Saturday, 23 August 2014

Draghi at Jackson Hole

To understand the significance of yesterday's speech (useful extract from FT Alphaville here), it is crucial to know the background. The ECB has appeared to be in the past a centre of what Paul De Grauwe calls balanced-budget fundamentalism. I defined this as a belief that we needed fiscal consolidation (austerity) even when we were in a liquidity trap (i.e. interest rates were at or very close to their zero lower bound). Traditionally ECB briefings would not be complete without a ritual call for governments to undertake structural reforms and to continue with fiscal consolidation.

An important point about these calls from the central bank for fiscal consolidation is that they predate the 2010 Eurozone crisis. As I noted in an earlier post, the ECB’s own research found that “the ECB communicates intensively on fiscal policies in both positive as well as normative terms. Other central banks more typically refer to fiscal policy when describing foreign developments relevant to domestic macroeconomic developments, when using fiscal policy as input to forecasts, or when referring to the use of government debt instruments in monetary policy operations.” The other point to note, of course, is that the ECB had in the past always called for fiscal consolidation, whatever the macroeconomic situation.

How can we explain both this obsession with fiscal consolidation, and the ECB’s lack of inhibition in its public statements? I suspect some might argue that the ECB feels especially vulnerable to fiscal dominance - the idea that fiscal profligacy will force the monetary authority to print money to cover deficits. In my earlier post I suggested this was not plausible, because in reality the ECB was less vulnerable in this respect than other central banks. Unfortunately I think the true explanation is rather simpler, and we get an indication from the Draghi speech. There he says:

“Thus, it would be helpful for the overall stance of policy if fiscal policy could play a greater role alongside monetary policy, and I believe there is scope for this, while taking into account our specific initial conditions and legal constraints. These initial conditions include levels of government expenditure and taxation in the euro area that are, in relation to GDP, already among the highest in the world. And we are operating within a set of fiscal rules – the Stability and Growth Pact – which acts as an anchor for confidence and that would be self-defeating to break.”

The big news is the first sentence, which suggests that Draghi does not (at least now) believe in balanced-budget fundamentalism. Instead this speech follows the line taken by Ben Bernanke, who made public his view that fiscal consolidation in the US was not helping the Fed do its job (and who was quite unjustifiably criticised in some quarters for doing so). However note also the second sentence, which clearly implies that the size of the state in Euro area countries is too large. Whether you believe this to be true or not, it is an overtly political statement. I think part of the problem is that Draghi and the ECB as a whole do not see it as such - instead they believe that large states simply generate economic inefficiencies, so calling for less government spending and taxation is similar to calling for other ‘structural reforms’ designed to improve efficiency and growth.

The simple explanation for the ECB’s obsession, until now, with fiscal consolidation is that its members take the neoliberal position as self evident, and that their lack of accountability to the democratic process allows them to believe this is not political.

As a result, it might be possible to argue that the ECB never believed in balanced-budget fundamentalism, but instead kept on calling for fiscal consolidation after the Great Recession through a combination of zero lower bound denial, panic after the debt funding crisis, and a belief that achieving a smaller state remained an important priority. It is hard to believe that members of the ECB, unlike other central banks, were unaware of the substantial literature confirming that fiscal policy is contractionary: there does not seem to be any difference in educational or professional backgrounds between members of the ECB and Fed, for example. 

Should we celebrate the fact that Draghi is now changing the ECB’s tune, and calling for fiscal expansion? The answer is of course yes, because it may begin to break the hold of balanced-budget fundamentalism on the rest of the policy making elite in the Eurozone. However we also need to recognise its limitations and dangers. As the third sentence of the quote above indicates, Draghi is only talking about flexibility within the Stability and Growth Pact rules, and these rules are the big problem.

The danger comes from the belief that the size of the state should be reduced. Whether this is right or not, it leads Draghi later on in his speech to advocate balanced budget cuts in taxes. He says: “This strategy could have positive effects even in the short-term if taxes are lowered in those areas where the short-term fiscal multiplier is higher, and expenditures cut in unproductive areas where the multiplier is lower.” My worry is that in reality such combinations are hard to find, and that what we might get instead is the more conventional balanced budget multiplier, which will make things worse rather than better.  

Friday, 22 August 2014

Types of unemployment

For economists

This post completes a discussion of a new paper by Pascal Michaillat and Emmanuel Saez. My earlier post outlined their initial model that just had a goods market with yeoman farmers, but with search costs in finding goods to consume. Here I want to look at their main model where there are firms, and a labour market as well as a goods market.

The labour market has an identical search structure to the goods market. We can move straight to the equivalent diagram to the one I reproduced in my previous post.



