Inflation risks

When it comes to the issue of when interest rates should start rising, one of the points I and others have often made is that the risks are not symmetric. If inflation starts rising faster than we expect monetary policy can quickly respond. Alternatively if we actually have more ‘spare capacity’ than we currently believe, it may take some time for this to become apparent (inflation is more sticky when it gets low), and the zero lower bound limits what monetary policy can do.

In this light, the following table from the Bank of England’s inflation report issued today is rather interesting. 

In scenario 1, there is more slack in the labour market than the Bank currently thinks. In scenario 2, firms are currently working at a higher rate of capacity utilisation than the Bank estimates. In both scenarios monetary policy is endogenous. Inflation is higher in scenario 2, but monetary policy succeeds in getting it back to target by the middle of 2017. In scenario 1, inflation remains below target throughout the period.

Now as a macroeconomist I really want to know more. These are different shocks, so they are not a pure test of asymmetry. The path of interest rates is not shown, so we do not know how much of a constraint the zero lower bound is (if at all) in scenario 1. In scenario 1 unemployment falls quite a lot more than in the central projection, but the additional GDP growth seems small by comparison. The opposite is true in scenario 2. This is undoubtedly a result of different shocks being applied, but all the report tells us is that judgement was used in deciding how to shock the model to best capture each scenario. As I am sure Tony Yates would say, it would be nice for those who are interested in this detail to know a bit more.

However, putting all these qualifications aside, these simulations are welcome given all the discussion underway. They suggest that the upside risks to inflation are small, because monetary policy is capable of responding quickly. Overestimating the degree of current slack does not lead to inflation ‘taking off’. Perhaps this helps to explain why the Bank appears to some to be rather relaxed about the need to raise rates.     

Humility and Chameleons

Macroeconomics tells you to (temporarily) raise, not cut, government spending when we have a recession caused by deficient demand and interest rates are at their lower bound. That is the claim that some of us make. Others say we are being far too sure of ourselves and our subject, in part because there exist models where this is not true. As a result, we should not loudly complain when politicians do not follow this advice. A bit more humility please.

If you think we should have more humility, imagine the following. The UK or US government tomorrow abolishes their independent central bank, and immediately raises rates to 5%, saying it was about time savers had a better deal. Well macroeconomists generally think that independent central banks are a good idea, and we nearly all believe that raising interest rates when inflation is below target and unemployment is high is crazy. But wait a minute. There are models that suggest keeping interest rates low is causing low inflation, and that raising rates could stimulate the economy - I discuss one here. So perhaps we should not be critical of a government that did this. We should be humble, and leave the politicians to do as they please while we get on with our research. Let us make sure we are absolutely sure before shouting too loud.

Why is that wrong? Two reasons. First, the existence of a model that says higher interest rates could stimulate the economy is not in itself evidence that it might. In an interesting paper, Paul Pfleiderer talks about Chameleon models. He defines a chameleon model as “built on assumptions with dubious connections to the real world but nevertheless has conclusions that are uncritically (or not critically enough) applied to understanding our economy.” The model that I discussed where higher rates could stimulate the economy assumes (among other things) agents believe the inflation target is negative, and that raising rates will show them they are wrong. Possible, but highly improbable.

Second, economic policy always takes place in an uncertain environment. Raising interest rates might have reduced inflation in the past, but maybe this time is different? If we wait until we are all absolutely sure about the impact of a policy change, we will wait forever. However, if we are more than 90% certain that raising interest rates, or cutting government spending, will make the recession worse, we should say so. If politicians ignore this advice, we should make sure everyone knows. This is no intellectual game - people’s welfare is at stake.

Yes, economic policy did fail

Tony Yates today criticises Paul Krugman’s argument that economics had the answer to how to respond to the crisis, but policy failed to follow the prescription. As I completely agree with Paul Krugman on this, let me say why I think Tony’s criticism is completely wrong. 

The argument he is criticising is that, following the recession, we had a demand deficit that fiscal stimulus could have tackled, but from 2010 policy went for fiscal contraction instead. How do we know that we had a demand deficit? Because interest rates went to their zero lower bound pretty well everywhere. Monetary policymakers had to go for largely untried and untested Quantitative Easing to try and plug the demand gap. Fiscal stimulus is a much more reliable method of achieving the same goal. That logic is, in my view, unassailable.

Tony’s first argument is that, despite this, we got lucky. If you look at inflation, “conventional demand-side fiscal policy was roughly on track”. So, when economists in twenty years time look back on the 2008/9 recession, Tony thinks they will describe it as a textbook example of how policy should deflate the economy in response to an inflationary shock. Policy did good - the recession was just what was needed to stop inflation going higher. Somehow I really doubt that is the story they will tell.

