That £170 billion bombshell

Paul Johnson of the IFS has written that under Labour “national debt [could be] around £170 billion higher (in today’s terms) by the end of the 2020s than would be achieved through a balanced budget.” That was all that certain newspapers needed to start talking about a borrowing bombshell under Labour.

£170 billion is a meaningless number, and the end of the 2020s is a meaningless date. First, we should put everything as shares of GDP. £170 billion is about 10% of GDP, and debt is currently around 80% of GDP. However it would be completely wrong to infer that under Labour debt to GDP would be 90% of GDP by 2030. If they achieved current balance by financial year 2017/18, then my excel spreadsheet says that with nominal GDP growth of 4% a year, by 2030 debt to GDP would be around 65% of GDP. (A few points below 65% if investment remained at 1.5% of GDP, a few points above it became 2% of GDP.) If the Conservatives balanced the overall deficit each year debt to GDP would be about 47% of GDP by 2030.

So a £170 billion bombshell actually means debt to GDP would have been reduced from 80% of GDP to around 65% of GDP. So the correct headline should have been “debt to GDP cut by a fifth in 2030 under Labour’s plans”. That is debt, which is much more difficult to reduce than the deficit. To say this is a ‘different interpretation’ is too polite – newspaper reports got it completely wrong. Who should you blame for this: Paul Johnson, innumerate journalists, biased newspapers? I’ll leave that to you.

There remains a real question of how quickly debt to GDP should be reduced. In terms of the analysis I did here and here, Labour’s plans - if it did achieve current balance by 2017/18 - are tougher than the path I described as ‘fast’ debt reduction, although not nearly as tough as Osborne’s plans. (This analysis was done before the Autumn Statement, but to pretend that the analysis needs to be revised on that account gives these numbers spurious precision.) However my ‘fast’ path did not keep to current balance after 2020, but had some further deficit reduction over the next five years. (As a result, debt to GDP was below 60% by 2030 under this fast path.) I have not seen Labour commit to sticking to current balance until the end of the 2020s. So in that sense as well the £170 billion number is meaningless.

What you should conclude from this is simple. First, as Paul Johnson and many others have pointed out, both Labour and Conservatives are aiming for tight fiscal policies (tighter than I and others think sensible given the macroeconomic situation), but the Conservatives’ plans involve substantially more cuts than Labour. Both involve reducing debt to GDP quite rapidly, so there is no question that both plans would not trouble the markets. So the only reason for going for Osborne’s plan, now apparently involving budget surpluses, is if you expect another financial crisis in the 2030s, and want debt to GDP to be something like it was before the last one. [1] Or, as a headline writer might put it (but somehow I doubt many would): “budget surpluses and austerity so we can afford to bail out the banks again soon”.

   

[1] For those who are really into fiscal rules, there is a technical question about whether it is better to have a target for the overall deficit or the current balance. As George Osborne has moved from the latter to the former, it may be best to read his detailed analysis of the issue. Cannot find anything? Well maybe, as I note here, he is simply following the discussion in Portes and Wren-Lewis (2014), which argues for deficit targets but a separate target for the public investment to GDP ratio.

Encouraging dialogue between economists and social scientists

In a way this is a rather trivial post, about language and attitudes as much as anything, that follows from some of the reaction to this post and related debates. One big difference between most (not all) mainstream economists compared to their heterodox or other social science colleagues is insularity. Political scientists will talk to sociologists who in turn talk to international relations people as a matter of routine. Economists by and large talk to each other. This is not because their subject matter is narrow - economists are notorious for applying their tools way beyond economics.

Most of the time I think that is fine, but sometimes it is not. How do we deal with the times that are not? I want you - as either an economist or social scientist or interested spectator - to think about a visit to your doctor. Why? Because economists should really think of themselves like doctors. (I know some want to think of themselves as physicists, but what can we do.) They are trying to understand highly complex and erratic systems based on a small number of principles, where most of the time they have very little idea of what is going on. But they have data, and some of the time they can make a lot of difference to people’s lives.