The firm needs ‘recruiters’ to hire productive workers (n). As labour market tightness (theta) increases, any vacancy is less likely to result in a hire. In the yeoman farmer model capacity k was exogenous. Here it is endogenous, and linked to n using a simple production function. Labour demand is given by profit maximisation. Employing one extra producer has a cost that depends on the real wage w, but also the cost of recruiting and hence labour market tightness theta. They generate revenue equal to the sales they enable, but only because by raising capacity they make a visit more likely to result in a sale. The difference between a firm’s output (y) and their capacity (k, now given by the production function and n) the paper calls ‘idle time’ for workers. As y<k, workers are always idle some of the time. So, crucially, profit maximisation determines capacity, not output. Output is influenced by capacity, but it is also influenced by aggregate demand.

Now consider an increase in the aggregate demand for goods, caused by - for example - a reduction in the price level. That results in more visits to producers, which will lead to more sales (trades=output). This leads firms to want to increase their capacity, which means increasing employment. (More employment reduces x, but the net effect of an increase in aggregate demand is higher x, so workers’ idle time falls.) This increases labour market tightness and reduces unemployment.

Here I think the discussion in the paper (bottom of page 28) might be a little confusing. It notes that in fixed price models like Barro and Grossman, in a regime that is goods demand constrained, an increase in demand will raise employment by exactly the amount required to meet demand (providing we stay within that regime). It then says that in their model the mechanism is different, because aggregate demand determines idle time, which in turn affects labour demand and hence unemployment. I would prefer to put it differently. In this model a firm responds to an increase in aggregate demand in two ways: by increasing employment (as in fix price models) but also by reducing worker idle time. The advantage of adding the second mechanism is that, as aggregate demand varies, it generates pro-cyclical movements in productivity. (There are of course other means of doing this, like employment adjustment costs.)

There are additional interesting comparisons with this earlier fixed price literature. In this model unemployment can be of three ‘types’: classical (w too high), Keynesian (aggregate demand too low), but also frictional. This model can also generate four ‘regimes’, each corresponding to some combination of real wage and price. However, unlike the fixed price models, these regimes are all determined by the same set of equations (there are no discontinuities), and are relative to the efficient level of goods and labour market tightness.

For me, this is one of the neat aspects of the model. We do not need to ask whether demand is greater or less than ‘supply’, but equally we do not presume that output is always independent of ‘supply’. Instead output is always less than capacity, just as unemployment (workers actually looking for work) is always positive. One way to think about this is that actual output is always a combination of ‘supply’ (capacity) and demand (visits), a combination determined by the matching function. This is what matching allows you to do. What this also means is that increases in supply in either the goods market (technical progress) or labour market will increase both output and employment, even if prices remain fixed. In Keynesian models additional supply will only increase output if something boosts aggregate demand, but that is not the case here. However, if the equilibrium was efficient before this supply shock, output will be inefficiently low after it unless something happens to increase aggregate demand (e.g. prices fall).

The aggregate demand framework in the model, borrowed from fixed price models, is rather old fashioned, but there is no barrier to replacing it with a more modern dynamic analysis of a New Keynesian type. Indeed, this is exactly what the authors have done in a companion paper

The paper ends with an empirical analysis of the sources of fluctuations in unemployment. It suggests that unemployment fluctuations are driven mostly by aggregate demand shocks. (This is also well covered in their Vox post.) This ties in with the message of Michaillat’s earlier AER paper, where he argued that in recessions, frictional unemployment is low and most unemployment is caused by depressed labour demand. What this paper adds is a goods market where changes in aggregate demand can be the source of depressed labour demand, and therefore movements in unemployment.    



Thursday, 21 August 2014

UK 2015: 2010 Déjà vu, but without the excuses

Things can go wrong when policymakers do not ask the right questions, or worse still ask the wrong questions. Take my analysis of alternative debt reduction paths for the UK following the 2015 elections. There I assumed that the economic recovery would continue as planned, with gradually rising interest rates, achieving 4% growth in nominal GDP each year. I set out a slow, medium and fast path for getting the debt to GDP ratio down, and George Osborne’s plan. On the latter I wrote: “I cannot see any logic to such rapid deficit and debt reduction, so it seems to be a political ruse to either label more reasonable adjustment paths as somehow spendthrift, or to continue to squeeze the welfare state.”

Ah, said some, that is all very well, but you are ignoring what might happen if we have another financial crisis. That will send debt back up again. The implication was that the Osborne plan might make sense if you allowed for this kind of occasional but severe shock. In a subsequent post I showed that this was not the case. However this also illustrates a clear example of asking the wrong question. Rather than setting policy today on the basis of something that might happen in 30+ years time, we should be worrying about much more immediate risks.

