy involves diminishing returns, but to be honest I have no idea whether that means there are limits to what the policy can currently do. There are also some who worry that unconventional monetary policy has dangerous side effects on financial stability if it becomes too large. As I said, the first argument is debatable.

What seems clear to me is that we know much less about the impact of QE, or other kinds of unconventional monetary policy, than we do about conventional monetary policy. This almost follows by definition: we have well established models for conventional policy, and much more data to check these models against. What data we have also suggests the impact of unconventional monetary policy is more uncertain. (This is the conclusion drawn by John Williams, who has done a good deal of work on their impact, and I have never heard anyone argue against this view.) That is why I think it is very difficult to deny that the impact of monetary policy at the ZLB is much more uncertain compared to monetary policy outside the ZLB. [2]

Why do I make this distinction? Good policy tries not only to achieve the best outcome for the economy, but it also tries to reduce the uncertainty associated with that outcome. Indeed, we might well be prepared to sacrifice some of the former for some of the latter: uncertainty is in general undesirable. A standard way to judge the merits of a particular rule for macro policy, for example, is to ask whether it reduces the variance of output or inflation when the economy is hit by a standard set of shocks.

Let me return to an old friend. Suppose you are a doctor, and you have two medicines to treat a disease. One is reliable, but the other requires trial and error to get the correct dose, and occasionally has nasty side effects. In these circumstances, you would rather not run out of the reliable medicine. Indeed, you would want to go out of your way to avoid running out of the reliable medicine.

Seen from this perspective, it becomes almost undeniable that fiscal austerity at or near the ZLB is a dangerous policy. By making us more reliant on unconventional monetary policy it increases macroeconomic uncertainty. It makes it more likely that we will have to resort to the unreliable medicine. I think too much of the argument over whether monetary policy is all you need focuses on the first reason why the ZLB may be important, and ignores the second. [3]

[1] I was tempted to write ‘in a moment’ rather than ‘soon’, but decided a bad pun might detract from the main text.

[2] The Williams paper also elaborates on a well known idea that uncertainty about the impact of policy instruments should make policy makers cautious in using those instruments. I think this is an additional consideration, which would reinforce the point I’m making here. I also agree that good policy should take into account the characteristics of uncertainties arising from the economy, and have used this to argue - for example - that policymakers should over rather than under estimate the size of the output gap at the ZLB.

[3] This is not an argument about whether fiscal stimulus is more or less reliable than monetary stimulus, interesting though that question is. All I require is that an austerity policy reduces short run aggregate demand, which it clearly does. It also does not say that there are no circumstances in which we should undertake austerity at or near the ZLB - in theory the benefits of austerity could be so great that they outweigh the costs of putting us in a dangerous place. In the absence of a significant and rising default premium on debt, I do not think those benefits exist, but that is a separate argument.

An argument for forward guidance in the UK

What is the Monetary Policy Committee (MPC) of the Bank of England (BoE) trying to achieve? I think there are two leading candidate answers.

1) Flexible inflation targeting, as understood by academics. This means trying to reduce both deviations of inflation from target, and the output gap, at all periods in time. Call this FIT for short.

2) Strict inflation forecast targeting (SIFT), or more specifically trying to minimise deviations of inflation from target in two years time. Under this policy, the outlook for the output gap in two years time is irrelevant.

In most circumstances FIT and SIFT will produce very similar interest rate decisions, because normally to achieve the inflation target within two years means aiming to eliminate the output gap by then too. However one time that the two objectives could give different decisions is if the economy is being hit by a persistent cost-push shock. Under FIT, that could lead in two years time to inflation being above target, and a negative output gap. Under SIFT, we might expect a tighter policy, trying to reduce inflation to target within two years, at the cost of a larger output gap. [1]

So which better describes MPC policy? The Bank of England publishes a forecast for inflation two years out, and the chart below shows this since independence. This is their forecast based on market expectations of interest rates: we unfortunately have no information about what MPC members expect future interest rates to be.

Bank of England forecasts for inflation two years ahead, by date of inflation report

The inflation target was 2.5% until 2004, but has been 2% since. You can see why many might think that SIFT is the policy. The financial crisis was such a big shock that the Bank did not think it could achieve this target for a year to two, but otherwise the two year ahead forecasts have been pretty close to target.

Unfortunately while this is consistent with SIFT, it could also be consistent with FIT. The Bank does not publish any estimates of the current output gap, let alone the expected output gap in two years time. In addition, the output gap before the recession was generally thought at the time to be fairly small, so it is quite possible that the inflation forecast above is also consistent with FIT. However, the last few years look much less like FIT than SIFT. Actual inflation has been above target, and we have a significant output gap, and this combination is at least partly down to some significant cost-push shocks (like increases in VAT). Yet expected inflation two years out is close to target. Can the Bank really be expecting the output gap to close in two years as well?

We have one additional piece of information, which are the Bank’s forecasts for GDP growth over the next two years. Even if the current output gap is large, if the Bank was forecasting growth well above potential in the next two years, it could be closing that gap in two years time i.e. doing FIT. As we get closer to the present, this looks less plausible. In particular, in 2012 the Bank’s growth forecasts were pretty low. Even if they were assuming growth in potential of just 1% p.a., that would imply that their estimate of the current output gap was between -1% and -1.5% if they expected to close the output gap in two years time. That seems implausibly low: the OBR has an estimate closer to -3%. I would therefore conclude that it is quite likely that the Bank has been pursuing SIFT, and not FIT. (The February 2013 inflation report is a possible exception.)

