Aggregate demand and the labour market

I’m surprised I do not see a diagram like this more often:

The black lines are familiar from any introductory macro textbook. There is a labour supply curve. It is drawn such that a higher real wage encourages more labour supply, but I will consider what happens if it is vertical later. What I call the ‘unconstrained labour demand’ curve is what firms would choose to do if (a) labour gets less productive as output increases (which is why the curve slopes downward), and (b) firms can sell whatever they like. This is the classical model, and you will find this diagram in nearly every introductory textbook. With flexible wages the level of employment is determined at the intersection of the two curves, and we could call it the ‘natural’ employment level.

However (b) is a fiction. No (surviving) firm produces what it wants to, irrespective of whether people want to buy its product. Aggregate demand can diverge from the level of output implied by the intersection of the two black curves for all kinds of reasons: Says Law does not hold. For simplicity, suppose the aggregate demand for goods in the economy is independent of the real wage, and there is no factor substitution. In that case employment is determined by my red line - it is determined only by aggregate demand. This is pretty clear in the case that I have drawn, where we have deficient aggregate demand. Firms produce what they can sell: they would like to sell more, but there is no point producing more if no one wants to buy more.

It is less clear what happens if the red line shifts right until we have excess aggregate demand. If the number of firms is fixed, why would they produce more than they want to - i.e. at a level where they are losing money on the extra products they are producing? In New Keynesian models where firms are monopolistic and prices are sticky they will produce more if excess demand is modest, because for given prices it is profitable to produce more up to some limit. But will firms be prepared to pay higher (e.g. overtime) wages to workers for long, or will workers be prepared to work more for unchanged wages for long? I will come back to this at the end.

If there is deficient demand, is there anything that makes the red line move right to achieve the natural employment level? With deficient demand, prices may tend to fall, but that alone is unlikely to shift the red line to the right: few people talk about Pigou effects anymore, and the general concern is that deflation is deflationary because the real value of debt has increased. It is monetary policy that shifts the red line in the required direction, either because it responds to falling prices or because it wants to reduce the output gap. Ironically, Real Business Cycle models, which assume the red line is always at the natural employment level, only make sense in a world where monetary policy is very efficient. However, monetary policy does normally work over the medium term, which is why the classical or RBC model makes sense if we are just doing medium/long term analysis.

What happens to the real wage? In the most basic of New Keynesian models, the labour market clears, which means real wages fall until the labour supply curve intersects the red line. (Here a vertical supply curve would be a problem.) If, in contrast, real wages were sticky, we would get involuntary unemployment - rationing in the labour market. Which is true matters a great deal to those unemployed, but it terms of modelling deviations from the natural rate the difference is not that great. Real wages have no direct impact on aggregate demand, and so all that might happen is that monetary policy could be influenced one way or the other. If it is not, what happens to real wages is irrelevant to the basic problem, which is deficient aggregate demand. This is one reason why New Keynesian economists may be happy to work with a model where the labour market clears, but there may be other reasons.

The vertical red line assumes no factor substitution. With factor substitution it can become downward sloping: falling real wages lead firms to substitute labour for capital, which can increase employment even if output is unchanged because aggregate demand is unchanged. As I speculate in this post, based on the work of Pessoa and Van Reenen, something like this could help explain the current UK productivity puzzle. If this speculation is correct, at some point as aggregate demand and investment expands real wages will rise, and labour productivity will increase as factor substitution is reversed.

I was prompted to write this post by this from Noah Smith, which in turn comments on a post by John Quiggin. (See also Mike Konczal and Nick Rowe.) They talk about models of labour market matching, which I have not mentioned, but similar considerations apply with matching models taking the place of the classical model (although there are key differences between the two). This gives me another chance to plug an AER paper by Pascal Michaillat, which addresses the possible asymmetry that may occur when we have excess demand. Michaillat’s model is a matching model when aggregate demand is strong, but a rationing model (with Keynesian involuntary unemployment) when aggregate demand is low. This is one, rather interesting, answer to the question I asked above about possible asymmetry. Putting matching together with Keynesian rationing is complicated, but if Michaillat’s paper is ignored just for this reason, that says something rather sad about current macro methodology. 

