Sunday, 26 April 2015

The problem of currency union, UK edition

In my last post, I discussed Richard Murphy's "green QE" proposal in the context of a functioning currency union in which the decision to monetise debt would be made by the UK government. But the context of Richard's piece opens the door to a disturbing idea. Some Scottish Nationalists interpreted his proposal as meaning that a fully fiscally autonomous Scottish government could demand that the Bank of England buy Scottish government bonds (whether or not issued by a Scottish Development Bank) in order to prevent Scotland's debt/GDP rising as a consequence of infrastructure investment.

The Scottish Nationalists who raised this possibility homed in on this part of Richard's piece:
In March 2014 Bank of England Governor Mark Carney confirmed in a letter to Green MP Caroline Lucas that “It is possible that if the Monetary Policy Committee did vote to increase its asset purchases in future, it could expand the range of assets it purchased. Such a decision, however, would need to be agreed with the government.” In other words. Green infrastructure quantitative easing, about which she was asking, is possible
What that means is that the SNP does have it within its power to demand this type of quantitative easing to pay for investment in Scotland. That’s important precisely because quantitative easing debt is effectively cancelled almost immediately after it is issued because it is effectively the issuing of new money, and not debt. And what that means is that in reality this new type of quantitative easing could be used to pay for the investment programme the SNP wants to build Scotland’s future without the debt going on the books of the Scottish government. Or to put it another way, Paul Johnson’s assumption that Scotland cannot afford to fund its growth is just not true if this innovative finance mechanism is used: it can.
So, having started by saying that the SNP should persuade the Westminster government to instruct the Bank of England to monetise infrastructure bonds issued by a UK government agency, Richard appears to have moved on to suggesting that the SNP should demand that the Bank of England monetise Scotland's debt. I don't think this is quite what he meant, but it is all to easy to interpret this section in that way. But whether he meant direct monetisation of Scotland's debt, or monetisation of infrastructure bonds issued by a Scottish development bank, this is a non-starter. The reason concerns the nature of a currency union and the status of the Bank of England.

The Bank of England should more correctly be named the "Bank of the United Kingdom". It is the monetary authority for the whole of the UK, just as the Bank of Canada is the monetary authority of the whole of Canada and the ECB is the monetary authority for the whole of the Eurozone. It is required to manage the monetary conditions across the UK as a whole, without favouring individual parts of the UK. Some may argue that the Bank of England tends to favour London, because of its links with the City: this is not a discussion for this post, but my counter-argument would be that if the Bank favours London it does so because London is dominant in the UK economy, just as the ECB is seen to favour Germany because Germany is dominant in the Eurozone economy.

In a currency union it is the job of fiscal policy, not monetary, to ensure that regions within the union do not diverge so much that monetary policy loses traction. In the Eurozone, this has proved extremely difficult because of the lack of a common fiscal authority, common automatic stabilisers (taxes & benefits) and fiscal transfers. The UK's fiscal union is undoubtedly flawed: London and the South East are far too dominant and other regions have suffered badly from foolish industrial policies of the past. But it is a whole lot more coherent than the Eurozone.

And it is this coherence that the Scottish National Party wishes to destroy. The Scottish First Minister's long-run ambition is for there to be full devolution of tax and spending to the Scottish Government ("full fiscal autonomy"), accompanied in due course by dismantling of the Barnett formula. This would reduce the UK to the same condition as the Eurozone - an incomplete and incoherent currency union. The arguments against this were fully rehearsed prior to the independence referendum. But it seems they need to be aired again.

So let me make it clear. It is not possible for members of a currency union to have full fiscal autonomy. Attempts to achieve full fiscal autonomy damage, and ultimately destroy, the currency union.

The SNP should now be told in no uncertain terms that full fiscal autonomy is not on the table and never will be. "The Vow" promised extensive devolution of powers to Holyrood. But it did not promise full fiscal autonomy. And the Smith Commission has also stopped well short of recommending full fiscal autonomy. That is where the debate must now rest.

But it is not just the SNP that is treating the UK's successful currency union in a cavalier and destructive manner. UKIP's manifesto proposes dismantling of the Barnett formula, not to replace it with something better (which would be sensible) but to "save money" by forcing Scotland, Wales and Northern Ireland to become self-funding. UKIP's policy is thus for England to remain "UK core" while Scotland, Wales and Northern Ireland become "UK periphery". And they claim that this has been signed off by CEBR economists? Good grief.

And the Conservatives are equally destructive. Their proposals for "English" income tax rates and benefits would dismantle UK automatic economic stabilisers, widening regional divergence and putting pressure on the currrency union. This is utter folly. Since they have actually been in government, they should know better.

However, let's assume for a moment that the SNP gets its wish: Scotland achieves "full fiscal autonomy" and creates a new Scottish Development Bank with a mandate to finance infrastructure development in Scotland by issuing bonds. Could Scotland legitimately demand that the Bank of England monetise these bonds?

SNP supporters claim that it could, on the grounds that Scotland is part-owner of the Bank of England. Monetising Scottish bonds would be done according to Scotland's capital share, much as the ECB's current QE purchases are done according to the capital shares of the Eurozone member states.

But hang on. Scotland has only a minority interest in the Bank of England. Since when has the owner of a minority interest been able to force a company to do something against both the wishes and the interests of the majority shareholder? If the SNP cannot persuade the Westminster government to instruct the Bank of England to monetise UK infrastructure bonds, it can have absolutely no power to force the Bank of England to monetise Scottish infrastructure bonds.