The question that should have been asked is what happens if we have a rather more modest negative economic shock in the next five years. The list of possibilities is endless: deflation in the Eurozone, the crisis in Iraq and Syria gets worse, Ukraine blows up, things go wrong in China etc. We can hope that they do not happen, but good macroeconomic policy needs to allow for the fact that they might.

That is the question that was not asked in 2010. The forecast attached to the June 2010 budget didn’t look too bad. GDP growth was between 2% and 3% each year from 2011 to 2015 - not great given the depth of the recession, but nothing too awful. But suppose something unexpected and bad happened, and economic growth faltered. The question that should have been asked is what do we do then. The normal answer would be that monetary policy would come to the rescue, but monetary policy was severely compromised because interest rates were at 0.5%. So 2010 was a gamble - there was no insurance policy if things went wrong. And of course that is exactly what came to pass.

As I have always said, there was an excuse for this mistake. In 2010 there was another risk that appeared to many to be equally serious, and that was that the bond vigilantes would move on from the Eurozone periphery to the UK. This was a misreading of events, but an understandable confusion. By 2011, as interest rates on government debt outside the Eurozone continued to fall, it was clear it was a mistake. Policy should have changed at that point, but it did not - instead we had to wait another year, and then we just got a pause in deficit reduction rather than stimulus.

Today, there is no excuse. There are no bond vigilantes anywhere to be seen. No one, just no one, thinks the UK government will default. This means we are free to choose how quickly we stabilise government debt. However what is very similar to 2010 is monetary conditions. Interest rates may have begun to rise by 2015, but any increase is expected to be slow and modest. So there will again be little scope in the first few years for monetary policy to come to the rescue if things go wrong. A negative demand shock, like another Eurozone recession, will quickly send interest rates to their zero lower bound again, and we will have little defense against this deflationary shock. The tighter is fiscal policy after 2015, the greater the chance that will happen. In that sense, it is just like 2010.

So the right question to ask potential UK fiscal policymakers in 2015 is how will you avoid 2010 happening again? If their answer is to do exactly as we did in 2010 and keep our fingers crossed, you can draw your own conclusions.

Wednesday, 20 August 2014

The symmetry test

Two members of the Bank of England’s Monetary Policy Committee (MPC), Ian McCafferty and Martin Weale, voted to raise interest rates this month. This was the first time any member has voted for a rate rise since July 2011, when Martin Weale also voted for a rate increase. A key factor for those arguing to raise rates now is lags: “Since monetary policy …. operate[s] only with a lag, it was desirable to anticipate labour market pressures by raising bank rate in advance of them.”

The Bank of England’s latest forecast assumes interest rates rising gradually from 2015. It also shows inflation below target throughout. The implication would seem to be that the MPC members who voted for the rate increase do not believe the forecast. But it could also be that they are more worried about risks that inflation will go above target than risks that it will stay below, much as the ECB always appears to be.

I like to apply a symmetry test in these situations. Imagine the economy is just coming out of a sustained boom. Interest rates, as a result, are high. Growth has slowed down, but the output gap is still positive. Unemployment is rising, but is still low (say 4%) and below estimates of the natural rate. Wage inflation is high as a result, and real wages had been increasing quite rapidly for a number of years. Consumer price inflation is above target, and the forecast for inflation in two years time is that it will still be above target.

In these circumstances, would you expect some MPC members to argue that now is the time to start reducing interest rates? Would you expect them to ignore the fact that price inflation is above target, wage inflation is high, the output gap is positive and unemployment is below the natural rate, and discount the forecast that inflation will still be above target in two years time? There is always a chance that they might be right to do so, but can you imagine it happening?

You could? Now can you also imagine large numbers of financial sector economists and financial journalists cheering them on? 

Monday, 18 August 2014

Balanced-budget fundamentalism

Europeans, and particularly the European elite, find popular attitudes to science among many across the Atlantic both amusing and distressing. In Europe we do not have regular attempts to replace evolution with ‘intelligent design’ on school curriculums. Climate change denial is not mainstream politics in Europe as it is in the US (with the possible exception of the UK). Yet Europe, and particularly its governing elite, seems gripped by a belief that is as unscientific and more immediately dangerous. It is a belief that fiscal policy should be tightened in a liquidity trap.

In the UK economic growth is currently strong, but that cannot disguise the fact that this has been the slowest recovery from a recession for centuries. Austerity may not be the main cause of that, but it certainly played its part. Yet the government that undertook this austerity, instead of trying to distract attention from its mistake, is planning to do it all over again. Either this is a serious intention, or a ruse to help win an election, but either way it suggests events have not dulled its faith in this doctrine.

