The personal debt time bomb

“Britain’s supposed economic recovery rests on a personal debt timebomb.” I’m sure you have read about this many times. If it often accompanied by the prediction that it will all end in tears at some point, just like it did last time. Now I do not want to flip to the other extreme and suggest everything is hunky dory. For example the UK’s high personal debt levels are in large part because of very high house prices, and high house prices are a real problem for many reasons. But I do want to suggest that the evidence for doom and gloom is not as clearcut as some suggest.

The first, and perhaps most basic, misapprehension is that the financial crisis was the result of UK defaults. It was not. UK banks got into difficulties because of their lending overseas. I discuss this in the context of the so called 2007 boom here. In particular I note that, as the Bank’s Ben Broadbent points out, in the Great Recession UK “losses on most domestic loans have actually been unexceptional. Instead, it is UK banks’ substantial overseas assets that caused much of the damage.” Northern Rock failed because its business model, which relied on it obtaining funds from the wholesale market, failed. Of course for UK banks, this misapprehension that the financial crisis was a result of foolish UK borrowers rather than their lending behaviour may be rather convenient.

A second common trait is to quote numbers for debt in nominal terms. Like cinema box office receipts, we are always breaking records. It is a classic example of the kind of bad practice I note here. This chart, from the Bank of England’s latest inflation report, shows the ratio of average household debt to income.

It is certainly true that this rose substantially in the years before the financial crisis. A good deal, but not all, of that is down to rising UK house prices, which means there are assets behind that debt. That is a concern, as I have already noted, but as I have also noted it did not cause the UK financial crisis. We are a long way from those peak levels, and this chart shows that the household sector as a whole has not gone on a borrowing binge over the last year or two.

This has a political dimension. It would be foolish for those on the left to predict that Osborne’s recovery was bound to fail by 2020. It might, but if I had to put my money on any outcome it would be more optimistic. The small number who suggested in 2012/13 that UK recovery would never come with Osborne’s fiscal regime were used to discredit all those who were against austerity. It would be far better to focus relentlessly on housing, and how a whole generation are being denied the possibility of home ownership without helpful and wealthy parents.  

Woodford’s reflexive equilibrium

 For macroeconomists

Karl Whelan recently tweeted: “Read Cochrane and Woodford on neo-Fisherism today. Cochrane - clear and thought provoking. Woodford - unclear and rambling.” I agree about the clarity of John Cochrane’s writing, both in absolute terms and relative to Michael Woodford. But on this occasion I think Woodford has a more realistic approach. So here is my attempt to explain the issue that both are addressing, and Woodford’s version of learning. The two papers Karl is referring to can be found here and here.

The ‘problem’ that both address is that in the standard New Keynesian model a fixed interest rate policy involves an infinite number of rational expectations equilibrium paths. Another way of saying the same thing is that the initial jump in prices is not tied down, but if you choose to select a starting point the subsequent path would preserve rational expectations. This multiple equilibrium result typically means that macroeconomists would regard this monetary policy regime as problematic, but Cochrane says that there is no logical reason to reject these paths, and Woodford agrees. However Woodford argues that this policy is problematic, because if you choose some particular way of selecting a particular equilibrium (and Cochrane does suggest one), it will not be learnable in the sense Woodford describes. (The idea that indeterminate rational expectations solutions are not learnable is not new, as I note below.)

What is Woodford’s reflexive approach to learning? For me the most intuitive way to describe it is that it is very similar to Fair and Taylor’s method of finding the solution to a dynamic economic model involving rational expectations, although it may be that this just reflects my background. (Woodford’s discussion of how his idea relates to the literature, which opens with this analogy, is very readable and can be found in section 2.4.) The method starts by assuming some arbitrary values for expectations variables in the model, and solves it. This gives a solution to the model conditional on those arbitrary expectations. Now take that solution, and recompute using these solution values as expectations. Iterate until the solution hardly changes, and take that solution as the rational expectations equilibrium. The logic is that if some set of expectations (almost) reproduce themselves in this way, they are (almost) model consistent.