Has the Great Recession killed the traditional Phillips Curve?

Before the New Classical revolution there was the Friedman/Phelps Phillips Curve (FPPC), which said that current inflation depended on some measure of the output/unemployment gap and the expected value of current inflation (with a unit coefficient). Expectations of inflation were modelled as some function of past inflation (e.g. adaptive expectations) - at its simplest just one lag in inflation. Therefore in practice inflation depended on lagged inflation and the output gap.

After the New Classical revolution came the New Keynesian Phillips Curve (NKPC), which had current inflation depending on some measure of the output/unemployment gap and the expected value of inflation in the next period. If this was combined with adaptive expectations, it would amount to much the same thing as the FPPC, but instead it was normally combined with rational expectations, where agents made their best guess at what inflation would be next period using all relevant information. This would include past inflation, but it would include other things as well, like prospects for output and any official inflation target.

Which better describes the data? The great attraction of the FPPC is that it can describe stagflation. We have a boom, which while it lasts steadily raises inflation. When the boom comes to an end, inflation stabilises, but at a much higher level than it began. So policy has to engineer a recession to get inflation back down again: a period in which above average unemployment is accompanied by above average inflation, which we call stagflation. If over this period we had had credible independent central banks setting inflation targets, the NKPC would not give us stagflation: when the boom came to an end, inflation would return to target. (For more explanation, see this post.) The trouble is we did not have inflation targeting during this period, so it is difficult to tell whether stagflation is evidence against the NKPC. (As an example of this ambiguity, see this survey of the empirical evidence by Nason and Smith. This enabled Robert Gordon to be quite supportive of the FPPC in 2009.)

The Great Recession could provide a much better test. In some countries output fell sharply in 2009, but has since seen a slow but steady recovery, such that the output gap today is less than it was in 2009. With the FPPC, inflation should have been steadily falling over this period, reaching its lowest level today. So if we plotted the output gap (x axis) and inflation (y axis) together, we should see a line pointing South East. With the NKPC, we can consider two polar cases. In the first, agents fully anticipate that the recovery will be slow, so we will get a sharp immediate fall in inflation, but subsequently inflation will rise towards the target. That will give us a line pointing North East. In the second, agents keep thinking inflation will return to target next year. That also gives us a line pointing North East, but it is flatter. [Postscript - I should have added that this last gives us what Krugman calls the Neo-paleo-Keynesian Phillips curve.]

Here is this plot for four countries, using OECD estimates for the output gap on the horizontal axis, consumer price inflation less 2% on the vertical axis, and OECD forecasts for 2014 and 2015. I’ve chosen these countries simply because in most of Europe we had a double dip recession, which is a more complicated experiment. If you do not like the idea of including forecasts, just ignore the last two points for each country.

The lines point North East, not South East. This gives more support to the rational expectations NKPC than the adaptive expectations FPPC. To take just one example, US inflation in 2013 is higher than it was in 2009, which is consistent with the NKPC. The traditional FPPC, on the other hand, would suggest that after a string of negative output gaps, US inflation should be a lot lower in 2013 than it was in 2009.

OK, now the caveats. Commodity prices will have an important influence on the CPI, and these are not part of either simple Phillips curve story. They may help explain the blip in inflation around 2011 in some countries, but they also helped depress inflation in 2009. Exchange rate changes will also matter. The simple Phillips curve also takes no account of non-linearity caused by a reluctance to cut nominal wages. And of course estimates of the output gap may be wrong.

In the case of Japan, we also had a recent increase in the inflation target. This may explain the forecast upward shift in inflation in 2014/5. If it does, that is clear evidence in favour of rational rather than adaptive expectations. 

