How to be a New Keynesian and an Old Keynesian at the same time

A recurring theme in economics blogs, particularly those that tend to be disparaging of mainstream Keynesian theory, is that Keynesians like to be New Keynesian (NK) when talking about theory, but Old Keynesian (OK) when talking about policy. John Cochrane has recently made a similar observation, which is picked up by Megan McArdle. To take just one example of this alleged sin, in the basic New Keynesian theory Ricardian Equivalence holds (see below), so a tax financed stimulus should be as effective as a debt financed stimulus, yet Keynesians always seem to prefer debt financed stimulus.

The difference between Old and New that Cochrane focuses on relates to models of consumption. In the first year textbook OK model, consumption just depends on current income. The coefficient on current income is something like 0.7, which gives rise to a significant multiplier: give these consumers more to spend, and the additional spending will itself generate more output, which leads to yet more income, and so the impact of any stimulus gets multiplied up.

Basic NK models employ the construct of the (possibly infinitely lived) intertemporal consumer. To explain, these consumers look at the present value of their expected lifetime income, and the income of their descendents if they care about them (hence infinitely lived). This has two implications. First, temporary shocks to current income will have very little impact on NK consumption (it is a drop in the ocean of lifetime income). The marginal propensity to consume out of that temporary income (mpc) is near zero, so no multiplier on that account. Second, a tax cut today means tax increases tomorrow, leaving the present value of lifetime post-tax income unchanged, so NK consumers just save a tax cut (Ricardian Equivalence), whereas OK consumers spend most of it. However NK consumers are sensitive to the real interest rate, so if higher output today leads to higher inflation but the nominal interest rate remains unchanged, then you get a multiplier of sorts because NK consumers react to lower real interest rates by spending more.

So far, so different. But the NK consumption model assumes that agents can borrow whatever they need to borrow. There are good theoretical reasons why that is unlikely to be true (e.g. asymmetric information), and even better empirical evidence that it is not. Empirical studies that look for ‘natural experiments’, where agents obtain an unexpected increase in post-tax income which is likely to be temporary, typically find a mpc of around a third (even for non-durables), rather than almost zero as the basic intertemporal model would predict. (For just one recent example: Consumer Spending and the Economic Stimulus Payments of 2008, by Parker, Souleles, Johnson, and McClelland, American Economic Review 2013, 103(6): 2530–2553.)

So if mainstream Keynesian theory wants a more realistic model of consumption, it often uses the (admittedly crude) device of assuming the economy contains two types of consumer: the unconstrained intertemporal type and the credit constrained type. A credit constrained consumer that receives additional income could consume all of that additional income, so their mpc out of current income is one. [1] That credit constrained consumer is therefore rather Old Keynesian in character. But there are also plenty of unconstrained consumers around (e.g. savers) who are able to behave like intertemporal maximisers, so by including both types of consumer in one model you get a hybrid OK/NK economy.

So it is perfectly possible to be an Old Keynesian and a New Keynesian at the same time, using this hybrid model. It may not be a particularly elegant model, and the microfoundations can be a bit rough, but plenty of papers have been published along these lines. It is a lot more realistic than either the simple NK or OK alternatives. It explains why you might favour a bond financed stimulus over the tax financed alternative, because there are plenty of credit constrained consumers around who are the opposite of Ricardian.[2] 

You can make the same point about one of the other key differences between OK and NK: the Phillips curve. The New Keynesian Phillips curve relates inflation to expected inflation next period, and assumes rational expectations, while a more traditional Phillips curve combined with adaptive expectations relates current inflation to past inflation. While I do not think you will find many economists using the OK Phillips curve on its own nowadays, you will find many (including this lot) using a hybrid that combines the two. The theoretical reasons for doing so are not that clear, but there is plenty of evidence that seems to support this hybrid structure. So once again it makes sense to be both OK and NK when giving policy advice.

