Microfoundations and the values of policymakers

For economists

This post started an interesting discussion, directed largely by Beatrice Cherrier‏ (@Undercoverhist), about how economists are increasingly tending to hide the value judgements they make. By value judgement I do not mean the trivial, like why did you get interested in this area rather than others, but more serious issues like what values are assumed as part of their analysis. (The distinction between the two was the point of my original post.)

It occurred to me that microfounded macro has an issue that is related to that discussion. It is in fact discussed in my OXREP paper, but used there as an example of where microfoundations had gone one step backwards, with only the prospect of going forwards in the future. The example is the derivation of a benevolent policy maker’s preferences from the utility function of the representative consumer assumed as part of the model, a line of research initiated by Michael Woodford.

Before getting on to the values point, let me note that it is a good example of the primacy of internal consistency in microfoundations rather than the Lucas critique. Before Woodford’s work, microfoundations macroeconomists were embarrassed that they typically assumed an ad hoc objective function for the policy maker choosing between the bads of deviations in inflation from target or deviations of output from its natural rate. Typically, results were presented with alternative values for the policy maker’s preferences between the two. But if the policy maker was benevolent and the model is internally consistent, shouldn’t this objective function reflect the utility function of the representative consumer in the model? What Woodford showed was how this could be done, and better still how it implied the form of objective function, quadratic, that had previously been used on an ad hoc basis. The preference between output and inflation deviations was now an implication of the model.

It was, it is important to admit, an exciting breakthrough. We could now tell policymakers that, if this is the utility function of the representative consumer, and the model was a good representation of reality (yes, I know), this is how you should be trading off output and inflation losses. It was a literature I participated in with colleagues. The derivations were hard and tedious to do, and could take pages of algebra, but within a year every macro paper of this kind had switched from ad hoc objective functions to derived objective functions. If you were doing macro and wanted the paper published in a good journal, this is what you had to do. 

There was only one problem. The simple version of a New Keynesian model that most researchers used implied that inflation deviations were much more important than output deviations. This was very different from the adhoc objective functions that had been used before, where equal weights were commonly used. It also appeared unrealistic: not only did policy makers not act as if inflation was all important in reality, but consumers in happiness studies tended to rate unemployment as more important than inflation. That was the step backwards that I mentioned earlier.

But what it also did, I think, was to make less transparent the value judgements that the researcher was implicitly making. Everyone, including policymakers, know that macro models are huge simplifications, but to get interpretable results that is what you have to do. Yet they also have some idea of their preferences between excess output and inflation. But if the policymaker’s preferences were now endogenised, they would generally get welfare results presented to them with no choice to make involving their own preferences.

Researchers were not hiding anything. The utility function of the representative agent was there to see, and most papers would show the derived objective function with a low relative weight on output deviations. But what was often not shown was how the results would differ under alternative objective functions: why would you as a modeller committed to microfoundations, as to use any other weights than those implied by the model was internally inconsistent. Thus internal consistency took a value judgement away from policy makers.   

Macroeconomics and Ideology

Jo Michell has a long post in which he enters in a debate between Ann Pettifor and myself about the role of mainstream macroeconomics in austerity. Ann wanted to pin a large part of the blame for austerity on mainstream macroeconomics, and Jo largely sides with her. Now I have great respect for Jo’s attempts to bridge the divide between mainstream and heterodox economics, but here he is both wrong about austerity and also paints a rather distorted picture of the history of macroeconomic thought.

Let’s start with austerity. I think he would agree that the consensus model of the business cycle among mainstream Keynesians for the last decade or two is the New Keynesian (NK) model. That model is absolutely clear about austerity. At the zero lower bound (ZLB) you do not cut government spending. It will reduce output. No ifs or buts.

So to argue that mainstream macro was pushing for austerity you would have to argue that mainstream economists thought the NK model was deficient in some important and rather fundamental respect. This was just not happening. One of, if not the, leading macroeconomist of the last decade or two is Michael Woodford. His book is something of a bible for those using the New Keynesian model. In June 2010 he wrote “Simple Analytics of the Government Expenditure Multiplier”, showing that increases in government spending could be particularly effective at the ZLB. The interest in that paper for those working in this area was not in that this form of fiscal policy would have some effect - that was obvious to those like myself working on monetary and fiscal policy using the NK model - but that it could generate very large multipliers.

This consensus that austerity would be damaging and fiscal stimulus useful was a major reason why we had fiscal stimulus in the UK and US in 2009, and why even the IMF backed fiscal stimulus in 2009. There were some from Chicago in particular who argued against that stimulus, but as bloggers like DeLong, Krugman and myself pointed out, they simply showed up their ignorance of the NK model. Krugman in particular was very familiar with ZLB macro, having done some important work on Japan’s lost decade.

What changed this policy consensus in 2010 was not agitation from the majority of mainstream academic macroeconomists, but two other events: the Eurozone crisis and the election of right wing governments in the UK and US Congress.

Jo tries to argue that because discussion of the ZLB was not in the macroeconomic textbooks, it was not part of the consensus. But textbooks are notorious for being about 30 years out of date, and most still base their teaching around IS/LM rather than the NK model. Now it might just be possible that right wing policy makers were misled by the consensus assignment taught in these textbooks, and that it was just a coincidence that these policy makers chose spending cuts rather than tax increases (and later tax cuts!), but that seems rather unlikely. You do not have to be working in the field to realise that the pre-financial crisis consensus for using changes in interest rates as the stabilisation tool of choice kind of depended on being able to change interest rates!

Moving on from austerity, Jo’s post also tries to argue that mainstream macroeconomics has always been heavily influenced by neoliberal ideology. To do that he gives a short account of the post-war history of macroeconomic thought that has Friedman, well known member of the Mont Pelerin society, as its guiding light, at least before New Classical economics came along. There is so much that could be said here, but let me limit myself to two points.

First, the idea that Keynesian economics was about short term periods of excess or deficient demand rather than permanent stagnation pre-dated Friedman, and goes back to the earliest attempts to formalise Keynesian economics. It was called the neoclassical consensus. It was why the Keynesian Bob Solow could give an account of growth theory that assumed full employment.

