Sheedy on NGDP targeting and debt contracts

An argument that is sometimes made for a monetary policy that targets a path for nominal GDP (NGDP) is that it reduces risk for most borrowers who take out debt contracts with repayments fixed in nominal terms (see, for example, Nick Rowe here). However, as far as I am aware, this argument has not been quantified in a way that allows it to be compared with the more familiar benefits of inflation targeting. A recent paper by Kevin Sheedy does just that.

Before getting to the punchline, it is worth setting out the argument more precisely. A good deal of the borrowing that goes on in the economy is to smooth consumption over the life cycle. We borrow when young and incomes are low, and pay back that borrowing in middle age when incomes are high. To do this, we almost certainly have to borrow using a contract that specifies a fixed nominal repayment. The problem with this is that our future nominal incomes are uncertain - partly for individual reasons, but also because we have little idea how the economy as a whole is going to perform in the future. If the real economy grows strongly, and our real incomes grow with it, repaying the debt will be much easier than if the economy grows slowly.

As most individuals are risk averse, this is a problem. In an ‘ideal’ world this could be overcome by issuing what economists call state contingent contracts, which would be a bit like a personal version of equities issued by firms. If economic growth is weak, I have a contract that allows me to reduce the payments on my debt. However most people cannot take out debt contracts of that kind, or insure against the aggregate risk involved in nominal debt contracts. We have what economists call an incomplete market, which imposes costs.

Monetary policy can reduce these costs by trying to stabilise the path of nominal GDP, because it reduces the risks faced by borrowers. Of course monetary policy cannot remove the uncertainty about real GDP growth, but if periods of weak growth are accompanied by periods of moderately higher inflation, then this is not a problem from the borrower’s point of view. (Koenig discusses this in detail in a paper here.)

How do we quantify this benefit of NGDP targeting, and compare it to the benefits of inflation targets? Sheedy defines a ‘natural’ debt to GDP ratio, which is the private debt to GDP ratio that would prevail if financial markets were complete. Under certain conditions the natural debt to GDP ratio is likely to be constant, and Sheedy suggests that departures from this benchmark are unlikely to be great. So a goal for monetary policy could be to close as far as possible the gap between the actual and natural debt to GDP ratio, in an analogous way to policy trying to close the output gap. To do this it would target the path of NGDP.

The current standard way of modelling the welfare costs of inflation, due to Woodford, is to measure the cost of the distortion in relative prices caused by prices changing at different times to keep up with aggregate inflation. This suggests monetary policy should have an inflation target rather than a NGDP target. (I note here that typically in the literature these costs are far greater than costs associated with output gaps.) What Sheedy does is set up a model which has these costs of inflation present, but also has the costs of nominal debt contracts discussed earlier. With these two different goals, an optimal monetary policy will go for some combination of inflation targeting and NGDP targeting. The key question is which kind of costs are more important. [1]

Sheedy’s answer is that the costs of nominal debt contracts are more important. The optimal monetary policy gives a 95% weight to the NGDP target, and just 5% to the inflation target. Now of course this is just one result from a highly stylised model, and Sheedy shows that it is sensitive to assumptions about the duration of debt contracts and the degree of risk aversion. Nevertheless it is very interesting result.

A very simplistic way of describing why this may be very important is as follows. If the focus of monetary policy is always on the cost of inflation, NGDP targets will appear to non-economists at least (e.g. politicians) to be second best. They are a nominal anchor, so we will not get runaway inflation or deflation by adopting them, but why not just target inflation directly? Who cares about nominal GDP anyway? This paper suggests a simple answer - borrowers care. If we see monetary policy has being important to the proper functioning of financial markets, as we now do, then reducing the risk faced by borrowers is a legitimate goal for policy. It may make sense for inflation to be high when real growth is low, and vice versa, because this reduces the risks faced by borrowers. I think a politician that was not beholden to creditors could sell that.