Neither story is as exciting as the idea that New Keynesians are really closet Old Keynesians, who only pay lip service to New Keynesian theory to gain academic respectability. Instead it’s a story of how mainstream Keynesian economists try to adapt their models to be more consistent with the real world. How dull, boring and inelegant is that!

[1] I say ‘could’ here, because if the increase in income lasts for less time than the expected credit constraint, then smoothing still applies, and the mpc will be less than one.

[2] My own view is that the mpc out of temporary income is also significant because of precautionary savings: see the paper by Carroll described here.

Eurozone Morality Plays

In my last post I wrote: “Mapping macroeconomics into a morality play is almost always a mistake.” I can think of lots of examples. For example: The private sector has to tighten its belt, so the public sector should too. Or: Recessions are a punishment for previous excess.

Within a currency union, when the central bank is willing and able to do its job, these morality stories are often about what happens when one part of the union deviates from the inflation target. (Any deviation of inflation from target is accompanied by unwarranted movements in output: I’ll take these as read in what follows.) Let’s imagine dividing the Eurozone in half, and call each half G and R. So the standard story is that ‘excess’ in R raises inflation in R: to 3% say. The ECB does its job, keeping average inflation at 2%, which means inflation is forced down to 1% in G. This makes G too competitive, so if the ECB was willing or able to keep average inflation at 2% we would have to have a period of 3% inflation in G and 1% in R to put things right.

The morality often drawn here is straightforward: irresponsible excess in R has led to uncomfortable deviations from the ideal of 2% inflation in G. The morality play normally skates over the fact that this excess in at least parts of R was financed by lending from G: morality always seems to reside with the borrower. But we could tell the story a different way. The problem started because G tried to undercut prices in R, by allowing inflation in G to be 1%. As the ECB had to keep average inflation at 2%, this 'forced' inflation in R to 3%. G is now enjoying the benefits of undercutting R, and is very reluctant to undo the process.

So which story is right? We all know there was excess in some parts of R, either by governments (Greece) or banks (Ireland), but both countries are small. One way of discriminating between the two stories would be to look at real interest rates. If the ECB was having to react to excess demand in R, we would expect to see high real interest rates. If instead the ECB was having to offset deflation in G, we would see low real interest rates. Here is what actually happened.

  

From 2000 to 2007 the ECB kept inflation pretty close to 2%. But it did not achieve this by raising real interest rates. Instead interest rates fell in 2003, so that real short rates were close to zero from 2003 to 2005. This seems much more consistent with the story where G tries to undercut R, and the ECB has to cut rates to keep average inflation at 2%, forcing inflation in R to 3%. Sure enough, 2003-5 were years when the output gap in Germany was significantly negative (OECD estimates -1.4% 2003, -1.7% 2004, -1.9% 2005).

Both the ‘undercutting by G’ story and the more traditional ‘excess in R’ story still contain much too much pseudo morality for my taste. The German government did not deliberately engineer zero growth in domestic demand from 2003-5, any more than governments outside Germany (Greece excepted) tried to stoke up excess demand. In an ideal world both could have used fiscal policy more effectively, but the system hardly encouraged that. But this evidence does suggest that seeing the competitiveness imbalances in the Eurozone as simply the result of excess outside Germany is at best only half the story, and at worst not a very realistic story at all. 

The view from Germany

As an exemplar, take this article that appeared in Spiegel (HT MT). It defends Germany against criticism of its current account surplus, but its main worry is not harsh words from the US government, or Paul Krugman, or Martin Wolf, but from Marco Buti of the European Commission. But before saying something about that, or the article itself, we need to be clear about the basic facts. (I have talked about the myths elsewhere.)

From 2000 to 2007, the periphery of the Eurozone (EZ) enjoyed a boom, while Germany did not. As a result, inflation in the periphery (and much else) of the EZ exceeded inflation in Germany by a significant and persistent amount. By 2007, this meant that Germany had become too competitive in relation to the rest of the EZ. This situation is not sustainable. The large German surplus is a symptom of that situation.

