Tuesday, 1 December 2015

The centrality of policy to how long recessions last

For economists

Paul Krugman reminds us that one of the most misguided questions in macroeconomics is ‘are business cycles self-correcting’. This is a particular case of another mistake, which is to say that the duration of the business cycle depends on the speed of price adjustment. That answer is seriously incomplete, because it only holds for a particular set of monetary policy rules (plus assumptions about fiscal policy).

It is very easy to see this. Suppose monetary policy is so astute that it knows perfectly all the shocks that hit the economy, and how interest rates influence that economy. In that case absent the Zero Lower Bound the business cycle would disappear, whatever the speed of price adjustment. Or suppose monetary policy followed a credible rule that related real interest rates to the output gap rather than excess inflation. Once again the speed of price adjustment is not central to how long business cycles last. As Nick Rowe points out, if you had a really bad monetary policy recessions could last forever.

A better answer to both questions (self-correction and how long business cycles last) is it all depends on monetary policy. Actually even that answer makes an implicit assumption, which is that there is no fiscal (de)stabilisation. The correct answer to both questions is that it depends first and foremost on policy. The speed of price adjustment only becomes central for particular policy rules.

So why do many economists (including occasionally some macroeconomists) get this wrong? Why are textbooks often quite unclear on this point? It could be just an unfortunate accident. We are so used to teaching about fixed money supply rules (or in my case Taylor rules), that we can take those rules for granted. But there is also a more interesting answer. To some economists with a particular point of view, the idea that getting policy right might be essential to whether the economy self-corrects from shocks is troubling. They prefer to think of a market economy as being ‘naturally’ self-correcting, and to think that government intervention only has a role to play if there is some serious ‘market imperfection’. The market imperfection in the case of business cycles is price rigidity.

Focusing on this logic alone can lead to big mistakes. I have heard a number of times good economists say that in 2015 we can no longer be in a demand deficient recession, because price adjustment cannot be that slow. This mistake happens because they take good policy for granted. It is almost certainly true that no recession should last this long, because fiscal policy can substitute for monetary policy at the Zero Lower Bound. But with sub-optimal policy the length of recessions has much more to do with that bad policy than it has to do with the speed of price adjustment.

Just how misleading a focus on the speed of price adjustment can be becomes evident at the Zero Lower Bound. With nominal interest rates stuck at zero, rapid price adjustment will make the recession worse, not better. Price rigidity may be a condition for the existence of business cycles, but it can have very little to do with their duration.        

Friday, 27 November 2015

Five small thoughts on the Autumn Statement

I talked about the big picture here and here, but as ever there is a lot of interesting detail. Here are five thoughts that I have not seen expressed elsewhere.

1) Tax credits. As people gradually began to twig, the U-turn on tax credits is only temporary: most tax credits will become part of Universal Credit when it is introduced, and the cuts there remain. As the Resolution Foundation show, those at the lower end of the income distribution are eventually going to be made a lot worse off.

But it’s still a big victory for those opposed to the tax credit cuts, for two reasons. First, a few years without the cuts are worth having. Second, and perhaps more importantly, Osborne wanted the cuts to come in early so that their memory would be diminished by the time of the next election. That will no longer happen, which might mean that when the time comes they too will be dropped/delayed.

2) Apprenticeship levy. One of the problems economists have with budget/autumn statement commentary is incidence - it is generally assumed that a tax on business is different from a tax on wages. But as the OBR point out, the evidence suggests that higher payroll taxes (‘taxes on jobs’), which this levy essentially is, will be largely met by firms paying lower wages. But if the Chancellor had raised the same amount of money by increasing employees NICs, everyone would be making much more fuss about this tax increase (particularly as he had pledged not to do so).

One point I didn’t hear mentioned is that we used to have an apprenticeship levy - it was abolished by Mrs. Thatcher.

3) Democracy. I’m occasionally told that I’m too critical of this government, and some even suggested on Wednesday that this Autumn Statement represented a move to capture the centre ground. But the Statement included a 19% cut in money provided to opposition parties. The Treasury said it was “time for political parties to pull their weight in difficult times.” I think the chief executive of the Electoral Reform Society was nearer the mark when she said it was “bad news for democracy”.

