Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 29 June 2012

What microeconomists think about macroeconomics

                There is a lot that is interesting in Diane Coyle’s 2012 Tanner lectures. What I want to respond to here is an associated post, where she expresses some of the frustrations that I know many microeconomists have with macroeconomics. These can be summed up rather crudely as: why do we disagree all the time, and yet appear so sure we are right, and don’t we realise we are bringing the whole discipline into disrepute? Diane says that “macroeconomists simply do not realise how low their stock has sunk in the eyes of their microeconomist colleagues”. This may be an exaggeration, but who knows what is said when we are out of earshot. Because I (and pretty well all macroeconomists) do have great respect for our microeconomic colleagues, we have some explaining to do. (Jonathan Portes has an excellent post responding to some of the more specific comments Diane makes in this post.)
                What I want to say in summary is this. Microeconomists are right in many of their criticisms, but what they often fail to see is the root cause of the problem. This is that macroeconomic policy is highly political, with strong ideological implications. Ideology and politics distort macroeconomics as a science. Yet despite this, there is – and for many years has been – a substantial body of analysis that most macroeconomics would sign up to, and which has sound empirical backing.
                What is this substantial body of analysis? It is what used to be called the new neoclassical synthesis (Goodfriend and King (1997) – see here for more background and references). For a closed economy, its details are well represented in Romer’s graduate textbook, for example. This body of analysis has important gaps and omissions, of course, such as a naive and simplistic view of the financial sector. However, as I argued recently, the financial crisis itself showed up this incompleteness, but did not invalidate most of what was in the synthesis. Indeed, events since the crisis have provided significant empirical support for the Keynesian elements of that synthesis. (Of course, there are caveats, some of which I have discussed in earlier posts, and which I will return to below.)
                So why the appearance of constant disagreement among macroeconomists? The first point to make is that the disagreement tends to focus on one part of the synthesis, which is short term macroeconomic fluctuations: their causes and cures. This is not the only part of the synthesis which has the potential for political and ideological controversy, but it is where there is constant popular and media interest. The second point, however, is that politics alone is not sufficient to explain controversy within a scientific discipline. Here I might give climate change is an example: despite strong pecuniary temptations, climate change science is pretty united, and typically dissenting views come from outside the discipline.
                The reason, I would suggest, why many macroeconomists do not sign up to the new neoclassical synthesis is that its Keynesian component conflicts with an ideological view which uses economics as part of its intellectual foundation. That view is that markets generally work well when left free from political interference and that government intervention is almost always bad. Now most microeconomists will immediately point out that microeconomic theory as a whole does not support this ideological view. Much microeconomic analysis is all about market imperfections. But that misses the point. Those attracted to this ideological position use a very partial take on economics for support, and are naturally attracted to that part of the discipline.
                Keynesian analysis is all about the consequences of one particular market imperfection. Conventionally this is seen as the externalities that arise from sticky prices. (I personally am increasing drawn to describe them as the consequences of the existence of money, but that is a different story.) It implies in general the need for constant involvement of one arm of the state – the central bank – in stabilising the economy, and in some circumstances the involvement of fiscal policy to do the same. I have argued that this analysis leaves those with the ideological view that free markets are good and government intervention bad feeling very uncomfortable, so they will try and find ways of avoiding and disputing this part of the synthesis.
                Now nothing I have said so far makes macroeconomics unique in attracting ideologically driven controversy. There are areas of microeconomics which are equally controversial for similar reasons. I would suggest the debate over minimum wages is an example. An outsider looking at this debate might well conclude that labour economists are as equally disputatious as macroeconomists on this issue. Another example from my youth I always like to use is the ‘Cambridge controversies’ over ‘reswitching’. This was a highly technical theoretical dispute, but its ideological implications were such that views on this technical debate were highly correlated with political beliefs.
                I think there is one factor that is peculiar to macroeconomics, and that is the role of ‘city’ economists. There are two elements here. One is that city economists work in an environment which has a strong vested interest in promoting the free market ideological view. The other is that part of the name of the game for these guys is to differentiate the product. These are of course tendencies: there are many excellent city economists who go with the evidence rather than with ideological conviction.
                Why is it important to say all this? First, because the influence of ideology on economics is not confined to macroeconomics. It is also not confined to the political right, so there is no simple bias, but recognition rather than denial is important. Second, the cure – if there is one – is evidence. As Jonathan points out, the recent evidence is clearly with those who accept Keynesian views, but I think there is an underlying problem. The way empirical evidence is marshalled in the microfoundations methodology associated with DSGE modelling makes it too easy for those who hold ideologically based priors to retain and defend those priors, which is one reason why I have tried to suggest that it should not be the only way serious macroeconomic analysis is done.