I'm not going to discuss the importance or otherwise of central bank solvency, since this has been exhaustively covered by Karl Whelan and Paul De Grauwe, among others. What concerns me is the lack of democratic accountability. The decision to issue infrastructure bonds would rest only with the Scottish government and its bank. The rest of the UK - over 90% of the population - would have no say in the matter. Under what version of democracy would the Bank of England be forced to backstop the fiscal expansion of one small part of the UK without the agreement of the rest?

Dismissing this as "merely a political argument" will not do. Democracy matters. Indeed the argument for Scottish autonomy is fuelled by the perceived failure of democracy in a Westminster government dominated by London and the South East of England. How would replacing this democratic failure with an even bigger one improve matters?

The fact is that while it remained in the currency union, a "fiscally autonomous" Scotland would have much less autonomy than it would like. It would not be able to run high deficits without the agreement of its union partners, since to do so would put the value of the common currency at risk. It could not monetise debt, for the same reason. And it would soon find that sharply divergent tax and spending policies proved impossible to maintain, particularly as North Sea Oil revenues dried up. It would be forced to adopt fiscal policies compatible with those of its largest partner. If it tried to escape from this straitjacket with a large programme of debt-fnanced fiscal expansion, then unless growth was spectacular (which, pace Richard, seems unlikely) it would either be forced out of the union or end up in permanent debt peonage - as Greece knows all too well.

The lessons from the Eurozone are plain to see. It is hubris to believe that they would never happen here. They could, and they would. We must not go down that road.

Related reading:

Smith, Barnett and the wily Salmond - Pieria

Green QE and the Juncker Plan: a response to Richard Murphy

Richard Murphy proposes what he calls "green quantitative easing" to support the Scottish government's plans for fiscal expansion.

I've criticised the "green QE" proposal before. But this is a particular framing of it that raises some interesting issues about the nature of currency unions and the purpose of monetary policy.

Here's the heart of Richard's proposal:
It is worth explaining what I think the SNP is referring to when it mentions ‘innovative finance mechanisms’. It is my belief that they are referring to green infrastructure quantitative easing,which was the subject of a speech I made at the Convention of Scottish Local Authorities conference in March. In that speech I made clear that if the SNP wanted to do a service to Scotland, and to the rest of the UK, it would use its bargaining power after May 7 to demand that the UK government create a new form of quantitative easing that would be quite deliberately intended to provide the funding for new investment in infrastructure, housing, new energy systems, transport and the other essential underpinnings of growth in Scotland and throughout the UK.
This form of quantitative easing is entirely possible. As an example, the proposed Scottish Development Bank could, using this form of quantitative easing, issue bonds to the finance markets (because that is what EU law requires) that could then be repurchased by the Bank of England using funds specifically created by for this purpose.
So, Richard's proposal has two parts:
  • bond issuance by a government agency to fund infrastructure projects
  • purchase of those bonds by the central bank using newly-created sovereign money.
Part 1: Bond issuance

The first part is eminently sensible. The UK has a desperate need for infrastructure development, while institutional investors such as insurance companies and pension funds have a desperate need for long-term investments giving low stable returns. There is clearly an opportunity for the next UK government to seize.

Furthermore, the crying need for regional rebalancing in the UK suggests that a network of regional development banks might be a better approach to the investment crisis than a single UK-wide institution. So it makes sense for the next UK government to create a network of regional Development Banks, of which the proposed Scottish Development Bank would be one. These regional Development Banks would issue their own bonds to fund infrastructure and other long-term developments in their regions.

So there is in principle no problem with the idea of a Scottish Development Bank issuing bonds to finance infrastructure, housing, renewable energy systems and transport improvements in Scotland, as Richard suggests. The framework would be similar to the EU's Juncker Plan: the Scottish government would provide capital to the Scottish Development Bank, which would then leverage that capital by issuing bonds to the private sector.

However, I would at this point issue a strong warning to a Scottish government interested in "innovative financing mechanisms". Innovative finance has a way of turning round and biting you if you don't pay attention to where the risk ends up. Juncker's plan is based entirely on public sector guarantees and leveraging of funds already committed to other enterprises. This is a recipe for disaster. State-owned banks can fail if they don't have enough real capital. And it isn't safe to assume that there will be no significant losses on long-term infrastructure projects. My uncle owned subordinated bonds issued by Eurotunnel in its very early days, some of which I inherited on his death. After years of losses they were eventually written down to zero. So a Scottish Development Bank must have sufficient REAL capital - i.e. Scottish taxpayers' money uncommitted elsewhere - to provide a reasonable cushion for leveraged infrastructure finance.

Part 2: Monetising the bonds

This is where the second part of Richard's proposal comes in. He envisages the creation of what we could describe as a "pump". The Development Bank would issue the bonds: the Bank of England would buy them: interest and repayments would be repatriated to the Government and effectively written off. It would, in short, be completely circular. The debt would be off the Government's books, any losses would be absorbed by the Bank of England and the new money would reflate the economy. What could possibly go wrong?

In a follow-up to my post about Juncker's synthetic CDO, I described such a "pump" mechanism involving the EIB and the ECB. And I suggested that the Juncker Plan had been concocted by Juncker and Draghi jointly with the intention of taking advantage of the ECB's forthcoming QE programme. There was no doubt at the time that the ECB planned to do QE, and EIB bonds are eminently suitable for ECB purchase because of their triple-A rating. Increasing EIB issuance to fund much-needed Eurozone infrastructure investment would be an effective way of channelling QE money directly to where it is needed. It's a very clever scheme.