Europe suffered a second recession thanks to a combination of austerity and poor monetary policy. Yet its monetary policymakers, rather than take serious steps to address the fact that Eurozone GDP is stagnant and inflation is barely positive, choose to largely sit on their hands and instead to continue to extol the virtues of austerity. (Dear ECB. You seem very keen on structural reform. Given your performance, maybe you should try some yourself.) In major economies like France and the Netherlands, the absence of growth leads to deficit targets being missed, and the medieval fiscal rules of the Eurozone imply further austerity is required. As Wolfgang Munchau points out (August 15), German newspapers seem more concerned with the French budget deficit than with the prospect of deflation.

There is now almost universal agreement among economists that tightening fiscal policy tends to significantly reduce output and increase unemployment when interest rates are at their lower bound: the debate is by how much. A few argue that monetary policy could still rescue the situation even though interest rates are at their lower bound, but the chance of the ECB following their advice is zero. 

Paul De Grauwe puts it eloquently. 

“European policymakers are doing everything they can to stop recovery taking off, so they should not be surprised if there is in fact no take-off. It is balanced-budget fundamentalism, and it has become religious.”

They still teach Keynesian economics in Europe, so it is not as if the science is not taught. Nor do I find much difference between the views of junior and middle-ranking macroeconomists working for the ECB or Commission compared to, for example, those working for the IMF, apart from a natural recognition of political realities. Instead I think the problem is much the same as that encountered in the US, but just different in degree.

The mistake academics can often make is to believe that what they regard as received wisdom among themselves will be reflected in the policy debate, when these issues have a strong ideological element or where significant sectional financial interests are involved. In reality there is a policy advice community that lies between the expert and the politician, and while some in this community are genuinely interested in evidence, others are more attuned to a particular ideology, or the interests of money, or what ‘plays well’ with sections of the public. Some in this community might even be economists, but economists who - if they ever had macroeconomic expertise - seem happy to leave it behind.

So why does ‘balanced-budget fundamentalism’ appear to be more dominant in Europe than the US. I do not think you will find the answer in any difference between the macro taught in the two continents. Some might point to the dominance of ordoliberalism in Germany, but this is not so very different to the dominance of neoliberalism within the policy advice community in the US. Perhaps there is something in the greater ability of academics in the US (and one in particular) to bypass the policy advice community through both conventional and more modern forms of media. However I suspect a big factor is just recent experience.

The US never had a debt funding crisis. The ‘bond vigilantes’ never turned up. In the Eurozone they did, and that had a scarring effect on European policymakers that large sections of the policy advice community can play to, and which leaves those who might oppose austerity powerless. That is not meant to excuse the motives of those that foster a belief in balanced budget fundamentalism, but simply to note that it makes it more difficult for science and evidence to get a look in. The difference between fundamentalism that denies the concept of evolution and fundamentalism that denies the principles of macroeconomics is that the latter is doing people immediate harm.  

Sunday, 17 August 2014

Why central banks use models to forecast

One of the things I really like about writing blogs is that it puts my views to the test. After I have written them of course, through comments and other bloggers. But also as I write them.

Take my earlier post on forecasting. When I began writing it I thought the conventional wisdom was that model based forecasts plus judgement did slightly better than intelligent guesswork. That view was based in part on a 1989 survey by Ken Wallis, which was about the time I stopped helping to produce forecasts. If that was true, then the justification for using model based forecasting in policy making institutions was simple: even quite small improvements in accuracy had benefits which easily exceeded the extra costs of using a model to forecast.

However, when ‘putting pen to paper’ I obviously needed to check that this was still the received wisdom. Reading a number of more recent papers suggested to me that it was not. I’m not quite sure if that is because the empirical evidence has changed, or just because studies have had a different focus, but it made me think about whether this was really the reason that policy makers tended to use model based forecasts anyway. And I decided it was probably not.

In a subsequent post I explained why policymakers will always tend to use macroeconomic models, because they need to do policy analysis, and models are much better at this than unconditional forecasting. Policy analysis is just one example of conditional forecasting: if X changes, how will Y change. To see why this helps to explain why they also tend to use these models to do unconditional forecasting (what will Y be), let’s imagine that they did not. Suppose instead they just used intelligent guesswork.

