Defending rational expectations

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

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

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

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

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

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

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

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

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

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

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

The real problem with German macroeconomic policy

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Something we can all agree on?

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

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

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

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

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

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

Politicians are (not) all the same

Chris Giles wrote about a month ago that “Britain will not have much of a choice at the 2015 election. However much they talk about clear differences, the parties have rarely been closer on economics”. He will probably hate me for saying this, but I was reminded of his article when I watched this interview between Jeremy Paxman and Russell Brand. The common theme, which Chris Dillow also picks up, is that the current political system offers no real choice.

This theme, common on the left, has a long pedigree. I remember being told to stop being exercised by hanging chads in 2000 because a Gore presidency would be very much like a Bush presidency. This idea is clearly ludicrous if we look at US politics today. But does it apply to the UK? I’m afraid I’m going to be very unforgiving. It either represents naivety or indulgence.

Chris Giles has grounds for his view, in that on issues like austerity Labour are trying hard not to appear very different from the current coalition. On the other hand, if you are struggling to ‘pay the bedroom tax’, Labour’s commitment to abolish it could make a big difference to your life. He may also be right that the actual content of Ed Miliband’s conference proposals on energy and housing are modest, and hardly the return to full bloodied socialism that some on the right hysterically proclaim. The governments ‘Help to Buy’ scheme is much more likely to involve a prolonged period of government intervention in a market. But I think if you were to conclude from this that a Labour government after 2015 would have a similar economic policy to a Conservative government, you would be being very naive.

Consider two big dividing lines between left and right on economic policy: the size of the state and the distribution of income. On the first, there are strong arguments that the current government’s austerity programme is not so much about the perils of high debt but a deliberate attempt to roll back the size of the state. Is it really likely that Labour would continue that policy if it was elected? It is much more likely that we would see a repeat of what happened under the last Labour government: an initial period of sticking to inherited plans to demonstrate prudence, and then a programme of real growth in areas like health and education. On the second, as I outlined here, the current government’s policies will lead to a significant increase in poverty over the next decade. When it was last in power, Labour tried very hard to achieve the opposite (although I agree it was much more concerned about poverty than inequality). Is it really likely that Labour will behave quite differently, and much more like the Conservatives, if they regain power?

Now you could argue that the financial situation of the government will remain so dire after 2015 that any government will be forced to keep cutting spending and welfare. Maybe. However I think it is more likely that the economic recovery will turn out to be much stronger than currently forecast, and that the OBR will revise up their estimate of potential output as this happens. This will create 'fiscal space'. If this occurs under the Conservatives, I would put my money on significant tax cuts, while under Labour we will see many of today’s cuts in spending and welfare reversed.

Another way of making the same point is that it is naive to believe politicians when they set out their political programmes. In a two party system within the framework of a simple left/right scheme, it may be optimal as an opposition to position yourself just to the side of your opponent, as long as this does not alienate your core vote. Once you regain power you can revert to type. (Remember Cameron’s compassionate conservatism before the last election.) The problem with that dynamic is that it may lead to the appearance that ‘all politicians are the same’ as we move towards an election, which may discourage some ‘rationally naive’ potential voters (those who are not too interested in politics) from voting. (It may also generate such a negative view of politicians that it leads otherwise sane people into rather silly positions.)

It is clear that Russell Brand is not disinterested in politics, so he should not be so naive. He seems pretty passionate about issues like equality and climate change, so it seems blindingly obvious to me who he should vote for. So why does he appear to encourage others not to vote? The argument of the true revolutionary is that anything that makes the current system more palatable just delays the revolutions eventual triumph. But that need not be what is going on here. Instead it could be a reluctance to be associated, however mildly, with a political party that is far from your political ideal (even though it is not quite as far from your ideal as the others). The number of times I have heard someone say: ‘Even though I hate party B, I couldn’t possibly vote for A because of their position on X’. But as I have argued above, the gap between parties A and B (and C) can make a significant difference when one gains power. So to refuse to vote for A because it makes you feel somehow complicit in the aspects of A’s platform you do not like seems to me just personal indulgence.