But Richard's plan, although apparently similar to Draghi's Machiavellian scheme, is in fact fundamentally different. And it carries huge risks.

Let's suppose that the SNP does succeed in persuading the Westminster government to instruct the Bank of England to buy infrastructure bonds. To keep it simple, I'm going to assume that only bonds issued by a single UK Development Bank can be bought. This is in fact how the Juncker-Draghi Plan works, since the ECB and EIB are both pan-EU institutions backed by the taxpayers of all countries in the union. Why would instructing the Bank of England to buy bonds issued by a UK Development Bank be a problem?

The key difference is that the Juncker-Draghi Plan does not involve "instructing" the ECB to do anything. Indeed no fiscal authority in the EU has the authority to do so. Rather, the fiscal plan is created to take advantage of the ECB's existing monetary policy plans. This is "monetary dominance"; the fiscal authority responds to the monetary authority. In contrast, Richard's plan would force the Bank of England to CHANGE its monetary policy stance in order to do the bidding of the fiscal authority. This is "fiscal dominance", and it would mean the end of operational independence for the Bank of England. It's quite a problem, considering that the UK is a member of the EU, which enshrines the independence of central banks in treaty directives, and the Bank of England is a member of the Eurosystem and therefore (in theory) answerable to no-one.

To be sure, I have pointed out before that "independence" for a central bank is an illusion: central banks are only as independent as politicians allow them to be. So the loss of independence is perhaps not the main problem. Far more important is the fact that if the fiscal authority forces the central bank to purchase bonds without regard to the monetary conditions in the economy, the central bank can no longer control inflation. This was demonstrated by Sargeant & Wallace in one of my favourite academic papers, "Some Unpleasant Monetarist Arithmetic".

Richard recognises the potentially inflationary impact of such a programme:
So long as e-printing money to pay for investment is kept at sensible levels to prevent the risk of serious inflation this process of green quantitative easing could be used to fund the investment Scotland wants and badly needs without risk. 
But this means that responsibility for controlling inflation would no longer rest with the central bank. It would rest with the government agency issuing the bonds. As long as the Bank of England was expected to underwrite infrastructure bond issuance, the path of inflation would be determined not by short-term interest rates but by the nominal value of bonds issued. This would be a fundamental change in the conduct of monetary policy. Indeed it would be hard to see how there could be any such thing as "monetary policy". Monetary conditions would be principally determined by the political imperative to invest in infrastructure.

And this creates a further problem. QE is done on the basis that it can be reversed, so that the effect of the monetary expansion is - at least in theory - temporary. Richard's proposal, however, envisages that purchased bonds would be cancelled. This would therefore be permanent expansion of the money supply. Some consideration needs to be given to how monetary conditions could be tightened if inflation started to rise, since the Bank of England would lack the means or the authority to sell the bonds it had purchased.

Currently, the Bank of England has no plans to do more QE, so it is not possible to construct anything remotely like the Juncker-Draghi plan. Richard thinks the Bank of England is wrong:
And let’s be clear: we printed £375 billion to pay for quantitative easing to bail out the financial markets in the three years from 2009 to 2012 and the outcome is that we now have zero per cent inflation, which is less than anyone thinks economically desirable. So we do in fact need new quantitative easing now to create the new money the economy badly needs to create the moderate inflation that keeps the economy on an even keel.
But sorry, Richard, if this is what you think then you need to influence the views of those on the MPC, not try to end the Bank of England's responsibility for monetary policy.

In short, Richard's proposal is for outright monetisation of sovereign debt. I have argued that monetisation of existing debt when growth is stagnant and both inflation and interest rates are negative and expected to remain so carries little inflationary risk. But the UK is not Japan, and this proposal monetises new debt, not existing debt. I'm worried about the replacement of the nominal interest rate anchor with a "quantity of bonds" constraint that is subject to fiscal dominance, and the lack of any mechanism for tightening monetary conditions if inflation started to rise. Maybe it's just me, but I can't help thinking this would not end well.


The Swiss have eliminated the Zero Lower Bound

So, this is fun. Via Zero Hedge comes this report from a little Swiss website, Schweizer Radio und Fernsehen (SRF). It seems that a pension fund tried to evade negative rates on deposits by withdrawing a very large amount of physical cash with the intention of vaulting it. But the bank refused to allow it to withdraw the money in the form of physical cash.

Is this lawful? Zero Hedge thinks it isn't. But the bank has not refused to allow the money to be withdrawn. It has simply restricted the form in which the money can be taken. Since electronic money and physical cash are fully fungible, it is hard to see how this restriction can be regarded as unlawful without undermining the value of electronic money - which would be highly destabilising in a modern monetary economy.

And this effectively means that the zero lower bound does not exist.....

Read the whole article on Forbes.

Related reading:

The ECB's policy mix is poison for banks - FT
The strange world of negative interest rates

Saturday, 18 April 2015

Rediscovering old economic models

Krugman says we do not need new economic models, we just need to make better use of the ones we already have. Indeed, even very old models that we long since consigned to dusty archives can help remind us of things we have forgotten about. Financial crises, for example.....

In his response to my speech at Manchester University in February - which became the post that whipped up the "state of macro" debate to which Krugman responded - Andrew Lilico gave four examples of economic models that in his view form the foundation of modern economics and (he claims) have not been shown to be inadequate or wrong. Lilico's four models are these:

- Capital Asset Pricing Model
- Modigliani-Miller Theorem
- Efficient Market Hypothesis
- Black-Scholes Option Pricing Model

Hmm.Only the EMH would I think be regarded as a macroeconomic model - and even then, is it really more fundamental than Shiller's irrational exuberance? When I was doing my MBA, we covered the other three in corporate finance, not macroeconomics. And all four have been seriously criticised.