All these caveats point to the need to do more empirical analysis. Nevertheless we can see why some more elaborate studies (like this for the US) can claim that recent inflation experience is consistent with the NKPC. It seems much more difficult to square this experience with the traditional adaptive expectations Phillips curve. As I suggested at the beginning, this is really a test of whether rational expectations is a better description of reality than adaptive expectations. But I know the conclusion I draw from the data will upset some people, so I look forward to a more sophisticated empirical analysis showing why I’m wrong.

Why macroeconomists, not bankers, should set interest rates

More thoughts on the idea that interest rates ought to rise because of the possibility that the financial sector is taking excessive risks: what I called in this earlier post the BIS case, after the Bank of International Settlements, the international club for central bankers. I know Paul Krugman, Brad DeLong, Mark Thoma, Tony Yates and many others have already weighed in here, but - being macroeconomists - they were perhaps too modest to draw this lesson.

To most macroeconomists, the theory of monetary policy is pretty straightforward. Interest rates should be set at a level which closes the output gap, which can be defined as the level of output and unemployment that will keep underlying inflation constant. We can call this real interest rate the Wicksellian natural rate. The difficulty is not in the concept, but in the practice of putting numbers to this concept when inflation is noisy, the output gap is hard to estimate, there are lags in the system etc etc.

But, respond those putting the BIS case, wasn’t that what monetary policymakers thought they were doing in 2007, and look what happened next. Monetary policy cannot afford to ignore the financial sector, and the risk of excessive lending and bubbles that subsequently blow up the economy. There are signs, they say, that what happened in 2007/8 may be happening again now, so we need to raise rates to prevent another crash, even though there is still a negative output gap and inflation is below target.

Which might seem plausible, until you notice what is going on here. The implication is that a financial crisis only happens because interest rates are set at the wrong level. The Great Recession was all the fault of the Fed, who kept interest rates too low after the 2001 recession. The gradual deregulation of the financial sector in the decades before? - not an issue. The widespread misselling of subprime mortgages? - these things happen. All the other examples of misselling and fraud? - boys will be boys. An industry that profits from a massive implicit public subsidy? - we see no subsidy. Classifying subprime products as AAA? Massive increases in bank leverage in the 00s? - all the result of keeping interest rates too low.

When those putting the BIS case tell you that macroprudential controls (a.k.a. financial regulations) are ‘untested’ and ‘uncertain in their impact’, what they are really saying is that the financial system cannot be regulated to make it safe when interest rates are low. There is no evidence for that proposition, and a lot of history that says otherwise. We do not have to accept a deregulated financial sector which has the power at any moment to derail the real economy. But of course most working in the financial sector hate regulation. They have an interest in perpetuating different stories about the Great Recession. If you spend too much time around bankers, there is a danger that you come to believe these self-serving stories.

But, you might say, what harm would a modest increase in interest rates do? Again, basic macroeconomics, which I have not seen anyone putting the BIS case address. Raising rates implies in current circumstances a larger negative output gap, which will reduce inflation further below its target. As happened in Sweden, and accurately predicted by macroeconomist Lars Svensson. Two things could then happen. First, interest rates come back down again (in Sweden’s case by outvoting the governor for the first time since it gained its independence in 1999), but the cost of lost resources and higher unemployment created in the meantime can never be redeemed. Second, interest rates stay high for long enough that the public will conclude that the inflation target has in reality been revised down, and we risk converging to a deflationary steady state (technical discussion here), or in non-technical terms a Japan-like lost decade or more of low output and deflation.

To see clearly why this makes no sense, consider the symmetric case. Suppose someone argued, when inflation was above target, that we should not raise rates, but instead allow the output gap to be positive. I suspect those currently making the BIS case would scream disaster – it is the 1970s all over again. So why is that wrong but doing the same thing in reverse OK? In fact it is worse than that. If long run expected inflation rises, a central bank can always signal its true inflation target by sharply raising rates. In the opposite case it may not be able to, because of the Zero Lower Bound.