Tuesday, 26 June 2012

But which inflation?



Friday, 22 June 2012

Teaching macroeconomics after the crisis

A slight variation on an old theme

                I was asked the other day how macroeconomics teaching at Oxford had changed as a result of the Great Recession of 2008-9. My answer, which was not much, seemed a little surprising at first. Does this reflect insularity or intellectual arrogance? Surely the failure to foresee the financial crisis must have led to some change in what was taught. Does this not confirm something rotten at the heart of economics?
                First I need to explain ‘not much’. [In what follows I only deal with core macro courses, and not options at either undergraduate or graduate level.] John Vickers, who gives the first year macro lectures, has added material on bank runs, leverage and banking reform, where for the latter he has of course played a major role in current UK policy. My own second year undergraduate lectures include a wealth of topical examples to illustrate basic theory. And perhaps most significantly, Martin Ellison now gives a couple of weeks of lectures on recent developments in modelling financial frictions as part of the core post-grad macro course.
                So why was my answer not much? Because although the crisis has added material, nothing has really been thrown away as a consequence of what has happened. We have not, either individually or collectively, decided that the Great Recession implies that some chunk of what we used to teach is clearly wrong and should be jettisoned as a result. Speaking for myself and my second year undergraduate lectures, quite the opposite is the case. As Paul Krugman has pointed out many times, recent developments have in many ways been a vindication of the basic Keynesian model that lies at the heart of any undergraduate macro course.
                Indeed, I would go even further. The mess we are currently in is due in part to policy makers ignoring this basic macroeconomic analysis. As a result, I teach this stuff with renewed vigour and determination. As many people know, both our current Prime Minister and the Leader of the Opposition will have attended a past version of the course I teach (although well before, I hasten to add, I started teaching it). Although George Osborne read Modern History at Oxford (and here ‘modern’ means from 1330, so the Great Depression was not necessarily covered in depth!), one of his principle advisors also read PPE (Politics, Philosophy and Economics). If any future Prime Minister or Chancellor follows a similar path, I want them to remember basic macro theory.
                Now I also teach the first part of the core macro for our MPhil (Oxford’s two year masters) course, and you might think that the basic Ramsey model which is covered there has less relevance to recent events. To some extent this is true: I’ve noted how the standard intertemporal consumption model is not going to explain trends in savings in the UK or US over the last few decades, and my colleague John Muellbauer has written extensively on this. On the other hand, I find the Ramsey model and its OLG variant very useful in discussing issues around the control of government debt.
                So while the Great Recession has clearly shown that macroeconomics is incomplete in important respects, it has not shown that what we thought we knew is all wrong.  In many respects it has shown it is exactly right.
                However I think I should add one important rider to this. Anyone wanting to understand what has happened over the last five years would be better off reading an undergraduate macro textbook like Mankiw than a masters textbook like Romer. This is not because the former is less technical than the latter, but because the former is more old fashioned in academic terms. They might do even better still by reading The General Theory. Before I am misunderstood, I am not suggesting anything is wrong with what we currently teach. Rather that the inevitable focus at the masters level on the recent macroeconomic literature leaves no place for the history of macroeconomic thought, and that is a problem.
                Now I must confess two things here. First, I have not always held this view. Indeed until quite recently, when I thought most macroeconomists signed up to the New Neoclassical Synthesis, I imagined economics might be like a physical science, where knowledge of bygone theory added little to our understanding of the world today. The Great Recession changed that view, for me at least. Second, this argument to teach the history of macroeconomic thought is one that tends to be made by those of a certain age, and even though they might also be very eminent (for example), don’t we all want to pretend we are still young? Well maybe it’s time to admit my age.