But finance is the heart of a modern monetary economy and financial economics should be part of macroeconomics. I might disagree with Lilico's choice of models - for example I would regard the quantity theory of money as more fundamental than Black-Scholes - but I don't disagree with his point. The problem is that models of the financial economy DON'T form the heart of macroeconomics.

So, since Krugman pointed me towards Diamond & Dybvig's model of banks, liquidity and deposit insurance, I got it out and re-read it.

For those of us used to endogenous money theory, there is an immediate and very obvious problem with Diamond & Dybvig's model. It is a loanable funds model with no central bank - which is odd, considering that by 1983 when it was written the world had been off the gold standard for more than ten years and every Western country had a central bank. But this is how banking is modelled all too often: banks as passive intermediaries channelling household savings to corporate borrowers. If only that were true. For the last decade or so the flow has been in the other direction - corporate savings channelled by banks to households in the form of mortgages against ever-rising property prices.

But the problem with loanable funds models is bigger than simple reversal of the savings flow. Loanable funds models are unable to explain how exuberance in credit creation results in the buildup of unsustainable leverage. Hyung Song Shin used a loanable funds model in his Mundell-Fleming lecture on the role of regulatory arbitrage in the credit boom leading to the financial crisis, which unfortunately managed to give the impression that the money lent to American and European banks by American households came from Mars. When I translated Shin's model into an endogenous money framework (though admittedly in a manner that was enormous fun and not at all rigorous) it became a dangerously unstable two-way leveraging spiral of credit creation and rising collateral prices, which is much closer to what we know actually happened. Loanable funds models do not adequately portray the role of credit creators in the modern monetary economy - banks, and things that aren't called banks but behave like them.

So Diamond & Dybvig's model needs to be used with some care. It can't simply be "taken off the shelf" and deployed in a crisis, as Krugman suggests. Apart from anything else, providing unfunded deposit insurance ex ante to everything that looks or behaves like a credit creator, regulated or not, creates moral hazard on an almost galactic scale. We already worry about implicit taxpayer subsidies to too-big-to-fail banks: but explicit taxpayer guarantees to too-big-to-fail asset managers, wealth funds, conduits, SPVs? Really, Paul?

Diamond & Dybvig's model is a multiple-equilibrium model, but it does not adequately model how leverage is created. It might be amusing to translate it into endogenous money terms, adding a central bank and establishing both the precedence of lending and the creation of deposits. This would of course make it a lot more complex, since endogenous money creation is by definition non-linear. It might make it a lot more fun, too. But does that mean it would necessarily be less rigorous, as Krugman seems to suggest? Surely not. "Fun" does not exclude rigour.  So, here is a challenge to a student econometrician who fancies a holiday project. Have some fun translating Diamond & Dybvig's model into endogenous money terms. But do it rigorously.

A bank run can be defined as sudden unravelling of bank leverage. And just as leverage creates money, so deleveraging destroys money. This is implied in Diamond & Dybvig's description of deposit insurance even though their model does not show it.

It works like this. A bank faced with sudden unexpected demand for cash withdrawals by depositors or investors is forced to sell assets to obtain the cash. This depresses the price of the remaining assets, destroying value on the asset side of the balance sheet and making it impossible for the bank to realise enough cash to satisfy depositor demand.

I say banks, but it is actually easier to see the "fire sale" effect when there is a run on a money fund, such as the run on Reserve Primary after the fall of Lehman. Reserve Primary was unable to guarantee return of par value to its investors because the value of its assets crashed. A bank facing a similar crash of asset value is also unable to return par value to its depositors. But instead of "breaking the buck" as Reserve Primary did (i.e. returning less than par to its investors), in the absence of central bank liquidity support and/or deposit insurance, the bank must close its doors (in Diamond & Dybvig this is "suspension of convertibility"). If the bank's balance sheet is very illiquid - for example, if it consists mainly of specialist loans for which there is no market - then doors will be closed earlier. Either way, the effect is the same. Deposit balances that cannot be withdrawn because the bank has closed its doors are effectively worthless.

Deposit insurance replaces the money destroyed in a run by drawing on future tax revenues (if unfunded) or drawing on money created by other banks ex post or ex ante. Central bank liquidity support does the same by drawing on future seigniorage. Without this, the economic effects of bank runs can be economically devastating. However, as Diamond & Dybvig point out, the essence of insurance is that it should not be called upon. The existence of credible deposit insurance and/or credible lender-of-last-resort support should be sufficient to prevent runs. In 2007, the run on Northern Rock occurred because deposit insurance was inadequate and it was not clear that lender-of-last-resort support would be forthcoming. In 2008, the most damaging runs occurred in the shadow banking network where there was no insurance or lender-of-last-support.

The fact that Diamond & Dybvig's model is framed in loanable funds terms means that it does not fully show the destructive economic effects of bank runs. After all, in their model, the money still exists, it has simply been converted into a different form (cash) which is equally useful. And nowhere do they state that their single bank can call in illiquid loans to pay depositors. If it can't, then investment is not suspended: the bank fails, but the borrowers still have their funds. Their assumption that production stops when money is removed from the bank is therefore questionable in terms of their own model, though it would be correct in a model that accurately modelled the destruction of money and the collapse of asset prices.