[1] For those interested in government debt, there is an interesting parallel in the literature. Some authors (e.g. Chari, V. V. and Kehoe, P. J. (1999), “Optimal fiscal and monetary policy", in J. B. Taylor and M. Woodford (eds.), Handbook of Monetary Economics, vol. 1C, Elsevier, chap. 26, pp.1671-1745.) developed the idea that nominal government debt contracts could be a useful way of avoiding costly changes in distortionary taxes following fiscal shocks, because inflation could change real debt. However Schmitt-Grohe and Uribe (Schmitt-Grohe, S. and Uribe, M.  (2004), “Optimal fiscal and monetary policy under sticky prices", Journal of Economic Theory, 114(2):198-230) showed that once you added in nominal rigidity to the model so that inflation was costly, inflation costs dwarfed any gains. This example makes the fact that we get the opposite result with private debt contracts particularly interesting, although as Sheedy and others have noted, this may be partly because this earlier literature assumed short maturity government debt.

 

Is UKIP the UK's Tea Party?

The UK Independence Party (UKIP) received a quarter of the vote in the recent council elections. UKIP has been described as the UK equivalent of the Tea Party movement in the US. Its policies are certainly very much to the right. Large tax cuts (possibly one flat rate) financed by huge reductions in public spending, except for defense spending which would increase, a five year freeze in immigration, a return to coal based power stations and no more wind farms, more prison places, and so on. Unlike the Tea Party, UKIP currently fights against the Conservative Party rather than working within it, but too much should not be made of this difference. UKIP’s leader says that he could cooperate with the Conservatives if they ditched Cameron as their leader, and there is some sympathy for UKIP’s aims within the Conservative Party.

One common reading of UKIP’s rise is that it represents the disaffected right wing of conservatism, generated by Cameron’s attempt to move the Conservative Party to the centre ground. However there is one problem with this interpretation - the Conservative Party has not moved to the centre ground. Apart from the odd token issue like gay marriage, the supposed move to the centre was just spin. Under the cloak of the need to reduce debt, the government has embarked on a programme to shrink the size of the state that goes well beyond anything attempted by Margaret Thatcher. Reforms to the National Health Service and education involve the large scale private provision of services or governance.

In terms of the distribution of income, the Conservative Party seem happy with increasing inequality and poverty. The 50% tax band on top incomes was reduced to 45%, while welfare spending is cut. The impact on child poverty will emulate what Margaret Thatcher achieved, according to the latest analysis from the Institute of Fiscal Studies (IFS) released today. Updating figures that I reported recently to take account of the latest welfare cuts, the IFS estimate that the percentage of children in poverty (in families with incomes 60% below the median) will rise from 17.5% in 2010 to 23.5% by 2020. Crucially, according to the IFS the rise in this measure of relative child poverty is entirely the result of the tax and benefit reforms introduced by this government. This is, quite literally, a government created increase in child poverty.

So if we have a government where major economic and social policies are very much to the right of the political spectrum, how do we account for the rise of UKIP? One possible story is that the Conservatives are a victim of their own spin. In trying to ditch the image of the ‘nasty’ party that came to be associated with the Thatcher era, they have alienated those that rather liked her openly right wing style. The parallels with the US may be quite close. Where the Tea Party is associated with, and definitely encouraged by, Fox News and talk radio, so the values of UKIP are also the values of the UK tabloid press, by which we essentially mean Murdoch’s Sun and the Daily Mail.

Yet there is one key feature of UKIP which has no US parallel, and that is in its name - independence from the European Union (EU). Since Thatcher’s time the Conservative Party has been seriously split in its attitude to the EU. The leadership knows that a decision to exit the EU will almost certainly have serious negative consequences for the economy, which is why most business leaders would be horrified by the prospect of leaving. However the tabloid press have run a relentless campaign to highlight any negative aspects of EU membership. It has to be said that Eurozone governance in particular gives them plenty to work with, but when that is not enough, then in true tabloid style stories are made up. While the Conservative leadership seems in its element in going along with the tabloid attack on the welfare state, when it comes to the EU, the game becomes appeasement.  

How all this turns out may depend on how the economy performs over the next two years, and how effective the Labour Party are at shifting the public debate. If the recovery is strong, and we see more of this kind of political naivety from Labour (yes, Ed did not read my post on the B word), then the tabloids will push Cameron as far as they can on Europe, but then rally round to support the Conservatives at the election. On the other hand if the recovery is weak, and if Labour is more effective (like here) and looks like winning, then the tabloids may continue to encourage UKIP, in the hope of engineering a reconciliation of the right under a new Conservative opposition leader hostile to the EU.