I like to praise the current UK government when I can. In setting up a Financial Policy Committee that is separate from the Monetary Policy Committee they did exactly the right thing. This formalises an assignment: macro prudential policy to control financial sector excess, and interest rates to control demand and inflation. Most macroeconomists know this makes sense. But the financial sector has a pecuniary interest in pretending otherwise. Those that get too close to that sector should be kept well away from setting interest rates. 

Hitting the poor and the disabled

In the UK, Wales has a degree of regional autonomy. This has helped shed some light on two aspects of UK government policy: taking income from the disabled and the working poor.

The Welsh government asked the highly respected Institute of Fiscal Studies (IFS) to examine the cumulative impact of the coalition government’s tax and benefit reforms up until April 2015. Ideally we would like such an assessment for the UK, but the government has said this would be ‘difficult’ and ‘meaningless’. However there is no reason why findings for Wales should be very different to the UK as a whole, and the Welsh government - run by Labour - had no inhibitions asking the IFS to do this for Wales.

In terms of income distribution, the report’s findings are summarised in this chart.

Summary of gains and losses across the income distribution, 2014–15 prices. From “The distributional effects of the UK government’s tax and welfare reforms in Wales: an update” by David Phillips, IFS.

The chart speaks for itself, except to say that UC and PIP stand for the new Universal Credit and Personal Independence Payments schemes, which will not have their full impact until beyond 2015.

The study also looks at how this breaks down among particular groups. Pensioners fare relatively well, losing only 0.5% of income as a result of all these changes. In contrast the working age disabled are hit relatively badly, suffering on average a 6.5% loss. Yet this loss may pale into insignificance compared to the fear that has been created by the government’s new assessment procedures, contracted out to private firms whose methods are confidential. (See also these case studies by Demos, and Alex Marsh and the Economist on the government’s welfare reform in general.)

You might cynically think that this kind of thing is an inevitable result of austerity, where help to the poor and disabled is considered a luxury that society can no longer afford. Certainly the UK is not alone here. However the second policy has nothing to do with austerity. As part of its drive to reduce ‘red tape’, the government abolished the Agricultural Wages Board (AWB), the last surviving wages council which set minimum terms and conditions for agricultural workers. The government’s argument was that the Board hindered ‘flexibility’ in the labour market, and that it duplicated the role of the national minimum wage.

The last argument is simplistic. Although the AWB set a basic hourly rate very similar to the national minimum wage, it also set overtime rates, which as anyone living near a farm will know are particularly relevant to farm workers. The importance of this can be found from the government’s own impact assessment of abolition, which suggests a transfer of as much as £33.4 million from farm workers to farm owners as a result of abolishing the AWB. (Farm workers are poorly paid on average: in 2011 the average wage was £8.17 per hour, compared to a minimum wage of £6.08.)

As to the need to increase market flexibility by reducing external intervention, this is particularly rich given the scale of public subsidies received by this sector. This government has fought hard to maintain the subsidies from Europe that go to large farms, so no free market there. Farm workers themselves are particularly powerless compared to their employers, which is why the AWB was the one wages council that the previous Conservative government did not abolish in 1993.  

What has this got to do with Wales? The Welsh government argued that it had the power to keep an AWB for Wales. The UK government disagreed, and took this all the way to the Supreme Court, but last Wednesday it lost. So Welsh farm workers will retain some protection.

I would love to say that these two cases are isolated examples, but they are not. Conservative ministers have recently proposed additional restrictions on the right to strike, requiring over 50% of all eligible members to vote in favour of strike action before a strike can be called. As Steven Toft says, this is a strikingly stupid idea, and is essentially just an attempt to further weaken an already weak trade union movement. In terms of the future of the welfare state, the Chancellor’s plans for future austerity require yet further reductions. With pensions protected, this means the disabled will be in the firing line once again.   

Rereading Lucas and Sargent 1979

Mainly for macroeconomists and those interested in macroeconomic thought

Following this little interchange (me, Mark Thoma, Paul Krugman, Noah Smith, Robert Waldman, Arnold Kling), I reread what could be regarded as the New Classical manifesto: Lucas and Sargent’s ‘After Keynesian Economics’ (hereafter LS). It deserves to be cited as a classic, both for the quality of ideas and the persuasiveness of the writing. It does not seem like something written 35 ago, which is perhaps an indication of how influential its ideas still are.