Under flexible exchange rates, the German currency would have been able to appreciate against the other EZ countries, eliminating the competitive advantage. In a currency union, the only feasible outcome is for German inflation to run ahead of the rest of the EZ by a significant and persistent amount for a number of years. If the ECB was willing and able to target 2% inflation, then that would mean future German inflation significantly and persistently above 2%. That would require excess demand in Germany, to balance deficient demand in the rest of the EZ. There is really no way around this consequence of a 2% inflation target - it is just arithmetic.

The problem arises because the ECB is unwilling or unable to target 2% inflation. That in theory allows Germany to attempt to force the EZ as a whole to make the required internal adjustment without inflation in Germany exceeding 2%. It can do this by a restrictive fiscal policy. This is exactly what it has done. The figure below shows the underlying primary financial balance in Germany and the whole EZ (including Germany). (Source: Oct 2013 OECD Economic Outlook.) The projected German surpluses are expected to bring down the debt to GDP ratio from 51% of GDP in 2012 to 48.5% of GDP in 2014.

Other EZ countries are defenseless against this deflation, because of imposed austerity or the EZ Fiscal Compact. As a result, the path we seem to be on involves German inflation at around 2% and average EZ inflation well below 2%. This may be in Germany’s narrow national interest, but for the EZ as a whole it is much more costly, partly because of the difficulties of reducing inflation when it is close to zero. Deflation in the EZ as a whole is also costly for those outside the EZ when everyone’s interest rates are near zero (see Francesco Saraceno here).

Much of the Spiegel article is about the pointlessness of blaming Germany for its success in exporting. This of course completely misses the point, but if outside criticism focuses on Germany’s current account rather than its inflation rate it is perhaps not a surprising reaction. The German current account surplus is a symptom of the underlying problem, which is a tight fiscal and monetary policy in the EZ. Whether the tight monetary policy (bringing EZ inflation below 1%) is an unforced or forced error (because interest rates are near zero) is not crucial here, except to the extent that German pressure is behind any reluctance until recently to cut interest rates. 

At one point, however, the article does note that criticism of Germany “holds that the Germans live and consume below their means, which is detrimental to foreign companies because there is less demand for their products in Germany.” But its response is to say that this is the fault of “countries like Greece, Italy and Spain, [who] have only themselves to blame for their troubles because they spent years living beyond their means and at the expense of their own competitiveness.” In other words, why should Germany suffer above 2% inflation because the rest of the EZ allowed themselves to become uncompetitive.

Mapping macroeconomics into a morality play is almost always a mistake. So let’s just stick to the rules of how the EZ is supposed to work. The ECB is supposed to have a (‘just below’) 2% inflation target. If it was able to meet that target, Germany would have to suffer 3%+ inflation for a number of years. Now you might respond that the ECB is within its mandate if it targets 1% inflation to allow Germany to only have 2% inflation, because below 2% inflation is allowed. I think that would be stretching the mandate rather a lot (see Andrew Watt here), but even so, if that were true, why didn’t the ECB target 1% inflation from 2000 to 2007 to avoid inflation outside Germany exceeding 2%?

A more reasonable interpretation would be that Germany is either putting pressure on the ECB so that its policies are favourable to the German national interest, or that it is taking advantage of the inability of the ECB to target inflation in a liquidity trap to force inflation below target through a restrictive fiscal policy. It is either trying to circumvent the rules, or take advantage while the referee's whistle is broken. [1]

Which brings us to one referee, which is the European Commission. I have been quite critical of the Commission in the past, and particularly of European Commissioner Olli Rehn (e.g. here). In March I also wrote a post criticising a paper co-written by Marco Buti, Director-General for Economic and Financial Affairs at the European Commission. That paper included the following quote: “In Germany, the fiscal stance is now broadly neutral, hence consistent with the call for a differentiated fiscal stance according to the budgetary space.” I was therefore slightly surprised to see Buti cast as chief German tormenter in the Spiegel article. To quote (my italics): “The chief economist of the European Commission, a native of Italy, has a tendency to blame many euro-zone ills on the nature and effects of German economic policy.” I find it tricky to reconcile Marco Buti’s March paper with this Spiegel description, but perhaps events in the intervening months (and the Commission’s own analysis) have strengthened views which could not have been expressed openly in public. (There are other constraints on the Commission, as John McHale notes here.) Whatever, I hope the Spiegel article is right, and those working for the Commission are applying all the pressure they can to change the view from Germany.