Tony defends this argument by invoking the social welfare functions implied by New Keynesian models, where inflation is much more costly than non-zero output gaps. At which point I do worry about what today’s macroeconomists actually believe. These social welfare functions may capture the costs of inflation - or at least the costs due to relative price distortions - but they certainly do not capture the costs of output gaps at all. We have a huge amount of evidence that tells us this. Just because we have not yet microfounded why people hate being unemployed so much does not mean they really don’t mind.

Tony acknowledges this, but then says “But, with the models thus binned, you are in the dark about what should be done.” That is just silly. New Keynesian models do not stand and fall according to the accuracy of the social welfare functions they imply. After all, many NK models have a labour market that clears. Economists use them not because they think the labour market actually clears, but because they give answers about output gaps and what to do about them that are not too far off. So there is absolutely no problem using a NK model with an ‘ad hoc’ social welfare function where weights follow the evidence rather than the model. If we do that, and use other measures of inflation besides consumer prices (as theory suggests we should), then 2009-13 does not look like an optimal response to an inflationary shock.

Then Tony falls back on the argument that there is so much we still do not understand about the financial crisis, so how can anyone argue that the economics is clear.

“PK seems to be backing away from all these intractable debates about the detail, and saying that we can ignore it.  Big picture, demand was weak, public demand had to be stronger.  Politicians did not get this message clearly enough, and were able to ignore it.  End of story.  Well, maybe.  Maybe not.  Perhaps only great minds can see the wood for all these unfinished modelling trees.”

No, you do not need to be a great mind to do this, and I should know. You just need to assess whether the things we do not understand can seriously compromise what we do know, which was that we had deficient demand and we knew how to deal with that. The only possible factor was - briefly - the Eurozone debt crisis, but then a balanced budget fiscal expansion could have been used to avoid increasing debt.

So Tony’s argument that the reason for this “policy failure is that our economics profession had not yet come up with clear answers” is not tenable. As he knows, monetary policymakers cope with uncertainty all the time, but we still tell them (or at least most of us do) that you cut rather than raise interest rates in a recession. For exactly the same reason, you undertake fiscal stimulus, not contraction, when interest rates are at the zero lower bound. It really is that simple. 

Sticky prices: how we confuse students, and sometimes ourselves

For teachers and students of macroeconomics.

I’m about to teach a small number of first year undergraduate students Keynesian macroeconomics, and my aim will be not to tell them that this is the macroeconomics of sticky prices. Yet I realise I’ve already gone wrong. In week one I talked about time periods in macro, and how the ‘short run’ was the length of time ‘it takes prices to fully adjust’. I must have been saying this for years. But it is at best highly misleading.

In both the New Keynesian closed economy model, and the IS/LM model, the short run is the length of time it takes the central bank to stabilise inflation (output goes to its natural rate), or less precisely to achieve full employment. For students we could equally say it is the period it takes monetary policy to achieve the real rate of interest implied by the RBC, or Classical, model.  Calling this the time period it takes prices to fully adjust only makes sense when monetary policy involves some kind of nominal anchor, like a fixed money target in IS/LM. It makes no sense when monetary policy involves a central bank trying to choose the best nominal interest rate. The impact of an unexpected but subsequently known preference/demand shock, for example, would be very short lived when such a central bank knew what it was doing. (See this excellent post from Nick Rowe.)  

The big danger in equating Keynesian economics with sticky prices is that students forget about the crucial role monetary policy is playing. Too many think that after an increase in aggregate demand, if contracts and menu costs were absent, higher prices would in themselves choke off the increase in aggregate demand.  As they have just learnt micro, it is a natural mistake to make. They then get very confused when price flexibility does (at best) nothing at the zero lower bound.

Yet the linking of the short run with sticky prices is ubiquitous. In the edition of Mankiw I have to hand it says

“In the long run, prices are flexible and can respond to changes in supply or demand. In the short run, many prices are sticky at some predetermined level. Because prices behave differently in the short run than the long run, economic policies have different effects over different time horizons.”

This kind of statement makes sense in a fixed money supply world, but it makes much less sense in the real world. (Mankiw uses the term ‘long run’ where others would use ‘medium run’, but let us not worry about that.) Compare it with this alternative statement:

“In the long run, monetary policy adjusts to achieve steady inflation, which means output goes to its ‘natural’ or Classical level. In the short run, monetary policy fails to achieve this, so we need to look at movements in aggregate demand to explain output.”

This works for any sensible monetary policy.