Second, the debates around monetarism in the 1970s were not about the validity of that Keynesian model, but about its parameters and policy activism. Friedman’s own contributions to macroeconomic theory, such as the permanent income hypothesis and the expectations augmented Phillips curve, did not obviously steer theory in a neoliberal direction. His main policy proposal, targeting the money supply, lost out to policy activism using changes to interest rates. And Friedman certainly did not approve of New Classical views on macroeconomic policy.

Jo may be on firmer ground when he argues that the neoliberal spirit of the 1980s might have had something to do with the success of New Classical economics, but I do not think it was at all central. As I have argued many times, the New Classical revolution was successful because rational expectations made sense to economists used to applying rationality in their microeconomics, and once you accept rational expectations then there were serious problems with the then dominant Keynesian consensus. I suppose you could try to argue a link between the appeal of microfoundations as a methodology and neoliberalism, but I think it would be a bit of a stretch.

This brings me to my final point. Jo notes that I have suggested an ideological influence behind the development of Real Business Cycle (RBC) theory, but asks why I stop there. He then writes

“It’s therefore odd that when Simon discusses the relationship between ideology and economics he chooses to draw a dividing line between those who use a sticky-price New Keynesian DSGE model and those who use a flexible-price New Classical version. The beliefs of the latter group are, Simon suggests, ideological, while those of the former group are based on ideology-free science. This strikes me as arbitrary. Simon’s justification is that, despite the evidence, the RBC model denies the possibility of involuntary unemployment. But the sticky-price version – which denies any role for inequality, finance, money, banking, liquidity, default, long-run unemployment, the use of fiscal policy away from the ZLB, supply-side hysteresis effects and plenty else besides – is acceptable.”

This misses a crucial distinction. The whole rationale of RBC theory was to show that business cycles were just an optimal response to technology shocks in a market clearing world. This would always deny an essential feature of business cycles, which is involuntary unemployment (IU). It is absurd to argue that NK theory denies all the things on Jo’s list. Abstraction is different from denial. The Solow model does not deny the existence of business cycles, but just assumes (rightly or wrongly) that they are not essential in looking at aspects of long term economic growth. Jo is right that the very basic NK model does not include IU, but there is nothing in the NK model that denies its possibility. Indeed it is fairly easy to elaborate the model to include it.

Why does the very basic NK model not include IU? The best thing to read on this is Woodford’s bible, but the basic idea is to focus on a model that allows variations in aggregate demand to be the driving force behind business cycles. I happen to think that is right: that is what drives these cycles, and IU is a consequence. Or to put it another way, you could still get business cycles even if the labour market always cleared.

To suggest, as Jo seems to, that the development of NK models had something to do with the Third Way politics of Blair and Bill Clinton is really far fetched. It was the inevitable response to RBC theory and its refusal to incorporate rigid prices, for which there is again strong evidence, and its inability to allow for IU.

That’s all. I do not want to talk about globalisation and trade theory partly because it is not my field, but also because I suspect there is some culpability there. I would also never want to suggest, as Jo implies I would, that ideological influence is confined to the New Classical part of macroeconomics. But just as it is absurd to deny any such influence, it is also wrong to imagine that the discipline and ideology are inextricably entwined. 2010 austerity is a proof of that.

Woodford’s reflexive equilibrium

 For macroeconomists

Karl Whelan recently tweeted: “Read Cochrane and Woodford on neo-Fisherism today. Cochrane - clear and thought provoking. Woodford - unclear and rambling.” I agree about the clarity of John Cochrane’s writing, both in absolute terms and relative to Michael Woodford. But on this occasion I think Woodford has a more realistic approach. So here is my attempt to explain the issue that both are addressing, and Woodford’s version of learning. The two papers Karl is referring to can be found here and here.

The ‘problem’ that both address is that in the standard New Keynesian model a fixed interest rate policy involves an infinite number of rational expectations equilibrium paths. Another way of saying the same thing is that the initial jump in prices is not tied down, but if you choose to select a starting point the subsequent path would preserve rational expectations. This multiple equilibrium result typically means that macroeconomists would regard this monetary policy regime as problematic, but Cochrane says that there is no logical reason to reject these paths, and Woodford agrees. However Woodford argues that this policy is problematic, because if you choose some particular way of selecting a particular equilibrium (and Cochrane does suggest one), it will not be learnable in the sense Woodford describes. (The idea that indeterminate rational expectations solutions are not learnable is not new, as I note below.)

What is Woodford’s reflexive approach to learning? For me the most intuitive way to describe it is that it is very similar to Fair and Taylor’s method of finding the solution to a dynamic economic model involving rational expectations, although it may be that this just reflects my background. (Woodford’s discussion of how his idea relates to the literature, which opens with this analogy, is very readable and can be found in section 2.4.) The method starts by assuming some arbitrary values for expectations variables in the model, and solves it. This gives a solution to the model conditional on those arbitrary expectations. Now take that solution, and recompute using these solution values as expectations. Iterate until the solution hardly changes, and take that solution as the rational expectations equilibrium. The logic is that if some set of expectations (almost) reproduce themselves in this way, they are (almost) model consistent.

Woodford’s reflexive learning is very similar, although he would impose some arbitrary, and small, cut off for the number of iterations (=n). This has various interpretations, but the one I like is that each period a proportion of the population fully recomputes their expectations assuming rationality (or iterates a large number of times), while others stick to their previous expectations. Another interpretation (which could also have diversity) is to appeal to ‘level k thinking’, which has been observed in experiments. The reflexive learning idea is based on work by Evans and Ramey, and is closely related to the E-stability concept developed by Evans and Honkapohja: Woodford explains why he prefers his approach. Evans and Honkapohja have also applied their learning technique to this very issue, with similar results: see George Evans here for example.

Woodford shows, both analytically and with numerical examples, how the reflexive equilibrium converges to the rational expectations equilibrium as the number of iterations n increases if monetary policy is described by a Taylor rule that obeys the Taylor principle, but does not for a fixed nominal interest rate policy. To quote:

“It is true that under the assumption of a permanent interest-rate peg, the only forward-stable PFE are ones that converge asymptotically to an inflation rate determined by the Fisher equation and the interest-rate target (and thus, lower by one percentage point for every one percent reduction in the interest rate). But for most possible initial conjectures (as starting points for the process of belief revision proposed above), none of these perfect foresight equilibria correspond, even approximately, to reflective equilibria — even to reflective equilibria for some very high degree of reflection n.”