Take output for example. Output tends to go up each year, but this trend like behaviour is spasmodic: sometimes growth is above trend, sometimes below. However output tends to gradually revert to this trend growth line, which is why we get booms and recessions: if the level of output is above the trend line this year, it is more likely to be above than below next year. Using this information can give you a pretty good forecast for output. Suppose someone at the central bank shows that this forecast is as good as those produced by the bank’s model, and so the bank reassigns its forecasters and uses this intelligent guess instead.

This intelligent guesswork gives the bank a very limited story about why its forecast is what it is. Suppose now oil prices rise. Someone asks the central bank what impact will higher oil prices have on their forecast? The central bank says none. The questioner is puzzled. Surely, they respond, higher oil prices increase firms’ costs leading to lower output. Indeed, replies the central bank. In fact we have a model that tells us how big that effect might be. But we do not use that model to forecast, so our forecast has not changed. The questioner persists. So what oil price were you assuming when you made your forecast, they ask? We made no assumption about oil prices, comes the reply. We just looked at past output.

You can see the problem. By using an intelligent guess to forecast, the bank appears to be ignoring information, and it seems to be telling inconsistent stories. Central banks that are accountable do not want to get put in this position. From their point of view, it would be much easier if they used their main policy analysis model, plus judgement, to also make unconditional forecasts. They can always let the intelligent guesswork inform their judgement. If these forecasts are not worse than intelligent guesswork, then the cost to them of using the model to produce forecasts - a few extra economists - are trivial.


Saturday, 16 August 2014

Search in the goods market?

For economists

Imagine an economy made up of independent producers, who individually produce some good. Producers each have a fixed ‘capacity’ k of the output they produce. Producers are also consumers, but cannot consume their own good. Instead they search for other goods by visiting other producers. Agents as consumers have a certain demand for goods, which will depend on how much of their own good they sell, as well as some initial endowment of money and the price of goods in terms of money.

Traditionally we ignore the costs for consumers of visiting producers, and we assume that any visit will result in a purchase. As a result, for a given price level, we can have three situations. In the first, aggregate consumption demand is below aggregate capacity (the sum of all k), and producers end up with either unsold goods or idle capacity. In the second, aggregate demand is equal to supply. In the third, aggregate demand is above capacity. In this case we must have rationing of goods.

In this framework output is not always determined by aggregate demand, but only up to some limit. This is not how macroeconomic models typically work - they generally assume output is always equal to aggregate demand. The way New Keynesian models justify this is by assuming that producers can produce above ‘capacity’ (or that they prefer to always have some spare capacity), and that they will be happy to produce above capacity at a given price because they are monopolistic.

A recent paper by Pascal Michaillat and Emmanuel Saez applies the framework of search to the goods market. First, each visit by the consumer is costly (visiting costs) - some of the produced good is ‘lost’ (does not increase utility) as a result. So output (y, the sum of all trades) is greater than consumption (c) because of these visiting costs. Second, a visit may not lead to a trade. Whether it does depends on a matching function, which depends on the ‘tightness’ of the goods market = x, defined as the ratio of visits to capacity. Here is a diagram from their paper.



The consumption demand line is downward sloping, because a larger number of visits raises the effective price of the produced good. The output line is upward sloping, because more visits result in more trade, but the matching function is such that it gets steeper with more visits. However if visiting costs are linear in visits, that implies what the paper calls ‘consumption supply’ has this rather odd shape. (Think about the constant capital line in the Ramsey model.) For a given price, the intersection of the consumption demand and supply lines defines equilibrium tightness. Perhaps a simpler way of putting it is that consumers plan the number of visits they need to make given their consumption demand schedule.

Now shift the consumption demand line outwards, by reducing the price. (In a New Keynesian framework, think about the price as the real interest rate.) The line pivots about the xm point, but output always stays below k. As tightness (number of visits) increases, more resources are used up in failed endeavours to make a trade, and consumption starts falling. Output is always ‘demand determined’, and there is no rationing.

It is still possible to think about different ‘regimes’, because the efficient level of tightness is where consumption is at a maximum. If tightness is below that point, we can say that demand is too low (the price level is too high), and vice versa.

Those familiar with matching models in the labour market will see the connections. Visits are equivalent to vacancies, for example. The key question is whether this transposition to the goods market makes sense, and what it achieves. To quote the authors: “casual observation suggests that a significant share of visits do not generate a trade. At a restaurant, a consumer sometimes need[s] to walk away because no tables are available or the queue is too long.” (What is it with economists and restaurants?!) We could add that this rarely means that consumption is rationed - instead the consumer attempts to make a similar trade at another restaurant. However this does have an opportunity cost, which this model captures.

In a subsequent post, I will look at their full model which has separate goods and labour markets, and the various types of unemployment that this can generate. Those that cannot wait can read their own account on Vox.