In my second year lectures, I ask my students to think about a monetary policy that involved moving real interest rates in response to the output gap, but not to excess inflation.  If that policy stabilised a closed economy, then what impact would the speed of price adjustment have on anything except inflation? Inflation aside, a world where price adjustment was quick would look much like a world where prices were much stickier. The ‘short run’ would have the same length, irrespective of how quickly prices adjusted.

All this is about how Keynesian economics is taught, rather than about how it is done. Yet how it is taught can also influence how it is eventually understood. One of the problems some people have with understanding that we are still in a situation of deficient demand is that it is five years after the recession ‘and surely prices should have adjusted by now’. There is also a rather more profound point. Many anti-Keynesians use this misunderstanding about price adjustment to dismiss Keynesian economics. When they say ‘I ignore Keynesian economics, because I think prices adjust rapidly’ they are really saying ‘I ignore Keynesian economics because I think monetary policy is very successful’. And in the real world, monetary policy can only be very successful by understanding Keynesian economics! 

Economists and methodology

Where I argue that mainstream economics should think about the methodology of their subject more, but that to study this methodology it is much better to look at what economists actually do than to look at their (occasional) writing on the subject.

Methodology? Why should I worry about that? It’s what all those heterodox people do - lots of ‘isms’ and ‘ologies’ that are totally incomprehensible! Unlike those guys, I get on with doing real economics. After all, doctors do not spend large amounts of their time worrying about the methodology of medicine. So why should economists?

This is a caricature, but not far off the mark for many economists. (When I refer to just economists/economics from now on, I mean mainstream.) Perhaps more of a concern is that very few economists write much about methodology. This would be understandable if economics was just like some other discipline where methodological discussion was routine. This is not the case. Economics is not like the physical sciences for well known reasons. Yet economics is not like most other social sciences either: it is highly deductive, highly abstractive (in the non-philosophical sense) and rarely holistic. This is all nicely expressed in the title of what I think is one of the best books written on economic methodology: Dan Hausman’s ‘The inexact and separate science of economics’.

This is a long winded way of saying that the methodology used by economics is interesting because it is unusual. Yet, as I say, you will generally not find economists writing about methodology. One reason for this is the one implied by my opening paragraph: a feeling that the methodology being used is unproblematic, and therefore requires little discussion.

I cannot help giving the example of macroeconomics to show that this view is quite wrong. The methodology of macroeconomics in the 1960s was heavily evidence based. Microeconomics was used to suggest aggregate relationships, but not to determine them. Consistency with the data (using some chosen set of econometric criteria) often governed what was or was not allowed in a parameterised (numerical) model, or even a theoretical model. It was a methodology that some interpreted as Popperian. The methodology of macroeconomics now is very different. Consistency with microeconomic theory governs what is in a DSGE model, and evidence plays a much more indirect role. Now I have only a limited knowledge of the philosophy of science, and have only published one paper on methodology, but I know enough to recognise this as an important methodological change. Yet I find many macroeconomists just assume that their methodology is unproblematic, because it is what everyone mainstream currently does.  

This reluctance by economists to investigate their own methodology has a consequence which is the main subject of this post. It occurred to me when I recently re-read a methodology paper entitled “Two Responses to the Failings of Modern Economics: the Instrumentalist and the Realist” by Tony Lawson. The paper, written in 2001, starts on the first page with “There is little doubt that the modern discipline of economics is in a state of some disarray.” This is a strong claim. For example, I have previously written that the influence of economists within the UK government at that time may have been at an all time high, and as this account (pdf) shows, economics remains very influential within the civil service. Where is the evidence for the claim about disarray? The answer in this paper is a selection of quotes from economists writing about aspects of their subject. Now any economist would immediately wonder how representative these quotes were. But more fundamentally, are expressions of concern within a discipline equivalent to it being ‘in disarray’? (For example, see the first quote from a physicist here. Would this be a good basis for a paper that asserts than physics is in disarray?)

Even if we ignore these concerns, given the unfamiliarity of most economists with methodological discussion, it may be unwise to use what economists write about their discipline as evidence about what economists actually do.  The classic example of an economist writing about methodology is Friedman’s Essays in Positive Economics. This puts forward an instrumentalist view: the idea that realism of assumptions do not matter, it is results that count.

Yet does instrumentalism describe Friedman’s major contributions to macroeconomics? Well one of those was the expectations augmented Phillips curve. Before his famous 1968 presidential lecture, the Phillips curve had related wage inflation to unemployment, and if expectations about inflation were included (in some way), the coefficient on this expectations term was often empirically determined (see above) and was often less than one. Friedman argued that the coefficient on expected inflation should be one. His main reason for doing so was not that such an adaptation predicted better, but because it was based on better assumptions about what workers were interested in: real rather nominal wages. In other words, it was based on more realistic assumptions. (For a good discussion of the history of the ‘expectations critique’, see this paper by James Forder.)