But these are dangerous games. Much of UKIP’s popularity comes from straightforward dissatisfaction with falling living standards and a lack of good jobs. It is expressed as hostility to immigration and welfare recipients, in part because the tabloid press suggest this is the cause of these problems, rather than it being the result of government economic policy [1]. Even if the recovery is strong and Labour opposition weak, this may not produce enough to enable the tabloids to put this genie back in its bottle. They may find it as difficult to control those who recently voted UKIP as the Republican Party has found it impossible to control the Tea Party.

[1] Some good posts on these tabloid myths: NEF here, the Guardian here, Ian Mulheirn here, and much more detail from Alex Marsh here.   

More on Naive Fiscal Cynicism

Paul Krugman is absolutely right that one of the rationales for the IMF and others framing fiscal policy in terms of the ‘speed of consolidation’ is a belief that left to themselves politicians will always and everywhere let debt rise. As he points out, the facts for the US tell a rather different story. Here I want to add a couple of additional points by looking at experience outside the US.

As should be well known by now, UK government debt was over a 100% of GDP between the wars, but declined rapidly and consistently to 50% from the second war to the mid 1970s. (See here, or this useful UK site.) The chart below, based on OBR data, takes up the story since then.

UK Debt to GDP ratio (%)

So perhaps the simplest description is that debt to GDP began to level off at around 40% of GDP (which was the target from 1998 to 2008), until the Great Recession hit. There is a lot of interesting detail here, but that would distract from the main point, which is that the UK is another clear counterexample to the idea that governments always let their debt rise.

However deficit bias is not a figment of international policymakers imagination. As I note here with Lars Calmfors, and others have noted before us, government debt in the OECD area as a whole almost doubled (40% to 75%) between the mid-70s and the mid-90s. This deficit bias came not from the UK, and not much from the US, but from Europe and Japan. (To see data on individual countries or country groups, see this nice IMF resource. [1])

So the only reasonable conclusion is that deficit bias is a problem, but not one that afflicts every government at all times. As Lars and I document, there have been various studies that have attempted to draw lessons from this diversity of experience: for example coalition governments may be more prone to deficit bias, but institutional set-ups where the finance ministry is strong less prone. My own support for fiscal councils partly stems from a desire to look for an institutional mechanism to help counter deficit bias. There is no magic bullet here, and institutional solutions will differ depending on national constitutional characteristics.

If this last point seems obviously reasonable, then lets change the dimension from across countries to across time and states of the world. While we may observe a tendency towards deficit bias in normal times, in times like now when government debt is high we seem to be observing a quite different bias - a bias towards austerity. The apparent consensus of 2008/9 that we needed fiscal stimulus looks like the aberration rather than the rule. An international organisation wanting to push sound economics needs to be doing more than arguing for a slower speed of consolidation. By advocating fiscal consolidation when the opposite is required you risk discrediting your advice at other times.

Here is another analogy. Doctors quite rightly encourage us to take more exercise. That is because we have a tendency to sit around too much, but this bias is not universal across people types or ages. Yet when we catch flu, the doctor prescribes rest, not exercise. Indeed, a good doctor may well be specific about the length of rest required, because they know too many patients may think they are better before they have fully recovered. If a doctor told us that while we had flu we should cut down from 30 minutes exercise to 15 or 10, we might begin to doubt their credentials.  

[1] To get the debt series, click on the blue subheading ‘Real GDP growth’.

Blanchard on Fiscal Policy

I was recently rather negative about the way the IMF frames the fiscal policy debate around the  right speed of consolidation. In my view this always prioritises long run debt control over fiscal stimulus at the zero lower bound (ZLB), and so starts us off on the wrong foot when thinking about the current conjuncture. Its the spirit of 2011 rather than the spirit of 2009.

Blanchard and Leigh have a recent Vox post, which allows me to make this point in perhaps a clearer way, and also to link it to a recent piece by David Romer. The Vox post is entitled “fiscal consolidation: at what speed”, but I want to suggest the rest of the article undermines the title. The first three sections are under the subtitle “Less now, more later”. They discuss the (now familiar from the IMF) argument that fiscal multipliers will be significantly larger in current circumstances, the point that output losses are more painful when output is low, and the dangers of hysteresis. I have no quarrel with anything written here, except the subtitle, of which more below.