What I want to explore is whether this manifesto for the New Classical counter revolution was mainly about stagflation, or whether it was mainly about methodology. LS kick off their article with references to stagflation and the failure of Keynesian theory. A fundamental rethink is required. What follows next is I think crucial. If the counter revolution is all about stagflation, we might expect an account of why conventional theory failed to predict stagflation - the equivalent, perhaps, to the discussion of classical theory in the General Theory. Instead we get something much more general - a discussion of why identification restrictions typically imposed in the structural econometric models (SEMs) of the time are incredible from a theoretical point of view, and an outline of the Lucas critique.

In other words, the essential criticism in LS is methodological: the way empirical macroeconomics has been done since Keynes is flawed. SEMs cannot be trusted as a guide for policy. In only one paragraph do LS try to link this general critique to stagflation:

“Though not, of course, designed as such by anyone, macroeconometric models were subjected to a decisive test in the 1970s. A key element in all Keynesian models is a trade-off between inflation and real output: the higher is the inflation rate, the higher is output (or equivalently, the lower is the rate of unemployment). For example, the models of the late 1960s predicted a sustained U.S. unemployment rate of 4% as consistent with a 4% annual rate of inflation. Based on this prediction, many economists at that time urged a deliberate policy of inflation. Certainly the erratic ‘fits and starts’ character of actual U.S. policy in the 1970s cannot be attributed to recommendations based on Keynesian models, but the inflationary bias on average of monetary and fiscal policy in this period should, according to all of these models, have produced the lowest unemployment rates for any decade since the 1940s. In fact, as we know, they produced the highest unemployment rates since the 1930s. This was econometric failure on a grand scale.”

There is no attempt to link this stagflation failure to the identification problems discussed earlier. Indeed, they go on to say that they recognise that particular empirical failures (by inference, like stagflation) might be solved by changes to particular equations within SEMs. Of course that is exactly what mainstream macroeconomics was doing at the time, with the expectations augmented Phillips curve.

In the schema due to Lakatos, a failing mainstream theory may still be able to explain previously anomalous results, but only in such a contrived way that it makes the programme degenerate. Yet, as Jesse Zinn argues in this paper, the changes to the Phillips curve suggested by Friedman and Phelps appear progressive rather than degenerate. True, this innovation came from thinking about microeconomic theory, but innovations in SEMs had always come from a mixture of microeconomic theory and evidence. 

This is why LS go on to say: “We have couched our criticisms in such general terms precisely to emphasise their generic character and hence the futility of pursuing minor variations within this general framework.” The rest of the article is about how, given additions like a Lucas supply curve, classical ‘equilibrium’ analysis may be able to explain the ‘facts’ about output and unemployment that Keynes thought classical economics was incapable of doing. It is not about how these models are, or even might be, better able to explain the particular problem of stagflation than SEMs.

In their conclusion, LS summarise their argument. They say:

“First, and most important, existing Keynesian macroeconometric models are incapable of providing reliable guidance in formulating monetary, fiscal and other types of policy. This conclusion is based in part on the spectacular recent failures of these models, and in part on their lack of a sound theoretical or econometric basis.”

Reading the paper as a whole, I think it would be fair to say that these two parts were not equal. The focus of the paper is about the lack of a sound theoretical or econometric basis for SEMs, rather than the failure to predict or explain stagflation. As I will argue in a subsequent post, it was this methodological critique, rather than any superior empirical ability, that led to the success of this manifesto.

Taylor rules: the ZLB and Euro Diversity

John Taylor originally suggested his rule as both a good guide to what central banks actually do and also one that “captures the spirit of the recent research”. It has been used ever since as a yardstick by which to measure monetary policy. However there are well understood reasons why it is likely to be a poor yardstick in a severe recession.