There is much more in the paper, but on the issue of reflective equilibrium a natural conjecture (mine not Woodford) is whether all indeterminate solution paths fail to be a reflexive equilibrium. In other words is this a rationale for ignoring indeterminate solutions, or perhaps more appropriately, designing policy to avoid them? Using the analogy with the Fair-Taylor algorithm, it may depend on the relationship between iterative stability and dynamic stability. When there was much more use of iterative methods for model solution I think there was a literature on this (and it may still be alive), and I seem to remember both similarities but also differences, but beyond that I have no idea.

I am not qualified to address the extent to which Woodford’s idea of a reflexive equilibrium adds to the learning literature, but it is now beginning to look as if the result that a fixed interest rate policy is not stable under learning is robust. As James Bullard says in a recent presentation (HT ‘acorn’ in comments), this may be “a sort of “victory” for the learning literature”. 

Postscript (31/12) See this note from Evans and McGough (in a Mark Thoma post) which I think is consistent with what I say here.         

Monetarist vs Fiscalist

Giles Wilkes (ex special advisor to Vince Cable, Business Secretary in the current UK government and LibDem) has a post that compares those he calls ‘fiscalists’ like myself and Jonathan Portes to market monetarists (MM). His post follows some comments and a post by Mark Sadowski responding to an earlier post of mine where Mark took exception to my saying “the major factor behind the second Eurozone recession is not [controversial] : contractionary fiscal policy”. You find much the same debate in this post by Scott Sumner, attacking (mainly) Paul Krugman.

I think Giles Wilkes gets a lot of things right, but I thought it might be useful to set out as clearly as I can how I see the nature of the disagreement. The first, and probably the most important, thing to say is that the disagreement is not about whether fiscal contraction is contractionary, if the monetary authority does nothing. (See, for example, Lars Christensen here.)That is actually what I meant with my statement about the Eurozone recession, which linked to a study that calculated the impact of austerity holding monetary policy ‘constant’. This is so important because, in their enthusiasm to denounce countercyclical fiscal policy, MM often give the impression of thinking otherwise.

The disagreement is over what monetary policy is capable of doing. The second thing to say is that this is all about the particular circumstances of the Zero Lower Bound (ZLB). I do not like the label fiscalist for this reason - it implies a belief that fiscal policy is always better than monetary policy as a means of stabilising the economy. (Giles Wilkes is not the first to use this term - see for example Cardiff Garcia, who includes more protagonists.) Now there may be some economists who think this, but I certainly do not, and nor I believe does Paul Krugman or Jonathan Portes. I described in this article what I called the consensus assignment: that monetary policy should look after stabilising aggregate demand and fiscal policy should be all about debt stabilisation, and there I described recent research (e.g.) which I think strongly supports this assignment. However there has always been a key caveat to that assignment - it does not apply at the ZLB.

Before talking about that, let me illustrate why language can confuse matters. Suppose we had fiscal austerity well away from the ZLB. Suppose further that for some reason the monetary authority did not take measures to offset the impact this had on aggregate demand, and there was a recession as a result. I suspect a MM would tend to say that this recession was caused by monetary policy, even though monetary policy had not ‘done anything’. (In this they follow in the tradition of that great monetarist, Milton Friedman, who liked to say that monetary policy caused the Great Depression.) The reason they would say that is not because fiscal policy has no effect, but because it is the duty of monetary policy to offset shocks like fiscal austerity. That is why fiscal policy multipliers should always be zero, because monetary policy should make them so. So Mark Sadowski got upset with my statement because in his view ECB policy failed to counteract the impact of Eurozone austerity, and could have done so, which meant the  recession in 2012/3 was down to monetary policy, not fiscal policy.

So we come to the heart of the disagreement - the ability of monetary policy to offset fiscal actions at the ZLB. This is all about the effectiveness of unconventional monetary policy (UMP), which is both Quantitative Easing and what I call forward commitment (promising positive output gaps in the future: see David Beckworth here). I do not want to go over these arguments again, partly because I have already written about them elsewhere (e.g. here, here and here). Instead I just want to make an observation about asymmetry.

Economists like Paul Krugman, Jonathan Portes and myself (and there are many others) do not argue against using UMP. Indeed PK pioneered the idea of forward commitment for Japan, and I have been as critical as anyone about ECB policy. We do not argue that fiscal policy will be so effective as to make unconventional monetary policy unnecessary, and so write countless posts criticising those promoting UCM. To take a specific example, I happen to think that the recent ECB moves will have less impact on the Eurozone than continuing fiscal austerity, but I do not say the ECB is wasting its time as a result. They should do more.   

I’m interested in this asymmetry, and where it comes from. Why do MM hate fiscal expansion at the ZLB so much? It could be ideological (see Noah Smith here), but I suspect something else matters. I think it has something to do with monetarism, by which I mean a belief that money is at the heart of issues to do with stabilisation and inflation. MM is not about controlling the money supply as monetarism originally was, but I think many other aspects of monetarism survive. My own view is more Wicksellian (or perhaps Woodfordian), whence the failure to be able to lower interest rates below zero naturally appears central. To those not trained as macroeconomists (and perhaps some that are) these sentences will appear mysterious, so if this idea survives comments I may come back to it later.   

Forward Guidance is not Forward Commitment

Some recent discussions I have had with those who follow monetary policy in the UK and US, and indeed some who actually make that policy, suggest deep confusion between forward guidance and forward commitment. By forward commitment I mean a policy of committing to a future stimulus that would raise future output and inflation, in order to assist the current recovery. This is the policy that was first suggested by Paul Krugman for Japan and championed by Michael Woodford in particular. For more background, I discussed a recent paper exploring this policy here.

Why am I so confident that central banks are not undertaking this policy? First, because this policy only works through its influence on expectations. So those undertaking forward commitment have to be completely clear about what they are doing. The more opaque they are about the policy, the less effective it will be, particularly as the policy is time inconsistent. (The central bank has an incentive to change its mind once the recession is over)

Second, there is a defining characteristic of a forward commitment policy that no central bank has so far committed to, and that is to raise output above its natural rate (or equivalently to reduce unemployment below its natural rate) in the future. In short, to create a future boom. So, if that is a defining characteristic of the policy, yet no central bank has committed to do this, then as the policy has to be clear to be effective it must follow that central banks are not following the policy.

