Friday, 27 March 2015

Protecting the public from policy entrepreneurs

One of Paul Krugman’s first books, Peddling Prosperity, made a distinction between academic economists and people he called "policy entrepreneurs". These are individuals who promote particular intellectual positions and ideological policy prescriptions which have little or no academic support, but which may appeal to certain politicians.

I remember it as a great book, and unfortunately one of the main subjects - the idea that tax cuts pay for themselves - is still current in the US. It remains the case that this idea has virtually zero academic support, but for whatever reason - the activities of policy entrepreneurs being one - it still has a tight hold on the Republican Party.

I also remember being dissatisfied with the concept of the policy entrepreneur. It seemed to me that the book failed to situate them in a more general framework of how different interests influenced policy. Why were policy entrepreneurs particularly prevalent in economics? Could academics also be policy entrepreneurs? But that was the social scientist in me speaking. It was clear that such people existed, and that their influence could be far from benign.

I was reminded of all this when someone referred me to Andrew Sentance’s latest piece where he advocates moving to a zero inflation target. Coupled with George Osborne and David Cameron proclaiming zero inflation as a great success, a horrible thought occurred. If these guys were re-elected, might they find the arguments of Andrew Sentance appealing, and actually go for zero inflation? (In the UK, the Chancellor sets the inflation target.) Getting rid of inflation completely - sounds like a vote winner!

Why is it a horrible thought? Because all the academic discussion has been going in the opposite direction, for a very good reason. The Great Recession has highlighted the problems caused by the lower bound for nominal interest rates. That problem will not go away if that lower bound turns out to be -1% rather than zero. The discussion of secular stagnation has highlighted how the ‘underlying’ level of real interest rates has steadily fallen over the last few decades. Put the two together, and you see that a 2% inflation target may mean that we hit the interest rate lower bound far too frequently for comfort. A higher inflation target is one way, although not the only way, of reducing this problem.

Given this, calling for a zero inflation target seems perverse. In response, Andrew Sentance says this: “And the fact that a target of zero inflation may not allow central banks to easily impose negative real interest rates may actually be a good thing – protecting savers, who have suffered heavily as a result of very low interest rates since the financial crisis.” This is just the kind of thing a policy entrepreneur would say: identify your target interest group, and appeal to their interests over the common good. A politician who wants to appeal to savers might think that sounds like a good idea, and before you know it the policy is in place.

I suspect things have moved on a little since Peddling Prosperity was published. The role of think tanks is probably greater. The good ones are a means of channelling academic research, as in this very recent discussion of how to enhance real wage growth from the Resolution Foundation (which I would call excellent if it didn’t have a contribution from me). But they are matched by others that are effectively the institutional equivalent of policy entrepreneurs.

One answer to this problem is delegation. If you delegate an issue to a non-political body, that institution is going to be less swayed by the policy entrepreneur, and more influenced by knowledge and evidence. The independent central bank is an obvious example. It is interesting that one of the contributions to the Resolution Foundation volume, from John Van Reenen, calls for a “permanent infrastructure strategy board”, to improve the level and quality of national infrastructure. Of course with delegation comes the danger of power without accountability, and one particular central bank is a good example of that.  

Is delegation the only way we have of protecting ourselves from the policy entrepreneur? I have one final thought. (The idea comes from Chris Dillow, but he said it on my blog first!). Policy entrepreneurs exist in part because of sectional interests. The problem arises if sectional interests drown out evidence based policy. Society as a whole clearly has an interest in evidence based policy, but one institution that is well placed to protect society’s interest here is academia. Although - in the UK at least - academia encourages the dissemination of research, most academics are always going to value their research above its dissemination, because that is how internal incentives work. So maybe the academic sector needs to create a few policy entrepreneurs of its own, whose mission is to disseminate not their own research, but research in a whole field. One of two examples already exist - maybe we should have more of them.  