Now supposing your doctor prescribes you a course of treatment. It involves drugs that you have read a little about, and you have some concerns. If you were a social scientist would you say to your GP something like the following:

“I’m a little worried about this. I feel that you may not have adequately addressed the ontological and epistemological issues that are raised here. What exactly is ‘treatment’, and when is it necessary? Have you thought about the complex social and economic interrelationships that lay behind your prescription? Is the nature of what you call ‘illness’ really independent of the nexus of interactions that could be loosely called the medical profession?”

I kind of hope you wouldn’t, because I do not think you would get very far if you did. You might be much better off asking something like the following.

“I’m a little worried about this. Have you thought about whether this treatment is appropriate to my particular circumstances (HT Ben Goldacre), or are you reacting to pressure from the drug company or someone else? Has that company published all its trial data, or only the trials that were successful, and how was success defined in this case. Is this really going to make me better, or just increase someone’s profits?”

It is a simple and obvious (I did say trivial) point - you will get much further if you talk specifics in a language your doctor will understand, rather than in generalities and terminology they will not. Economists want (or need) to know why their approach is missing key issues or linkages which compromise their analysis, just as the doctor needs to know why they might be recommending the wrong treatment. You would not insist that your doctor needed to have studied economics before they can be a good doctor.

But if you were an economist, would you think it legitimate for your GP to respond like this.

“How inappropriate of you to ask me these questions. I’m a doctor, and I know from my years of knowledge and experience what is the right treatment for you. As you cannot know what I know, then you should not get involved in these issues. Some of the things you mention are really none of my business, and I do not see why I should worry about them.”

Now as an economist you know that such a response from your doctor would be both arrogant and naive. The doctor should ask about the quality and objectivity of the information they receive, and know full well that drug companies exist to make money. But might your response to a social scientist be as arrogant and naive?

Let me take a real world economic problem: the response to the financial crisis. Some have suggested that banks have become too large and need to be broken up, or that the activities of high street banking need to be separated from the activities of the casino. Your economic analysis tells you that networks of many small entities can be as subject to crises as networks involving a few large banks. You are also able to devise a system of Chinese walls that mean that the activities of the casino can be separated from those of the high street even within the same company, and your political masters seem to prefer this approach. You recognise that different assets differ in their liquidity, and so you devise complex weighting algorithms for computing capital ratios. Your suggestions form the basis of negotiations between officials and bankers, and a set of rules and regulations are agreed.

Over the next few years you watch in dismay as your complex system begins to unravel. The CEOs of the large banks seem to constantly have the ear of politicians, who in turn gradually compromise your elaborate controls to render them less and less effective. Those in charge of administering the rules find it much more lucrative to work for the banks, and so regulators gradually lose expertise and resolve.

And you realise that right from the start you made the wrong choice. You decided to focus on what you knew, which was how to design systems that worked well as long as those systems remained unchanged, but which were not robust to intervention by self-interested parties. In short, they were too open to rent-seeking. You realise that actually the best thing to have done was to break up the banks so that their political power was forever diminished. And you recall a conversation with your social science colleague when this all started, who might have been trying to tell you this if only you had understood the words he was using.      

When central bank losses matter

This is a post about why the taboo against helicopter money or money financed fiscal stimulus is irrational once we have Quantitative Easing, but might nevertheless be in the interest of some groups.

Many macroeconomists have argued that we shouldn’t think about central banks in the same way as private banks. A central bank can never be insolvent, at least as long as people use the currency it issues. It can cover losses by creating more money. All that matters, from a macroeconomic point of view, is whether it has the ability to do its job, which is to control inflation. 

I do not want to talk about controlling inflation here. Instead I want to talk about these losses, and in particular who gains when these losses are made. Macroeconomists tend to focus on the controlling inflation point, so let me avoid that by imagining a really simple world. There is a constant price level target, and base money velocity (nominal GDP/money) is constant in the long run, so base money must return to some constant value in the long run to meet the target. In the short run velocity is not constant and we can have recessions due to demand deficiency in the usual way.

Think about Quantitative Easing (QE). [4] The central bank creates money to buy government debt in the market at a time when that debt is expensive, because it only does QE when interest rates are low. [1] Suppose it just so happened that all this government debt that the central bank buys comes from pension funds. These funds sell their debt, take the money and keep it as money. After some time, the economy recovers, interest rates rise and the price of this government debt falls. The central bank no longer needs the debt, and it wants to reduce the money stock to get to the price level target, so it sells the debt back to the market, or more specifically to the same pension funds it bought it from. As the price of these assets has fallen, the central bank makes a loss. The pension funds gets back the debt they originally sold, but they have some money left. They have gained.