Why does this matter? With continuing cost-push shocks (such as an increase in student fees), SIFT is going to mean tighter policy than FIT. In addition, my own interpretation of the Treasury’s March 2013 review of the MPC’s remit is that they do not want SIFT, but instead favoured something closer to FIT.

Suppose I am wrong, and the MPC is pursuing FIT, but I am not alone in incorrectly thinking it is doing SIFT. Or alternatively, suppose it has been doing SIFT, but now - following the Treasury review and a new governor - it wants to do FIT. How can it clarify this? Well one possibility is just the kind of forward guidance that the Fed has given. If the MPC state that if - say - unemployment looks like remaining above 6% over the next two years, they would aim to have inflation significantly above 2% in two years time, then it becomes clear they are not doing SIFT.

So one argument for forward guidance is that it could avoid damaging ambiguity in what the MPC is trying to do. There are of course other arguments for and against forward guidance, and here I want to plug a new blog by ex-BoE, and now Bristol University, economist Tony Yates. His first post considers some of these issues, and his most recent post deals with the Treasury March review.

My own worry about forward guidance, which I expressed in the slides attached to this post, is that it is too incremental. I think a much clearer way of signalling the importance of the output gap is to adopt a path for nominal GDP as an intermediate target. I look forward to Tony’s future posts, which I suspect will include why he thinks this would be a bad idea!

[1] Two important caveats here. The first is obvious: if the output gap is given a trivial weight compared to inflation in the Bank’s objective, FIT morphs into SIFT. I have discussed why that is an unreasonable weighting here. Second, the optimal response to a cost-push shock if the central bank attempts to use future policy commitments to achieve the best outcome today will involve future periods in which inflation is below target, as I explain here. That would complicate discriminating between FIT and SIFT. However, as this policy is time inconsistent, the MPC would have to be quite open about this policy, and in the absence of such openness I think we can exclude that possibility.

Economic History and Krugman’s Crib Sheet

One of the positive things about reading blogs is that sometimes you see connections in apparently diverse offerings. So here are two seemingly unconnected posts: Paul Krugman’s discussion of how he came to do his path breaking research in international trade and economic geography, and Kevin O’Rourke’s post on why economics needs economic history.

I remember many years ago being in a large interdisciplinary forum, where Krugman’s research on economic geography came up. The economists in the room were of course very positive, but the geographer there could not hide his disdain. There is nothing in this work that geographers have not actively discussed for the past 50 years, he said. I have no reason to doubt that he was right, but it kind of missed the point. What Krugman and others did was manage to formalise these earlier thoughts in a particularly tractable and useful way.

What is so great about formalism, you might ask. The trouble with just talking and writing about the way the world works is that it is quite easy to become confused or to make mistakes. Macro, because it deals with a highly interconnected system, is full of these pitfalls. The example I use with undergrads when they first come to IS/LM is as follows. Cutting taxes may appear to boost the economy, but if it is financed by more government borrowing, to persuade people to lend more will probably push up interest rates. These higher interest rates reduce output, so as a result tax cuts could end up reducing output. Sounds reasonable, but the reasoning is incorrect. The worst that can happen with a tax cut is that people save it all, in which case output does not change, and neither do interest rates. IS/LM shows us that if interest rates rise it is because output has increased.

So it is good to be able to express ideas about how the world works in terms of simple models. But creating a new type of model for the first time is not an easy thing to do, which is why you get prizes for this kind of thing. Crucially, it may take a long time (decades or more) before someone comes up with that nice simple formalisation that captures those ideas. Yet those ideas are as important before the formalisation as they are afterwards - it is just the reasoning about them that has improved.

How is economics generally taught? In both macro and micro, most of the time we teach the formalisation. This is understandable (it is what has advanced the discipline and made it science like) and to a degree appropriate (understanding models is difficult). However there is a real danger that teaching this stuff crowds out all else. I used not to be concerned about this for macro, because I saw the discipline as inherently progressive, where the data would naturally push advances in the right direction. (My excuse for believing this in part comes from my background in building structural econometric models, where the data really did do that.)

If that is your view, you are likely to be a little dismissive about things like economic history, economic methodology or the history of economic thought. After all, most scientists do not worry too much about these things in their own discipline, and economics tries to be like a science. Even if we take a more realistic view, and think that economists are more like doctors (who fail to understand quite a lot), doctors do not spend too much time thinking about things like the methodology of medicine.

I changed my view in the last few years as a result of both the financial crisis and the subsequent domination of austerity policies. Teaching just what can be currently formalised in what now passes as a rigorous manner excludes too much of what is important. Of course we (hopefully) tell students that there are gaps in what economists can do this way, but perhaps these gaps need to be given a little more space than footnotes. There is a great deal of knowledge and insight in less formal economic reasoning, insight that can too easily be dismissed. Unfortunately it is natural for future academics or policy makers to believe that what is taught in undergraduate or graduate macro is what is important, rather than what has so far been formalised, or what the demands of this particular time and context require formalising, or worse still what political or ideological forces wish to formalise.

The analogy with doctors breaks down because, unlike doctors, an economist does not constantly have the full range of empirical problems thrown in their face. They are also unlikely to have politicians picking and choosing which treatments they like to promote based on the interests of those they serve. In particular, developments in macro over the last few decades have shielded economists from having to explain much of the data. (In my view the dismissal of single equation time series work as a vital component in model building because of identification problems was a crucial mistake.)

As Kevin O’Rourke eloquently argues, teaching economic history provides a useful counterweight to these tendencies. We also need to make room for teaching some elements of methodology and the history of thought, for similar reasons. This is why I have actively supported Diane Coyle’s initiative in the UK (see here, here and here). I think having the occasional option in these subjects misses the point. It is much more about integrating these elements into core courses, although how best to do this remains an open question.