Monday, 18 June 2012

Quantitative Easing and Fiscal dominance


Friday, 15 June 2012

Mansion House Myths and Excuses

                In his speech yesterday, George Osborne said this:

“Of course, there are those who argue we should not be reducing the deficit – we should be spending and borrowing even more. But that argument ignores a crucial fact: inflation in the UK has been significantly above the Bank of England’s 2% target since the end of 2009. That is due to a combination of commodity price shocks, the lagged effects of a lower exchange rate and a worsening underlying productivity performance, and it has very important implications for fiscal policy. Looking backwards it means that over this period looser fiscal policy would almost certainly have been offset by tighter, or less loose, monetary policy.”

This is an argument I have already discussed, but it is the first time I have seen the government use it. It is an improvement on those based on bond markets, confidence fairies, or expansionary fiscal contraction. Yet even if you buy it (which I do not think you should), the key phrase here is ‘looking backwards’.
                In judging policy, we should not look backwards. Lots of things are true in hindsight, whereas policy has to be made under uncertainty. Good policy should be as robust as possible to this uncertainty. In 2010, when additional austerity was announced, the government did not know that inflation was going to be unexpectedly high in 2011. So it cannot have known that the MPC would have been debating whether to increase interest rates in the spring of that year. A more likely outcome was that inflation would be falling and interest rates would be firmly anchored at their lower bound. As a result, high inflation in 2011 is a poor excuse for a bad decision.
                It was a bad decision because the government should, at the very least, have considered the possibility that demand was going to be weaker than they expected, and that monetary policy would be unable to do much about it because interest rates were at the zero lower bound. If they did not think about this possibility, it was irresponsible. If they did and took a risk, we are now experiencing the consequences.
                The Chancellor in his speech also quoted Mervyn King as saying that current UK policy was a “textbook response” to the current situation. I do not know where that quote comes from (it is not in the text of the Governor’s speech at the same occasion), so I will focus on what the Chancellor thinks. He goes on to explain:  “Theory and evidence suggest that tight fiscal policy and loose monetary policy is the right macroeconomic mix to help rebalance an economy in the state [of high indebtedness].” To which I can only say – no, not when interest rates are stuck at zero.
                Central banks get a lot of criticism: some justified, some not. When it comes to what monetary policy can do in a liquidity trap, they do not want to appear too pessimistic. But there is a danger of giving the opposite impression, which is that nothing much has changed except the way policy is implemented. I would much prefer them to be quite explicit about how much more uncertain Quantitative Easing is as an instrument, and that fiscal policy will have a much greater impact on demand as a result.
                Regular readers may think I’m beginning to sound like a record on this. Indeed, Jonathan Portes argues that the proposed new programme discussed yesterday by the Chancellor of government guarantees to support new house-building and infrastructure investment concedes the intellectual and economic argument.  To quote:  “The economic difference between the government borrowing from the private sector to finance investment spending, and the government guaranteeing the borrowing of another entity - with the government guarantee meaning that the lender has no more or less risk of non-repayment than if the money was lent direct to government - is marginal.” If the new investment happens, I would agree.
I also suspect that Mervyn King would not describe such schemes as pure monetary policy. He says: “But the long term nature of the lending and its pricing mean that the Bank could conduct such an operation only with the approval of the Government, as offered by the Chancellor earlier. So such a scheme would be a joint effort between Bank and Treasury. It would complement the government’s existing schemes, and tackle the high level of funding costs directly.” That sounds like code for this is also fiscal policy.
But why quibble. If measures of this kind allow the government to carry on the fiction that they are sticking to Plan A, and if it produces a recovery which it is then claimed has nothing to do with fiscal policy, should we mind? I think we should, because today’s myths have a danger of becoming tomorrow’s received wisdom.             