This is not to dispute that many like Brand or Dillow feel that we require much more radical change than is offered by mainstream politics. They should continue to use the media to promote that view when they can. But for people like them, working out which political party is the least bad is fairly costless. Using this knowledge to vote, and making this knowledge public, does not compromise their more radical views, and it could help make a significant difference to many peoples’ lives. 

The ‘official’ cost of austerity

Well, not quite, but probably as close as we will ever get.[1] In a new paper, Jan in‘t Veld uses the European Commission’s QUEST model to estimate the impact of fiscal consolidation in the Eurozone (EZ) from 2011 to 2013. The numbers in the table below include spillover effects from other EZ country fiscal consolidations, so they are best interpreted as the impact of overall EZ fiscal consolidation over this period. There are at least two important things to note about the exercise. First, they do not attempt to analyse the impact of the particular mix between cuts in spending and increases in taxes applied in each country. Instead the ‘input’ is simply the change in the general government primary structural balance each year, which is assumed to be equally balanced between expenditure and revenue measures. (More on this below.) Second, to a first approximation this fiscal consolidation is assumed to lead to no change in short or long term real interest rates during the 2011-13 period.

GDP losses due to Eurozone fiscal consolidation (including spillovers) 2011-13. Source European Economy Economic Papers 506, Table 5.

	Impact on GDP 2013	Cumulative Impact 11-13
Germany	3.9%	8.1%
France	4.8%	9.1%
Spain	5.4%	9.7%
Ireland	4.5%	8.4%
Greece	8.1%	18.0%

Of course many would argue that had countries like Spain or Greece not undertaken this degree of austerity, long term interest rates might have been even higher than they actually were. (Perhaps short rates might have also been higher, if with stronger growth the ECB had raised short rates, but remember that tax increases also helped raise EZ inflation.) However a significant amount of fiscal consolidation took place in Germany, and this had significant spillover effects on other EZ countries. It is difficult to see why that consolidation was required to ease funding pressures.

One slightly surprising aspect of the exercise has already been noted. To quote: “As detailed information about the composition of the actual consolidations is not available, it is assumed the composition is equally balanced between expenditure and revenue measures.” As other institutions like the IMF publish exactly that kind of information, I’m puzzled. What the paper does report is that QUEST shows that consolidation implemented through spending cuts has about twice the short run multiplier as consolidation through higher taxes, but of course this is exactly what theory would suggest. In a forward looking model like this it also matters a great deal how agents perceive the permanence of these policy changes.

Of course QUEST is just one DSGE model, which just happens to be maintained by the Commission. An earlier study (pdf) by Holland and Portes at NIESR had important differences in detail, but the bottom line was similar: EZ GDP was 4% lower in 2013, and the cumulated GDP loss was 8.6%. These numbers are of course large, and so it is quite reasonable to say that the proximate cause of the second EZ recession is simply austerity.

Now many would argue that much of this was forced by the 2010 crisis. There seems to be a mood of fatalism among many in Europe that this was all largely unavoidable. I think that is quite wrong. Some fiscal tightening in Greece was inevitable, but if EZ policy makers had taken a much more realistic view about how much debt had to be written off, we could have avoided the current disaster. What ended the EZ crisis was not austerity but OMT: if that had been rolled out in 2010 rather than 2012, other periphery countries could also have adjusted more gradually. And of course fiscal consolidation in Germany and some other core countries was not required at all. If instead we had seen fiscal expansion there, to counter the problem of hitting the ZLB, then the overall impact of fiscal policy on EZ GDP need not have been negative. (Section 5 of Jan in‘t Veld’s paper looks at the impact of such a stimulus.) That means that over 3 years nearly 10% of Eurozone GDP has been needlessly lost through mistakes in policy. This is not the wild claim of a mad macroeconomist, but what simple analysis backed up by mainstream models tell us.