Good for them you might say - why should I care? Well the central bank is concerned that it has not got all its money back (it made a loss), and to control inflation it needs to take more money out of the system. It asks the government to recapitalise it, which the government does by raising taxes. What has in effect happened is that money has passed from the taxpayer to the pension fund.

My purpose in pointing this out is not to make some distributional point. Instead it is to note that QE in this case involves the central bank giving money away to pension funds. So why is this considered kosher, but the central bank giving the same amount of money (its loss on QE) directly to the public is considered deeply problematic? [2] Why would it be thought completely wrong for the central bank to voluntarily give the same amount of money to the government so that they could help stimulate the economy by some fiscal means (a money financed fiscal stimulus)? [3]

If you think that my assumption about price level targets and constant long run velocity was somehow critical here, imagine the case where to meet its inflation target the money newly created in the long run (the loss on QE) did not need to be taken out of the system. The pension funds gain but no one seems to lose. But if the expansion of money had been via a helicopter, then every citizen would gain instead. So why is acceptable to create new money and give it to pension funds (through losses on QE), but not create money to give to ordinary people or the government? The former is called monetary policy and is OK for a central bank to do, but the latter is called fiscal policy and this the central bank cannot do.

Why does this matter, apart from the distributional point? Because as a means of stimulating the economy in the short run the effectiveness of QE is highly uncertain compared to the effectiveness of direct transfers to citizens or public works. We seem to be stuck with an ineffective form of stimulus, because something more effective is taboo, or goes by a different name. To repeat it in a simple but more provocative way: a central bank giving money to people or governments is out of the question, but a central bank giving money to parts of the financial sector is just fine. That is a very convenient taboo for some.  

[1] Suppose this is government debt issued many years ago, when interest rates were 5%. So debt with a nominal value of £100 pays 5% interest. If interest rates are now 2.5%, then this debt is more valuable than its nominal value - indeed someone would pay you something near £200 for it if it had a long maturity. However if interest rates go back to 5%, the value of the debt would fall back to £100.

[2] Assume Ricardian Equivalence does not hold, so giving money away now is expansionary even though that money has to eventually come back when the central bank is recapitalised.

[3] If the money financed fiscal stimulus was in the form of additional but temporary government spending, and when the central bank was recapitalised the Treasury paid for this by temporarily reducing government spending, we get what I call a ‘pure’ money financed spending stimulus. I know of no theory which says that would not be expansionary. 

[4] If you want to be topical, you could think about creating money to buy foreign currency instead.

Mediamacro and responsibility

The Chancellor gives a huge pre-election bribe to the moderately wealthy over 65s, and describes the fact that everyone who can is trying to get hold of the bribe (and completely overwhelming the NS&I as a result) as a great success. [1] Chris Dillow describes this as corruption. To their credit, right wing think tanks have also condemned it for what it is. But the Chancellor says this is all part of his economic plan.

I suspect the penny is beginning to drop in mediamacro. This was supposed to be a government where deficit reduction was the overriding priority. It was of such importance that it was worth the risk (which materialised) of delaying the recovery until 2013 to achieve. Hard, sometimes painful choices had to be made to achieve the goal of reducing the deficit. A Chancellor who was prepared to do unpopular things for the greater good. The essence of responsibility.

Unless you were a top rate tax payer, of course. Or, following the Prime Minister’s conference speech last year, a moderately well off taxpayer. And now if you are moderately well off and over 65. Penny dropped? But this last example also tells mediamacro a difficult truth. Its modus operandi is that it can rely on the opposition to expose such things, but Labour appears to have been silent on this. Obviously, because these kind of bribes work because those that receive it are thankful and the much larger number who pay for it are not so fussed. [2] So it needs to seek out those who will call a spade a spade. It has a responsibility to do so. This time it could use right wing think tanks. Next time it may have to resort to economists who write blogs.