Woodford’s reflexive learning is very similar, although he would impose some arbitrary, and small, cut off for the number of iterations (=n). This has various interpretations, but the one I like is that each period a proportion of the population fully recomputes their expectations assuming rationality (or iterates a large number of times), while others stick to their previous expectations. Another interpretation (which could also have diversity) is to appeal to ‘level k thinking’, which has been observed in experiments. The reflexive learning idea is based on work by Evans and Ramey, and is closely related to the E-stability concept developed by Evans and Honkapohja: Woodford explains why he prefers his approach. Evans and Honkapohja have also applied their learning technique to this very issue, with similar results: see George Evans here for example.

Woodford shows, both analytically and with numerical examples, how the reflexive equilibrium converges to the rational expectations equilibrium as the number of iterations n increases if monetary policy is described by a Taylor rule that obeys the Taylor principle, but does not for a fixed nominal interest rate policy. To quote:

“It is true that under the assumption of a permanent interest-rate peg, the only forward-stable PFE are ones that converge asymptotically to an inflation rate determined by the Fisher equation and the interest-rate target (and thus, lower by one percentage point for every one percent reduction in the interest rate). But for most possible initial conjectures (as starting points for the process of belief revision proposed above), none of these perfect foresight equilibria correspond, even approximately, to reflective equilibria — even to reflective equilibria for some very high degree of reflection n.”

There is much more in the paper, but on the issue of reflective equilibrium a natural conjecture (mine not Woodford) is whether all indeterminate solution paths fail to be a reflexive equilibrium. In other words is this a rationale for ignoring indeterminate solutions, or perhaps more appropriately, designing policy to avoid them? Using the analogy with the Fair-Taylor algorithm, it may depend on the relationship between iterative stability and dynamic stability. When there was much more use of iterative methods for model solution I think there was a literature on this (and it may still be alive), and I seem to remember both similarities but also differences, but beyond that I have no idea.

I am not qualified to address the extent to which Woodford’s idea of a reflexive equilibrium adds to the learning literature, but it is now beginning to look as if the result that a fixed interest rate policy is not stable under learning is robust. As James Bullard says in a recent presentation (HT ‘acorn’ in comments), this may be “a sort of “victory” for the learning literature”. 

Postscript (31/12) See this note from Evans and McGough (in a Mark Thoma post) which I think is consistent with what I say here.         

The FTPL version of the Neo-Fisherian proposition

Probably for macroeconomists

The Neo-Fisherian doctrine is the idea that a permanent increase in a flat nominal interest rate path will (eventually) raise the inflation rate. It is then suggested that current below target inflation is a consequence of fixing rates at their lower bound, and rates should be raised to increase inflation. David Andolfatto says there are two versions of this doctrine. The first he associates with the work of Stephanie Schmitt-Grohe and Martin Uribe, which I discussed here. He like me is not sold on this interpretation, for I think much the same reason. (There is a closely related discussion of the Neo-Fisherian doctrine by John Cochrane, which I will refer to in a subsequent post on Woodford’s recent idea of reflective equilibrium.) But he favours a different interpretation, based on the Fiscal Theory of the Price Level (FTPL).

Let me first briefly outline my own interpretation of the FTPL. This looks at the possibility of a fiscal regime where there is no attempt to stabilise debt. Government spending and taxes are set independently of the level or sustainability of government debt. The conventional and quite natural response to the possibility of that regime is to say it is unstable. But there is another possibility, which is that monetary policy stabilises debt. Again a natural response would be to say that such a monetary policy regime is bound to be inconsistent with hitting an inflation target in the long run, but that is incorrect.

A simple example is a model without sticky prices where bonds are denominated in nominal terms, and a monetary policy that involves a constant nominal interest rate. A constant nominal interest rate policy is normally thought to be indeterminate because the price level is not pinned down, even though the expected level of inflation is. In the FTPL, the price level is pinned down by the need for the government budget to balance at arbitrary and constant levels for taxes and spending.