One final point. The UK equivalent to these ‘official’ numbers are the OBR’s estimates of the impact of fiscal consolidation on the UK. While they are significant in size, they are smaller than these EZ numbers. The OBR estimate that UK GDP in 2013 is about 1.5% lower as a result of fiscal consolidation, and the cumulated GDP loss due to fiscal tightening from 2010 to 2013 is a bit above 5%. There is a good reason and a bad reason for this difference. First, the UK is a more open economy than the EZ as a whole, and we would expect openness to cushion the impact of fiscal consolidation. Second, the OBR’s numbers are more crudely derived, based on multipliers that take no account of the zero lower bound or deep recession. The numbers from the QUEST model allow for both, which of course raises the size of the fiscal impact. 

[1] As the disclaimer says, “The views expressed are the author’s alone and do not necessarily correspond to those of the European Commission.” A good example of the official line is Buti and Carnot, but this line does not tend to be backed up by model simulations, which I think is revealing. 

Rational expectations, the media and politics

As those of you who have read a few of my posts will know, on the occasion that I venture into political science I like to push the idea that the attitudes and organisation of the media are an important part of trying to understand the political dynamic today. (See for example here and here, but also here.) To put it simply, the media help cause changes in public opinion, rather than simply reflect that opinion. Yet, if you have a certain caricature of what a modern macroeconomist believes in your head, this is a strange argument for one to make. That caricature is that we all believe in rational expectations, where agents use all readily available information in an efficient way to make decisions. If that was true when people came to form political opinions (on issues like immigration, or crime, for example), then information provided by media organisations on these issues would be irrelevant. In the age of the internet, it is fairly easy to get the true facts.

Some who read my posts will also know that I am a fan of rational expectations. I tend to get irritated with those (e.g. some heterodox economists) that pan the idea by talking about superhuman agents that know everything. To engage constructively with how to model expectations, you have to talk about practical alternatives. If we want something simple (and, in particular, if we do not want to complicate by borrowing from the extensive recent literature on learning), we often seem to have to choose between assuming rationality or something naive, like adaptive expectations. I have argued that, for the kind of macroeconomic issues that I am interested in, rational expectations provides a more realistic starting point, although that should never stop us analysing the consequences of expectations errors.

So why do I take a different view when it comes to the role of the media in politics? The answer simply relates to the costs and benefits of obtaining information. If you are trying to think about how consumers will react to a tax cut, or how agents in the FOREX market make decisions, you are talking about issues where expectation errors will be costly to the individual agents involved. So there are benefits to trying to gather information to avoid those mistakes. Compare this to political issues, like whether the government should be taking action over climate change. What are the costs of getting this wrong for the individual? Almost negligible: they may cast their vote in the wrong way. Now for society as a whole the costs are huge, but that is not the relevant thought experiment when thinking about individual decisions about whether to be better informed about climate change. Most people will reason that the costs of being better informed are quite high relative to the expected benefit, because the impact of their vote on the actual outcome of an election is negligible. [1]

Which is why, as Paul Krugman often reminds us, most people do not spend much time (on the internet or elsewhere) gathering information about issues like climate change, crime or immigration. That is a rational decision! They do, however, engage with media for other reasons, and are therefore likely to pick up information from there at little cost. So if the media distorts information, it matters.

That is my a priori conjecture, but what about evidence? Take opinions about climate change in the US. As this study (pdf) shows, a distressingly large proportion (45%) of those polled thought that there is “a lot of disagreement among scientists about whether or not global warming is happening”, whereas in fact there is near unanimity among scientists. Now you could I suppose argue that this misperception had nothing to do with Fox News or talk radio, but just reflected the fact that people wanted to believe otherwise. But that seems unlikely, as you could more easily believe that although climate change was happening, the costs of doing anything about it outweighed the benefits. Certainly those institutions dedicated to climate change denial think beliefs about the science are important.    