Thursday, 14 June 2012

Helicopter money, Inflation targets and Quantitative Easing

For economists


Saturday, 9 June 2012

What is it about Latvia?

                that either makes visitors lose their critical faculties, or non-visitors like myself and Paul Krugman lose theirs. In my earlier post, I was not that surprised that a member of the ECB’s Executive Board would trumpet Latvia’s ‘success story’, because that fitted the party line. I was a little more surprised to find the head of the IMF saying similar things, because the IMF has been rather more realistic about the consequences of austerity and internal devaluation. (Although the contrast between the IMF’s recent UK assessment in writing, and what Lagarde said in public, was widely noted at the time). What really surprised me was this post from Dani Rodrik, who has also just visited Latvia.
                Dani Rodrick’s post goes into more detail about recent Latvian macroeconomics. In particular, he suggests that despite the massive decline in GDP and huge rise in unemployment, the economy may still have not completely regained the competitiveness they lost in the preceding boom. So, in terms of the evidence, he sees what I see if not worse. But then he says this.

“The main lesson I take from all this is the need to avoid easy generalizations that do not respect country peculiarities. Fiscal austerity missionaries are surely off base when they say Latvia’s experience decisively proves Keynesians and advocates of currency depreciation wrong.  It is too early to judge the Latvian experience a success.  But it is also too early to say Latvia has been a failure.  Growth may continue, in which case the country will look better and better.”

                When someone like Dani Rodrik looks at the same facts, but comes to rather different conclusions than me, I get worried that perhaps I’m wrong. It is also wise to heed Brian Ashcroft’s warning, that small countries do have different characteristics to larger countries. With this in mind, let me go through some of my own macroeconomic reasoning carefully.
                Was the depth of the recession inevitable given the preceding boom? Paul Krugman is perhaps a little too dismissive on this point. The economy clearly was overheating in 2007/8, which is why it became uncompetitive. At the very least, inflation had to come back to a reasonable level. In principle this need not require any subsequent deflation if we have a totally credible macroeconomic policy, a suitable devaluation and a completely forward looking Phillips curve, but that is an idealisation. So some recession was probably inevitable, as it has been for many Eurozone countries. But in 2008/9 Latvia suffered the worst loss of output in the world!
                The key issue is not that Latvia had to get inflation down, but that having done that it also needed to regain competitiveness. It is here that the macroeconomics of a short sharp recession with a fixed exchange rate looks so bad. To see why, think of the following little experiment.
                We have an economy, which through overheating has become uncompetitive. It needs to get its prices in Euro terms down by, say, 20%. The government has dealt with the overheating: the output gap is now zero and inflation is at its competitors’ level. But prices are still 20% too high.
                The least cost option is to devalue the currency by 20%. Now it would be foolish to believe that is all you need to do. Restoring competitiveness will boost demand, so to prevent the overheating starting up again you need to undertake deflationary policy of some kind. You may also need some negative output gap because higher import prices will raise price inflation. However you do not need a 20% decline in output.
                But suppose we take the fixed exchange rate as given. Even in this case, a short sharp recession makes no macroeconomic sense. Suppose that, for given inflation expectations, a 1% output gap will reduce inflation by 1%. A short sharp shock of output 20% below potential for a year will give you -20% inflation in that year, so you will have restored competitiveness quickly, but at great cost. Now think about spreading the correction over two years.
                To see how that works, we need to say a bit more about the Phillips curve. As we discovered in the 1970s, inflation today depends not just on the output gap, but also expected inflation. Suppose our Phillips curve is of the modern New Keynesian kind, so this year’s inflation rate depends on next year’s expected inflation, and let’s assume people are pretty rational in forming their expectations. What if we have an output gap next year of -10%. This will mean that inflation next year will also be -10%. But this year we do not need any output gap at all. Inflation will still be -10%, because expected inflation is -10%. So we get our competitiveness adjustment over two years, but at half the cost in terms of lost output.
                Is my assumption about rational expectations critical here? No. Imagine instead that the Phillips curve is of the old fashioned kind, where expectations are naive and backward looking, so current inflation effectively depends on past inflation. In this case we need an output gap of -10% this year, but then nothing next year, and we still get our correction over two years at half the cost. (We have to do something to get inflation back up after two years in this case, but that is not important to the point I’m making.)
                Now this is all very stylised and partial equilibrium, but there is one important message that will survive complications. The Phillips curve tells us that reducing the price level gradually over time is more efficient than doing it quickly. So even if you believe that you have to stick with a fixed exchange rate, a short sharp recession is much less efficient than a more modest but prolonged recession. Thinking about the convexity of the social welfare function reinforces this point.
                As a result, even if output growth this year and next year was over 5% p.a., and the country achieves a sustainable level of competitiveness, I would not call the Latvian experience a success story. The competitiveness correction will have cost the economy a huge amount in wasted resources and unemployment misery, when it could have achieved this correction at a much reduced cost.