The idea still works even with sticky prices and indexed debt, as my EJ paper with Tatiana Kirsanova shows. Here the budget is balanced, after a positive shock to debt say, by a period of above target inflation which reduces real government debt through lower real interest rates. This raises a somewhat pedantic point about David’s post. I’m not sure the path he shows for inflation, with no inflation surprises and no period of lower real rates, would be sufficient to stabilise the government’s budget constraint. Unless I have missed something, a period of higher inflation is required to do this. 

However I have a much more serious problem with this FTPL interpretation in the current environment. The belief that people would need to have for the FTPL to be relevant - that the government would not react to higher deficits by reducing government spending or raising taxes - does not seem to be credible, given that austerity is all about them doing exactly this despite being in a recession. As a result, I still find the Neo-Fisherian proposition, with either interpretation, somewhat unrealistic.

Exploring one set of reasons why austerity happened

In a new paper (here or here) based on my talk at the IMK anniversary in Berlin, I discuss the intermediaries between academic economists and politicians. Very few politicians have much knowledge of economics themselves, and so rely on intermediaries to transmit that knowledge. One important intermediary, particularly if you are not in government, is the media, and another is what Paul Krugman called policy entrepreneurs. In government you have the civil service. In the case of fiscal policy, central banks are a potential intermediary.

In the paper I look at how needless austerity could represent a failure in that transmission mechanism. I do not think for one moment that they are as important a reason as political opportunism by those on the right that want a smaller state. But I still think they are important, particularly in helping to explain why so many on the left feel unable to counter the populist line that the government must ‘tighten its belt’ even in the midst of the deepest recession since the war.

It is also important in explaining how opportunist politicians can get away with it. Just imagine if central banks had used their models to quantify the impact of austerity, and had made that analysis public. Imagine also if there had been some authoritative way of conveying the wisdom of the majority of academic economists, like the National Academy of Sciences in the US or the Royal Society in the UK. In the UK and US I think that might have made a difference.        

Is OMT a bluff?

Tony Yates yesterday commented on my two recent pieces on Germany. The second issue he raises, on countercyclical fiscal policy, is I think quite easy to deal with. He may be right that there was general unhappiness with how fiscal freedoms had been abused in the past. But if so, that suggested something very similar to the SGP (i.e. rules designed to reduce debt policed by Brussels), but with an additional countercyclical element. That in particular would have applied pressure on the Irish and Spanish governments before the recession, pressure that the actual SGP notably failed to do.

His discussion of OMT (the ECB acting as a sovereign lender of last resort) suggests OMT is a bluff. The argument is that if, under the protection of OMT, the market still refused to buy a government’s debt, the ECB would be forced to buy it, and because there was the possibility of a loss for the ECB they would not do so. I think this is unlikely in practice and is certainly wrong if it is true.

OMT is not extended to any Eurozone country that gets into difficulties. The ECB has to have the right to say no, leading to almost certain immediate default. The test is whether the government is willing and able to stay solvent. The ECB also has to have the right to withdraw support if conditions change sufficiently to put its earlier judgement in question. That is a good argument for why OMT support should come with some form of conditionality, so as to give the country fair warning that support might be withdrawn.

If the ECB gets that judgement right, then there are no implications for inflation. Just as with QE, the central bank will have created money to buy assets which it will at some point sell off again. In fact the central bank makes profits, because the interest it receives from the government on that debt will exceed the interest it pays on reserves. If the ECB gets it wrong there will be costs, but they are not unlimited: they are simply the amount of debt it bought until it decided to withdraw support. The benefits that OMT provides surely outweigh the expected value of those costs, although I agree with Tony that some in countries that are never likely to require OMT may take a more narrow view. Even then there are no necessary implications for inflation, as Eurozone governments should make good the ECB’s losses.