Here in the UK is a survey that Ipsos MORI conducted for the Royal Statistical Society and King’s College London (HT Tim Harford). The survey highlights the misperceptions they found, and in some cases errors were huge. To give two examples, the public think that £24 out of every £100 spent on benefits is claimed fraudulently, compared with official estimates of £0.70 per £100, and people think that 31% of the population are immigrants, when the official figure is 13%. In contrast, estimates of the number of people who regularly read a newspaper, or had a facebook account (where people probably had to draw on their own experience rather than stories in the media), were much more accurate.

These surveys certainly suggest that people’s views on at least some key issues are based on perceptions that can be wildly inaccurate. The UK survey also suggests there is an understandable tendency to overestimate things that are ‘in the news’: the level of unemployment was overestimated (pdf) by a factor of 2 or 3, the number of UK Muslims by a factor of 4 or 5, whereas the estimated proportion of those living in poverty was pretty close to the true figure. But it is also striking that the really wild misperceptions were on issues that tend to receive disproportionate tabloid coverage: apart from the benefit fraud example quoted above, we have

“people are most likely to think that capping benefits at £26,000 per household will save most money from a list provided (33% pick this option), over twice the level that select raising the pension age to 66 for both men and women or stopping child benefit when someone in the household earns £50k+.  In fact, capping household benefits is estimated to save £290m, compared with £5bn for raising the pension age and £1.7bn for stopping child benefit for wealthier households.”

One final point. Some of the comments on my recent post on this issue said, in effect, how typical of those on the left [2] to think that people who hold views they don’t like must have been brainwashed. But of course there are plenty on the right (almost certainly more than on the left) who spend a lot of their time complaining about media bias the other way. The refrain about liberal bias in the US media is ubiquitous, and in the UK it is mainly right wing think tanks and politicians who go on about BBC bias. And if you think that is because the BBC is biased (towards Labour, Europe etc), then unfortunately the facts suggest otherwise, as Mike Berry outlines here. In fact, if you are looking for people who honestly believe the media is not that important politically, I suspect you will find more of them on the left than the right. But wherever they come from, I think they are mistaken.

[1] Of course elections are fought over many issues, which just reinforces this point. People are also increasingly likely to be apathetic about the political process, often because ‘all political parties seem the same’. I want to talk about this view in a subsequent post.

[2] I should note that on this blog I have never said how I vote, or advised others to vote in any way. I try to either focus on the macroeconomics (and criticise politicians only when they get this wrong), or to focus on understanding political trends when I stray beyond economics. I have no problem with others doing political advocacy, as long as they are honest about it, but it is not my comparative advantage so I try and avoid it. I have of course been highly critical of the current coalition’s macro policy, but if it was a Labour government undertaking austerity (as it might have been) I would be just as critical of them. If you think I’m to the left because (a) I think policy should be evidence based, or (b) because I do not like the fact that current government policy is knowingly raising UK poverty, and (c) because I think climate change is a critical problem, then all I would say is that either you are being unfair to the political right, or that this says something really worrying about where the right is just now. 

In defence of forward guidance

Although this post is prompted by the bad press that the Bank of England’s forward guidance has been getting recently, much of what I have to say also applies to the US, where the policy is very similar. But there is one criticism of the policy in both countries that I agree with which I will save that until the end.

A good deal of the criticism seems to stem from a potentially ambiguity about what the policy is designed to do. The policy could simply be seen as an attempt to make monetary policy more transparent, and I think that is the best way to think about it in both countries. However the policy could also be seen as a commitment to raise future inflation above target in an attempt to overcome the ZLB constraint as suggested by Michael Woodford in particular [1]. Let’s call this the Woodfordian policy for short. (John Cochrane makes a similar distinction here.)  Ironically the reason why it helps with transparency is also the reason it could be confused with the Woodfordian policy.