But this does not make the model useless. From the point of view of the depositors trying to remove their funds, whether those funds were created by the bank in the course of lending or came from Mars is irrelevant. What matters is whether depositors believe that they can convert their deposits to cash. And that, as Diamond & Dybvig note, depends on the depositors' view of the creditworthiness of the bank. If depositors believe that the value of the bank's assets is less than its liabilities, they will rush to withdraw their money: no-one will want to leave their money in the bank and risk not getting it back at all.

Deposit insurance in effect replaces the bank's own deposit guarantee, which in Diamond & Dybvig's "bad" equilibrium is not credible, with a guarantee from a more reliable source. In the past that has been the sovereign, though the public mood since Lehman has pushed regulators towards requiring the banking system as a whole to guarantee the deposits of each of its members and fund that guarantee at least in part ex ante. Those promoting full reserve banking might like to recall that bank funded guarantee schemes amount to full reserve banking for insured depositors. And those who think that deposit insurance schemes are about protecting depositors might like to think again. The original purpose of deposit insurance was to prevent banks failing.

Diamond & Dybvig explain that central bank liquidity support can have the same effect as deposit insurance, but with an important caveat: if depositors do not believe the bank is solvent then injections of central bank liquidity cannot stop the run. This is not just a theoretical effect. In 2007, injections of liquidity by the Bank of England failed to stop the run on Northern Rock. It took unlimited guarantees from HMG, including for wholesale deposits (which are more likely to run than retail deposits and can be far more destructive). This is the reason for Bagehot's dictum about lending to SOLVENT banks, although for a very large bank mitigating the destructive economic effects may justify lending even if it is believed to be insolvent. And in a systemic crisis it can be hard to decide which bank is alive and which is dead anyway: throwing money at everything is usually the best approach until the panic calms down, as I have explained before.

The point of all this is that models don't have to model everything, and even "wrong" models can be helpful if used in the right way. And narrative has its uses too. Diamond & Dybvig's paper has some interesting insights into the behaviour of banks and their customers. I particularly like this:
If the technology is risky, the lender of last resort can no longer be as credible as deposit insurance. If the lender of last resort were always required to bail out banks with liquidity problems, there would be perverse incentives for banks to take on risk, even if bailouts occurred only when many banks fail together. For instance, if a bailout is anticipated, all banks have an incentive to take on interest rate risk by mismatching maturities of assets and liabilities, because banks will all be bailed out together.
Perverse incentives and moral hazard. This presumably is one of Krugman's "self-fulfilling prophecies". What a pity we forgot about it....

Then there is this:
Internationally, Eurodollar deposits tend to be uninsured and are therefore subject to runs, and this is true in the United States as well for deposits above the insured limit.  
Uninsured deposits have a tendency to run. You don't say. In the rush to limit taxpayer liability in a crisis and ensure that senior creditors - including large depositors - share in the losses, has everyone forgotten this?


Sunday, 12 April 2015

Colds, strokes and Brad Delong

Brad Delong takes issue with me over my criticism of Olivier Blanchard. Here's the paragraph from my piece "The failure of macroeconomics" that he finds particularly uncharitable:
Blanchard's call for policymakers to set policy in such a way that linear models will still work should be seen for what it is–the desperate cry of an aging economist who discovers that the foundations upon which he has built his career are made of sand. He is far from alone…
"It's not that bad", says Brad. And he goes on to use the analogy of heart attacks and the common cold to explain why linear models are ok really, mostly:
A more charitable reading of Olivier is that he wants to make this point:

  • Heart attacks have little in common with the common cold.
  • You treat heart attacks with by shocking the heart to restart it.
  • Heart attacks and the common cold are both diseases that debilitate.
  • Nevertheless, to get out the defibrillator pads when the patient shows up with the sniffles will probably not end well.
Well yes, true. So, when the economy catches a cold, by all means treat it with a hot toddy (plenty of whisky, please!). And if we all keep warm and dry, eat well and get plenty of sleep, we might not get so many colds anyway. This is indeed within the remit of policymakers: avoid obviously stupid or high-risk policies and try to keep the economy on a steady path. If policymakers do this, then clearly linear models will generally be adequate.

The trouble is that in 2008 the economy did not catch a cold. No, it had a stroke. (Brad Delong's heart attack analogy is good, but I like the stroke better.) A stroke is sudden interruption of blood flow to part of the brain, causing tissue death and brain damage. If damage is not too extensive, the brain can rewire itself, creating new connections and activating new regions to take over functions previously done by the damaged areas. But such redirection of activity can take a long time, and during that time the patient may be unable to care for herself unaided, let alone work at previous output levels.

The authorities did not recognise the stroke for what it was. They thought it was simply a particularly nasty cold, so they put extra whisky in the hot toddies. When the patient developed pneumonia, they gave powerful antibiotics (TARP, TALF, QE....). And they carried on giving some of them long after the pneumonia had cleared up, because the patient was still obviously ill. But they failed to see the underlying problem.

Just as the patient was beginning to show signs of improvement, it experienced a second stroke. This one was not as catastrophic as the first, but it seriously set back the patient's recovery. Once again, the stroke was misdiagnosed, this time as a hospital-acquired infection. More antibiotics were given, and the hospital was placed in special measures. The staff had to deep clean the entire place, which redirected many of them away from patient care, leaving the patients to look after themselves. Unsurprisingly, several of the patients got worse, though so far none has died.