Thursday, 26 March 2015

Rollercoasters and rules

Chris Giles says today that “there is a gap [between Labour and Conservatives plans] of more than £30bn a year in public spending by the end of the decade, at least 1.4 per cent of national income. This is a bigger political divide seen in any election since the days of Margaret Thatcher.” Chris is absolutely right to focus on this fact, and it is really important that other journalists (including those on the political side) do the same. The reason is that neither Labour nor the Conservatives want to admit this. Labour wants to appear as if they are being ‘tough on the deficit’ and the Conservatives want to turn this into a ‘Labour would put up taxes’ election. With all the noise that these phoney debates throw up, it is important that someone tells people what the consequences of their vote will be.

Chris may also be right that the rollercoaster for public spending set out in the Budget (sharp cuts followed by increases) will not happen. However I think it would be wrong to expect a smooth ride under the Conservatives either. They will have won an election based on an initial two years of substantial spending cuts (particularly to public investment), followed by later years when the overall pace of fiscal consolidation slowed substantially (in part because of Budget tax cuts). If that wins them this election, they will want to repeat that pattern. [1]

The term rollercoaster was coined by Robert Chote, head of the Office for Budget Responsibility. But if the rollercoaster will never happen, was Robert wrong to use this word? Absolutely not - in using that term he was doing his job in a very effective way.

As Chris explains, the reason why the numbers given to the OBR generate a rollercoaster profile is the revised fiscal rule, which says that there should be (cyclically adjusted) balance within three years. Like the old rule, this is a rolling target (but now for three years ahead rather than five), so it means in effect that governments can keep putting off the date balance is achieved as each year rolls past.

If governments start planning their fiscal actions with this in mind, the rule becomes largely worthless: it means reducing deficits maƱana. As I explained here, rolling targets are a good idea because they allow policy to be flexible in the face of shocks. But rolling targets can also be abused by an irresponsible government to forever put off deficit reduction.

As I argued here, there was no good reason for Osborne to switch from a five to three year rolling target, and good reasons to stick to five years. The move to three years looked like a political ploy to embarrass the opposition. When politicians start messing around with fiscal rules for political ends, and these rules then produce silly results which politicians have no intention of sticking to, it is important that an independent institution with the words ‘budget responsibility’ in their title calls attention to what is going on. Robert Chote did that very effectively by using the term rollercoaster. 

[1] Where I think Chris is wrong is in describing plans to decrease debt slowly as risky. The opposite is the case. With interest rates near their floor, sharp austerity puts the economy at risk from adverse macroeconomic shocks. 

Wednesday, 25 March 2015

Why do central banks use New Keynesian models?

And more on whether price setting is microfounded in RBC models. For macroeconomists.

Why do central banks like using the New Keynesian (NK) model? Stephen Williamson says: “I work for one of these institutions, and I have a hard time answering that question, so it's not clear why Simon wants David [Levine] to answer it. Simon posed the question, so I think he should answer it.” The answer is very simple: the model helps these banks do their job of setting an appropriate interest rate. (I suspect because the answer is very simple this is really a setup for another post Stephen wants to write, but as I always find what Stephen writes interesting I have no problem with that.)

What is a NK model? It is a RBC model plus a microfounded model of price setting, and a nominal interest rate set by the central bank. Every NK model has its inner RBC model. You could reasonably say that these NK models were designed to help tell the central bank what interest rate to set. In the simplest case, this involves setting a nominal rate that achieves, or moves towards, the level of real interest rates that is assumed to occur in the inner RBC model: the natural real rate. These models do not tell us how and why the central bank can set the nominal short rate, and those are interesting questions which occasionally might be important. As Stephen points out, NK models tell us very little about money. Most of the time, however, I think interest rate setters can get by without worrying about these how and why questions.