4) Labour. Talking of opposition, there was a lovely moment at the end of Osborne’s speech where he noted that Labour had suggested maybe a 10% cut in money for police was appropriate, only to announce no cut at all. It was just one more example of how timid Labour has become. Would it have dared increase the stamp duty on second homes/buy to let by so much? And then of course there was the higher minimum wage in July.

I normally try to avoid watching/reading political speeches, and only turned the TV on to see how John McDonnell performed. As I have said before, many on the left are their own worst enemies when it comes to the issue of political spin. They despise it, which is healthy in itself, but they actually need to be far better at it than their opponents because of media bias. Of course some things are so blindingly obvious …

5) Fragile fiscal forecasts. The thing I really dislike about occasions like this is all the emphasis on the aggregate fiscal numbers. Some people seemed surprised that the OBR should make such a big change to its tax take forecast, but as a one time forecaster it did not surprise me a bit. Macro forecasts are very unreliable anyway, and one of the hardest macro numbers to forecast is the budget deficit. Yet people obsess over small changes to the deficit in future years, as if this mattered. It does not.

One final comment on comments. This end of austerity meme is silly. Here is a chart.

Thursday, 26 November 2015

Is this the right way to shrink the state (NHS edition)?

In terms of changes since his July budget, the basic story of the Autumn Statement is that George Osborne has used more favourable tax forecasts from the OBR to ease up a little on planned spending cuts. The stress here is on ‘a little’. This is why my piece for The Independent focuses on the big picture. (There are a number of minor points that I think are interesting, and I’ll comment on those in a later post.) We still have sharp fiscal tightening, with the OBR’s estimate of the cyclically adjusted budget deficit showing a turnaround worth 4% of GDP between 2015/16 and 2019/20. (That is nearly as much as the contraction from 2009/10 until 2015/16. The turnaround in the actual deficit is slightly larger.) While the US and Euro area ease off on fiscal consolidation, George wants to carry on.

For regular readers there are two new points that I make in The Independent article. The first is about the myth of ‘protected departments’. It is classic spin: employ words which the media will use endlessly that do not mean what most people think they mean. The second is that if the goal is to reduce the size of the state, this seems a remarkably incompetent way of doing it. Rather than look at what the state does and strategically decide what we could do without, the method seems to be to keep cutting until a crisis becomes visible. I do not think enough is made of this government’s incompetence. I want to illustrate both points by looking at health.

Let’s start with this nice chart from John Appleby of the King’s Fund. It should be shown every time anyone claims that NHS spending under this government has been protected.
For reasons that are well known, the share of spending on health pretty well everywhere has been rising steadily since WWII. Try to reverse that and you get a crisis. Try to reverse that when you are also slashing local authority spending for community help, so that elderly patients cannot be discharged into local authority care, and you get a major crisis.

But that is not the only sign of incompetence. Under the coalition Cameron undertook a massive reorganisation of the NHS, which was badly conceived and used up precious resources. (Perhaps the biggest political failure of the Liberal Democrats in coalition was to allow this reorganisation to go through: see this Institute for Government report aptly titled ‘Never Again?’) Then before the last election the Conservatives thought it would be a clever strategy to establish a ‘7-day a week’ health service. To try and justify that policy, health minister Jeremy Hunt made dodgy use of data to argue that health outcomes were worse if you were admitted to hospital at the weekend. Did no one tell him that this might lead some to do themselves harm by trying to delay going into hospital?

There is no money to fund this new policy, so Hunt has tried to restructure junior doctors contracts to pay for it. With many junior doctors already leaving the UK to work overseas, this was the last straw and they have voted overwhelmingly to go on strike. (Watch this video if you think picking this fight is clever politics.) In 2012 training places for nurses were cut, so now hospitals have to use more expensive agency nurses. All this indicates basic incompetence by those who ultimately are responsible for the NHS.

It was this kind of thing that I had in mind when I wrote: “It is difficult to know which is worse: duplicity to achieve an ideological goal or pursuing that goal incompetently.”

Postscript: More detail on the small print of the spending review settlement from Sally Gainsbury here.