So why the confusion? First, I think there is a presumption that central bank communication will always be obscure, and that money can be made from trying to decipher their true intentions. Sometimes that may be true. In those circumstances, statements by certain policymakers that talked positively about a Woodford type policy might be relevant. However for this particular policy clarity is central. To pursue forward commitment yet to be mysterious about doing so is like announcing that you are targeting inflation but not announcing what your inflation target is.

The second source of confusion comes from focusing on inflation. A second feature of the forward commitment policy is that inflation will be above target during the boom (and perhaps before). So some have taken the part of forward guidance that says the central bank will be relaxed about inflation up to 2.5%, when their target is 2%, as indicating forward commitment. Yet that same forward guidance also features unemployment thresholds, which are above the estimated natural rate. [1] That would be a perverse thing to announce as part of forward commitment, because the whole idea is to get future unemployment below its natural rate.

A much more plausible explanation of forward guidance in the UK and US is that it is clarifying the short term trade-off the central bank will allow between inflation and unemployment. That could simply be informing the public about existing policy at a time when shocks might push inflation above target without also pushing output above the natural rate. Alternatively it could be indicating a change in that trade-off - a change in policy. In either case, the framework of that policy is entirely traditional. There is no commitment to engineer a future boom.

If I am right about this, it raises the interesting question of why no central banks during this recession have tried forward commitment. A closely related question is why no central banks have established price level or nominal GDP targets. In the case of the former this is the puzzle addressed in a recent paper by Steve Amber. To quote from the introduction: “Price-level targeting has convincing advantages, especially as a tool for avoiding the worst consequences of economic downturns. Then why haven’t central banks experimented with the regime?” He suggests that central banks are too fond of their current discretion to make this kind of commitment. If I have something interesting to say about this it will be for a future post.

[1] Here is the Fed's discussion of forward guidance. It suggests that it will be "appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent". But at no point does it say it intends to reduce unemployment below the natural rate (between 5% and 6%) in order to raise inflation above target in the future. 

How the ECB could be radical by being old fashioned

In a recent post I wondered whether, in 20 years time, we might look back on this period with the same bewilderment that we now look back on monetary policy in the early 1930s or 1970s. After the 1929 crash the Federal Reserve was relatively slow to cut interest rates, and Milton Friedman argued the Fed was largely to blame for the subsequent depression. In the 1970s central banks failed to raise interest rates in response to rising inflation. As my previous post was ‘for economists’, let me spell out what central banks may be missing this time.

As we all know, short term nominal interest rates in the US, UK, Eurozone and Japan are as low as they can go, so it appears as if there is nothing more central banks can do with conventional interest rate policy. However that is not the case. What they can do is promise to keep future interest rates lower than they would otherwise be. This policy, first suggested by Paul Krugman for Japan and championed by the highly influential Michael Woodford, I will call ‘forward commitment’. It is not the same as ‘forward guidance’, which central banks are implementing.

The form of forward guidance that the US and UK operate involves giving the public some information about when interest rates might begin to rise. For example, if unemployment falls below some figure, each central bank may think about raising rates, but there is no commitment to do so. I believe the best way to understand this policy is that it is entirely conventional, targeting a combination of expected inflation and the output gap, but that it gives the public a bit more information about the trade off between these two goals.

The forward commitment policy is radically different. It promises to allow both inflation and the output gap to be above target in the future, so as to increase demand today. How does this work? Perhaps the easiest way to think about this is by considering long term interest rates. Long term (say 5 year) interest rates are mainly a combination of expected short rates from now until 5 years ahead. If you promise to have above target inflation tomorrow, the central bank must allow future short term interest rates to be lower tomorrow, which reduces long term rates today. Lower long term interest rates encourage additional consumption and investment today.

I call this the forward commitment policy because the central bank has to make the private sector believe it will carry it out. The problem is that the policy has a built in temptation for the central bank to cheat. They increase demand today by making the promise to allow inflation to be above target tomorrow, but once tomorrow comes they can change their mind - because who likes above target inflation? Yet if the private sector believes they will change their mind, the policy will not work today. So the central bank has to commit to allow inflation to be above target in the future, and get the private sector to believe in that commitment.

There are various ways it could do this. One is to have a target path for the level of nominal income (nominal GDP). The recession reduces nominal income, so nominal income has to grow more rapidly to catch up with its target path. That may well involve inflation rising above 2% for a prolonged period.

You might wonder whether this policy just helps one problem (lack of demand in the recession) by creating another - above target inflation after the recession is over. That is true, but if the recession is deep enough the net result is still positive on balance. However what is also true is that the policy is best implemented at the beginning of the recession. Once the recovery is underway, and the period at which nominal interest rates would normally be stuck at zero decreases, the net benefits of implementing the forward commitment policy decline.

Some people have interpreted forward guidance as forward commitment, because forward guidance in the UK and US allows inflation to go slightly above target if unemployment remains high. I think that is a mistake. Traditional inflation targeting allows inflation to go above target if unemployment is high (as we have seen in the UK and US). The distinctive feature of forward commitment is a promise to allow inflation to be above target when unemployment is low (or equivalently the output gap is positive, rather than negative as it is at present). No central bank has made this promise.

So what we may ask in 20 years time is why central banks did not try this forward commitment policy. In simple toy models, as my previous post showed (where conventional policy is called ‘discretionary’), it can lead to much better outcomes. Is it too late? In the US, with the recovery well under way, I suspect it is. In the UK, where we seem to have got very excited by the economy actually growing again, the same is probably (if regretfully) true. However the story might be very different in the Eurozone.

The Eurozone experienced a real double dip recession. Although positive growth has recently resumed, the OECD still expect the output gap to be -3.5% in 2015: much higher than they forecast for the US or UK. Inflation is currently below 1%, and my colleague Andrea Ferrero argues that there is a real risk of deflation. So the case for a forward commitment policy in the Eurozone remains strong. Furthermore, the ECB feels it cannot implement a Quantitative Easing programme of the type followed by the UK and US, so it may be more inclined to try forward commitment.