Chris Giles, economics editor of the FT, wrote an interesting opinion piece a few days ago. It appears at first sight to be an attack on Labour’s record in opposition. But it ends with “the intriguing thing about Mr Miliband’s Labour party is that its broad economic prospectus for the 2015 general election is perfectly sensible.” In contrast “the Tories’ plans appear ideological and border on calamitous for many public services.” If you want more detail on this, see my debate with Oliver Kamm in Prospect magazine. So his article is a form of puzzle: how did responsible Tories and reckless Labour change places?

One possibility, of course, is that there never was a puzzle. Chris lists many alleged failings by Labour, but a lot look superficial and presentational to me. Furthermore (and I know Chris will not want to admit this) when Ed Balls said Osborne was cutting too far too fast, he was right. In particular, public investment (school repairs, flood prevention) was cut immediately when there was no need to do so to meet the coalition's fiscal rules. Those who think it had to be done to appease the market should reflect on the fact that Britain lost its AAA rating because of weak growth, and pretty well everyone thinks that public investment has the largest GDP multiplier.

It is the media’s responsibility, which Chris for his part has grudgingly fulfilled, to point out - one way or another - who has the more responsible macroeconomic plan post 2015. The opposition will not make that case, because it has become terrified of being labelled spendthrift. Yet it is hard to find a macroeconomist who does not think Labour has the better macro policy from 2015, whatever their views about 2010 austerity. A responsible media needs to get this point across, just as it needs to point out pre-election bribes.

[1] Once upon a time NS&I was just a way that the government could sell its debt to ordinary people at slightly below market rates because it was safer than banks. However after the financial crisis, when it became clear how risky banks were, the government seems to have contracted the range of products that NS&I sell, I guess because of lobbying by these same banks. Once you could buy indexed linked assets from NS&I - no longer. Now it has become a vehicle for giving bribes to selected groups of savers.

[2] This is the ‘common pool problem’, one of the reasons economists give to explain deficit bias, which is of course being irresponsible about the deficit. 

What does the end of the Swiss Peg tell us about central banks?

A lot of the discussion in blogs about the end of the Swiss exchange rate peg has focused on whether the original peg, which started in September 2011, was a good idea in the first place. [1] This post asks a rather different question, which has wider relevance.

First some facts, which you can skip if you have already read some of those posts. The safe haven status of the Swiss Franc meant that during the Eurozone crisis people wanted to buy the Swiss currency, and the resulting appreciation was in danger of driving some Swiss producers out of business. [2] The chart below plots competitiveness, measured as relative consumer prices, in Switzerland and in the UK. [4]

      

The appreciation problem in 2011 was real and the exchange rate cap fixed that, but to prevent the exchange rate appreciating beyond the 1.2 Swiss Francs (CHF) per Euro mark the central bank had to create lots of money to buy Euros. You can think of it as Quantitative Easing (QE) that buys foreign currency rather than domestic government debt. [3]

The interesting question is why the central bank ended the cap. Perhaps the cap was always meant to be a transitional measure, to allow firms time to adjust to a loss in competitiveness. (Here is the official explanation.) This is not that convincing. If the central bank was worried that its producers were becoming too competitive, it could have changed the cap from, say, 1.2 CHF per Euro to 1.1 CHF per Euro. Removing the cap completely would only make sense if you thought your safe haven status had reached some kind of equilibrium, and with the Greek elections and other things currently happening that seems unlikely. Even if you did think this, caution might suggest testing the market with a more appropriate cap and seeing how much defending you had to do.

As a result of ending the peg, the Swiss Franc has appreciated substantially, from 1.2 CHF per Euro to around 1 CHF per Euro, even though the central bank has lowered the interest rate on sight deposit account balances that exceed a threshold to −0.75%. There seem to be two alternative interpretations.

The first is that the central bank simply made a serious mistake. For some, the mistake was to impose the cap in the first place. If you do not take that view, and assuming the market’s immediate move is not a very temporary overreaction, the large appreciation partly undoes the benefits of the original peg. Either way, a major mistake has been made at some point. This can be added to what is now a seriously long list of recent major central bank mistakes: see in particular Sweden and the Eurozone. Does the fact that central banks in the UK and US seem rather less error prone have something to do with the greater influence of economists (inside and outside) on those banks? [5]

The second interpretation is that the open ended money creation that the policy implied just became too much for the central bank. In theory the central bank could go on creating money and buying Euros forever. As long as the exchange rate peg was reasonable this policy could be consistent with its inflation target (the target is ‘below 2%’, while actual inflation is currently negative). If it ever decided it was not and there was too much Swiss money around, the policy could be reversed by selling Euros. The central bank might make a loss when this was done, but economists generally dismiss this as a non-problem (a central bank is not like a commercial bank), just as they dismiss the same problem with conventional QE. But perhaps central banks do not see things this way (HT MT), because they worry about the political consequences of such losses. If this is the case, then this is something that economists need to respond to in one way or another.  