[1] It would be interesting to compare this deflationary bias in the EZ, reflecting a combination of the Fiscal Compact and the Zero Lower Bound, with Keynes’s worries about the Bretton Woods system, which helped create the IMF. Barry Eichengreen draws an analogy between current policies and the 1930s here.

Medium term exchange rates and current accounts

For teachers and students of macroeconomics

This is about how real exchange rates are determined in the medium term. So we abstract from the complications caused by sticky prices and monetary policy. However as anyone who understands uncovered interest parity knows, exchange rates in the short run depend crucially on expectations about medium term exchange rates, so the determination of medium term exchange rates is important whatever your time horizon.

The framework I use when teaching at masters level is the ‘new open economy’ (NOEM) approach, associated with Obstfeld and Rogoff in particular. A classic survey is by Philip Lane. If this framework could be summed up in one sentence, it would be this. In a world where most international trade takes place in goods sold in imperfectly competitive markets, the real exchange rate moves to equate the demand and supply for domestically produced output. [1] What follows is not about whether that framework is empirically useful, but why teaching it can avoid some confusions and pitfalls.

This concept was not of course invented by NOEM. John Williamson’s approach to determining equilibrium exchange rates, later taken up by the IMF and others, is based on the same idea. (See this earlier post for references. Williamson's work can in turn be seen as a development of the 'Swan diagram'.) Indeed I sometimes get annoyed that the NOEM literature typically ignores its antecedents. However one source for confusion is that the essentially empirical literature associated with Williamson focuses on the current account, rather than the supply and demand for domestic output. It does this because the current account is a readily available indicator of this supply and demand balance much of the time. But not always, as the following classic example shows.

Suppose an economy discovers a finite natural resource, like oil, which takes a negligible amount of labour to extract.[2] It takes a few years before the discovery leads to the resource being extracted, but the extent of the resource is common knowledge. This is a standard exercise in consumption smoothing. Consumption rises the moment the resource is discovered, anticipating higher future income. This leads to a current account deficit until the resource is extracted. Once it starts being extracted, consumers are now consuming less than their income, first to pay off their borrowing, and then to save for the day the resource runs out. So while the resource is extracted we get a current account surplus.

What happens to the real exchange rate? If we focus on the current account, we might be tempted to say that it first depreciates, and then appreciates when we have a surplus. This would be wrong. We could start with a special and highly unrealistic case, where there are no non-traded goods, the economy is so small that only a negligible amount of the additional consumption is spent on home produced goods, and labour supply is fixed. In that case nothing would happen to the real exchange rate at any time. More realistically, transport costs will mean there is some ‘home bias’ in consumption, and also some of the consumption will go on domestically produced non-traded goods. Both imply a domestic real appreciation, which begins while the current account is in deficit, and which stays the same as the current account switches to surplus.[3] In addition, if consumers want to match higher consumption with more leisure, labour supply will decrease, and we get an appreciation to choke off demand for domestically produced goods. Again this happens throughout, and not just when the resource is extracted.

The reason why looking at the current account is misleading is that we are ignoring the capital account. Before the resource is extracted, consumption rises through borrowing from abroad. If all the extra consumption is on overseas goods, those lending to consumers require no domestic currency (they can lend in dollars). But if some of the additional consumption is spent domestically, some of the lending must also be in domestic currency, so we get an appreciation. Once the resource begins to be sold (for dollars), it is as if all the extra income is used to buy overseas assets. So the size of the appreciation remains unchanged.