But, you may rightly say, isn’t the ECB also notoriously conservative? In particular, German central bankers and their allies would never allow a promise of above target inflation. I suspect this is right, but let me offer a glimmer of hope. Forward commitment could be sold not as a radical new policy, but a return to a very old one: money targeting. The one major central bank that did maintain a money targeting policy for more than a few years was the Bundesbank.

Why is money targeting like a forward commitment policy? Because the level of the money stock is closely related to the level of nominal income. So having a target path for the stock of money is like having a target path for nominal income. And as I suggested above, having a target for nominal income is one way of implementing a forward commitment policy.

So if I was ever in the position of advising the ECB (!) I would sell forward commitment this way. I suspect it would not work, partly because the Bundesbank in practice never rigidly targeted the level of the money supply. However I could reasonably argue that the inflation performance of the German economy in the 1970s was better than in the UK or US partly because expectations were anchored through money supply targeting. It would be worth a try.      

In defence of forward guidance

Although this post is prompted by the bad press that the Bank of England’s forward guidance has been getting recently, much of what I have to say also applies to the US, where the policy is very similar. But there is one criticism of the policy in both countries that I agree with which I will save that until the end.

A good deal of the criticism seems to stem from a potentially ambiguity about what the policy is designed to do. The policy could simply be seen as an attempt to make monetary policy more transparent, and I think that is the best way to think about it in both countries. However the policy could also be seen as a commitment to raise future inflation above target in an attempt to overcome the ZLB constraint as suggested by Michael Woodford in particular [1]. Let’s call this the Woodfordian policy for short. (John Cochrane makes a similar distinction here.)  Ironically the reason why it helps with transparency is also the reason it could be confused with the Woodfordian policy.

In an earlier post written before the Bank of England unveiled its version of forward guidance, I presented evidence that might lead those outside the Bank to think that it was just targeting 2% inflation two years out. We could describe that as the Bank being an inflation forecast nutter, because it gave no weight to the output gap 2 years out. An alternative policy is the conventional textbook one, where the Bank targets both inflation and the output gap in all periods. I suggested that if the Bank published forward guidance, this could clearly establish which policy it was following. It has and it did: we now know it is not just targeting 2% inflation 2 years out, because it says it will not raise rates if forecast inflation is expected to be below 2.5% and unemployment remains above 7%. 2.5% is not hugely different from 2%, but in the world of monetary policy much ‘ink’ is spilt over even smaller things.

So forward guidance has made things clearer, as long as you do not think monetary policy is trying to implement a Woodfordian policy. Unfortunately if you really believed a central bank was an inflation forecast nutter, then you could see forward guidance in Woodford terms. Now I think there are good arguments against this interpretation. First, 2.5% is an incredibly modest Woodfordian policy. Second, for the US, there is a dual mandate, which would seem to be inconsistent with being an inflation forecast nutter. Third, for the UK, the MPC has made it pretty clear (most recently here) that it is not pursuing a Woodfordian policy. For all these reasons, I think it is best to see forward guidance as increasing transparency.

For those who just want to know whether monetary policy changes represent stimulus or contraction, this can be confusing. We saw this in the UK with the questioning of Mark Carney by the Treasury Select Committee, and Tony Yates has pursued a similar theme. Mark Carney kept saying that the stance of monetary policy is unchanged, but forward guidance makes monetary policy more ‘effective’. Now you could spend pages trying to glean insights into disagreements among the MPC from all this, and I do not want to claim that the Bank is always as clear as it might be here. However it seems to me that if the Bank wants for some reason to call reducing uncertainty increasing effectiveness, then there is nothing wrong with what Carney is saying. Forward guidance helps agents in the economy understand how monetary policy will react if something unexpected happens. In particular, growth could be stronger than expected (UK third quarter output has subsequently increased by 0.8%), but the decline in unemployment could remain slow (it fell from 7.8% to 7.7% over the last three months). Charlie Bean makes a similar case here. [2]

In much of the UK media forward guidance has been labelled a failure because longer term interest rates went up as forward guidance was rolled out. Now if you (incorrectly) see forward guidance as a Woodfordian policy, you might indeed be disappointed that long rates went up (although you would still want to abstract from other influences on rates at that time). However if it is about clarifying monetary policy in general, no particular movement in long rates is intended.

Ironically, some of the apparent critics of forward guidance in the UK, like Chris Giles here, also think the Bank of England could be much more transparent in various ways. The most comprehensive list is given by Tony Yates, and I agree with much of what he says. But we all know that central banks are very conservative beasts, and do things rather gradually. So any improvement in transparency is going to be incremental and slow. When they do happen, in this case through forward guidance, they should be welcomed rather than panned. Criticising innovation by central banks risks fuelling their natural conservatism.

This suggests that the major weakness with forward guidance is that it does not go far enough. In the current context, as events in the US have shown, the major problem is that it applies only to interest rates and not to unconventional monetary policy. This allowed the market to get very confused about what the Fed’s future intentions about bond buying are. So why not welcome forward guidance by saying can we have more please.  

[1] Gauti B. Eggertsson & Michael Woodford, 2003. "The Zero Bound on Interest Rates and Optimal Monetary Policy,"Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 139-235. See also Krugman, Paul. 1998. “It’s Baaack! Japan’s Slump and the Return of the Liquidity Trap.” BPEA, 2:1998, 137–87.

[2] If you wanted to be pedantic, you could argue that to the extent that some thought growth might be faster than expected, and that this would lead to higher rates even if unemployment remained high, then dispelling this particular possibility must mean that averaged across all states of the world policy has become more stimulatory. Carney might not want to acknowledge that because some on the MPC would get upset. My reaction to this would be, why do you want to be pedantic. 

Expectations driven liquidity traps

For macroeconomists

This is my own take on the idea of expectations driven liquidity traps (as opposed to liquidity traps where the natural real interest rate is low and unobtainable). I note some of the literature that has promoted these thoughts at the end, but I am not trying to summarise what these papers actually say, but rather to give my own thinking on how such a trap could arise. The usual health warning on such occasions applies: if you think I have got something wrong, or missed something important from the literature, please let me know.