[1] The discussion in the media, as often with mediamacro, is obsessed with the markets. The Guardian had a link entitled “Swiss franc - what the economists say”. What you got were 6 City economists, who wrote the kind of thing City economists write. Now I’m sure the Guardian will say they needed something fast, and academics - even academic bloggers - are unreliable in that respect. But please label this properly: you are getting the reactions of City economists, whose primary concern is what this all means for the markets, and not what it means for ordinary people.

[2] Economists have a theory, Uncovered Interest Parity (UIP), which says that short term capital flows like this should not influence exchange rates, because the market will keep rates close to fundamentals. It does not work too well, partly I suspect because the market has little idea what the fundamentals are, and partly because no one in the market is prepared to take bets that last years rather than days.

[3] Switzerland has a really large current account surplus, which since 1997 has averaged 10% of GDP. The reason for this surplus is complex, but it suggests that there is scope for a gradual real exchange rate appreciation over time.

[4] Source: OECD Economic Outlook. The level is arbitrary, at 2010=100. A rise is an appreciation, which means a loss of competitiveness. The average level of this measure of Swiss competitiveness was around 96.5 from 1998 to 2004.

[5] However the suggestion by Tony Yates that every blogger should be given a job at the SNB seems to be going too far.

Osborne's RES speech and proposed new fiscal rule

I suppose I should say something about this, even though I find it painful reading his speeches. Not because they are so partisan - what would you expect? Perhaps I can describe it by comparing it to an academic reading a student’s essay. With something like Vince Cable’s speech last year, you can read whole paragraphs quite happily, and then make a comment at the end like ‘yes, but you have ignored this etc’. With Osborne’s speeches, you feel the need to get the red pen out after every sentence. Each sentence seems as if it is crafted to mislead.

Take, for example, the issue about whether high debt inhibits growth. Now I happen to think that there are good theoretical reasons why high debt might reduce growth. However my reading of the empirical evidence - exhaustively examined following the critique of Reinhart and Rogoff - is that while there may be some (rather weak) correlation between high debt and low growth, there is no evidence of causality running from debt to growth, and more evidence that causality goes the other way. This is what Osborne speech says:

“And the conclusion of the academic literature is that high debt is undoubtedly correlated with lower growth. Even the possibility should give us cause for concern given the huge impact that small growth differentials can have over time.”

Does this give a rather different impression? But read it carefully - does he say anything that is clearly wrong? As I say, it is calculated to mislead, and the speech is full of this stuff. You may think that just means he has very good speech writers, but this makes it hard for an academic to read, and maybe an odd thing to do in an academic lecture. If the invitation was given because the RES was hoping to get something more substantial than the usual Osborne fare, I fear they will have been disappointed.

Still, let’s put that aside and talk about fiscal rules. I have argued that the form of Osborne’s original rule - achieve a particular deficit target over a 5 year rolling horizon - is very sensible for normal times. Here he proposes something that seems different - to start operating once the budget has got to a surplus. He distinguishes between good times and bad times. In good times the budget should be in surplus. In bad times, as called by the OBR, the budget can go into deficit.

How to compare new and old? Could we reframe the new rule in terms of the old, by simply replacing the target of current balance with a new target of overall surplus? I’m honestly not sure - the speech is vague. What he may be doing is thinking about bad times not as your typical economic downturn, but something much worse, like the recent recession. In other words, he may be thinking about the kind of exercise I did here. If he was, we can make the following points:

1)    To allow debt to GDP to go up substantially when there are occasional large negative shocks (which are not followed by large positive shocks), it makes sense to have debt to GDP falling in more normal times. I recommended such an approach in 2009.