Thinking about both current and capital accounts in this situation is tricky, but thinking about the supply and demand for the domestically produced tradable goods gives us the same answer much more easily.

[1] In a simple model without capital, supply is just labour supply and productivity. For a small open economy where there are no non-traded goods or home bias, demand for domestically produced goods just depends on world output and competitiveness=real exchange rate. In this simple set-up a consumer price based real exchange rate is constant (PPP holds), but once we introduce realistic features like home bias or non-traded goods competitiveness influences a consumer price based real exchange rate, and PPP no longer holds.

[2] For simplicity ignore the capital required to extract the resource, and we assume all the income from the resource goes to domestic consumers.

[3] The two mechanisms work in different ways, however. The additional demand for non-traded goods takes labour away from traded goods production, so reduced traded goods supply leads to an appreciation. With home bias we get an appreciation because of the additional demand for domestically produced traded goods.

Defending rational expectations

Whenever I post anything which suggests that the idea of rational expectations was a useful innovation in macroeconomics, Lars Syll writes something to the effect that I am (and therefore most mainstream macroeconomists are) “so wrong, so wrong”. Now why does this bother me? Well, to be honest, it does not bother me very much. As Bob Dylan sang: ‘Yes, I received your letter yesterday (About the time the doorknob broke)’.

But it does bother me a bit. Professor Syll does write very eloquently, and this kind of eloquent prose can appeal to the occasional young economist, who is inclined to believe that only the radical overthrow of orthodoxy will suffice. I meet one or two each year I teach. I remember the feeling: been there, done that. It also appeals to people like Aditya Chakrabortty who are understandably unhappy by the current state of things economic. (See this nice recent post by Diane Coyle on both this particular article but also heterodox critiques more generally.) There is plenty to legitimately criticise about mainstream economics (and its textbooks), so it is a shame Professor Syll wastes his talents on one of its major achievements, which is rational expectations. On this he is, well, so wrong.

This discussion can easily get populated with straw (super)men, so let's be clear about some things. It is not a debate about rational expectations in the abstract, but about a choice between different ways of modelling expectations, none of which will be ideal. This choice has to involve feasible alternatives, by which I mean theories of expectations that can be practically implemented in usable macroeconomic models. In the past, I have attempted to try and start a dialog with heterodox economists on the level of practical macroeconomics, to get beyond the fine words and phrases. It did not seem to work. I tried again in that recent post, asking for practical alternatives to rational expectations. Professor Syll referred me to behavioural economics, or Frydman and Goldberg’s ‘Imperfect Knowledge Economics’. But perhaps I did not make it clear what I meant by practical.

If I really wanted to focus in detail on how expectations were formed and adjusted, I would look to the large mainstream literature on learning, to which Professor Syll does not refer. (Key figures in developing this literature included Tom Sargent, Albert Marcet, George Evans and Seppo Honkapohja: here is a nice interview involving three of them.) Macroeconomic ideas derived from rational expectations models should always be re-examined within realistic learning environments, as in this paper by Benhabib, Evans and Honkapohja for example. No doubt that literature may benefit from additional insights that behavioural economics and others can bring. However it is worth noting that a key organising device for much of the learning literature is the extent to which learning converges towards rational expectations.

However most of the time macroeconomists want to focus on something else, and so we need a simpler framework. In practice that seems to me to involve a binary choice. Either we assume that agents are very naive, and adopt something very simple like adaptive expectations (inflation tomorrow will be based on current and past inflation), or we assume rational expectations. My suspicion is that heterodox economists, when they do practical macroeconomics, adopt the assumption that expectations are naive, if they exist at all (e.g. here). So I want to explain why, most of the time, this is the wrong choice. My argument here is similar but complementary to a recent piece by Mark Thoma on rational expectations.