In an earlier post written before the Bank of England unveiled its version of forward guidance, I presented evidence that might lead those outside the Bank to think that it was just targeting 2% inflation two years out. We could describe that as the Bank being an inflation forecast nutter, because it gave no weight to the output gap 2 years out. An alternative policy is the conventional textbook one, where the Bank targets both inflation and the output gap in all periods. I suggested that if the Bank published forward guidance, this could clearly establish which policy it was following. It has and it did: we now know it is not just targeting 2% inflation 2 years out, because it says it will not raise rates if forecast inflation is expected to be below 2.5% and unemployment remains above 7%. 2.5% is not hugely different from 2%, but in the world of monetary policy much ‘ink’ is spilt over even smaller things.

So forward guidance has made things clearer, as long as you do not think monetary policy is trying to implement a Woodfordian policy. Unfortunately if you really believed a central bank was an inflation forecast nutter, then you could see forward guidance in Woodford terms. Now I think there are good arguments against this interpretation. First, 2.5% is an incredibly modest Woodfordian policy. Second, for the US, there is a dual mandate, which would seem to be inconsistent with being an inflation forecast nutter. Third, for the UK, the MPC has made it pretty clear (most recently here) that it is not pursuing a Woodfordian policy. For all these reasons, I think it is best to see forward guidance as increasing transparency.

For those who just want to know whether monetary policy changes represent stimulus or contraction, this can be confusing. We saw this in the UK with the questioning of Mark Carney by the Treasury Select Committee, and Tony Yates has pursued a similar theme. Mark Carney kept saying that the stance of monetary policy is unchanged, but forward guidance makes monetary policy more ‘effective’. Now you could spend pages trying to glean insights into disagreements among the MPC from all this, and I do not want to claim that the Bank is always as clear as it might be here. However it seems to me that if the Bank wants for some reason to call reducing uncertainty increasing effectiveness, then there is nothing wrong with what Carney is saying. Forward guidance helps agents in the economy understand how monetary policy will react if something unexpected happens. In particular, growth could be stronger than expected (UK third quarter output has subsequently increased by 0.8%), but the decline in unemployment could remain slow (it fell from 7.8% to 7.7% over the last three months). Charlie Bean makes a similar case here. [2]

In much of the UK media forward guidance has been labelled a failure because longer term interest rates went up as forward guidance was rolled out. Now if you (incorrectly) see forward guidance as a Woodfordian policy, you might indeed be disappointed that long rates went up (although you would still want to abstract from other influences on rates at that time). However if it is about clarifying monetary policy in general, no particular movement in long rates is intended.

Ironically, some of the apparent critics of forward guidance in the UK, like Chris Giles here, also think the Bank of England could be much more transparent in various ways. The most comprehensive list is given by Tony Yates, and I agree with much of what he says. But we all know that central banks are very conservative beasts, and do things rather gradually. So any improvement in transparency is going to be incremental and slow. When they do happen, in this case through forward guidance, they should be welcomed rather than panned. Criticising innovation by central banks risks fuelling their natural conservatism.

This suggests that the major weakness with forward guidance is that it does not go far enough. In the current context, as events in the US have shown, the major problem is that it applies only to interest rates and not to unconventional monetary policy. This allowed the market to get very confused about what the Fed’s future intentions about bond buying are. So why not welcome forward guidance by saying can we have more please.  

[1] Gauti B. Eggertsson & Michael Woodford, 2003. "The Zero Bound on Interest Rates and Optimal Monetary Policy,"Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 139-235. See also Krugman, Paul. 1998. “It’s Baaack! Japan’s Slump and the Return of the Liquidity Trap.” BPEA, 2:1998, 137–87.

[2] If you wanted to be pedantic, you could argue that to the extent that some thought growth might be faster than expected, and that this would lead to higher rates even if unemployment remained high, then dispelling this particular possibility must mean that averaged across all states of the world policy has become more stimulatory. Carney might not want to acknowledge that because some on the MPC would get upset. My reaction to this would be, why do you want to be pedantic.