2)    This can be done without going for a surplus in normal times, just because of GDP growth. The exercise I did showed that. What is optimal obviously depends on the size and frequency of shocks, and the extent that fiscal policy is actively used to offset the shock. In my exercise, I allowed for another Great Recession in 2040, and thereafter every 40 years. I also allowed for much more fiscal stimulus than occurred under Obama. I assume Osborne would not allow any fiscal stimulus. Despite this, I still had debt to GDP trending downwards, with a target in normal times that was always a deficit.

3)    One interesting and clear difference between his new and old rules is the focus on the overall deficit rather than the current balance. This is also something that Jonathan Portes and I recommended in our paper. It has to be combined with a separate target for public investment as a share of GDP, and in his lecture Osborne said that in the next Parliament capital investment will grow at least in line with GDP.

4)    His proposal appears to give rather more influence to the OBR during these negative shocks. Jonathan and I also suggested an enhanced role for the OBR. In our proposal large shocks would be identified by the central bank suggesting interest rates might hit their zero lower bound, but we also said the OBR should be involved in thinking how deficits might evolve after the shock.

So there are some sensible ideas here, although the failure to acknowledge the problem of liquidity traps remains. There also seems to be an unnecessary obsession with surpluses, but I expect that is just a consequence of his short term goal of shrinking the state.

OK, one last piece of Osborne speak from the speech with relevance to my last post:

“Core inflation ... remains relatively stable and indeed rose slightly in yesterday’s data.”

And here is the data.

Why below target inflation is a big problem

Much of the coverage of deflation seems to miss the key point. Deflation is a sign that resources are being wasted. The lower inflation is, other things being equal, the more resources are being wasted. Wasted resources are probably a bit economics speak. What it means is that society as a whole - you and I - are worse off for no reason. There are also good grounds for thinking the sums involved could be very large, dwarfing the numbers the media normally frets about. [1]

Once you look at it this way, lots of rather silly debates become clear. First and most obviously, there is nothing magic about the number zero. Other things being equal, zero inflation suggests more resources are being wasted than if inflation is 1%, but resources are still being wasted when inflation is 1% and the target is 2%.  

Economists have worried about some of the knock on effects that deflation might have. In particular, because deflation means that the real value of debts fixed in nominal terms is rising, that may induce debtors to cut back spending, with no matching increase in spending by creditors. This will make the waste of resources worse. However this effect is not a non-linear one that kicks in when inflation is zero. If this effect is important, debtors will still be more inhibited by their debt if inflation is 1% compared to 2%. And, of course, even if this effect is unimportant resources are still being wasted if inflation is below target.

This is also why looking at some measure of core inflation is important. If below target inflation is just due to lower oil prices, say, which in turn are just lower because of increased supply, say, [2] then this is no reason to think resources are being wasted. Just as inflation targeting central banks should largely see through any inflation caused by higher oil prices, they should also do the opposite. However in the UK, US and Eurozone core inflation is significantly below target, suggesting resources are being wasted everywhere.

The really interesting thing about the current situation is that in all three places nominal wages seem to be going nowhere fast. This could be partly because plenty of domestic spare capacity exists, but partly also because workers are aware of the potential employers have to use overseas labour as an alternative. In either case, the really good news that this implies is that we can allow the economy to grow at an above average rate for some time. (It also suggests that current fiscal projections may be too pessimistic.)

This is only good news if we take the opportunity it presents. We should use the monetary and fiscal tools we have at our disposal (and invent some new ones if need be) to do so. There is no magic to raising demand - we have various tried and tested means of doing so. The basic barrier to raising demand has been and always will be inflation, so when that barrier is nowhere in sight (in fact appears to be moving further away) it is a criminal waste not to expand demand.

But what of those who advocate caution. We should raise interest rates now, so as to avoid rapid increases later? I am sure some people who argue this way are genuine, but just wrong because they have not realised the implications of the position we are now in, and in particular the balance of risks involved. But I cannot also help noticing that some on the right have been arguing for higher interest rates for some time, and refuse to admit they were wrong. They are confirming Kalecki’s idea that although what he called full employment was good for society, it may not be good for some particular parts of society. Those pursuing this line should not be dismissed: they should be laughed into obscurity.   

[1] This would be clearer if all central banks had a dual mandate.

[2] Which in the current situation is probably not true, so this is just to make the point.