Suppose we have an equation determining wage or price inflation (a Phillips curve), where inflation expectations appear on the right hand side of the equation. We need some way of determining those expectations. Lots of nice words like ‘non-ergodic’ will not do: we need something simple that can be used to solve the model. To assume, as mainstream macroeconomists once did, that these expectations just depend on past observations about inflation seems to assume that agents are stupid. These agents ignore everything that economists and the media say about inflation: they ignore monetary policy, and whether the economy is in a boom or recession. Now if getting expectations right did not matter too much to these agents, then maybe such naivety would be understandable. But in this case making expectations errors can mean getting real wages or profits wrong, so it matters.

Perhaps you think the alternative is equally unbelievable. Rational expectations, often called model consistent expectations, implies that agents know the model that the modeller has constructed, and use it to generate expectations. This is where the elegant prose comes in - you can make this sound incredible. Of course it will not be literally true, but I think it is a lot nearer the truth than the adaptive expectations alternative. The reason why mainstream economics replaced adaptive expectations with rational expectations in the 1970s was because the new approach was consistent with what economists did elsewhere. Firms may not know the true demand curve for their product and work out the price that maximises profits each period, but that is a better approximation to how they choose prices than a model where they have a fixed mark-up on costs. So it just seemed consistent to also assume that agents used relevant and available information to generate expectations when those expectations mattered. The closest we can get to that, without assuming an elaborate learning model, is to assume rational expectations.

This is an empirical claim. But how else do you make sense of a whole forecasting industry, and the newsworthy character of macro forecasts. Rational expectations at least acknowledges that endeavour, while adaptive expectations pretends it does not exist. And how else do you make sense of the response of Japanese inflation expectations to little more than a policy change: see Carola Binder’s discussion. How can you make sense of all the discussion of forward guidance without the concept of rational expectations?

Most of the references I make to rational expectations in posts are in the context of the history of macroeconomic thought. I suspect the problem some people have is that they associate rational expectations with the New Classical critique of Keynesian economics, and therefore think rational expectations must be anti-Keynesian. This confuses who fought wars with the weapons they used. I see it quite differently. Before rational expectations, mainstream Keynesian theory that incorporated the Phillips curve depended on a rather fragile story of why economic booms (downturns) could occur, which was that workers kept under (over) estimating inflation. New Keynesian theories based on rational expectations are more compelling, and can include the fact that information is both costly and incomplete.

So I just do not get this obsession that some heterodox economists have with rational expectations. I think its fine to criticise mainstream theory (particularly macro theory) for being too wedded to rationality in general: I seem to remember some remarks of my own along those lines. But mainstream macro does take learning, and the problem of costly and limited information, seriously. However for the foreseeable future, rational expectations will remain the starting point for macro analysis, because it is better than the only practical alternative. 

The choice really matters. An economy where agents form their expectations in a naive adaptive way is like an elaborate machine which takes no account of what policymakers are doing. In reality the economy appears more intelligent than this: policy is difficult because people in the economy take actions which anticipate what policymakers might do. This makes designing good policy difficult, but the concept of rational expectations has allowed macroeconomists to tackle this problem. To throw all that away by abandoning rational expectations would not improve macroeconomics, it would impoverish it.  

The real problem with German macroeconomic policy

Paul Krugman has been laying into Germany in the past few days (1, 2, 3, 4, 5, 6). I think it might be interesting to look at two possible defences for the German position. The first is that they are doing what any government would do, which is act in their national interest. The second is that, for from being at the centre of the Eurozone’s (EZ) problems, they have been holding it together.

Take the national interest argument first. If the EZ really had an EZ government that took decisions in the overall EZ interest, then given the problems with ECB monetary policy (whether self-inflicted or otherwise), EZ fiscal policy should be expansionary - or at least not contractionary. Given the needs of periphery countries, this implies fiscal expansion in Germany. The problem is that this appears not to be in the German national interest, because growth has been relatively healthy in German, unemployment is low and inflation not that low.