Consider the diagram below, which represents the simplest possible model. Real interest rates are always constant, which is the 45 degree line. Monetary policy follows the Taylor principle, but nominal rates cannot go below zero, so the bold monetary policy line kinks. There is one ‘locally stable’ equilibrium at the inflation target (let us call that the ‘intended’ equilibrium), and one ‘indeterminate’ equilibrium when we are at the ZLB (which involves negative inflation).

It is often said that the intended equilibrium is ‘globally unstable’. (Michael Woodford in Interest and Prices  - page 123 onwards - talks about global ‘multiplicity of equilibria’.) By this is meant that, in the absence of imposing an endpoint constraint that has to be met, there are infinitely many rational expectations solutions to the model, many of which involve inflation exploding. I trace one: if we start at A, the monetary authority raises nominal interest rates, but for constant real rates that must mean that expected inflation next period is even higher etc etc.

John Cochrane says: “Transversality conditions can rule out real explosions, but not nominal explosions.” As a result, he suggests, we cannot rule out travelling along this unstable path. After all, hyperinflations do occur. I am less worried about this. Hyperinflations occur when monetary policy makes no attempt to stabilise inflation. Here we have a model where everyone understands it does, so it makes sense to impose an endpoint on any dynamic path. 

For example, what happens when interest rates and inflation go up when we are at A. Do agents say to themselves ‘hyperinflation here we come’. Of course not. This is inconsistent with the model, which involves an inflation target. They say instead ‘that was unexpected - we must have got something wrong’. We only travel along the unstable path for as long as agents do not revise their ‘beliefs’ (in this case, expectations about the inflation target and the real interest rate). Once they revise their beliefs, whether it is their belief about the inflation target or the real interest rate, inflation is likely to fall towards the intended steady state. [1]

Note that we cannot just say - suppose we start at A, as if history put us there. History does not put us there: in this forward looking model history is irrelevant. Given the Taylor principle, there are only two reasons we could be at A within the context of this model: agents get the real interest rate wrong, or the inflation target wrong. Once we allow beliefs to be revised, it seems inconceivable that hyperinflations would occur within the context of this model.

In looking at how beliefs change we are applying a simple notion of learning. The fact that learning helps stabilise inflation around the intended steady state should not be surprising, because what we are in effect doing is adding some backward dynamics into the model. A locally stable steady state with forward looking dynamics will tend to flip to a stable steady state with backward dynamics. This property is helpful, because we probably do not know the mixture of backward and forward looking dynamics we have in the real world, so it is good that policies should be robust to this.

A consumer has to eventually get on to their stable saddlepath because it is stupid for them to accumulate infinite wealth and stupid for others to carry on lending them more and more (no Ponzi games). But things in this model are not so very different - all we are saying here is that we are working with a model in which we rule out hyperinflation because that is a stupid thing for central banks to allow. But unlike the consumer case, it is not impossible that central banks could allow it, which is why we sometimes see hyperinflation. [2]

If we start off with inflation below the inflation target, then we can apply a symmetrical argument. Nominal interest rates will fall. This is inconsistent with agents’ beliefs, so if they revise these beliefs it seems likely that inflation will rise rather than carry on falling. But suppose they do not revise their beliefs. In that case we do not shoot off to hyper negative inflation. This path will converge on the ZLB steady state. This steady state is not ‘locally stable’, but ‘indeterminate’.

Indeterminacy means that the model does nothing to tie down the initial point. We could start anywhere below the intended steady state, and a solution of the model would get us to the indeterminate steady state. While this may sound desirable, it is not, because we normally want the model to give us a unique dynamic path. With a forward looking model where history does not matter we need something to give us our starting point. Often indeterminate steady states flip to unstable points if we change from forward looking to backward looking dynamics.

This is where the desirability of the Taylor principle comes from. If we replace the Taylor rule plus the Taylor principle by a constant nominal interest rate that passes through the intended steady state, then the fact that this steady state would be indeterminate is conventionally seen as a very strong argument against constant nominal interest rate policies. The ZLB is just a particular constant interest rate policy.

To put this point another way, recall that in this purely forward looking model history is irrelevant. We cannot say ‘history means we start somewhere, and then we converge to the indeterminate steady state’. Now incorrect beliefs could start us anywhere, but beliefs are not completely independent of the model and subsequent dynamic paths. All along the approach to the ZLB equilibrium, events are contradicting those initial beliefs.

However, it may be as unrealistic to assume beliefs are continually revised as it is to assume they are never revised. Suppose beliefs are not revised for some time, and the initial belief involves an inflation target which is below the actual target. Inflation is below target, which leads to interest rates falling, which if real rates are constant implies still lower inflation next period. If beliefs do not get revised, we do not go to hyper disinflation, but to the ZLB steady state. Suppose agents only revise their beliefs once they get close to the ZLB steady state. What will happen then?

Recall that originally agents thought that the inflation target was a bit below the actual target (1% rather than 2%, say). Inflation has now fallen much further (to -3%, say). Is it possible that they might conclude that they originally overestimated the true inflation target? If they ignored the fact that the ZLB is a constraint, they might decide that current stability implied that the inflation target was -3%. The central bank cannot demonstrate that this is incorrect by lowering nominal rates, because of the ZLB. This is why this situation is very different from the hyperinflation case.

In a model this simple, we have stretched credibility a bit to get us to a point where we stay at the ZLB steady state. Agents ignore all the observations on the path towards that position, each of which was inconsistent with a -3% inflation target. But if you add in additional uncertainty, allowing the real interest rate to temporarily change for example, things get more complicated. Agents could interpret falling nominal rates when inflation was 1% as being due to temporarily lower real interest rates.

So for a time, at least, we could stay at the ZLB steady state because of ‘self-fulfilling’ but mistaken expectations. If we allow real interest rates to change, then at some point real interest rates will rise and agents will recognise this. Instead of nominal rates rising (as they should if the inflation target was -3%), they will stay at zero, which should make agents revise their belief about the inflation target. So the ZLB steady state remains transitory. But we could stay stuck in the ZLB steady state because of mistaken beliefs for some time: for as long as beliefs remain unchanged or no information arrives that makes them change.

Does this story of an expectation driven liquidity trap fit the evidence better than stories based on an unobtainable negative natural real rate? Or is it instead just a cute (‘liberating’) theoretical construct with zero application. I think it is difficult to argue that something like this applies today to countries like the US or UK. Expectations of inflation are still positive, and central bank inflation targets are clearly positive and pretty credible. (The concept of pessimistic beliefs, or animal spirits, might well be more applicable in the context of other models with different unobservable variables.)