Friday, 8 June 2012

Automatic Stabilisers and Discretionary Fiscal Policy  


Thursday, 7 June 2012

Why cannot other European countries show this courage?

                The outcome of the ECB meeting yesterday was rather more positive than I had hoped. Why? Because the decision to do nothing was not unanimous. That’s it I’m afraid, but my expectations beforehand were very low. One reason was reading this short speech by Jörg Asmussen, a member of the Executive Board of the ECB. (HT P O Neill) It was delivered in Riga, and extols the path of internal devaluation and austerity taken by Latvia.
                Let me quote, to give you the flavour. “From 2008, Latvia was faced with the deepest recession in the world. The cumulative output decline was 24%; unemployment peaked at 20%. Keeping the euro peg was considered by many as a “mission impossible””. “External devaluation was presented as the only way forward. But Latvia did not choose the easy “quick fix”. It embarked on a courageous fiscal consolidation path and structural reforms. Two years later, the speed of the economic rebound is as extraordinary as the depth of the recession. Against all the odds, Latvia recorded a real GDP growth rate of 5.5% in 2011.”
                An extraordinary success story: after an 18% decline in GDP in 2009, and flat GDP in 2010, we now have 5.5% growth in 2011. But surely I’m being economical with my quotes here. Isn’t the 5.5% growth last year just the beginning, with the economy achieving a new dynamism. Mr. Asmussen does not provide any additional evidence on this. Perhaps wisely, as the IMF are predicting 2% growth this year, and 2.5% next year. So the 5.5% growth last year is all we have.
                Mr. Asmussen could have talked about unemployment, which has also fallen rapidly, from a peak of 20% to 15% currently. Perhaps he did not, because unemployment shows more clearly what has actually happened. We have had a huge recession, followed by a much more modest recovery. And, as we might guess, there is apparently much more talk about structural unemployment in Latvia today. For a rather more objective account of the Latvian experience of internal devaluation, see this (US) CEPR study, or a number of Paul Krugman's posts.
Earlier this year I wrote that when growth returned, some would say this proved those pessimistic Keynesians had been all wrong. I must admit the ‘some’ I had in mind were politicians and journalists, not senior central bankers. By this logic, an even better strategy is to close the whole economy down for a year. The following year we could get fantastic growth as the economy starts up again.
But the really scary thing about this speech is the lesson Mr. Asmussen draws from Latvia’s ‘success’. “The Baltic experience shows clearly that speed is of the essence. In all three Baltic countries, the government reacted swiftly to the deterioration of public finances and frontloaded fiscal adjustment. With a budget consolidation of around 9% of GDP in 2009 alone, Latvia’s effort is unparalleled in Europe.” So, Ireland and Greece, you know where you went wrong. You have been far too tentative with your austerity.
The language is indicative. We have a “courageous fiscal consolidation path”, “it is better to take the medicine right away than to let the fever rise for months”, and “Latvia’s effort is unparalleled”.  Perhaps we can describe this as ‘masochism macroeconomics’. Or is it faith in the macroeconomic afterlife: penury (a massive waste of resources) today bringing virtue (austerity and structural reform) that promises redemption (wealth creation) in the distant future.
So this is why I was pleased to hear that the ECB’s decision had not been unanimous. At last, some policymakers in Europe do not believe this dangerous nonsense any more. 

Postscript. Mark Weisbrot at the Guardian alerts us to Christine Legarde singing from the same script, alas.