Why not just use the restricted RBC version of the NK model? Because the central bank sets a nominal rate, so it needs an estimate of what expected inflation is. It could get that from surveys, but it also wants to know how expected inflation will change if it changes its nominal rate. I think a central banker might also add that they are supposed to be achieving an inflation target, so having a model that examines the response of inflation to the rest of the economy and nominal interest rate changes seems like an important thing to do.

The reason why I expect people like David Levine to at least acknowledge the question I have just answered is also simple. David Levine claimed that Keynesian economics is nonsense, and had been shown to be nonsense since the New Classical revolution. With views like that, I would at least expect some acknowledgement that central banks appear to think differently. For him, like Stephen, that must be a puzzle. He may not be able to answer that puzzle, but it is good practice to note the puzzles that your worldview throws up.

Stephen also seems to miss my point about the lack of any microfounded model of price setting in the RBC model. The key variable is the real interest rate, and as he points out the difference between perfect competition and monopolistic competition is not critical here. In a monetary economy the real interest rate is set by both price setters in the goods market and the central bank. The RBC model contains neither. To say that the RBC model assumes that agents set the appropriate market clearing prices describes an outcome, but not the mechanism by which it is achieved.

That may be fine - a perfectly acceptable simplification - if when we do think how price setters and the central bank interact, that is the outcome we generally converge towards. NK models suggest that most of the time that is true. This in turn means that the microfoundations of price setting in RBC models applied to a monetary economy rest on NK foundations. The RBC model assumes the real interest rate clears the goods market, and the NK model shows us why in a monetary economy that can happen (and occasionally why it does not). 

Tuesday, 24 March 2015

Zero UK Inflation

Today it was announced that UK consumer price inflation hit zero in February. The ONS estimate that we have to go back to the 1960s for the last time this happened. More importantly, core inflation fell back 0.2% to 1.2%, after 0.1% increases in the previous two months. As Geoff Tily points out, if you take out the 0.2% contribution from the decision to raise student fees (which are hardly an indicator of excess demand), then the Governor could be writing a letter to the Chancellor based on core inflation, and not just the actual inflation rate.

The Chancellor is in election mode and so does not care: in fact he says zero inflation is good news, and he just hopes no one asks him why he chose to reaffirm a symmetrical 2% target. For the Bank of England it means the key question is now should they cut rates? As I noted here, optimal control exercises on the Bank’s model and forecast say they should, and I discussed here why there is an additional strong prudential case for doing so.

The point I want to make now is about survey evidence on capacity utilisation. I had a number of memorable meetings with various economists and officials at the Treasury, Bank and elsewhere when the Great Recession was at its height, but the one that left me most puzzled was with one of the more academic economists at the Bank of England. It was at about the time that core inflation started rising to above 2%, despite unemployment being very high and very little signs of a recovery. At much the same time survey measures of capacity utilisation were suggesting a strong recovery, completely at variance with the actual output data. The gist of our discussion was: what the hell is going on!? It was particularly puzzling for me, because I had many years before done a lot of work with survey data of this kind, and back then it seemed pretty reliable.

The problem with the 2010 period was that it was exceptional, and so in that sense it was not that surprising to see surprising things going on. My own pet theory at the time was that the financial crisis had made firms much more risk averse, which made them less likely to cut prices in an attempt to gain market share. Move on to today, and things are perhaps a bit less exceptional. What today’s figures emphasise is that the inflation ‘puzzle’ of 2010/11 has gone away. Levels of inflation are now much more consistent with substantial spare capacity in the economy. However the bizarre behaviour of the survey data has not disappeared.

Here is a nice chart from the ONS, comparing various different measures of spare capacity.

What it shows is that labour market indicators suggest an amount of spare capacity well outside the ‘normal’ range from the pre-recession years. In contrast, both hours worked and survey based indicators (the first six measures) suggest the output gap is quite small, and in one case actually positive. As this OBR paper shows, survey measures of capacity utilisation were suggesting a positive output gap as early as 2012.

