Is zero the new normal?

Larry Summers talk on secular stagnation has led to a burst of discussion on whether nominal interest rates may be at their Zero Lower Bound (ZLB) for longer than we might have thought. I would like to use this post to clarify a number of different ideas that may be involved here. Crucial to this discussion is the concept of the natural real interest rate (NRR). I will define this as the real interest rate that keeps inflation constant. (Sometimes economists define the NRR as the real interest rate that would occur if all prices were flexible, but I think that can be misleading when we are at the ZLB.) There are important issues about risk and different real rates that Tyler Cowen mentions which I will have to ignore.

Crucial to Summer’s argument is that our problems did not all start with the recession. However it may be worth just noting some arguments that the ZLB may be around for some time that do begin with the recession.

1) It takes a long time to adjust balance sheets

One way many economists think about the current recession is that it involves balance sheet adjustment: consumers and firms need to save to reduce their borrowing or increase their wealth. Ideally we would try and offset this by encouraging them to make this adjustment more slowly, or encouraging others to offset this, through negative real interest rates. If adjusting balance sheets takes a decade rather than five years, this may mean that the NRR is negative for much of this period, so we will be stuck at the ZLB for some time to come.

2) Fiscal policy

Tightening fiscal policy lowers the NRR. One of the unusual features of this recession relative to earlier downturns is fiscal austerity, and this will reduce the NRR.

3) Financial intermediation

There has been a lot of discussion about how recessions that result from a financial crisis may be longer lasting. In some countries there is a concern that banks are still carrying a large amount of bad loans, and that this may inhibit their lending for some time. Others worry that tighter regulation could have the same impact, although this is disputed. Just as a reduction in credit rationing can lead to a prolonged economic boom, an increase in rationing can have the opposite effect. There are also more complicated arguments involving a shortage of safe assets (like government debt) that can be used as collateral.

 4) Pessimistic expectations

The way the global economy eliminates deficient demand is not through price flexibility per se, but through movements in real interest rates. If the ZLB means that output is below the natural rate for some time, this could lead consumers and firms to revise down their estimate of what long run output will be. (We can see this happening already when some argue that productivity has permanently fallen as a result of the recession.) If these expectations are more pessimistic than those of policymakers, interest rates might have to be at the ZLB until these expectations are revised. (I discuss some related ideas here.)

All these stories generally start with the recession. However in the decade before the recession, the real interest rate associated with stable inflation appeared to be much lower than before: this is Bernanke’s savings glut. It seems clear that we have to take a global perspective on this, otherwise we end up chasing contradictory red herrings: worrying about the lack of investment in the US, and also worrying about overinvestment in China. The importance of thinking globally is emphasised in Daniel Alpert’s book, and by many others.

One straightforward possibility is that the long run equilibrium NRR has fallen. In standard macroeconomic models, this rate is usually related to impatience, population growth, and technical progress. We know that population growth has shown substantial declines in the developed world, and will show similar declines in the developing world, so that world population may eventually stabilise in around 100 years. Some have also argued that the rate of technical progress has already, or is about to, decline. So there are good reasons for believing that the long run equilibrium NRR has fallen. It might be possible to construct demographic arguments for the medium term NRR to be below the long run NRR, but I will leave that to those who know more about savings behaviour in China and its neighbours.

Another, but rather different, popular argument relates to inequality. It is often put very simply: as the rich have a lower propensity to consume out of income, shifts in the distribution of income towards the rich will tend to reduce aggregate consumption. For a more sophisticated discussion, see Interfluidity.

Often solutions to problems depend on a good diagnosis of why these problems have arisen, but I can think of two solutions that appear to be robust to any of the stories outlined above. The first, discussed by Ryan Avent and made fairly explicitly in recent remarks by Blanchard, is to raise the inflation rate. The second, which a great many economists would sign up to even if they swear they are not Keynesian, is a sustained increase in public investment. The advantage of the latter over the former is that the former has clear costs, whereas the latter could have clear benefits. Of course we may need to do both.

Let me finish with a point about government debt. A major reason why high government debt is a problem in the medium to long term is that - unless Ricardian Equivalence holds - it crowds out private capital. It does that by raising the NRR. Too much saving goes into buying government debt, so there is not enough to invest in private capital. Yet if the NRR is actually negative, and likely to stay very low for some time, and this is a problem because of the ZLB, then the fact that government debt is currently raising the NRR is useful. To put it another way, this means we have plenty of time to deal with the problem of government debt. Which is good, because all the analysis suggests that it is optimal to reduce debt slowly. In the short term, high public debt is helping, not hurting. (Similar arguments can be made in relation to unfunded social security schemes.) 

Why no public fury over austerity?