Now, seven years after the first stroke and three years after the second, the patient is still partly paralysed down the left side and has a speech impediment, which makes working difficult. As can be seen from this chart (h/t John Van Reenen), UK output is well below its previous level and shows no sign of returning to previous trend growth:


Nor is the UK the only economy to show such a pattern. Indeed it is now one of the better-performing Western economies: output in the Eurozone, for example, is much worse. So economists are scratching their heads and wondering why the patient is still in such a state. After all, the patient recovered well from previous nasty colds (1975, 1981, 1992) and there was no significant change in output trend growth. Surely the patient should be back to normal by now?

And herein lies my beef with Blanchard. Hot toddies and antibiotics are not the right treatment for strokes. Nor is deep cleaning of hospitals, important though this is. But the economics profession's toolkit seems to be limited to hot toddies, antibiotics and cleaning ladies. It can only treat nasty colds and hospital-acquired infections. It didn't even recognise the 2008 and 2012 strokes, let alone know how to treat them. And it justifies its limited diagnostic skills and inadequate toolkit by arguing that if only we keep warm and dry and eat well, we won't catch colds or suffer strokes anyway. But economists do not know why economies catch colds and have strokes. The argument that if we get policy settings right we will never be ill is an old wives' tale - or rather, an old economists' tale.

To be fair, the economics profession seems to be waking up to the idea that 2008 and its aftermath was no ordinary recession. Central banks and supranational institutions seem to be leading the way on recognising the monetary nature of the modern economy and the critical importance of accurate modelling of the financial system: Haldane at the Bank of England, Borio at the BIS and various researchers at the IMF have all explored non-linear modelling for the financial economy. Borio has called for financial cycles, which are longer than business cycles and seem to be increasing in amplitude, to be incorporated into economists' models. But the financial system is known to be in disequilibrium much of the time. I confess I find it difficult to see how a system that is normally far from equilibrium can be adequately represented by a general equilibrium model, but then I am not a mathematician. I am encouraged therefore to see that Borio seems to share my concerns (my emphasis):
Modelling the financial cycle raises major analytical challenges for prevailing paradigms. It calls for booms that do not just precede but generate subsequent busts, for the explicit treatment of disequilibrium debt and capital stock overhangs during the busts, and for a clear distinction between non-inflationary and sustainable output, ie, a richer notion of potential output – all features outside the mainstream. Moving in this direction requires capturing better the coordination failures that drive financial and business fluctuations. This suggests moving away from model-consistent expectations, thereby allowing for endemic uncertainty and disagreement over the workings of the economy. It suggests incorporating perceptions of risk and attitudes towards risk that vary systematically over the cycle, interacting tightly with the waxing and waning of financing constraints. Above all, it suggests capturing more deeply the monetary nature of our economies, ie, working with economies in which financial intermediaries do not just allocate real resources but generate purchasing power ex nihilo and in which these processes interact with loosely anchored perceptions of value, thereby generating instability. In turn, this in all probability means moving away from equilibrium settings and tackling disequilibrium explicitly
So, sorry Brad, but I do not think I am wrong to say that the economics profession's love affair with linear models must be ended. Multiple equilibria, disequilibrium and non-linearities are the new flame.

Having said that, Brad's last comment is spot on:
The key questions of macroeconomic political economy then are not the questions of the construction of nonlinear multiple-equilibrium models that Frances Coppola wants us to study. They are, instead, the questions of why ideological and rent-seeking capture were so complete that North Atlantic governments have not deployed their fiscal and credit policy tools properly since 2008.
Indeed, if policymakers want to deny stroke patients essential treatment and force them back to work before they are properly recovered, there is not a great deal economists can do to stop them. Such is democracy.

I must say, I do like being described as femina spectabilis. And despite my criticisms, Olivier Blanchard deserves credit for acknowledging the hubris of the 1980-2008 economic paradigm, and for attempting to change it within his own organisation. Some of the IMF's economic research in recent years under his leadership has been outstanding. He is indeed a vir illustris.

Related reading:

When the Nile floods fail

Saturday, 11 April 2015

The limits of monetary policy

Here is Cullen Roche quoting Ben Bernanke:
"Let there be no mistake: In light of our recent experience, threats to financial stability must be taken extremely seriously. However, as a means of addressing those threats, monetary policy is far from ideal. First, it is a blunt tool. Because monetary policy has a broad impact on the economy and financial markets, attempts to use it to ‘pop’ an asset price bubble, for example, would likely have many unintended side effects. Second, monetary policy can only do so much. To the extent that it is diverted to the task of reducing risks to financial stability, monetary policy is not available to help the Fed attain its near-term objectives of full employment and price stability."
And Cullen then goes on:
That’s a pretty interesting quote. You could actually apply that perfectly to, well, using monetary policy for anything. After all, it is an inherently indirect and imprecise policy tool. It works only through indirect transmission mechanisms like overnight interest rate changes, expectations channels, wealth effects, etc. If the past five years haven’t proven that monetary policy is a rather indirect and blunt policy, then I don’t know what would.
Basically, monetary policy is weak sauce....
This is from Cullen's commentary on Ben's post about financial stability. Ben argues that monetary policy is not the right means of addressing financial stability concerns, and makes the case for greater use of macroprudential tools. The whole post is well worth reading, but I've summarised Ben's key argument here:
  • The Fed has kept interest rates very low ever since the Lehman shock. Because of Fed easy money policies, the US economy is now recovering, unemployment is at near normal levels and deflation risk is low.
  • Nonetheless, Fed easy money policies have come in for continual criticism. Initially the criticism focused on fears of high inflation, but since inflation has failed to materialise, criticism now centres around financial stability concerns.
  • Monetary policy is not the right tool to address financial stability concerns. It is too blunt an instrument to pop asset bubbles safely, and using it to address financial stability concerns may conflict with using it to achieve primary mandates of price stability and full employment. 
  • Therefore central banks should use macroprudential measures to ensure financial stability, not monetary policy
So, monetary policy is not a cure-all. It has a specific purpose, namely to influence demand in the economy so as to achieve the Fed's twin mandates of price stability and full employment. And that is ALL it should be expected to do. But that doesn't make it useless, as this tweet from Ralph Musgrave suggests:

No, Ralph, Ben never said any such thing. On the contrary, he said that monetary policy over the last few years had reduced unemployment and created recovery.