First some theory. In a world of certainty, when inflation expectations are equal to the inflation target, the optimal interest rate to set is one that delivers what is called the ‘natural’ real interest rate. You can describe this as the real interest rate that would achieve a level of demand and output which eliminated the output gap, and put unemployment at its natural rate. At that point, there should be no pressure from the domestic economy for inflation to rise or fall.

In this context it becomes obvious why the output gap (or deviation of unemployment from the natural rate) appears in the Taylor rule. Yet in reality our estimates of the output gap are poor, so it also makes sense to include the difference between inflation and its target in the rule. Finally the rule also contains a constant, which is an estimate of what the natural interest rate would be if inflation was at target and there was a zero output gap. As to the coefficients on inflation and output, you want those to be modest to avoid overreacting to false signals and to allow for lags between interest rate changes and their impact on inflation.

The best way to think about the Taylor rule is as a simple ‘horse for all courses’. It is designed to be a robust rule for all situations: booms as well as busts, small as well as large deviations from target, and where we have no additional reliable information.

In the current recession we know a number of additional things. First, the natural real rate of interest is likely to be a lot lower than the constant in any Taylor rule. There are a number of reasons for this. In the short term a balance sheet recession means that consumers want to save much more than they would normally, so the natural rate has to be unusually low to offset the impact of this on demand. In the longer term we have the issue of secular stagnation, which is one reason why policymakers in both the UK and US say that even when the economy recovers interest rates are likely to be lower than they have been in the past. (Austerity is another.)

There are other factors as well. At low levels of inflation, inflation appears to be less responsive to excess demand. On its own this means that the coefficients on excess inflation in a horse for all courses Taylor rule will be too low when inflation is below 2%. (The possibility of hitting the Zero Lower Bound can also imply the same thing.) If forecasts indicate that inflation will remain below target for some time, that can also suggest we can afford to react to inflation being too low by more than the Taylor rule would suggest.

If you want a practical illustration of all this, consider this post from Zsolt Darvas at Breugel. It uses a typical Taylor rule for the Euro area, and finds that interest rates set by the ECB have been below the level implied by that rule every year since about 2001! That is a clear illustration of the problem of assuming a constant long run natural real interest rate, in this case beginning with Bernanke’s savings glut. Exactly the same points arise in trying to assess whether US monetary policy was too expansionary in the mid-00s. This same rule also implies that the ECB raised rates by too little in 2010/11, which is clearly silly in the light of what subsequently happened. (Again we had more information, in this case about austerity.)

However the Breugel post is not really about how appropriate the ECB’s monetary policy is for the Eurozone as a whole. Instead it focuses on what the rule tells us monetary policy might have been in each individual Eurozone economy, if they had retained their own currency and had floated. Or to put it another way, it tells you for which countries the ECB’s policy is too tight, and for which it is too easy. Used in this way, the analysis is a handy way of combining information on inflation and unemployment diversity across the Eurozone.

Where is the ECB’s policy too tight? There are the obvious countries: Spain, Portugal, Italy and especially Greece. But there is another, which is the Netherlands. There is no mystery here: CPI inflation is currently (May) 0.8%, the harmonised rate is 0.1%, and unemployment has been over 7% this year, compared to an average of below 4% from 2000 to 2007. As the Netherlands does not have an independent monetary policy, it desperately needs a countercyclical fiscal policy, yet instead it is locked into the austerity trap imposed by the Eurozone’s fiscal rules. All of this was horribly predictable, which is why I wrote these posts: May12, Sept12, June13, Dec13.

These fiscal rules are not going to be abolished anytime soon, even though their intellectual rationale has disappeared. The best that we can hope for is that their impact can be softened or partially circumvented by allowing additional public investment spending: see Reza Moghadam from the IMF here, or Wolfgang Münchau here and here, Guntram Wolff here, or Mariana Mazzucato here. But if in the future anyone wants to see the clearest example of where these rules led to large and completely unnecessary social costs, just look at the Netherlands.

