Tuesday, 2 September 2014

Simplistic theories of inflation

After I wrote this I saw that Frances Coppola has a post that covers some of the same ground, but the point I want to make is different.

One of the things that made monetarism so popular until governments actually tried it was its simplicity. You can express this simplicity in many ways, but most involve the idea that there is a stable demand for the real value of money (M/p), so if you can control M you must control p. Never mind that the immediate influences on inflation were much more complicated: if you knew what M was, you would know what p would be. If you controlled M you would eventually control p.

There are lots of problems with this idea. I talked about the difficulty in explaining prices by just using money in this post. The difficulty of finding the ‘right’ definition of money is not a technical problem but a feature: because money can be saved as well as buy goods (the medium of exchange is also a store of value) focusing on its role in buying goods (‘hot potatoes’) is misleading. But even if there was a stable long run demand for money for some definition, the usefulness of this becomes questionable if we cannot say what the future quantity of money will be.

This becomes blindingly obvious if money is base money and we think about Quantitative Easing. Printing base money under quantitative easing does not imply hyperinflation because the expansion in the monetary base will be reversed once the recession is over. Knowing what base money is becomes useless as a tool for saying what future prices will be. (For those more technically minded who still think there is a Pigou effect, I discussed why the Pigou effect has disappeared from modern macro here. It is based on the same point.)

The Fiscal Theory of the Price Level is potentially another simplistic theory of inflation. This works from the identity that the real value of government debt must equal the discounted value of primary surpluses (taxes less government spending). It also can be used in a naive way: treat future primary surpluses as fixed, and any increase in nominal government debt must lead to higher prices. But, as Chris Sims explains in this nice exposition at Lindau, future primary surpluses are not fixed. If debt increases, future primary surpluses can increase to pay the interest on that additional debt, and more.

There may be some that say that we cannot trust politicians to do that. To which I say which planet have you been on for the last five years? As Brad DeLong reminds us for the US, this recession has been unusual in the zeal that governments have shown in rapidly reducing primary deficits, and of course in the Eurozone this zeal - embodied in the fiscal compact - has led to a second recession. Chris Sims raised the possibility that so great has this zeal been that even though nominal debt has risen, the price level might fall to make the identity hold.

One lesson I would draw from this is that the Fiscal Theory of the Price Level, like monetarism, is not a terribly helpful way of thinking about future inflation. The idea that we can take one variable, or one equation, and distil from that the future price level is a fantasy. What is surprising is that this fantasy has been, and still remains, so attractive for some economists.


Monday, 1 September 2014

Labour's austerity problem

One of the political/economic soap operas over the last year has been the UK Labour Party’s agonising over the perception of its economic competence. The story always starts with current polling data: either Miliband’s personal ratings or Labour’s rating for economic competence. It then often seeks to find the answer to these problems in the past: either the last years of the Labour government, or the first year of opposition when Labour was preoccupied with electing a new leader.

The latest example can be found in an article today by the Guardian’s chief political correspondent, Nicholas Watt. Here Gordon Brown’s call to invest rather than cut in 2009 is blamed, and this is contrasted with an alternative that would acknowledge the need to cut, but focus on the idea that cuts would have been fairer under Labour.

I know nothing about internal Labour politics, but it seems to me that what is going on here is confusion over what the right policy should have been, rather than how to frame it. I also suspect that what really puts the electorate off is when a political party appears confused or divided about a key aspect of policy. The taboo in Labour circles over mentioning the word borrowing is a case in point, which I made fun of before Ed Miliband fell into the same trap.

So what should Labour’s line have been? As it does not have a hidden agenda to reduce the size of the state, its line should have been based on sensible macroeconomics. As my paper with Jonathan Portes suggests, the policy should have been to avoid cuts and to invest while interest rates were stuck at ‘zero’. In other words, the recovery takes priority, and the deficit should be dealt with after the recovery has been assured. Sometimes translating good macroeconomics into simple messages can be difficult, but not in this case.  

Saturday, 30 August 2014

The ECB and the Bundesbank

There can be no doubt that some of the responsibility for the current Eurozone recession has to be laid at the feet of the ECB. Some of that might in turn be due to the way the ECB was set up. Specifically

1) That the ECB sets its own definition of price stability

2) This definition is asymmetric (below, but close to, 2%)

3) No dual mandate, or even acknowledgement of the importance of the output gap

4) Minimal accountability, because of a concern about political interference

It is generally thought that the ECB was created in the Bundesbank’s image. Tony Yates goes even further back in this post. Yet the irony is that the ECB abandoned the defining feature of Bundesbank policy, which could be providing significant help in current circumstances.