Here are the latest OECD forecasts (and outturns) from the September OECD Economic Outlook.

	2012	2013	2014
Consumer prices	2.1	1.6	2.0
Unemployment	5.1	5.0	4.7
GDP growth	0.4	1.3	2.1
Output gap	0.1	-0.8	-0.2

While this performance is nothing to write home about, it is also not enough to overcome the longstanding distrust in Germany of countercyclical fiscal policy. Why risk inflation going above 2%, when unemployment is less than half the EZ average?

Pointing out that the macroeconomic interests of Germany and the EZ as a whole conflict is important, because (for some at least) it strengthens the arguments for fiscal union. It is almost the fiscal equivalent to the arguments for monetary union in the 1990s. Pre-Euro we had a quasi-fixed exchange rate system where French and Italian monetary policy was effectively tied to what the Bundesbank wanted, and the Bundesbank’s job was to focus on Germany. This all came to a head after German unification, when German monetary policy was tightened as the rest of Europe was suffering a period of low growth. The parallel is not exact because today Germany does not dictate fiscal policy outside Germany: well, at least not in theory.

From this perspective, arguments about the German current account surplus are beside the point. Macroeconomic policy should not be geared to current account surpluses or deficits, but to economic fundamentals like unemployment and inflation. In the absence of fiscal union, German macroeconomic policy looks OK from a German point of view.

The second defence of the German position is that, far from acting selfishly, it is providing the financial glue which is holding the EZ together. As Gideon Rachman writes in the FT

“The Germans are also often given far too little credit for what they have already done to keep the eurozone together. German contributions and loan-guarantees to the various EU bail-out funds already total the equivalent of an entire year’s federal budget in Germany.”

As it becomes increasingly clear that some part of the funds provided by the Troika to Greece will have to be written off, this point of view can only strengthen in Germany.

I think both lines of defence are quite powerful, yet I think they are in danger of missing the point. The problem with German macroeconomic policy is not that it is acting in the national interest, or otherwise, but that it is based on a discredited and harmful set of ideas. In particular there are three key myths that are leading German policy making astray.

Myth 1: The EZ crisis stemmed from fiscal irresponsibility in the periphery EZ countries, and that the crisis can only be solved by reversing this through harsh austerity

Reality: The crisis was at least as much to do with private as public sector excess.

Myth 2: An anti-Keynesian view that fiscal policy has no place in managing aggregate demand, which can be safely left in the hands of the ECB as long as the ECB sticks to its job of keeping inflation below 2%.

Reality: The Keynesian argument against austerity at the Zero Lower Bound is correct. Keynesians also argue, correctly, that restoring competitiveness in a monetary union is much more difficult when inflation in your key competitor country is low.

Myth 3: To be independent, central banks must never buy government debt, as this indicates fiscal dominance.

Reality: EZ governments need the ECB to (potentially) act as a sovereign lender of last resort, to prevent self-fulfilling market panics. The introduction of OMT demonstrated this.

To see how these myths have distorted German policy, let’s start with the assistance Germany has provided to the periphery. Myth 1 has led to a focus on austerity, and a reluctance to see the pressure for austerity eased. (See my post here, or Krugman 4.) Myth 2 means that the damage caused by this austerity is discounted, and Myth 3 leads to reluctance to let the ECB help reduce market pressure. In short, the money that Germany has or will provide could have been much better spent. Ironically it could have been better spent in Germany, boosting domestic demand, which would have helped raise demand and inflation in Germany (the latter being the sacrifice Germany would make to help keep the EZ together), which would have done much more to help the periphery adjust their competitiveness at lower cost. Myth 2 prevents Germany from seeing this, although it is quite clear in the Commission’s QUEST simulations that I commented on here. (See also the subsequent comments from Jan I’nt Veld, particularly concerning the Commission’s view on this.) The financing needs of the periphery would have been much reduced if more Greek debt had been written off, and had German resistance (Myth 3) not delayed OMT until September 2012.