Ben acknowledges that there might be a role for monetary policy in financial stability, but expresses concern that the costs may outweigh the benefits. He cites the experience of Sweden in 2010-11, which hiked rates to take heat out of the housing market despite poor economic indicators and ended up squashing economic growth and tipping the country into outright deflation. Ben observes that current research, though limited, does not support the idea that monetary policy should be used to address financial stability concerns:
As academics (and former academics) like to say, more research on this issue is needed. But the early returns don't favor the idea that central banks should significantly change their rate-setting policies to mitigate risks to financial stability.
However, the limited remit of monetary policy does not necessarily mean that Janet Yellen's commitment to financial stability is undermined, as Cullen seems to suggest. Macroprudential measures are also part of the central bank's toolkit. They are as yet underdeveloped. untried and their effects are to some degree unknown: as Richard Sharp of the Bank of England's Financial Policy Committee explained in June 2014, central banks are engaging in "an experiment in macroprudential management". But the fact that these measures are experimental does not mean they are useless. The Bank of England successfully used macroprudential tightening in June 2014 to take some of the heat out of London's prime residential housing market. It remains to be seen how effective macroprudential measures will be on future occasions, and what their unintended consequences might be.

But Cullen goes on to make an important and far-reaching point:
....Maybe we should stop believing in the idea that central bankers can steer the economy in certain directions and fix all of the world’s problems.
Belief in central bank omnipotence has led the world to dump all responsibility for generating economic recovery and preventing further crises onto the shoulders of central bankers. Belief in the uselessness of fiscal policy has encouraged central bankers to accept that burden even when it was clearly too great for them to bear alone. And belief in the evils of deficit spending and sovereign debt has led fiscal authorities to make central bankers' job even more difficult by engaging in fiscal tightening when their economies are already on the floor. Though central bankers hardly deserve our sympathy. They have actively encouraged the denigration of fiscal policy and reification of monetary policy. "Whatsoever a man soweth, that shall he also reap...."

Unlike Ralph, I do not think monetary policy is powerless: but neither do I think it can single-handedly generate economic growth when fiscal authorities are determinedly squeezing demand out of the economy with tax rises and spending cuts.

Cullen calls for greater use of other tools - such as "regulatory changes". Err, these wouldn't in any way be related to the measures that Ben talks about, would they? Ben seems to think so:
Effective financial oversight is not perfect by any means, but it is probably the best tool we have for maintaining a stable financial system. In their efforts to promote financial stability, central banks should focus their efforts on improving their supervisory, regulatory, and macroprudential policy tools.
But Cullen goes further. He calls for tax reforms and infrastructure investment. We can disagree over the details, but in principle this is eminently sensible. When the economy is on the floor, the public sector should invest in the infrastructure that will support business in the future, and make fiscal reforms complementing, rather than counteracting, the central bank's efforts to support demand and encourage business investment. What a pity that governments around the world have done the exact opposite, hiking taxes and cutting investment.

Artificial separation of fiscal and monetary policy cripples policymaking. It is time for monetary and fiscal policymakers to acknowledge their joint role in generating economic growth and preventing future crises.

Saturday, 21 March 2015

Repeat after me: sectoral balances must sum to zero

I do like sectoral net lending charts. This one is from the OBR's latest Economic Forecast:


The thing to remember about sectoral balances is they must sum to zero. It is not possible to have a negative external balance, as the UK does, with concurrent surpluses in the public, household and corporate sectors. If the UK is a net borrower from the rest of the world because of its current account deficit, then somewhere in the domestic economy must be a balancing deficit.

It is pretty obvious where this deficit has been. In 2010, the external sector was in deficit (green line on chart) and corporates (yellow line) were net saving. The external balance had been in deficit for a long time, but corporate net saving commenced at the same time as the public sector (red line) switched from surplus to deficit. This may have been a traumatic response to the dot-com crash, but to me this looks more like a policy change around 2001 that encouraged corporate saving. I wonder what it was. Any suggestions?

The net saving of corporates and foreigners during the pre-crisis years was balanced both by a public sector deficit and by a growing deficit in the household sector (blue line). We now know that the household deficit was associated with unsustainable credit growth. When the crash came, households switched abruptly from deficit to surplus. Foreigners, corporates and households were all net saving at the same time. As I said, the sectoral balances have to sum to zero: so the increase in the government deficit balanced the desire of all three private sectors to save at the same time. When no-one wants to spend, someone must, and that someone is inevitably government. Government is the "spender of last resort".

The trouble is that when everyone is saving like crazy (including paying down debt, which economically is equivalent to saving) people get very worried indeed at the sight of apparently out-of-control government deficit spending, failing to see the relationship of that spending to their own saving behaviour. So governments then embark on austerity programmes to shrink the deficit. The result of this (assuming no fall in GDP) is that deficit spending moves around. The public sector deficit is shifted back to the private sector.