Wednesday, 25 November 2015

Political economy assignments

Suppose you have two objectives for monetary policy: financial sector stability and real economy stability. You have two main instruments: interest rates and macroprudential policy (things like changing the capital requirements of banks, or making it less easy to get a mortgage; often called macropru for short). Should you assign one instrument to one objective (often called an assignment), or try and achieve both goals with both instruments?

As Tony Yates points out, assignments are rarely optimal from a purely macro point of view. Even if, say, interest rates are less effective at achieving financial stability than macropru, you would still want interest rates to contribute something to that objective. An exception is when one instrument completely dominates the other: then assignment is optimal. An example of this exception in a certain class of model is monetary over fiscal policy as means to achieve real stabilisation, as discussed here and here (less technical discussion here). But this type of result is unusual, and even when you get a result like this for a certain class of models it is not hard to add real world complications that remove the result.

If assignment in the case of real and financial stabilisation is not optimal, does this imply that those setting interest rates should take financial stability into account? It is important to understand what we are talking about here. We are not talking about how financial conditions might influence what interest rates need to be to achieve real stabilisation, which is the kind of issue discussed in this post by Bianca De Paoli for example. Nor is it talking about allowing for risk as I discussed here. Instead it would be saying that institutions like the US Fed should have a triple mandate when setting interest rates, where the third mandate was financial stability. Interest rates could be changed if financial stability was a concern, even if this had no implications for inflation or output. Equivalently, interest rates could move to help financial stability even if this took output and inflation away from target.

However we already have assignments that are clearly suboptimal from a purely macro perspective. Fiscal policy is assigned to the control of government debt, and reducing debt is certainly not a monetary policy objective. But in standard models this assignment is clearly suboptimal: when debt is high, reducing interest rates can be quite effective in reducing debt (particularly if government debt is mostly short term), and undesirable knock on effects on output and inflation can be countered by fiscal policy. Yet the mainstream consensus is that monetary policy should not be used to reduce debt.

The reason for this suboptimal assignment is most probably because of political economy concerns. Or to put it another way policy is mainly concerned about knowingly sub-optimal decisions. Reducing interest rates to reduce debt sounds too much like fiscal dominance. There is a fear that if there is no institutional assignment, politicians will depart from optimal policy and by keeping rates too low to reduce debt they will allow excessive inflation.

Can such political economy concerns be applied to financial stability and monetary policy, particularly as the same actor - an independent central bank - is in charge of both? My instinct is that it can, because central bankers are heavily influenced by pressures from the financial sector. As a result, there is a danger that if interest rates are set with both objectives in mind, central bankers will depart from optimal policy and, for example, needlessly raise interest rates before the real economy requires them to rise. The recent experience of Sweden is a clear example where this happened. For this reason I rather like the UK institutional set-up, with a separate MPC and FPC and a clear assignment for each.

Tuesday, 24 November 2015

Economists and the Eurozone: wake up calls and political capture

This VoxEU post tries to build a consensus narrative about why the Eurozone crisis happened, because you can only effect a cure if you get the diagnosis right. I agree with the post. In particular it makes two crucial points that suggest where reform should be taking place but is not.

First, it points out that the crisis was generated by unsustainable flows of lending from the core to the periphery. This was a combination of irresponsible borrowing and irresponsible lending. It is a classic macroeconomic problem with a classic (partial) remedy: more effective macroprudential and countercyclical fiscal policies. The existing Eurozone fiscal rules, which focus on debt and deficit limits, failed and would fail again because they ignore this problem. Replacing them with rules that allow or mandate effective countercyclical policy should be the focus of policy makers attention, but is off the radar.

Second, the crisis was brought to an end by the ECB becoming a sovereign lender of last resort. That immediately suggests that the crisis could have been far less serious if the OMT policy had been in place much earlier. It raises important issues about how to reinterpret a no bail out policy when OMT is possible, and the nature of any conditionality. Those questions are not at present being addressed by the Eurozone leadership.

Why is it necessary to repeat once again what is a consensus position among most economists? Alas there are powerful political interests within the Eurozone that want to foster an alternative narrative, which sees every country like Greece. This erroneous narrative has already done great damage, creating a second recession from excessive fiscal tightening and insufficient monetary easing across the Eurozone.