The defining feature of Bundesbank policy was a money supply target. Whereas the UK and US experience with money supply targeting was disastrous and short lived, the Bundesbank maintained its policy of targeting money for many years. There is little doubt that this was partly because the Bundesbank was in practice quite flexible, and the money target was often missed. Nevertheless the Bundesbank felt that maintaining that money target played an important role in conditioning expectations, and there is some evidence that it was correct in believing this.

When the ECB was created, it adopted a ‘twin pillar’ approach. The first pillar was the inflation target, and the second pillar involved looking at money. It was generally thought that the second pillar was partly a gesture to Bundesbank practice, and subsequently most analysis has focused on the inflation target.

There are very good reasons for abandoning money supply targets: they frequently send the wrong signals, and are generally unreliable in theory and practice. However a monetary aggregate should be related to nominal GDP (NGDP), and you do not need to be a market monetarist to believe there are much better reasons for following a NGDP target. What a NGDP target does for sure is make you care about real GDP, which would go a long way to correcting points (2) and (3) above. What it can also do, if you target a path for the level of NGDP, is provide a partial antidote for a liquidity trap, as I discuss here. More generally, it can utilise most effectively the power of expectations, which is why perhaps the most preeminent monetary economist of our time has endorsed them.

So do not blame the Bundesbank for the flawed architecture of the ECB. The ECB abandoned the critical aspect of Bundesbank policy, which was to target an aggregate closely related to nominal GDP. ECB policy has suffered as a result.

Friday, 29 August 2014

Eurozone delusions

I have already had a number of interesting comments on my previous post which illustrate how confused the Eurozone macroeconomic debate has become. The confusion arises because talk of fiscal policy reminds people of Greece, the bailout and all that. That is not what we are talking about here. We are talking about what happens when the Eurozone’s monetary policy stops working.

If Eurozone monetary policy was working, the Eurozone would be experiencing additional (monetary) stimulus everywhere, and average inflation would be 2%. Because Germany through 2000 to 2007 had an inflation rate below that in France and Italy, it now has to have an inflation rate above these countries. Something like 3% in Germany and 1% in countries like France and Italy for a number of years. If ECB monetary policy was working, Germany would get no choice in this, because it is part of what they signed up to when joining the Euro.

Monetary policy is not working because of the liquidity trap, so we instead have average Eurozone inflation at about 0.5%, with Germany at 1% and France/Italy at nearer zero. That implies a huge waste of Eurozone resources. That waste can be avoided, in a standard textbook manner, by at least suspending the Stability and Growth Pact (SGP), and preferably by a coordinated fiscal stimulus.

Why is this not happening? There are two explanations: ignorance or greed. Ignorance is a non-scientific belief that fiscal stimulus cannot or should not substitute for monetary policy in a liquidity trap. Greed is that Germany wants to avoid having 3% inflation, because it controls fiscal policy.

Those that say that Germany would be ‘helping out’ France and Italy by agreeing to suspend the SGP and enact a stimulus therefore have it completely wrong. If things were working normally, Germany would be getting a (monetary) stimulus, whether it liked it or not. What Germany is doing is taking advantage of the fact that monetary policy is broken, at the rest of the Eurozone’s expense. Germany gains a small advantage (lower inflation), but the Eurozone as a whole suffers a much larger cost.

Often greed fosters ignorance. It is unfortunate but not surprising that many in Germany think this is all about Greece and transfers and structural reform, because that is what they keep being told. How many of its leaders and opinion makers understand what is going on but want to disguise the fact that Germany is taking advantage of other Eurozone members I cannot say. What is far more inexplicable is that the rest of the Eurozone is allowing Germany to get away with it.
       

Thursday, 28 August 2014

Lessons of the Great Depression for the Eurozone

It is easier to consider the problems of the Eurozone by first thinking about the Eurozone as a whole, and then thinking about distribution between countries. In both cases, the Eurozone is making exactly the same mistakes that were made in the Great Depression of the 1920s/30s.

The Eurozone is currently suffering from a chronic lack of aggregate demand. The OECD estimates an output gap of nearly -3.5% in 2013. Monetary policy is either unable or unwilling to do much about this, so fiscal stimulus is required. This is the first lesson from the Great Depression that is being ignored. Instead of stimulus we have austerity imposed by the Stability and Growth Pact (SGP).

Within the Eurozone, we have a problem created by Germany undercutting pretty well every other economy in the 2000-2007 period. I am not suggesting this was a deliberate policy, but the consequences were not appreciated by any Eurozone government at the time. Some correction has occurred since 2007, but it is incomplete. The second lesson of the Great Depression and the Gold Standard is that achieving correction through deflation and trying to cut wages is both hard and unnecessarily painful.