However, if we take the idea seriously at all, it does suggest that one-sided inflation targets are dangerous. Central banks that have a target of 2% or less invite speculation that they would settle for zero inflation if that came around, which would make falling into an expectations driven liquidity trap that much easier. Perhaps the major economy where the central bank’s intentions towards inflation have been least clear, and therefore the potential for an expectations driven liquidity trap greatest, has been (until very recently) Japan.

Some literature:

Benhabib, J, and Farmer, R (2000) ‘Indeterminacy and Sunspots in Macroeconomics’ , in John

Taylor and Michael Woodford (eds.): Handbook of Macroeconomics, North Holland.

Benhabib, J, Schmitt-Grohe, S and Uribe, M (2002) ‘Avoiding Liquidity Traps’, Journal

of Political Economy 110(3), pp. 535–563. (pdf)

Cochrane, John, 2011, “Determinacy and Identification with Taylor Rules”, Journal of Political Economy 119(3), pp. 565–615. (pdf)

Farmer, R (2012a) “Confidence, Crashes and Animal Spirits,” Economic Journal, Vol. 122, No. 559, Pages, 155-172

Mertens, K and Ravn, M (2012) ‘Fiscal Policy in an expectations driven liquidity trap’ (pdf)

[1] With asset market bubbles, we can get the rather interesting possibility that we continue to travel along the explosive path, not because expectations of the fundamentals are wrong, but because agents think they can make money along that path but get out before the bubble bursts. However, this does not seem to apply to inflation and monetary policy.

[2] Of course it is not completely impossible that some people are misers or get away with Ponzi schemes, which illustrates the point that the difference in rationale for imposing end point conditions in each case is not that great.

Fiscal backing

In an earlier post I went through the logic of why we do not think higher government debt necessarily causes inflation, even if that debt is denominated in nominal terms, as long as the central bank does not monetise that debt. As I argued there, talk of monetisation is largely unnecessary: we just need to say that the central bank uses interest rates to control inflation, and can therefore offset the impact of any increase in government debt.

However, as Mervyn King said, central banks are obsessed with budget deficits. This seems to contradict the previous paragraph. Are there some ways in which central banks would either lose the power to control interest rates, or be forced to abandon any inflation targets, as a result of fiscal policy? 

In the previous post the thought experiment I considered was a sustainable increase in the level of government debt. By sustainable I mean that the fiscal authorities raise taxes (or cut spending) to service this higher level of debt. But suppose they do not: suppose the budget deficit increases because spending is higher, but there is no sign that the government is prepared either to cut future spending or raise taxes to a sustainable level.

In 1981 Sargent and Wallace published a well known paper which said that, in this situation, the central bank could in the short term control inflation, but in the longer term inflation would have to rise to create the seignorage to make the government budget constraint balance. In other words, to keep the economy stable the central bank would eventually be forced to monetise. This was later generalised by the Fiscal Theory of the Price Level (FTPL). If the government did not act to stabilise debt itself (which Eric Leeper called – a little oddly - an active fiscal policy, and which others - including Woodford, Cochrane and Sims - have called even more confusingly a non-Ricardian policy [1]), then the price level would adjust to reduce the real value of government debt. Fiscal policy determines inflation.

One of the critiques of this theory is that the government budget constraint appears not to hold at disequilibrium prices. See, for example, Buiter here, and a response from Cochrane. I do not want to go into that now. Let’s also concede that if the monetary authority does either follow a rule that allows the price level to rise (by fixing the nominal interest rate for example), or tries to move interest rates to both stabilise debt and inflation (as in my recent paper with Tatiana Kirsanova), then the FTPL is correct.

The case I want to focus on here is where the central bank refuses to do either of those things, but carries on controlling inflation and ignoring debt. Suppose the government is running a deficit which is only sustainable if we have a burst of inflation which devalues the existing stock of government debt, but the central bank refuses to allow inflation to rise. You can say it does this by fixing the stock of money, or by raising the rate of interest - I do not think it matters which. This is an unstable situation: interest payments on the stock of debt at the low price level can only be paid for by issuing more debt, so debt explodes. In this situation, we have a game of chicken between the government and central bank.

Now the game of chicken would probably end when the markets refused to buy the government’s debt. That would be the crunch moment: either the central bank would bail the government out by printing money, or the government would default, which forces it to change fiscal policy. But in Buiter there is an elegant equilibrium outcome: the market just discounts the value of debt by an amount that allows the central bank to set the price level, but for the government’s budget constraint to hold at that price level. We get partial default. This discount factor becomes the extra variable that solves for the tension that both fiscal and monetary policy are trying to determine the price level.

You could quite reasonably suggest that such a central bank could not exist, because the government has ultimate power. It can always instruct the central bank to monetise the debt. However suppose the central bank actually managed the currency for a whole group of nations, and could only be instructed to do anything if they all agreed to do so. Furthermore that central bank was located in the one country in that group that would never contemplate monetisation, so it would be immune to pressure ‘from the street’. That central bank should be pretty confident it could win any game of chicken. [1]

Has any of this any relevance to today’s advanced economies? It seems to me pretty clear that these governments are not playing any game of chicken. Quite the opposite in fact: they are being far too enthusiastic in doing what they can to stabilise debt, despite there being a recession. So we certainly do not seem to be in a FTPL type world. Instead monetary policy right now retains fiscal backing.

Yet in a way we are having the wrong conversation here. Rather than trying to convince central banks that their fears are groundless, we should be asking whether monetary policy should – of its own free will – raise inflation to help reduce high levels of debt. I agree with Ken Rogoff that it should, and have argued the case here. Yet however optimal such a policy might be, the chances of it happening in today’s environment are nil. It looks like we may have to go through a lost decade before we are allowed to contemplate such things. 

[1] I guess a rationale for calling this fiscal policy ‘active’ is that stable regimes in Leeper require one partner to be active and the other passive. So in the normal regime monetary policy is active and fiscal passive, and this flips in a FTPL regime. In a FTPL regime, Ricardian Equivalence no longer holds (because taxes are not raised following a tax cut) – hence the label non-Ricardian.