Janan Ganesh has an article in the FT today that made me so cross I just have to write about it, even though I should probably let it pass. The theme of the article is how mature the British have been in accepting austerity. To quote: “For countries menaced by the symbiosis of economic suffering and political turmoil, Britain has lessons to impart.”

Of course I see it rather differently. Austerity is either a major technical error, or a political con. According to very conservative estimates from the OBR, it has already cost around 5% of UK GDP. That is a huge amount of money to waste: resources that wanted to be used to produce goods and income that everyone could enjoy, but which have been kept idle as a result of government action. Of course this cost has not been spread evenly, and has been much greater for some.

If this was just my personal view, or the view of a cranky minority, then there is not much more to be said. But instead it is the view you will find in the economic textbooks, and I suspect among the majority of macroeconomists. So given this, the fact that the policy has been accepted with little protest is not something to be commended (unless you are in the business of manipulating opinion), but a major problem. It is a huge failure for good government, and our democratic system. In fact you see similar failings elsewhere. Austerity as a policy has not been seriously challenged in Europe among mainstream parties, and even in the US I think it would be fair to say that views both within the Democratic Party and from the President have been mixed.

So how can Ganesh have completely the opposite view: that the British have shown “impressive calm” in taking their medicine with little protest, and that the lack of any passionate public debate about austerity in the UK is somehow a virtue? I can think of three reasons, none of which is very flattering.

1) That the “elite dialogue” that did take place on austerity is just so much intellectual hand wringing, and that the public know better what the real score is. I might not be surprised if a government politician took that line, but you would expect that a journalist working at the FT, and previously at the Economist, would know better.

2) That his admiration for George Osborne has distorted his view of the real world. Or, to put it slightly more kindly, if you spend your time talking to people who think austerity is inevitable, you begin to believe the propaganda.

3) That he is trying to analyse how the Conservatives have got away with the con of achieving a smaller state by fueling a panic over debt, without of course admitting that that is what he is doing.

Yet whichever of these is the case, the article seems to miss two obvious points. Could it be that the reason there is not a passionate public debate in the UK about austerity is that there is no one to lead that debate? When the political class, of which he is a member, view austerity as inevitable, is it any wonder that the public takes a similar view (particularly when it is dressed up in terms of household economics). He acknowledges that the trade union movement has been vocal about austerity, but does not examine why this voice is largely ignored by the UK media.

There is also no discussion about how popular anger against the impact of austerity may still be there, but that in the absence of any public debate on the policy, it is manifested in other ways. He writes that “Britain remains gloriously free of a serious far right or far left”, which of course is a put down of UKIP. But although Ganesh may not find UKIP serious, Cameron certainly takes UKIP seriously, and has geared his policy on Europe and immigration with them in mind. Perhaps he sees the current obsession in the media (and government) about welfare cheats and benefit tourists as totally unconnected with the unemployment and cuts in living standards that austerity has helped bring about. (For some serious analysis on these issues, see Alan de Bromhead, Barry Eichengreen and Kevin O’Rourke here.)

But none of that was what made me so cross reading the article. Instead it was its juxtaposition with something that I heard about 4 days ago. A reader of my blog, a retired teacher of A level economics and a LibDem member, is about to give a talk on austerity related themes. The features writer on a local newspaper was interested, and spent an hour interviewing him, later writing 750 words. The article was spiked by the editor, because it was controversial and critical of the government. Perhaps the editor was also showing the “impressive calm” which so pleases Mr. Ganesh. 

Should fears of financial instability raise interest rates?

Inflation is significantly below 2% almost everywhere. In the US, Japan and the UK (even though in the UK inflation is still just above 2%) central banks are doing a great deal to get inflation back to 2%. Maybe not enough, but their goal is clear. The ECB is belatedly following the same path (although it remains somewhat behind), but this has caused a very public split in its ranks. One reason given by those who have opposed the ECB’s latest rate cut is a risk to financial stability, and house price increases in certain Eurozone cities. [1] In the US some have raised concerns that continuing QE might generate financial instability. In the UK one of the three ‘knockouts’ to forward guidance, that could allow interest rates to rise even if unemployment remained above 7%, concerns financial stability.

And in one country, Sweden, the independent central bank has kept interest rates above the ZLB, even though prices have been literally falling. While the central bank cut short rates to 0.25 in 2009, during 2010 they were increased to 1%, and during 2011 to 2%. They have since been cut to 1%, but the central bank does not want to cut any further despite prices being flat or falling throughout 2013. Yet the central bank has a clear target for inflation of 2%.

The reason the Swedish central bank - the Riksbank - is overriding its inflation target were clearly set out in a speech given by Kerstin af Jochnick, First Deputy Governor of the Sveriges Riksbank, in January 2013. The Riksbank is concerned that low interest rates will exacerbate a housing bubble. The discussion is interesting for at least two reasons. The first is that the Riksbank is not primarily concerned about the impact of any bursting bubble on the financial sector itself. It is not worried about a second financial crisis. Instead it is worried about the impact a bursting bubble might have on households (creating another balance sheet recession) and overseas confidence.