The most worrying thing in Tony’s post is his suggestion that limits should be applied to the amount central banks outside the Eurozone should provide as a sovereign lender of last resort. Such limits can only do harm. They are based on a myth that independent central banks can stop a highly profligate government from raising inflation. It is a myth because the first thing such a government would do is abolish those limits. More generally, a government that is so profligate that future default was inevitable would have no hesitation in abolishing central bank independence. You cannot stop a government of central bank nightmares. Such limits are therefore either meaningless, or could do harm.  

A crisis made in Germany

The headline in my latest article for The Independent may seem like a wild exaggeration. But if we are talking about a crisis that impacted on unemployment in the entire Eurozone (except Germany) rather than just the periphery, then I think it is reasonable. It was German policy makers that insisted that the Eurozone embark on general austerity in response to problems in the Eurozone periphery. It was the influence of the Bundesbank and others in Germany that helped the ECB raise interest rates in 2011, and delayed a QE programme until 2015. Those two things together created a second Eurozone recession.

Even if we stick to the periphery countries, the crisis outside Greece would have been a lot more manageable if the ECB’s OMT programme (which allowed the ECB to act as a sovereign lender of last resort) had been implemented in 2010 rather than 2012. It is politicians in Germany that have attempted to declare the OMT programme illegal. And none of this touches on the impact of Germany on Greece. I could also add (although it is not in the article) that if the Eurozone had adopted sensible countercyclical fiscal rules from 2000 the scale of the periphery crisis would have been reduced, and Germany had a large role in the deficit focused rules that were actually adopted.

Of course Germany did not make Greek governments behave in a profligate manner. Of course Germany did not force Irish banks into reckless lending. Their own banks may have helped facilitate both, but so did banks in other core countries like France, and in the UK for that matter. Yet German influence helped magnify the periphery crisis, and Germany was central in turning a periphery crisis into an existential event that impacted on pretty well every Eurozone country, except Germany.     

Using economic statistics in an impartial and informed way

The BBC Trust is conducting a review on this issue, and has put out a public call for evidence. I thought I might reproduce my own evidence here because it may be of wider interest. I've decided to do this prior to actually submitting it, so that readers can add in comments any examples that go with the theme of what I am saying that would bolster my case. Note that the review is specifically about the use of statistics rather than economics.

Draft submission

I would just like to make a few specific points about the use of economic and financial data. This data should be presented in a way that informs the public, rather than in a way that is meaningless to everyone except experts, or worse still in a way that fosters some political position.

Unfortunately this standard is not upheld at present. To take just one example, I have seen a well known BBC financial journalist quote, without qualification, numbers for how much UK government debt is increasing every day, in a manner that is clearly designed to suggest that this is a very serious problem. But numbers like this are meaningless on their own. For example, we could do exactly the same for nominal GDP to give a positive impression about the health of the economy. To the layperson any number would seem large, but it would be a meaningless measure of economic health, particular if all the growth was coming from inflation. Needless to say the view that rising debt in nominal terms represent an urgent problem is a political position, and not one shared by many macroeconomists.  

Mistakes like this could be avoided to a large extent by applying some normalisation. To return to the debt example, numbers for debt and deficits should routinely be given as shares of GDP. Economic journalists should also point out that the debt to GDP ratio will not rise if the deficit is positive, but (based on current numbers) only if the deficit as a share of GDP is above something over 3%. An alternative normalisation that would make such figures more meaningful would be to divide them by total household income. Figures for aggregate personal debt should always be normalised with respect to household income, because only then can we really see if rising debt is something we should be concerned about, or just the result of growing incomes

When presenting movements over time, journalists are familiar with the danger of presenting increases in nominal terms, where any growth may just reflect inflation. However in a period like the present with large scale net inward migration, it becomes increasingly important to normalise by the number of people in the economy. The most frequent case where this point is ignored is for GDP growth. Per capita growth is much more relevant for the public, because it is closer to how fast average incomes are growing. Another example is for data on employment: with large inward migration employment will routinely be at record levels. For most purposes some measure of participation is more appropriate.  