If you are Germany, deficit spending moves abroad, and you run an ever-larger trade surplus. But if you are the UK, with a deeply entrenched external deficit in part because of a still-dominant financial sector, deficit spending moves to domestic households and corporations. George Osborne's claim that he wants to build an economy "based upon savings and investment" is economic gibberish, since his plans aim only to eliminate the fiscal deficit, not the trade deficit. As the chart above shows, the OBR forecasts - based upon the Treasury's spending plans as outlined in the Budget last week - that for the foreseeable future the only people doing any significant saving will be foreigners.

Saving is not necessarily a good thing. Generally, we expect households to save (for their old age, for rainy days) but corporations to invest. The problem prior to the financial crisis was that corporations were saving and households were investing (in property). Now, despite everything we have heard about corporations hoarding cash, corporate saving is falling and the corporate sector has switched from surplus to deficit. This is a welcome development, since it suggests that corporations are investing. And indeed they are:


Business investment is now back to its 2000 level. This is no doubt what has generated the UK's recovery. Perhaps the malaise that has affected corporations ever since the dot-com crisis is over? The OBR seems to think so. It forecasts corporate investment continuing to rise to historically unprecedented levels. Is this credible? I confess that I am unconvinced. The path of business investment has never been smooth. Not only the level of investment projected for 2020 but also the rate of change looks unsustainable to me. I reckon it would level off or dip sooner than that. Indeed there was a dip at the end of 2014 which the forecasters chose to ignore. Hockey-stick projections always worry me.

Sadly, the picture for households is not so encouraging. The household saving ratio has already fallen considerably from its 2010 high:


Perhaps more worringly, there is an evident downwards trend in this chart. Household saving has been diminishing since the late 1990s. The OBR projects that the household sector will be in deficit by 2018, no doubt as a result of the planned sharp fiscal squeeze in 2016-18. As older and richer households would still be net savers, the growing deficit of the household sector would be due to sharply rising debt, particularly among younger and poorer people. Here is the OBR's projection for household debt to income:


The OBR expresses some concern about this:
Strong growth of residential investment and ongoing growth in house prices and property transactions leave households’ gross debt to income ratio rising back towards its pre-crisis peak by the forecast horizon. That seems consistent with supportive monetary policy and other interventions (such as Help to Buy and further support for first-time buyers announced in this Budget), but it could pose risks to the sustainability of the recovery over the medium term.
This concern is well-founded. Despite all his rhetoric about encouraging saving, the Chancellor's fiscal plans actually depend on blowing up a household debt bubble of larger proportions than that which burst disastrously in 2008, and using various forms of government support to delay its inevitable implosion. Why do we have to repeat the errors of the past?

Perhaps more importantly, it is by no means clear that such an increase in debt is actually possible. Productivity is on the floor and nominal wage growth remains poor. The OBR identifies this as a key risk to the recovery:
Domestically, productivity and real wages remain weak and the pick-up we forecast from 2015 is a key judgement. If productivity fails to pick up as predicted, consumer spending and housing investment could falter as the resources to sustain them would be lacking
If productivity and wage growth do not pick up, then the fiscal squeeze planned for 2016-18 would have serious consequences for the recovery. The OBR points out that deep spending cuts to unprotected government departments and the welfare budget would have a direct impact on GDP, and expresses concern about the scale and pace of the cuts:
We expect some significant changes in the composition of expenditure associated with the fiscal consolidation and, in particular, with the fact that on current policy so much of that consolidation is delivered through cuts to day-to-day spending on public services that will directly reduce GDP. The scale and speed of the adjustments this switch in spending implies may also represent a risk to the economy evolving in line with our central forecast.
 The OBR's central forecast for the path of GDP shows real GDP growth over the next 5 years of around 2% per annum. But there is a considerable amount of uncertainty around this forecast:


Note that the worst-case scenario here is for the UK to fall into recession from 2016 onwards. This would be likely to be the case if productivity and wage growth disappointed and the fiscal squeeze hurt household incomes sufficiently to eliminate debt-fuelled consumption and investment spending.

And this brings me back to my sectoral net lending. Remember that sectoral balances must sum to zero. If household income falls so much that spending and borrowing cannot be sustained, as the OBR suggests, then there are two possibilities. The first is that there is a sharp correction to the trade balance. This would be due to collapse in imports as domestic demand falls, and rising exports as corporations seek markets elsewhere. We have seen this in many EU (not just Eurozone) countries in the last few years. It is always accompanied by recession, which may be severe.

But if the trade balance does not correct - and remember that the UK's trade deficit is deeply entrenched - then fiscal consolidation becomes all but impossible. Deficit reduction slows to a crawl, as this chart from the OBR shows:



The worst-case scenario here (deficit of 4% of GDP in 2020) would be associated with the worst case in the GDP fan chart, i.e. the UK in recession. When GDP is falling, public sector borrowing as a proportion of GDP naturally rises. This chart therefore assumes that fiscal consolidation efforts would continue despite recession, no doubt because of disappointing deficit reduction. But continued attempts to eliminate the deficit and reduce the deficit would drive the economy ever deeper into recession. Although the deficit itself may reduce further, debt/GDP actually rises in this scenario. As Irving Fisher put it, "the more the borrowers pay, the more they owe". For Greece, this nightmare was probably inevitable. But the UK has no reason whatsoever to go down that path. If it does, it will be because of political stupidity on a simply mammoth scale.

Unfortunately the simple fact that sectoral balances must sum to zero is currently being ignored by all of the main parties. I do wish politicians would pay more attention to national accounting. It would save a lot of grief.