Economists do not think enough about their own methodology. This means economists are often not familiar with methodological discussion, which implies that using what they write on the subject as evidence about what they do can be misleading. Yet most methodological discussion of economics is (and should be) about what economists do, rather than what they think they do. That is why I find that the more interesting and accurate methodological writing on economics looks at the models and methods economists actually use, rather than relying on selected quotations.

Afterthought

There is a nice self-conformational element to this post. Someone is bound to tell me that, in my comments on Freidman, I do not really understand what instrumentalism means. And that, of course, just goes to make my point that you should not rely on what economists say about their own methodology!

Hawkery, or is the Bank biased

An interesting contrast in my evening reading yesterday. In the US, Matt O’Brien in the Washington Post’s Wonkblog making fun of reporting that inflation is just around the corner. There is one particularly nice line: “Well, there's always demand for pieces about why we need to raise rates — mostly from 60-year-olds who think it's always 1979 …” The contrast is with the Financial Times’s Chris Giles, who in yesterdays FT accuses the Bank of England of ‘institutional dovishness’, which he compares to institutional racism. The Bank is “institutionally biased against higher interest rates.”

Now, lest I be misunderstood, let me say three things before addressing Chris Giles’s charge. First, I’m pretty sure Chris is well short of 60. Second, Chris is no fool who blindly follows some party line: this piece on the Treasury’s exercise in dynamic scoring is as good as economic journalism gets. Third, central banks can suffer from what I and others prefer to describe as ‘groupthink’. Laurance Ball argued that this happened at the Fed when it came to not trying what I call forward commitment (promising higher inflation and a positive output gap in the future to combat the zero lower bound).

Having said that, Chris can occasionally pursue a line that, while popular in some quarters, makes little macroeconomic sense. The idea that UK austerity did not matter much had him clash with not just the usual suspects (including me), but also US academics Alan Taylor and Oscar Jorda. (I discussed an earlier version of their paper here: their latest version is here). In a similar way, over the last few months Chris has relentlessly pursued the idea that UK interest rates should rise very soon.

Chris’s charge against the Bank is that they keep moving the goalposts. For example, they say they will think about raising interest rates when unemployment dips below 7%, but when unemployment does go below 7% they decide that there is no reason to raise rates, and so on. But for the Bank the goalposts are the inflation target, and inflation is below target.

In the past I have made the point that, given uncertainties about the size of the output gap, it is best to err on the side of expansionary policy. This is because the Bank can easily deal with inflation if it does begin to rise, but because of the lower bound the opposite is not true. Chris responds that “no one should expect that an overheating economy will quickly set prices and wages on the climb”. “As the pre-crisis period showed, economies can overheat and develop dangerous imbalances without displaying the usual warning sign of inflation.” He is of course talking about house prices. But raising rates is a very inefficient way of dealing with a housing boom, which is why we now have the Financial Policy Committee at the Bank with its macroprudential tools. It is also very inefficient for the Bank to be trying to undo effects caused by the Chancellor’s policies (Help to Buy).

To see what can happen in this situation, we just need to look at Sweden. Sweden raised interest rates from almost zero to 2% beginning in 2010, because they were worried about overheating in the housing market. They now have deflation: inflation was -0.6% in March. As a result, the central bank has had to bring interest rates back down again. Lars Svensson, one of the world’s leading macroeconomists who resigned from their equivalent of the MPC while this happened, can only say I told you so.

While we are on the subject of premature interest rate increases, let us not forget the ECB raising rates just before the second Eurozone recession. And let us not also forget that the MPC almost followed their lead - not much evidence of institutional dovishness there.

I suspect and hope that the Bank and MPC have their eyes on the big picture. UK GDP per capita is currently around 15% below the level we might have expected it to be at if it had followed pre-recession trends. At no time since WWII has the economy not come back to this trend. We have no even half decent theories about why this trend should have dramatically changed. In these circumstances, starting to put on the brakes when we have only just begun to catch up lost ground, and when inflation is below target, just seems dumb and dangerous. 

Central bank advice on austerity

As I wrote recently, the economic debate on the impact on austerity is over bar the details. Fiscal contraction when interest rates are at their zero lower bound is likely to have a significant negative impact on output. Of course the popular debate goes on, because of absurd claims that recovering from austerity somehow validates it. Next time you get a cold, celebrate, because you will feel good when it is over! Which means more articles like this will have to be written.