Tuesday, 5 June 2012

Unfunded pension schemes and intergenerational equity

                In two earlier posts (here and here) I looked at issues involving debt and intergenerational equity. The second attracted a lot of interesting comments. Some had difficulty with the idea of debt as a burden, and I think one way to help here is to look at pension schemes. (I hope to return to other comments later.)
                When I talk about intergenerational equity to students, I go through all the ways that the current generation is exploiting future generations, like climate change, rising house prices, and rising government debt. I also say that of course the older generation could just get the younger generation to pay them directly. I then reveal, to the surprise of some, that that is exactly what happens in many countries because these countries run unfunded pension schemes.
                An unfunded scheme is where the working generation pays social security contributions, and that money goes straight into paying the pensions of the old, rather than buying some kind of asset (hence unfunded). When the scheme starts, the current old receive a windfall: a pension without having contributed anything. The young pay contributions, but then receive a pension when they get old from the new younger generation. So the older generation when the scheme starts are clearly winners, but are there any losers? The answer depends on two things.
                The first is whether the scheme ever stops. If it stops, the young in the period beforehand are clear losers. They paid contributions (which went straight to the then old), but get nothing when they get old. Obviously the scheme is a huge burden on this ‘final generation’. However if the scheme goes on forever, there is no last generation, so there is no loser on that account.
The second issue is whether those who are forced to save by contributing to the pension lose out because they could have done better saving for themselves. That in turn depends on whether the rate of interest (r) is greater than the rate of growth (g). Those who contribute to the pension scheme get back more than they put in because of economic growth. The income of the young as a whole will be higher either because of technical progress which raises income per head (assuming contributions are a fixed proportion of income), or because there are more of them which raises the number of heads. In either case the current young generation contributes more than the old did when they were young, so the old benefit from that extra money. However if they had saved themselves their return would be the rate of interest. So if r>g, each generation of young lose out a bit by being forced to save in a way that produces a return equal to g rather than r.
All that is happening here is that money is passing from one group to another, with the government acting as an intermediary. Society is ‘paying itself’. But this statement says nothing about intergenerational equity. Suppose the scheme only lasted one period. Money passes from the young to the old, but it would be absurd to say that this implied that the young were not losing out.
Those who read this earlier post will see the parallel with the case of government debt. With pensions the young get an implicit promise that they will receive their money back with a return equal to g, whereas those that buy debt get an explicit note saying they will get their money back with some rate of interest r. The implicit/explicit thing is not crucial here – after all the government can default! The key difference is that, if people are to buy the debt voluntarily, they get a return equal to the return on other forms of saving (=r). If r>g, taxes have to rise to make up the difference between the two when debt is issued.
An unfunded pension scheme has the same macroeconomic costs that I discussed before in relation to government debt. In particular, if the young save at least part of their pension this way, they will save less in productive capital, and if the amount of capital in the economy as a whole is less than the optimal level, this will be an important cost. In addition, to the extent that the contributions act like an income tax, it can distort work effort.
Does this mean that an unfunded pension scheme is a bad idea? You can see why it might be introduced even if it was a bad idea – its introduction is great for the current old, so they will always vote for it. There are two potentially important benefits, if the alternative is funded private schemes. First, it takes away a lot of the uncertainty in funded schemes. If you buy your private pension when the stock market is high, and retire when it is low, you could lose out in a big way. You might also want insurance against labour income risk. (See, for example, this paper by David Miles.) Second, it provides a safety net for those who were misguided enough not to contribute to a private pension. (For a useful reference on pension issues, see Oxford Review of Economic Policy Vol 22, No1, Spring 2006.)
                I think this nicely illustrates why intergenerational equity can never be the overriding concern when it comes to issues involving government debt or unfunded pension schemes. There are many other factors to consider that may be more important. If it was decided that the costs of unfunded pension schemes exceeded the benefits (or, more realistically, that the balance should move to funded schemes), then the generations involved in any transition would almost certainly lose out. They would become like the final generation in my discussion above. That issue of intergenerational equity should be important in any decision, but it should never be the only consideration.

Saturday, 2 June 2012

Is monetary policy taking Euro uncertainty seriously?