Faced with this combination of spare capacity in the labour market and firms reporting its absence, a macroeconomist would suggest it could be a consequence of high real wages, encouraging substitution from labour to capital. Firms were fully utilising their capital – hence no spare capacity – but had hired less labour as a result. However a notable characteristic of this recession in the UK has been the high degree of labour market flexibility, with large falls in real wages. One of the more persuasive theories for the UK productivity puzzle, which I outlined here, is that we have seen factor substitution going in the other direction.

Back in 2010, I was reluctant to suggest the survey data were simply wrong, partly because of their past reliability but mainly because inflation was telling a similar story. On the day that inflation hits zero, I think the argument that these survey measures are not measuring what we used to think they measured has become much stronger. But that still leaves an unanswered question - why have they gone wrong, when they worked well in the past? 

Sunday, 22 March 2015

Controlling the past

In his novel 1984 George Orwell wrote: “Who controls the past controls the future: who controls the present controls the past.” We are not quite in this Orwellian world yet, which means attempts to rewrite history can at least be contested. A few days ago the UK Prime Minister in Brussels said this. [3]

“When I first came here as prime minister five years ago, Britain and Greece were virtually in the same boat, we had similar sized budget deficits. The reason we are in a different position is we took long-term difficult decisions and we had all of the hard work and effort of the British people. I am determined we do not go backwards.”

In other words if only those lazy Greeks had taken the difficult decisions that the UK took, they too could be like the UK today.

This is such as travesty of the truth, as well as a huge insult to the Greek people, that it is difficult to know where to begin. Let’s start with the simple statement of fact. According to OECD data, the 2010 government deficit in Greece was 11%, and in the UK 9.5%. The Prime Minister is normally well briefed enough not to tell outright lies. But look at this chart you can see why the statement ‘virtually in the same boat’ is complete nonsense.

General government financial balances, % GDP: source OECD Economic Outlook
The real travesty however is in the implication that somehow Greece failed to take the ‘difficult decisions’ that the UK took. ‘Difficult decisions’ is code for austerity. A good measure of austerity is the underlying primary balance. According to the OECD, the UK underlying primary balance was -7% in 2009, and it fell to -3.5% in 2014: a fiscal contraction worth 3.5% of GDP. In Greece it was -12.1% in 2009, and was turned into a surplus of 7.6% by 2014: a fiscal contraction worth 19.7% of GDP! So Greece had far more austerity, which is of course why Greek GDP has fallen by 25% over the same period. A far more accurate statement would be that the UK started taking the same ‘difficult decisions’ as Greece took, albeit in a much milder form, but realised the folly of this and stopped. Greece did not get that choice. And I have not even mentioned the small matter of being in or out of a currency union. 

From the Prime Minister, let’s move to Janan Ganesh, FT columnist and Osborne biographer. He says that Osborne’s secret weapon is his “monstrously incompetent adversaries”. If only the Labour party had “owned up to its profligacy in office during the previous decade” it would have more authority in the macroeconomic debate today. I have written a great deal on this, but actually you can get the key points from the chart above. If you have a target for government debt which is 40% of annual GDP, and nominal annual growth is around 4%, you want to aim for a deficit of 1.6% of GDP. Labour clearly exceeded that, which is why the debt to GDP ratio drifted up from 30% of GDP in FY 2000 to 37% in FY 2007 (OBR figures).

A mistake? Yes, particularly in hindsight. Profligacy - absolute nonsense. The debt to GDP ratio in FY 2007 was below the level Labour inherited, which does not sound like a profligate government to me. Nor does a deficit in 2007 that is only about 1% above a long run sustainable level signal profligacy.

What blew the deficit was the recession. Ganesh acknowledges that, but says “there was no excuse at all for pretending that a recession was never going to happen “. This is pure hindsight stuff. In 2007, the consensus was that the UK was close to balance in terms of the output gap. It is only subsequently that some have tried to suggest, rather unconvincingly, that 2007 was really a global boom. So Labour was not pretending anything.