    

The financial instability argument for raising rates

There is a nice juxtaposition of recent articles in the Economist. This one, by P.W. (it is weird this convention they have for signing with just their initials), puts the “case against maxing out monetary policy” (a.k.a. raise rates now). The Fed, Bank of England and ECB “argue that the priority is to restore growth and to do battle against low inflation. But [they] grievously misread the risks before the financial crisis, which weakens their claim to be reading them correctly now.” Let’s call the proposition that we should raise rates now to avoid financial instability the BIS case, after the Bank of International Settlements who have been making this argument ever since the recession began. In contrast Ryan Avent writes that there are two big problems with this argument. I want to expand on his discussion, and be a little less polite.

I want to begin by conceding a point. Suppose, as a monetary policymaker, you believe a financial crisis is possible, and that by raising rates you may be able to prevent it. Assume, crucially, that there is nothing else you can do to help prevent the financial crisis. In that case, you will consider raising rates, even if inflation is below target. If you have just one instrument (interest rates) and two targets (inflation and preventing a crisis) you will be influenced by both targets. If you want this point expressed more formally, see this post and the paper by Mike Woodford it discusses. 

 

However that is not the end of the story. If you raise rates to prevent financial instability when inflation is below target, inflation will remain below target or may fall even further. You cannot ignore that. So if interest rates are raised today to head off a financial crisis, they will have to be lower in the future to deal with the lower inflation or even deflation you have caused.

This is not just what macroeconomic theory says. In mid-2010 the Swedish central bank started raising interest rates (from 0.25% to 2%), despite forecasts that inflation would stay below target and with unemployment well above its natural rate. They did this explicitly because they were worried about the build up of household debt and a possible housing bubble. Inflation began to fall, and since 2013 it has been at or below zero. As Lars Svensson has pointed out, even on its own terms this is not a very clever policy, because with lower inflation the real value of debt is higher than it would otherwise have been. But the key point for the current discussion is that now interest rates are coming down again (currently 0.75%), because you cannot ignore inflation being over 2% below target.

Some of those making the BIS case understand this. What they hope is that if interest rates are raised to, say, 2% and stay there, that will still give us enough monetary stimulus to eventually get inflation back up to target. It clearly was not correct in the Swedish case, and with Euro inflation still at 0.5% it looks pretty improbable there too. But maybe it could be correct for the US and UK. So by raising rates by a modest amount today we might prevent financial instability, but at the cost of delaying the recovery.

I want to make two observations that follow from the BIS argument. The first is that they are in effect saying that the Zero Lower Bound (ZLB) constraint on monetary policy is even more severe than we thought, because if we leave interest rates at the ZLB for too long this generates an unacceptable risk of financial instability. That in turn must strengthen arguments (pdf) for raising inflation targets above 2%. Strangely, I do not hear advocates of the BIS case also arguing for higher inflation targets. The second is that, the more severe the ZLB constraint is in practice, the more compelling the case for using fiscal stimulus when we hit the ZLB. (Fiscal policy has become more expansionary in Sweden.) Again, this is something you do not hear BIS advocates argue for – in fact they often push austerity.

As Ryan Avent says, we can avoid all these difficulties by adding an extra instrument, which is macroprudential regulation. If parts of the financial system appear prone to instability because people are taking insufficient account of risks, bring in controls (or maybe taxes) of various kinds to stop this happening. Now, as R.A. notes, those taking the BIS position counter that such measures are untested and may not be effective. Here is a typical example in the FT, where it is stated that “macroprudential policies will fail to stop investors taking irrational risks”.

So we must raise interest rates, and delay the recovery, because nothing else can stop some in the financial system taking excessive risks. To which I can only say, summoning all my academic gravitas, what audacity, what impudence! Not only have we had to suffer the consequences of the Great Recession because of excessive risk taking within a largely unregulated financial system, we now have to cut short our main means of getting out of that recession because they might do it again. I do not know what planet these people are on, but if its mine, can they please get off and play their games elsewhere.