                There is a wonderful scene is the film Being There, where the innocent gardener played by Peter Sellers is asked by the President whether he should stimulate the economy. I thought of this while wondering why central banks seem to be gripped by inactivity as the global economy looks more perilous by the day (see R.A. here). I remembered being equally puzzled by the actions of the UK’s Monetary Policy Committee at a similar time last year, when they almost voted to raise interest rates, and by the ECB that did raise rates. On both occasions spring was in the air, and when much of the natural world is coming back to life, perhaps central bankers are filled with undue optimism about economic growth. This led me to think of Being There.
                I doubt, however, if this hypothesis would survive econometric testing.  A better hypothesis, which I talked about here, is that central banks take inflation targeting rather more literally than economists thought they did.  Actually, we probably suspected this of the ECB, but I really did believe that both the Fed and MPC saw themselves as pursuing ‘flexible inflation targeting’, which meant also being strongly influenced by the output gap. Perhaps I was naive, but in the case of the MPC I know these people, and they are all really good economists who know what optimal policy is all about.
                Perhaps my naivety partly comes from underestimating the influence of public accountability. With an explicit inflation target, the performance of the MPC is judged by most of the media as success in meeting that target. Very few non-economists blame the continuing recession on monetary policy, but the MPC has had a really hard time as a result of underestimating inflation. As I said here, forecast errors are generally down to bad luck rather than incompetence, but that is not widely recognised.
                It is true that knowing what the output gap is at the moment is very difficult, but that should not mean that you ignore it. As I argued here, at the Zero Lower Bound (ZLB) output gap uncertainty should make you more inclined to pursue an expansionary policy. Another factor I suspect is having to rely on Quantitative Easing to stimulate the economy. The impact of QE is very uncertain, the numbers involved are very large, and we should not discount the influence of those who look at these numbers and say hyperinflation is nigh. Other possible factors were mentioned in that earlier post.
                But these are explanations, not excuses. In that earlier post I talked about central projections. However the MPC prides itself (and quite rightly) on stressing the uncertainty of forecasts by using its famous fan charts. It was therefore with some surprise to read, via Britmouse, that one member of the MPC thought that “The forecasts in May were consistent, two years out, with roughly balanced risks on either side of the (inflation) target.” To which I immediately thought: balanced risks, what about the Euro?
                So I went to the Inflation Report, and sure enough the fan chart shows the forecasts for inflation pretty evenly distributed around 2%. I then read the section on uncertainty. I’ll be honest here – this is normally part of the report where I tend to skip. It is full of platitudes like ‘Inflation depends on X, and X could be higher, but then again it might be lower’. I found “..the biggest risks stem from developments in the Euro area..” which is consistent with Mervyn King's recent remarks. But then I read this “As was the case in past Reports, the MPC sees no meaningful way to quantify the size and likelihood of the most extreme outcomes associated with developments in the euro area and they are therefore excluded from the fan charts.”
                This is something I should have picked up before, but as I said that is my fault. As a principle it strikes me as a little odd – we try and quantify uncertainty, unless it’s really important! But it also raises an immediate question. If the forecast probabilities are evenly distributed around 2% without allowing for a really bad Euro outcome, what allowance was the MPC making for this bad outcome when deciding not to undertake further QE?  I would have thought that, as the Inflation Report says that a bad Euro outcome would reduce output, the MPC also believes this bad outcome would reduce inflation. So, making some allowance for this would reduce expected inflation below the 2% target. So what happened to this downside risk?
                I cannot think of an answer. Perhaps there is some equally large but imponderable uncertainty on the positive side, which can be set against a bad Euro outcome. If there is, I think we should know about it, if only to cheer everyone up. But maybe it’s just that spring air.