The best way on television to put data into historical context is to show a chart. This is occasionally done, but it should happen far more often. I remember watching in despair the coverage of the 2013/4 winter floods, where the Prime Minister repeatedly said that the coalition had maintained previous levels of spending, by including spending committed by the previous administration in the numbers he used. One glance at a chart would show that in reality spending had been cut back sharply in 2011 and 2012, yet I never saw the relevant data shown by the BBC, and I could not find it on the BBC’s website. To their credit, recent Newsnight coverage of the recent floods did show this data.
 

Charts together with normalisation would also put the ‘protection’ given to some departments in recent Budgets and Autumn Statements into context. Health spending is ‘protected’, but if a chart of health spending as a share of GDP is shown, this makes it clear that the planned reduction in spending as a share of GDP coupled with the reductions that have already taken place are unprecedented. Viewers who otherwise may find it difficult to understand why the NHS seems to be in current crisis even though it has been ‘protected’ will immediately understand on seeing this chart. Education spending may be ‘protected’ in real terms, but as the number of pupils is likely to grow real spending per pupil will fall.

Although charts cannot be shown on radio, journalists should have them at their disposal so they can describe their main features, or as ammunition when interviewing politicians. If a chart cannot be shown, historical averages can put figures into context. Consider recent economic growth, using the more relevant and comparable measure of GDP per head. Has growth since 2013 been a real recovery? Showing a chart of growth going back 50 years or so immediately puts such claims into perspective, but failing this merely noting that recent growth is at best close to historic averages suggest that this is no recovery in the normal macroeconomic meaning of that term. (We normally think of a recovery as GDP per head returning to some trend line, whereas recent growth has simply maintained our distance below it.)

This was one example where a failure to put data into context meant that BBC coverage of the election failed to be impartial. Here are two more examples. (A more complete list of what I have called ‘mediamacro myths’ can be found at http://mainlymacro.blogspot.co.uk/2015/04/mediamacro-myths-summing-up.html) The first is the claim, repeated endlessly by Conservatives, that they had to clear up the mess left by Labour profligacy. The claim was absolutely central to their attempt to blame the previous Labour government for austerity. This claim was echoed by the right wing press, and largely believed by much of the electorate.

While it was true that in the last few years of his Chancellorship Gordon Brown did slightly bend the rules to achieve his fiscal targets, there is no way under any conceivable definition that this could be called profligate behaviour. In no conceivable way did it put the economy at risk, or require substantial austerity to correct it. The Conservative claim was therefore false, but I do not recall it ever being challenged on the BBC. Once again simply showing a chart for the debt or deficit relative to GDP over time would have gone a long way to establishing this point.

The second relates to the necessity of reducing the deficit quickly. It was austerity over the first two years of the coalition government that help stall a nascent recovery: OBR analysis suggests GDP growth was reduced by about 1% as a result of fiscal consolidation in both those first two years (figures which I never recall seeing quoted on the BBC, still less used to challenge George Osborne) . The justification given by the government for this was that austerity was needed to restore the ‘trust of the markets’. The BBC appears to have relied on economists working in the financial sector to support this claim. Unfortunately this source is biased, both politically, and in its own self interest: playing up the unpredictability of the markets fosters their self-appointed position as ‘high priests’.

At the very least journalists should have consulted those in the academic community more about this claim. (There is, for example, a widely held view among academics that since the recession there has been an acute shortage of safe assets like government debt.) However some simple use of data would have thrown doubt on the idea that the UK was about to suffer a debt funding crisis. Interest rates on government debt were lower in 2009 and 2010 compared to 2007 or 2008, both in absolute terms and relative to US rates. If you look at rates just before and after the election, they show no impact from the election result: if rates were being driven by prospective deficit levels then you would expect them to fall immediately after the election. By failing to use these simple statistics to challenge the government’s narrative the BBC failed to be impartial.