It is natural at this point to talk about Germany, and the fact that as a result of low wage increases undercutting Eurozone neighbours before the recession, Germany is not suffering as much from this recession as other countries. But I have often tried to avoid stopping there, and instead to ask whether Germany's strange stance on these macro issues simply reflects this different conjunctural position. I think the answer is no.

I'm increasingly drawn to the view that Germany's stance reflects similar political economy pressures as you will find in other OECD economies: there is no German exceptionalism, but rather that the forces that everywhere are pushing austerity and tighter monetary policy happen for various reasons to be stronger in Germany. From this perspective, this post from Frances Coppola is particularly interesting. Perhaps the problem at the heart of the Eurozone is that economic policy advice in Germany has been effectively captured by employers' interests, and perhaps the interests of banks in particular.

Sunday, 22 November 2015

Is this really social democracy versus socialism?

One of the more depressing reads over the past week is this from Colin Talbot. It ends with
We may yet end up with a more ‘continental’ configuration of the left in Britain: two parties, one social democratic and the other reformist socialist with maybe a revolutionary wing.
But is there currently a civil war in the Labour party between social democracy and reformist socialism?

In a sense it would be nice if that was what current debates were about, but it does not seem like that. The main debating point in the election was austerity, where the dividing line was between those prepared to follow the economics and those that thought doing so was electoral suicide. The latest fracas was about bombing Syria. Both seem to have more to do with an agenda set by the Conservatives and the media rather than any fundamental divide on the left.

Here is an alternative interpretation. There are these two traditions among MPs, but perhaps the majority of the (far more numerous) social democratic tradition are trying to work with the socialist leadership to formulate a policy platform that both sides can live with. This majority accept the reality demonstrated by the Labour leadership election, which was essentially a vote against the platform and perhaps more importantly the strategy that the other candidates at least appeared to represent. Obtaining this compromise means struggle for sure, but not open civil war.

Within both traditions, there are those who are less prepared to compromise. In particular, there are a significant group of MPs among the social democrats that believe a civil war might be to their advantage. They reason that the quicker it becomes clear that the current leadership are failing in the polls, the sooner party members will see the folly of their previous decision and they can win back the leadership. A civil war can hasten that day. Perhaps they might even be able to stage a coup before then.

A coup would surely split the party. Given the leadership election result, those on the right would lose in any battle to control the party. If that happened, the lessons of the past (which this group draw freely upon when arguing that the current situation is doomed to fail at the polls) suggest that a split would be disastrous in the short term, and those that split to the right would eventually fail. However attempting to openly sabotage the current leadership is also in danger of being counterproductive, as it allows the leadership to use this as an excellent excuse for any failure at the polls. Party members will be rightly appalled that at a time when the mistakes of the current government were becoming increasing apparent others seemed more concerned with overturning their leadership vote.

I think here Colin Talbot is wrong when he writes
History may well judge that [social democrats] missed their opportunity to seize their party back when they had the chance and by the time they did try it was too late.
The chances of replacing Corbyn before the election and still winning it appear incredibly slim.  A successor to Corbyn has to emerge who can both appear to share the spirit and strategy that led Corbyn to victory, but at the same time is capable of uniting the parliamentary party behind them. They need to have time to establish a personality and media acumen that can enable them to get away with standing against a Labour leader and still win over enough of his original supporters to win a leadership contest. All this, and still have time to unite the party enough to win the next election.

The harsh reality, which some Labour MPs seem unable to accept, is that if their pessimism about Corbyn's chances in the polls is correct, the next election is almost certainly lost. But Talbot implies an urgency beyond this: that somehow as time goes on the position of the social democrats will become too weak. This I just do not see. The programme that will be hammered out between the leadership and its MPs over the next year or so will be pretty social democratic. There is little in John McDonnell's latest speech that is socialist rather than social democratic. For the great majority of Labour MPs, their best strategy for winning back the party is to be patient and let Corbyn fail on his own terms without their help.

Thursday, 19 November 2015

When central bankers should keep quiet

I suspect the standard view among economists about what monetary policy makers should and should not say in public is set out clearly in this talk by Willem Buiter. (The paper is worth reading for other reasons as well. I wish I had called an earlier discussion of mine on German macro myths the ‘Triad of Teutonic Fallacies’.) He gives what I think is the standard view among economists. Put simply, it says that monetary policy makers should stick to talking about monetary policy: ‘sticking to their knitting’ to use an Alan Blinder phrase. They should talk about other things only in terms of how it influences their ability to fulfill their remit.