The solution eventually arrived at in the 1920s/30s was a series of devaluations (leaving the Gold Standard). That is not possible within the Eurozone. However adjustment is much less costly if it is achieved by raising prices in the country that is too competitive, rather than reducing prices in those that are uncompetitive. In practical terms we are not talking about very much here: a period with inflation in Germany at 3%, and at a little above 1% elsewhere, should be sufficient. Instead we now have inflation in Germany of 1% and in the rest of the Eurozone only a little above zero.

Relative unit labour costs (2000=100): source, OECD Economic Outlook May 2014

At this point a sort of moral indignation overcomes economic logic in the debate. Many Germans say why should we suffer 3% inflation to help put right irresponsible policy elsewhere? This is illogical, because it sees inflation below the Eurozone average as a virtue rather than a sin. A country within a monetary union obtaining inflation below the average (as Germany did in the early 2000s) is not a sign of virtue but a sign of a problem, just as it is for other union members to exceed the average.

A country cannot undercut its competitors forever. Any country experiencing below average Eurozone inflation should expect that this will be followed at some point by above average inflation. If the Eurozone could achieve average 2% inflation over the next few years that would mean 3% inflation in Germany - that is part of the Euro contract. To the extent that German policymakers attempt to renege on this contract by either preventing the ECB using unconventional means to achieve its target, or insisting on maintaining the deflationary SGP, then they become directly responsible for the misery that the Eurozone is currently going through.

I have not mentioned at any point levels of debt or structural reforms. Both are distractions for the current problem of inadequate demand and below target inflation. They are relevant only in that they allow policymakers to distract attention from the basic issues. Two of the major lessons of the Great Depression are to use fiscal stimulus to get out of a liquidity trap, and that it is far too painful to insist that uncompetitive countries should bear all the costs of readjustment. The Eurozone has failed to learn either lesson.

  

Wednesday, 27 August 2014

Filling the gap: monetary policy or tax cuts or government spending

Suppose there is a shortfall in aggregate demand associated with a rise in involuntary unemployment in a simple closed economy with no capital. Do we try and raise private consumption (C) or government consumption (G)? If the former, why do we prefer to use monetary policy rather than tax cuts?

If consumers have stable preferences over privately and publicly produced goods, then ideally we want to keep the ratio C/G at its optimal level. So if the aggregate demand gap is caused by a sudden fall in C, we will want to do something to raise C. As real interest rates are the price of current versus future consumption, the obvious first best policy is to set nominal interest rates to achieve the real interest rate that gets C to a value that eliminates the consumption shortfall. That is the basic intuition behind the modern preference to use monetary policy as the stabilisation instrument of choice: part of what I have called the consensus assignment.

In classical or real business cycle models this happens by magic. It normally goes by the term ‘price flexibility’, but it is magic because it is rarely explained how a lack of aggregate demand gets translated into lower real interest rates. In the real world, the magicians are central banks. Note that I have not mentioned anything about implementation lags associated with monetary or fiscal policies, which is one of the reasons you will find in the textbooks for the consensus assignment. My reason for preferring monetary policy is more intrinsic than that.

What happens if the aggregate demand shortfall occurs because ‘supply’ increases through technical progress? Once again the first best policy is to lower interest rates to increase consumption, but we would also want to raise public consumption to keep the optimal C/G ratio.

Finally consider a more difficult shock - a ‘cost-push’ shock to the Phillips curve that raises inflation for a given level of output and aggregate demand. We know that we want policy to reduce output (to create a negative demand gap) to partially reduce inflation, assuming that both the output gap and inflation are costly. However it is less obvious in this case that monetary policy is first best. However, as Fabian Eser, Campbell Leith and I showed in this paper, it still is. It turns out we can complicate the model in some ways (but not others) and the result that we use just monetary policy to maximise social welfare still holds.  

If we return to the case of a demand gap caused by a fall in consumption, suppose we cannot use monetary policy because nominal rates are stuck at zero. As we want to increase private consumption, the obvious alternative to try is a tax cut. If we had access to a lump sum tax (a tax that is independent of income, like the poll tax), and if consumers responded to a tax cut, then this would work pretty well too. There are two problems: Ricardian Equivalence, and there are no lump sum taxes.

If Ricardian Equivalence held completely tax cuts would be totally ineffective at stimulating consumption, but the consistent evidence is that Ricardian Equivalence does not hold. But this evidence does suggest that at least half and perhaps more of any tax cut would be saved, which means that tax cuts would have to be relatively large in money terms compared to the consumption gap. It also adds a degree of uncertainty to their effectiveness. If there is some financial limit on the size of any stimulus package (as often seems to be the case), this puts tax changes that rely on income effects at a severe disadvantage. Even if financial limits are not present, the relative ineffectiveness of tax cuts in stimulating consumption is a problem for another reason.