But why this urge for Labour to apologise for what is a relatively minor misdemeanour which had no major consequences. [1] Because it plays to the Conservative narrative: their version of history where Labour was responsible for the mess that the Conservatives had to clean up. Labour has been forced by mediamacro to buy into the deficit reduction narrative enough as it is: asking for more is just self-serving political nonsense.

As I explained here, it is really important for the coalition parties to sustain this narrative, because without it Osborne’s record looks pretty awful. When people realise that this poor record was not an inevitable result of ‘Labour profligacy’ or any other mess Osborne inherited, and that to focus on reducing debt was a choice rather than a necessity, then the responsibility becomes clear, and support for yet more sharp austerity quickly disappears. [2]

As for the phrase ‘monstrously incompetent’, I really wonder what world Ganesh lives in. When I look back at Chancellors of the past, I see few candidates for this label, and Brown and Darling are not among them. However what term would you use for a Chancellor that freely chose a policy of premature austerity, and as a result lost every UK adult and child resources worth at least £1,500? That unforced error does sound like something worth owning up to. 

[1] The worst that can be said is that, had Labour kept debt at 30% of GDP, they might have felt less constrained in 2009 and undertaken greater countercyclical fiscal action. But George Osborne argued against the countercyclical fiscal actions Labour did take in 2009! 

[2] That is of course an unsubstantiated conjecture, and the following is not meant to be evidence, because its a small and unrepresentative sample. In a previous post I mentioned a debate that Prospect magazine organised between myself and Oliver Kamm. I hadn’t realised until someone pointed it out (along with a rather biased editorial in that same issue), but readers get a chance to vote after reading this debate on whether ‘austerity is right for Britain’. At time of writing, we had 17% voting Yes and 83% voting No.

[3] HT Ari Andricopoulos

Saturday, 21 March 2015

Default panic and other tall stories

People still say to me that the UK or the US had to embark on austerity, because otherwise the markets would have taken fright at the ‘simply huge’ budget deficit. How do they know this? Because people ‘close to the market’ keep telling them so.

What can I do to show that this is wrong? The most obvious point is that interest rates on UK or US government debt have been falling since 2008, but the response I sometimes get is that rates have only stayed low because of austerity policies. So how about looking at one very short period, around the UK general election of 2010. The election itself was on 6th May, but Gordon Brown only resigned on 10th May, and the coalition agreement was published on 12th May.

Labour were proposing a more gradual reduction in the deficit than the Conservatives, but the Liberal Democrats (the eventual coalition partners) were during the election closer to Labour. So if there was any default premium implicit in yields on UK government debt, it should have fallen between 5th May and 13th May, either because Labour were defeated, or because the LibDems capitulated on the deficit. Now you may say that the markets were anticipating a Conservative victory, but even if that is true, on 5th May there was some doubt about that, which should have been reflected in the price. The coalition agreement published on 12th May clearly states a commitment to “a significantly accelerated reduction in the structural deficit”, so that doubt should have disappeared by then. If there was a default premium in rates before 6th May, it should have fallen by 13th May.

Yield on 10 year UK government debt: source Bank of England

As you can see, rates were higher on 13th May compared to 5th May. More to the point, there was no noticeable decline in rates because fiscal consolidation was going to be greater. Now of course other things may have happened over these few days to offset any default premium effect, and you can always spin stories about how markets were concerned about a coalition government so maybe the accelerated deficit reduction was not going to happen, etc. But they are stories: in terms of the data, there is no obvious effect.

The more sophisticated defence of austerity, as here from the Permanent Secretary at the UK Treasury in reviewing William Keegan’s new book, is that there exists a ‘tipping point’ somewhere: some level of the deficit at which the markets will take fright. It is then suggested, with reference to the Eurozone crisis, once you reach that point it is very hard to return, because a vicious circle sets in. Interest rates rise, making any new debt more expensive to service, which raises the deficit itself, making default even more likely. As we do not know where that tipping point is, it is best to stay well away from it by taking precautionary action before it is reached. The problem with this argument is that having your own central bank makes a key difference, not just to the chance of a funding crisis, but to its dynamics as well.

