Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 28 August 2019

A New Macropolicy Assignment


At the recent Jackson Hole conference of central bankers there seemed to be a general acceptance that central bankers just do not have the tools to effectively fight a new recession. I discussed some of the reasons here. The most familiar is the lower bound for nominal interest rates, but Anna Stansbury and Larry Summers argue that even before we get to the lower bound interest rates may be an ineffective stabilisation tool when they are very low. [1]

This is not a problem specific to this period of time. Most people agree that the natural real interest rate (the real rate at which inflation is stable) has fallen with little sign that this fall will be reversed. That means nominal interest rates are likely to remain low for decades. So its not just this recession where monetary policy is impotent, but every recession in the foreseeable future.

One response is that, as I argued in my earlier piece, central bankers should aim to develop new tools that are effective in recessions. This includes differential interest rates for borrowers and savers, and helicopter money. But for whatever reason central bankers are in no hurry to do this. Instead their current view is that fiscal policy needs to take some of the burden of fighting recessions.

Unfortunately for a variety of reasons many politicians in government have not got the message. In the Eurozone they are stuck with primitive fiscal rules that assume monetary policy can always control demand. In the US and perhaps the UK they think a fiscal stimulus is giving the rich tax breaks, which is perhaps the most ineffective way of stimulating demand.

More generally we have had decades were central banks were responsible for controlling inflation and avoiding downturns, and both politicians and the media (and to some extent economists) will require something more than one Jackson hole conference to shift this expectation. Maybe another recession might do it, but the largest recession since WWII failed to do the job. Part of the problem is that central bankers will try to fight the next recession with ineffective measures like Quantitative Easing, and this appearance of activity will fool too many into thinking they have the problem in hand.

As we saw in the last recession, the danger is not just that politicians will fail to fight a recession, but they may actually do the wrong thing. In their minds and also the minds of most media commentators, the central bank is responsible for controlling demand (and therefore fighting a recession) but politicians are responsible for controlling the deficit. This leads to a perverse response in an economic downturn if monetary policy is ineffective.

Macroeconomists call a simple division of labour between monetary and fiscal policy an assignment. What I call the conventional assignment is that interest rates control demand (and therefore inflation) and politicians control the deficit. I called this assignment conventional because it had become ingrained in the minds of economists, the media and politicians. Right now the conventional assignment is not working in terms of fighting recessions.

If central banks remain conservative in developing new tools, what we need to do is give back to politicians the responsibility for fighting economic downturns. One way of doing that is to take monetary policy away from independent central banks, and give it back to politicians. This would make politicians responsible for avoiding recessions as well as controlling inflation, and they will realise that a fiscal stimulus is a more effective means of doing this than any kind of monetary policy stimulus.

I do not want to rehearse the arguments for or against central bank independence (CBI), but simply note that the popularity of CBI comes from a suspicion that politicians are unreliable when it comes to fighting inflation. And unlike supporters of MMT I see no reason to believe that interest rates chosen by independent central bankers are not effective at moderating periods of excessive inflation.

My suggestion is instead a modified assignment. Central bankers remain responsible for controlling inflation, but politicians become responsible for fighting recessions. That is two different bodies managing the same variable - aggregate demand - but at different parts of the business cycle. Think of it like a car, with independent central bankers as the brake and politicians as the accelerator.

Cars are designed so it is difficult to push the accelerator and brake at the same time. We need something similar for this assignment: some way of coordinating between politicians and central banks so they don’t try to manage demand at the same time. The obvious coordination device is the adoption of a common belief about what the NAIRU is (or something similar to the NAIRU) and a common forecast (as actions will depend on expectations of future states of the economy).

The advantage of this asymmetric assignment is that it makes politicians responsible for tackling recessions, which in turn avoids a mistaken view that in a recession they should be controlling the deficit. In other words it is an assignment that rules out austerity. Any assignment that prevents austerity has to be worth considering.

[1] I will wait to see the paper before commenting on this idea, but there is no theoretical reason why the IS curve should be linear. What we need is some empirical evidence, but unfortunately the microfoundations hegemony means that is thin on the ground.


  1. typos:
    1 - second "Jackson hole" -> "Jackson Hole"
    2 - "too different bodies" -> "two different bodies"
    3 - "central bankers as the break" -> "central bankers as the brake"

  2. A question from a cousin from across the pond. What happens if parliament does not accept suspension? Seems there are many possible outcomes and most not happy ones.

  3. What may be missing is allowance for hysteresis. Regardless of the assignment, a large demand shock calls for a large enough response to reverse the damages, in the presence of hysteresis.

  4. That is what would happen if governments adjusted the amount and timing of their public investments according the NPV when inputs are valued at marginal cost, not market prices.

    OTOH, it's hard to see why they would be pessimistic about fighting recessions so long as they do not already own all all the assets than could be exchanged for costlessly created central bank liabilities. If they run out of government bonds they could buy private bond indexes or buy and sell NGDP futures, or foreign exchange.