The second is that the Governor is explicit that higher interest rates are a second best solution to this problem. The first best solution is macroprudential regulation. But, to quote the speech: “One reason why monetary policy in Sweden has needed to give consideration to financial imbalances is because there has been no framework for macroprudential policy.” The speech discusses the progress that the central bank has made in developing a framework for macroprudential regulation.

In passing I would want to add that interest rate policy is probably the third best solution to housing market concerns. The potential for using particular fiscal policy instruments is often overlooked. For example, just as the UK government has tried (somewhat opportunistically) to stimulate the housing market through fiscal means (Help to Buy), these means can also be used to dampen that market. Indeed Goodhart and Baker have argued that Help to Buy can be seen as a macroprudential instrument.

My more substantive point is that a monetary policy of the Swedish kind risks undermining the legitimacy of independent central banks. As regular readers will know, I believe strongly that there are areas of macroeconomics where delegation can be highly beneficial. You only need to look at the influence that misguided, and sometimes crazy, macroeconomic ideas can sometimes have among politicians to see why. On the other hand, delegation potentially undermines the democratic process. There is nothing which says that central bankers, or experts who sit on monetary policy committees, have any particular right to take decisions which can have a substantial impact on people’s lives.

That is one reason why Alesina and Tabellini [2], among others, stress that successful delegation happens when there is a broad consensus on what constitutes sound policy. I think one reason that delegation of monetary policy to central banks has been largely uncontested so far is that this consensus existed for monetary policy. Essentially the task of central banks was to keep inflation low. Of course there is plenty of scope to discuss the details of how this is done, which macroeconomists spend a great of time doing. But the primary task, and the proximate means by which it should be achieved, were clear and commanded near universal support.

For some time the only potentially competing goal was keeping unemployment low: hence the dual mandate in the US. However there was near universal agreement amongst economists that the only sustainable level of unemployment or output that monetary policy should try to achieve was precisely the level that kept inflation stable. If that level of unemployment was too high, then means other than monetary policy should be used to address that problem. Again there are disputes at the margins, particularly when supply or cost-push shocks hit, but little dispute about the basic idea.

The moment central banks start allowing inflation to be persistently below target (with the loss in output that this implies) because of concerns about housing bubbles, this consensus will evaporate. Again Sweden provides a clear example. Lars Svensson, a highly respected academic and a former Deputy Governor of the central bank, has strongly disputed that this policy will achieve the goals it is designed to achieve, and instead suggests that the central bank is violating its mandate. (A good summary is here.) On the more general issue of how much monetary policy should take account of financial risk or housing bubbles there is a wide spectrum of views among economists.   

It is also not difficult to see how reasoned debate could easily escalate into attacks on central bank independence itself. If the central bank begins to be perceived as protecting the interests of the financial sector rather than the public at large, then demands for the government to take back the control of interest rate setting could become difficult to resist (even if the government wanted to resist). I would have no difficulty writing the slogan myself. First the banks created the recession, and now (through the central bank) they want to take away the recovery.

One response to this argument might be that the public would not forgive a central bank that allowed a second financial crisis to develop. I would agree that in the absence of any other remedy interest rate policy should be influenced by the possibility of a financial crisis, as Michael Woodford has demonstrated formally (see this post). So how do you exercise this option of last resort, but still ensure the legitimacy of independent central banks by focusing on the control of inflation? I quite like the arrangement in the UK, where there is a separate Financial Policy Committee (FPC) that works with but is independent of the Monetary Policy Committee (MPC). The FPC, not the MPC, is in charge of macroprudential policy. The knockout to forward guidance that I mentioned above involving financial instability is called by the FPC, and the MPC can then decide whether to act on that call.

Such an arrangement works best if both committees are populated by experts from outside the central bank, and in the case of the FPC those experts are not just current or past bankers. It has the advantage that before the MPC can even begin to consider allowing fears of financial instability to influence its interest rate judgement, the FPC has to in effect say we have exhausted all the other means at our disposal. It would be also good if the FPC was explicit about any micro fiscal issues that might also be involved, just as Bernanke has been explicit about the problems macro fiscal policy has caused him in the last year or so. This institutional arrangement makes it clear that it is for others, and not those who set interest rates, to protect mortgage borrowers from their own potential folly.

[1] See this article by Hans-Werner Sinn for example. To be fair housing is only briefly mentioned there, and the main point seems to involve something else, although what exactly is less clear to me.

[2] Alesina, A. and Tabellini, G. (2007) “Bureaucrats or politicians? Part 1: A single policy task.” American Economic Review 97: 169–179.

      

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.