Having your own central bank does not rule out the possibility of default. As Corsetti and Dedola explain, the costs of inflation created by monetising the debt may exceed the costs of default. Markets know that, so they may still at some point begin to suspect that default could happen. It therefore follows that the markets could get it wrong: they may begin to suspect default even when there is absolutely no intention within government to let this happen.

Suppose this fate had befallen the UK or US governments in 2010. The markets suddenly panic that the government may default, even though the government has no intention of doing so. Interest rates start rising on government debt. But both governments have a Quantitative Easing programme, which is designed to keep long term interest rates low, so their central banks respond by buying more government debt. The cost of servicing government debt does not rise, because additional money is created, so there is no vicious circle. There is plenty of time for the government to take whatever action it wishes to take to reassure the markets. And unlike the model of Corsetti and Dedola, because there is a recession and a liquidity trap, the extra money created does not immediately lead to inflation. [1]

Having your own central bank, which is already undertaking Quantitative Easing, does not just make a funding crisis a lot less likely, it also crucially changes the dynamics. If a crisis occurs, the government is not trapped in a vicious circle. This in turn means that there is no obvious reason to act in a precautionary way. So why did no one make this point nearer the time? The answer of course is that they did.

[1] If you think that in these circumstances a foreign exchange crisis will get you, you need to explain why Paul Krugman’s analysis is wrong. 

Thursday, 19 March 2015

Sticky wages both sides of the Atlantic

At the beginning of last year, there were many who were predicting a rise in UK interest rates in 2014. By then UK unemployment had been falling for many months, and we had had four quarters of solid growth. However I said that if rates did rise in 2014 it would be extraordinary. One of the reasons I gave was that there was absolutely no sign of any increase in nominal wage inflation. I thought it would be particularly odd if UK rates rose before US rates, given that the UK’s recovery was lagging a few years.

Unemployment continued to fall rapidly. By June 2014 even the Bank’s governor, Mark Carney, was giving indications that rates might rise sooner than some were expecting. US monetary policymakers showed no signs that they were about to raise rates, and I still thought they should be the first to move, but I was worried that the MPC was sounding too itchy. Sure enough in August two MPC members voted to raise rates. But wage inflation showed no signs of increasing.

Move forward to March 2015, and the prospect of rate increases seem to be receding on both sides of the Atlantic. On Wednesday the FOMC revised down their forecasts for inflation, and also revised down their estimate for the natural rate of unemployment. The reason is straightforward: despite continuing falls in unemployment, wage inflation refuses to budge. John Komlos argues that this state of affairs is unlikely to change anytime soon.

Much the same seems to be true in the UK, as this excellent account from Andy Haldane makes clear. In the UK there is an additional twist. To quote Haldane: “Back in 2009, the MPC’s judgement was that the benefits of cutting rates below 0.5% were probably outweighed by their costs, in terms of the negative impact on financial sector resilience and lending. With the financial sector now stronger, the MPC judges there may be greater scope to cut rates below 0.5%.” It now looks like the Zero Lower Bound (ZLB) may actually be zero.

Haldane goes through in great detail the possible reasons why wage inflation seems so sticky. Moving to the monetary policy implications, he talks about asymmetries, and many of the issues that I raised here he also raises. However he ends with something that I think is even more telling. The chart below shows an optimal interest rate path, using the Bank’s COMPASS model, and assuming a ZLB of zero.

What it does is confirm a suspicion that both Tony Yates and I had about the MPC’s current stance. The policy of doing nothing, and waiting for the inflation rate to gradually converge towards 2%, does not look optimal even if the Bank’s forecast is completely correct.