Why should they be so coy? Because they have been given a privileged position to take decisions that would otherwise be taken by a democratically elected government, and they should not use that platform to get additional publicity for their views on issues beyond their remit. A strong exponent of this view is Tony Yates, whose latest complaint about Mark Carney straying beyond his remit related to his public position on the benefits of UK membership of the EU.

I also used to take this position, and my instinctive reaction was similar to Tony’s. But I now think the situation is much more nuanced. Of course there should be restraints on what central bankers should say in public: if one of them told you which political party would be ‘best for the country’ that would be way out of line. However I think it is possible to construct a number of defences for monetary policy makers when they do stray beyond their knitting.

1.  It influences the outlook for monetary policy defence

This may seem obvious, but I think it goes further than some people think. For example Willem goes too far in criticising Bernanke’s support for fiscal stimulus in 2009. It is a great pity that more central bankers did not say in 2009 and later that hitting the zero bound for interest rates seriously compromised their ability to do their job, and that fiscal stimulus would have been effective in increasing output. Saying that this was political, and therefore out of bounds for monetary policy makers, is a bad argument. Anything can be labelled political. Some people think global warming is political. But is also a fact, and therefore central bankers are quite right to treat it as a fact when discussing its implications for financial sector stability, for example.

2. I know about this stuff defence

In an earlier post I defended Andy Haldane talking about corporate governance because it would be socially harmful not to hear his views on these issues, given his considerable talents and expertise. It would be a great shame if becoming a member of a monetary policy committee meant that you had to keep quiet about other issues where you had - prior to that appointment - considerable expertise. Of course MPC members could abuse this by talking about issues on which they have no expertise or insights, but that surely suggests we should judge each of these cases on their merits.

3. Improving the influence of economic expertise in the public debate

Neither of the two defences so far would cover Mark Carney making statements about the past benefits of EU membership. The first defence would cover a discussion of how Brexit might influence the ability of the MPC to do their job, or how UK exit might impact on activity and inflation, but those are different issues. Nor am I aware that Carney has some personal expertise in assessing the benefits of membership, which would be the second defence.

However even Tony acknowledges that the report Carney was speaking to is very good. It contains a summary of existing analysis of the economic benefits of membership. If analysis of this kind was widely discussed or acknowledged in the media as part of the Brexit debate, then we might legitimately question what the Bank is doing spending public money repeating them. In reality we have exaggerated claims from either side, with little use made of more reputable academic analysis. In short, the Bank is helping raise the quality of the political debate. The fact that its conclusions are uncomfortable reading for one side is irrelevant.

It is true that the Bank was not established to do this kind of thing. If there was some institution set up by UK universities that routinely pooled economic knowledge in this way, then they would be the people to write a report of this kind. Perhaps such an institution should exist, but it does not. Note that this defence relies crucially on the analysis being fair and comprehensive.

4. Transparency

The example that clearly exercised Willem the most, and which I initially focused on, was the behaviour of the ECB. But the real scandal at the ECB is what was done behind the scenes (some of which Willem discusses), rather than what was said in public. Are we not better off knowing what they were saying in private because they also said it in public? There are clearly costs and benefits here.

This raises a further thought, which as far as I know is never discussed. Should central banks ever give private advice to governments about matters that are not financially sensitive? For example, it was said that in the UK in 2010 the coalition partners were given briefing from the Bank, which may have helped persuade the minority party in that coalition to back austerity. Why should that advice have remained secret?

I have in mind here the position that I believe is adopted by the OBR, the UK’s fiscal council. All its work is made public. The government does not commission the OBR to produce reports for its eyes only. The OBR adopts this position because it is concerned to establish its independence from government. Some questions were recently raised about the government trying to influence what the OBR writes. An obvious way to avoid such concerns is for the OBR to make public all such ‘advice’ from government.

If we look around the world today, the main issue is not what central bankers say in public, but the influence they have on politicians behind closed doors.