Lump sum taxes do not exist, so some distortionary tax (a tax that influences incentives) has to be used. This means that a tax cut violates tax smoothing. This is the idea that the best policy is to keep tax distortions constant. A tax rate of 30% is better than a tax rate of 10% in odd years, and 50% in even years. So filling the consumption gap with a cut in the income tax rate (to be followed by increases in that rate) has a cost. The more tax cuts are saved, the bigger the cost. It is highly unlikely that this cost will be sufficient to stop us trying to fill the consumption gap, because unemployment costs are far greater than uneven tax distortions. However there are costs, unlike the first best of changing real interest rates.

In contrast, using public spending to fill any demand gap is much more straightforward, as its impact on demand and employment is more predictable. But it too has a cost: we get the C to G balance wrong (too much G compared to C). Chris House has a recent post on tax cuts versus government spending as alternative means of fiscal stimulus. (Noah Smith wrote a subsequent post and Chris responded.) The proposition he wants to put forward is that government spending should only be used as a stimulus measure if its social benefits outweigh its social costs. I’m not sure that is a very helpful way of thinking about it. Far better, in my view, is to accept that the demand gap must be plugged (because the costs of not doing so are very large), and then work out the way of doing that which leads to the lowest collateral damage. That might well be an increase in G rather than a tax cut. It will almost certainly be so if there is a financial limit on the size of the stimulus.

The same reasoning can and should be applied to unconventional monetary policy, but that has to be another post.



Monday, 25 August 2014

Austerity, France and Memories

Just a day after ECB President Draghi acknowledges the problems caused by European fiscal consolidation, President Hollande of France effectively sacks his economy minister for speaking out against austerity. There was a key difference of course: Draghi was careful to say that “we are operating within a set of fiscal rules – the Stability and Growth Pact – which acts as an anchor for confidence and that would be self-defeating to break.” In contrast French economy minister Montebourg apparently called for a “major change” in economic policy away from austerity, and complained about “the most extreme orthodoxy of the German right”.

Whatever the politics of what just happened in France, the economic logic is with Montebourg rather than Draghi and Hollande. Once you acknowledge that fiscal consolidation is a problem, you have also to agree that the Stability and Growth Pact (SGP) is also a problem, because that is what is driving fiscal austerity in the Eurozone. The best that Draghi could do to disguise this fact is talk about an “anchor for confidence”, to which the response has to be confidence in what? He must know full well that it was his own OMT that ended the 2010-12 crisis, not the enhanced SGP.

Writing for the Washington Post recently, Matt O’Brien asks didn’t you guys learn anything from the 1930s? That the left in particular appears to ignore these lessons seems strange. In the UK part of the folklore of the left is the fate of Ramsay MacDonald. He led the Labour government from 1929, which eventually fell apart in 1931 over the issue of whether unemployment benefits should be cut in an effort to get loans to stay on the Gold Standard. The UK abandoned the Gold Standard immediately afterwards, but Ramsay MacDonald continued as Prime Minister of a national government, and has been tagged a ‘traitor’ by many on the left ever since.

Not that France needs to look to the UK to see the disastrous and futile attempts to use austerity to stabilise the economy in a depression. By at least one account, the villain in the French case was the Banque de France, which in the 1920s used every means at its disposal to argue the case for deflation in order to return to the Gold Standard at its pre-war parity, and it was instrumental in helping to bring down the left wing Cartel government. When it did rejoin the Gold Standard in 1928, the subsequent imports of gold helped exert a powerful deflationary force on the global economy.

So why has the European left in general, and the French left in particular, not learnt the lessons of the 1920s and 1930s? Why do most mainstream left parties in Europe appear to accept the need to follow the SGP straightjacket as unemployment continues to climb? Perhaps part of the answer lies in more recent memories. After many years in the political wilderness, Fran├žois Mitterrand was elected President in 1981, and his government became the first left-wing government in 23 years. In the UK and US high inflation was being met with tight monetary policy, but he and his government took a different course, using fiscal measures to support demand, and hoping that productivity improvements that followed would tame inflation. Although the demand stimulus did help France avoid the sharp recession suffered by its neighbours, inflation remained high in 1981 (not helped by increases in minimum wages and other measures that raised costs) and rose in 1982, at a time when inflation elsewhere was falling. The sharp deterioration in the trade balance that followed led to pressure on the Franc, and the government’s fiscal measures were reversed. Economic policy changed course.

To a macroeconomist, this story is very different from today, where Eurozone inflation is 0.4% and French inflation 0.5%. However, the political story of the early 1980s associates fiscal stimulus and demand expansion with ‘socialist policies’, and their failure and abandonment is associated with Mitterrand staying in power until 1995. When the markets again turned on fiscal excess in Greece in 2010, perhaps many on the left thought they would once again have to subjugate their political instincts to market pressure and undertake fiscal consolidation. Unfortunately it was not the 1980s, but events over 50 years earlier, that represented the better historical parallel.