An interesting question for an economist then becomes why austerity happened. There are some groups who have a clear self interest in promoting austerity: those who would like a smaller state, for example. While arguments for ‘less government’ are commonplace among the more affluent in the US, in Europe there is much less natural antagonism to government. As a result, as Jeremy Warner said, you can only really make serious inroads into the size of the state during an economic crisis. Large banks also have a direct interest in austerity, because they need low debt to make future bank bailouts credible, enabling them to carry on paying large bonuses from the implicit state subsidy that this creates. So, from a cynical point of view, for this and other reasons those close to finance will always talk up the danger of a debt funding crisis just around the corner.

However there is a large middle ground who genuinely believes austerity was required to prevent the chance of a funding crisis, particularly after Greece. Yet Quantitative Easing (QE) fundamentally changes this. If the central bank makes it known that QE drastically reduces the chance of a debt funding panic, and anyway they have the means to offset its impact if it occurred, any contrary advice from the financial sector might be defused. The middle ground might be persuaded that fiscal stimulus is possible after all.

Now this was never going to happen at the ECB. It takes every opportunity to promote austerity. It took two years of continuing crisis to get it to introduce OMT. I do not follow the US closely enough to know what, if anything, the Fed said about the impact of QE on the prospect of a bond market panic, but I do know Bernanke was not afraid to warn of the dangers of excessive austerity in his final days in charge of the Fed. Which brings us to the UK, and the coalition agreement of 2010. The Conservatives may well have advocated their austerity programme whatever the Bank of England had said: it was a golden opportunity to reduce the size of the state. However their coalition partners, the LibDems, had campaigned on a more gradual deficit reduction plan similar to Labour. Mervyn King’s advice during this period is often credited with helping persuade the LibDems to accept the Conservatives’ proposals. (See, for example, Neil Irwin, or for more detail Andrew Lydon).

So why did King advocate austerity, rather than telling politicians that with QE in place, a funding crisis was both much less likely and less damaging. We may get a clue from something recently published by the Bank, as part of its stress test scenario for UK banks (HT Britmouse). The application is to 2014 rather than 2010, but it may still indicate what the Bank’s thinking might have been four years earlier. It talks about “concerns over the sustainability of debt positions” leading to a “sharp depreciation in sterling and a build-up of inflationary pressures in the UK.” As a result, monetary policy is tightened and long term interest rates rise - presumably because QE stops.

In one of my first blog posts two and a half years ago I wrote that “austerity is not even a sensible precautionary policy when we have QE”. Does this scenario give me cause to doubt that verdict? It does not, for two reasons. First, what makes a funding crisis so scary when you cannot print your own currency is that it is a bit like being blown off a cliff. Once interest rates start rising because of fears of default, this in itself makes default more likely. We have a clear nonlinearity, such that it may become too late to retrieve the situation once the process begins, as periphery Eurozone countries found out. Depreciation in the exchange rate when rates are floating is not like that. The further the exchange rate falls, the more attractive the currency becomes, because trade in goods ties down the medium term level of the currency.

The second reason why a loss of confidence in a currency is not like a debt financing crisis is that the former cannot force default, whereas the latter can. That makes all the difference. Without QE the markets have to worry about what others in the market think. The government may not intend to default, but if they cannot roll over their debt, they do not get that choice. With QE the government cannot run out of money, so the markets no longer need to worry about a self-fulfilling market imposed default. All that matters is what the government will do, and there was never any serious chance that the UK would default on its debt whoever won the election.

However it is possible to see why the Bank might still have worried in 2010. Output had only just stabilised after the worst recession since WWII. They wanted to keep interest rates as low as possible to help a recovery. Yet inflation was more than 1% above target, partly as a result of the depreciation of 2008. The MPC believed their remit was to target 2% inflation two years ahead. If sterling had fallen further, they would have found it very difficult not to raise rates. Yet Mervyn King would not have wanted to go down in history as the Governor who raised rates during the depths of a recession.

I think this says a lot about whether we had the appropriate monetary policy framework. (For further discussion of the economics see this post and links therein.) But my main point is this. It is all speculation, because as far as I am aware the Bank said very little officially. The Governor let his views be known in private, and publicly endorsed the government’s austerity plan after the election (much to the annoyance of some MPC members), but there was no open debate about the issues. The Bank could have initiated this debate, but chose not to.

So when the next recession hits, and interest rates go to zero and budget deficits increase, will anything be different? The central bank is in a position to make it clear what the risks of a market panic really are when QE is in place - indeed you could say that it has a responsibility to do that. Or instead it can publically argue that it still has all the tools it needs to manage the economy, and advocate austerity in private. Mervyn King once said (pdf) “Central banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy.” Is this always going to be the case?