These myths have also damaged Germany’s own narrow domestic interests. Myths 1 and 2, besides leading to harsh austerity in the EZ periphery, has also led to fiscal contraction in the core (both outside - e.g. Netherlands - and inside Germany), which has reduced German GDP and led to inflation below 2% this year. The Fiscal Compact, despite slight softening around the edges, is a deeply flawed and damaging policy which comes directly from Myths 1 and 2.

So the problem is not with Germany, but with the macroeconomic myths that seem to be so deeply embedded in current policy. I do not think Germany has been simply acting in its own national interest, but the myths prevent it seeing that its current account surpluses are a key part of the problem and why some overheating in Germany is the best solution for the EZ as a whole. Although these three myths have a particular Ordoliberal flavour, they are not so very different from similar myths expounded by politicians and the occasional economist in the US, the UK and elsewhere in Europe. The myths are the problem.  

Something we can all agree on?

Well, all economists at least. Can we all agree that public spending on maintaining and modernising public infrastructure should be increased rather than reduced in a severe recession, whatever the concerns about debt? The spending I have in mind are repairing and refurbishing state owned schools, hospitals, roads - that kind of thing.

Now all those who believe in countercyclical fiscal policy at the Zero Lower Bound will of course agree. But I think those economists who remain worried about the level of government debt should also be able to agree. The reason is that concerns over debt are almost always concerns about long run sustainability. Yet by not fixing holes in the road, or leaks in the school roof, you do nothing to improve the long run sustainability of debt. Almost certainly you are just postponing something that will have to be done sometime, and the act of postponing probably makes the eventual expenditure higher. So postponing public infrastructure investment justs shifts around the timing of public spending, and could well increase its eventually size. It does nothing to tackle issues of debt sustainability.

To see the logic of this more formally, you just have to slightly adapt the analysis in DeLong and Summers (pdf). Their model focuses on hysteresis effects from lower GDP today in reducing output tomorrow, which reduces tax receipts tomorrow etc. But public investment today, in the form of improving existing public capital, will increase output tomorrow just because public capital enhances private output. This idea is pretty standard. For example, in the European Commission’s QUEST DSGE model that I highlighted recently, whereas the long run GDP impact of permanent fiscal consolidation is generally positive for most instruments (because permanently lower government consumption eventually reduces debt and distortionary taxes), the long run multiplier from reducing public investment increases over time, as Annex 1 shows. (By the way, if you read this post, do read Jan i’nt Veld’s response in comments here.) 

There are two other reasons why shifting government spending from the future to the present is clearly a good idea in a recession. First, undertaking public investment is likely to be cheaper in a recession. Firms that will do the repairs want jobs and labour is relatively cheap. Second, to the extent that aggregate demand is a problem, shifting the pattern of public spending this way (what I call ‘pure’ countercyclical fiscal policy) is obviously a good idea. This, after all, is essentially what monetary policy is trying to do for private spending.

I am encouraged to think that nearly all macroeconomists could sign up to this by Ken Rogoff, who while clearly being sympathetic to the attempts by some governments to go in for overall fiscal consolidation, does agree that public investment should not have been cut. Why do I think this is an important point to make? Because it just might stop governments doing the opposite. I have discussed UK public investment before (or the strange attempts to get the private sector to fund public investment), and yesterday Cardiff Garcia pointed out how much US non-defense spending on structures has fallen in the last few years.

This reflects a natural tendency of politicians to do the opposite of what is sensible when they feel they have to cut back on spending. Reducing consumption spending is nearly always politically painful, but it is easier to get away with delaying repairs to (or modernisation of) schools, hospitals or highways. It was partly for this reason that Gordon Brown exempted investment spending from his first fiscal rule in 1998, even though the macroeconomic justification for doing so was debatable (see my discussion here). If all economists could sign up to saying that cutting public investment in a recession is a bad idea, whatever the concerns about debt, then just maybe politicians might think twice about doing this.