[2] In this situation, would buying that government’s debt ‘show weakness’ in the game? If we follow Corsetti and Dedola and treat reserves as default free debt issued by the central bank rather than money, then not at all. Instead the central bank is giving the fiscal authority the best chance it can to put its house in order, by removing any bad equilibrium, but it retains the power to force default at any point. We no longer have Buiter’s method of resolving that game, but only because the central bank has the means which could force a win. As long as the government believes that the central bank would prefer the government to default rather than see inflation rise, the government should back down.

Government debt, Inflation and Money

Do budget deficits cause inflation? Let me be a little more specific: does raising the level of debt and keeping it there when the economy is at full employment raise the price level? The conventional answer is: not if the central bank controls inflation. Sometimes economists say the same thing in a different way: not if the debt is not monetised. High debt may be problematic for other reasons (e.g. crowding out of private capital, default risk, increasing distortionary taxation), but not because it must cause inflation.

This post is about explaining this conventional view. The two ways of giving the answer reflect two different ways to describe the conventional view, and I think that tells us something interesting - although perhaps controversial - about the role of money.

In the textbooks, the conventional view starts by talking about the demand for the medium of exchange, money. The amount of money in the economy, it is assumed, is related to the amount of money created by the central bank, but not the amount of debt issued by the government. The demand for nominal money is proportional to the price level, which is what economists mean when they say people demand ‘real balances’. So, if the stock of nominal money does not change, neither can the price level. When economists talk about not monetising the debt, they mean that the central bank keeps nominal money fixed.

There are two elements in this argument. The first has to do with the relationship between the amount of money created by the central bank (‘base’ or ‘high powered’ money), and what the financial institutions that create money (private banks) can do. The second has to do with money demand, which is what I want to focus on first. To do so, imagine an economy where the only money is cash printed by the government.

It is trivial to show why there can be this tight and simple link between cash and the price level. The economic system is all about real variables: not just consumption and output, but also relative prices like real wages. Furthermore people want money to buy some real quantity of goods, so the demand function can be written as M/p = f(...) where (...) includes real output. So, if the price level only appears on the left hand side of this equation and nowhere else in the system of equations describing the economy, and the central bank controls the supply of cash M, then this will lock down the price level. This is the famous neutrality of money. Furthermore, the mechanism by which this lock down works is intuitive: if the central bank creates more cash, we have ‘too much money chasing too few goods’, so prices rise.

Once we allow private banks to create money, the story can get much more complicated. The textbooks try and short circuit this by teaching the money multiplier, which I think does a lot more harm than good. But we could just assume there is some mechanism by which the central bank can control the amount of money created by banks, and continue to tell our neutrality story.

So according to this conventional view there is no worry about government debt, as long as the central bank ignores debt when ‘fixing the money supply’. Whether it always will ignore debt, or whether it always can, is a separate issue for another post. The critical assumption I make here that allows me to avoid this issue is that the fiscal authority does adjust its taxes or spending to make the higher level of debt sustainable.

This story is missing a key ingredient, and to see why consider the following. Let all government debt be nominal (not indexed). Suppose that, just as there is a demand for real money, there is also a demand for a real quantity of government debt: B/p = g(....). The government, by cutting taxes for a period, raises the supply of nominal debt by a fixed amount. Suppose it keeps nominal debt at this level. In that case, using an argument analogous to the earlier one involving money, will the price level not increase, until the supply of real debt matches the demand for real debt? If so, higher government debt has raised the price level.

One argument here is to say that, as the government increases the nominal quantity of debt, the demand for debt also rises in step, so there is no need for prices to rise. This will happen if consumers are completely Ricardian, because they believe tax cuts today mean tax increases tomorrow, and they save to pay for those future tax increases by buying government debt. In this sense, the supply of government debt creates its own demand, so we do not need anything else, including the price level, to change.

Suppose, however, that this process is incomplete, perhaps because some consumers are credit constrained, and so spend rather than save their tax cut. Does that not mean prices will still have to rise a bit to match the increase in the supply of nominal bonds? However, if we still have a fixed nominal amount of money, then higher prices will raise the demand for money, giving us a contradiction. What squares this circle is that interest rates rise, which makes people economise on money, and also raises the demand for government debt without the need for prices to increase. So higher debt might raise interest rates, but it will not raise the price level if it is not monetised.

Now an interesting feature of this story is that we could cut out the stuff about money altogether. We could just talk about the supply and demand for nominal government debt, and how the demand for debt is positively related to interest rates and prices. If the government wants to borrow more, the demand for nominal bonds needs to rise, and this can happen either because interest rates rise or because the price level rises. If interest rates rise sufficiently there is no need for higher prices. Loanable funds vs liquidity preference and all that. [1]

It is a small additional step to just talk about the central bank controlling interest rates to fix the price level. Nowadays this is how many macroeconomists would explain why higher government debt does not raise prices: the central bank changes interest rates to make sure it does not. This explanation not only has the advantage of simplicity (we do not need to talk about the demand for money, or how the central bank controls its supply), but it also seems to match how central banks think.

Of course something about money is there in the background. When we talk about interest rates being varied to control inflation, and why therefore we can ignore the size of the stock of government debt as an influence on inflation, we are assuming that the central bank has the ability to control interest rates. This depends on the fact that the government can issue money, or more specifically that the central bank’s “liabilities happen to be used to define the unit of account”, to quote from the bible Michael Woodford’s Interest and Prices (p 37). So money is there, but like the impresario of a play, it does not need to appear on stage.

In terms of the question posed by the title, both ways of describing the conventional view (with or without money) end up with the same answer to the question about government debt and inflation, which is good. However I remain puzzled about one thing. Do those who still tell the story using money think that telling the story just with interest rates is equally valid, or in some way misleading? When, with Campbell Leith, I first started using ‘cashless’ models of the Woodford type, a frequent complaint was ‘where was money?’. To appease potential referees we occasionally put money in, even though this added nothing to the main points of the paper. Yet I think those asking the question thought we might be missing something more fundamental, but I never discovered what it was. I remain genuinely curious.     

[1] Recall that I am assuming full employment in all this. In a recession caused by people saving more, higher saving will raise the demand for bonds, so even if the supply of bonds also rises following budget deficits, interest rates or the price level could fall rather than rise.