Friday, 1 June 2012

The Euro: an alternative moral tale

                Part of the austerity mindset that I talked about in the context of the Irish referendum is the belief that transfers from creditors to debtors are unfair (HT MT) because they result from the feckless behaviour of the debtor. There is a clear parallel with the attitude to benefit recipients within a society, which Chris Dillow talks about here. I do not want to get into the economics or politics of attitudes of this kind, but just claim that they are important in influencing policy, a position I think David Glasner supports here. Instead I want to confront this mindset with an alternative moral tale. Let’s talk about the Core countries and the Periphery, because I want to look at why they became creditors and debtors.
                When the Euro was formed, its fiscal architecture was embodied in the Stability and Growth Pact (SGP). This architecture was the construction of the Core, not the Periphery. In political terms, it was the price that the low inflation countries of the Core laid down for their participation in the Euro. That fiscal architecture was all about containing deficits, and said nothing about using fiscal policy to control domestic demand. To many economists, this was something of a surprise. Much of the academic work leading up to the formation of the Euro had stressed the crucial role that countercyclical policy could play in reducing the consequences of asymmetric shocks in a monetary union. The SGP effectively ignored that work.
                Why? Perhaps because in the debate on the wisdom of setting up the Euro, the problem of asymmetric shocks (or asymmetric adjustment to common shocks) was the key argument used by the anti-Euro camp. So it was easier to deny that the problem would arise, rather than talk about how it might be reduced. However I suspect countercyclical fiscal policy was also ignored because many in the Core just did not believe in the kind of Keynesian world in which the policy worked. In that sense, we were seeing the forerunner to a belief in expansionary austerity. To put this in simple terms, the view was that any demand and competitiveness imbalances would be quickly self-correcting, as uncompetitive countries would lose exports, output would fall and inflation would decline. The Keynesian view that this self-correction might be slow, costly and painful, and that fiscal policy could reduce those costs and pain, was discounted.
                Much the same can be said about monetary policy and the ECB. This was designed by the Core. The ECB was independent of government, but also explicitly prevented from acting as a lender of last resort to governments.
                After the Euro was formed, interest rates came down substantially in the Periphery. There was a substantial amount of lending by the Core private sector to the Periphery private sector. This led to inevitable overheating in these periphery countries relative to the core. At this point the Core, and the bureaucratic apparatus that was essentially under the Core’s control, should have been sounding alarm bells. But instead they continued to follow the flawed fiscal architecture. In the case of Spain, as is well known, the budget deficit looked OK according to these fiscal rules, so the overheating there was allowed to continue. As a result, we got a housing and construction bubble. The aftermath of this is what countries like Ireland and Spain are dealing with now.
                So, the basic problem was one of excessive private sector borrowing in the Periphery, partly financed by excessive lending by the Core. The Core countries had set up a fiscal architecture that effectively ignored this kind of problem, and they did nothing to address their mistake in subsequent years.
                So who is to blame? Consider a parallel with the sub-prime crisis. Do we hold the low income households who took out mortgages they could not afford responsible for the financial crisis that ensued? Do we blame them for the Great Recession? Do we pity the poor financial institutions that lost money lending to these irresponsible people? I hope not. Instead we ask, how can the financial system have allowed this to happen? What was wrong with the architecture of regulation, and who was responsible for this?
                I think we should have the same response to the Euro crisis. What was wrong with the fiscal and banking architecture that allowed housing bubbles and the like in the Periphery, and who was responsible for this architecture?
                But in the case of the Euro, it gets worse. Even after the crisis, the Core countries continued with their anti-Keynesian mindset. As the immediate manifestation of the crisis was unwillingness by markets to lend to Periphery governments, then it was assumed the problem must be excessive borrowing by Periphery governments. Never mind that the problem in Ireland was in large part because the government bailed out its banking sector (and therefore lenders to that sector, some of whom were of course from the Core), and the problem in Spain was that it might be forced to do the same. (On Spain, read this from Yanis Varoufakis.) So the Core countries imposed sharp fiscal austerity on the Periphery, as the price for ‘rescuing’ these countries. It was conveniently forgotten that the reason these countries governments found it difficult or impossible to fund their deficits was because the common currency denied them their own central bank, and that the ECB had been designed by the Core such that it could not explicitly play that role. The terms of the rescue were hardly generous, because it was argued these governments needed to learn their lesson.
                It then got even worse. The austerity inflicted on Greece led the electorate there to believe that there was no hope down this path, and so the terms of their particular rescue needed to be renegotiated. Impossible, responded the Core. If you try to do that, you will have to leave the Euro. The damage that response has done to the operation of the Euro is immense, and entirely predictable. The gains from the ‘permanent’ abolition of exchange rate risk – gains that were central to the economic rationale for the Euro – are being unraveled.
                From this perspective, the actions of the Core from before the Euro was formed until the present day have been misguided and irresponsible. They risk destroying the Euro. It would not be the first time that the actions of a creditor had caused needless destruction. Bear this in mind when you next read about how the terms of Greece’s rescue cannot possibly be changed because of the message this would send to other Periphery countries. If the Euro is to survive, the Core has to stop thinking like the aggrieved party, and instead must recognise that it designed the system that, quite simply, created this crisis.