A more interesting section is the one subtitled “More now, less later”. This section starts by noting that the textbook case for consolidation is that high debt crowds out productive capital and increases tax distortions. Yet these issues are not discussed further. The article does not say why, but the reason is pretty obvious. While both are long term concerns, they are not relevant at the ZLB.

Instead the section focuses on default, and multiple equilibria. After running through the standard De Grauwe argument, the text then says: “This probably exaggerates the role that central banks can play: Knowing whether the market indeed exhibits the good or the bad equilibrium, and what the interest rate associated with the good equilibrium might be is far from easy to assess, and the central bank may be reluctant to take what could be excessive risk onto its balance sheet.” This is more a description of ECB excuses before OMT than an argument.

More interesting is what comes next. Does default risk actually imply more austerity now, less later? I totally agree with the following: “The evidence shows that markets, to assess risk, look at much more than just current debt and deficits. In a word, they care about credibility.” “How best to achieve credibility? A medium-term plan is clearly important. So are fiscal rules, and, where needed, retirement and public health care reforms which reduce the growth rate of spending over time. The question, in our context, is whether frontloading increases credibility.”

So here we come to a critical point. Does more now, less later, actually increase the credibility of consolidation? If it does not, then the only argument for frontloading austerity disappears. The next paragraph discusses econometric evidence from the crisis, and concludes it is ambiguous. The whole rationale for more now, less later, is hanging by a thread. And there is just one paragraph left! Let me reproduce it in full.

“The econometric evidence is rough, however, and may not carry the argument. Adjustment fatigue and the limited ability of current governments to bind the hands of future governments are also relevant. Tough decisions may need to be taken before fatigue sets in. One must realise that, in many cases, the fiscal adjustment will have to continue well beyond the tenure of the current government. Still, these arguments support doing more now.”

Is this paragraph intentionally weak and contradictory? If credible fiscal adjustment requires consolidation by future governments, why does doing more now add to credibility? You could equally well argue that overdoing it now, because of the adverse reaction it creates (‘fatigue’ !?), turns future governments (and the electorate) away from consolidation, and so it is less credible.

So what we have is an article that appears to be a classic ‘on the one hand, on the other’ type, but is in fact a convincing argument for ‘less now, more later’. Perhaps that is intentional. But even if it is, I’m still unhappy. Although the arguments on multipliers, output gaps and hysteresis appear under the subtitle ‘less now, more later’, they in fact imply ‘stimulus now, consolidation later’, once you take the ZLB seriously. If you are walking along a path, and there is a snake blocking your way, you don’t react by walking towards it more slowly!

Why does this matter? Let me refer to recent comments David Romer made about the ‘Rethinking Macro’ IMF conference, which he suggests avoided the big questions. For example he notes “I heard virtually no discussion of larger changes to the fiscal framework.” He goes on (my italics)

“Another fiscal idea that has received little attention either at the conference or in the broader policy debate is the idea of fiscal rules or constraints. For example, one can imagine some type of constitutional rule or independent agency (or a combination, with a constitutional rule enforced by an independent agency) that requires highly responsible fiscal policy in good times, and provides a mechanism for fiscal stimulus in a downturn that is credibly temporary.”

As I argued here, it is not a matter of having a fiscal rule for consolidation that allows you to just ease up a bit at the ZLB. What we need is a rule that obliges governments to switch from consolidation to stimulus at or near the ZLB. Otherwise, the next time a large crisis hits (and Romer plausibly suggests that could be sooner rather than later), we will have to go through all of this stuff once again.

Microfounded Social Welfare Functions

More on Beauty and Truth for economists

I have just been rereading Ricardo Caballero’s Journal of Economic Perspectives paper entitled “Macroeconomics after the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome”. I particularly like this quote:

The dynamic stochastic general equilibrium strategy is so attractive, and even plain addictive, because it allows one to generate impulse responses that can be fully described in terms of seemingly scientific statements. The model is an irresistible snake-charmer.

I thought of this when describing here (footnote [5]) Woodford’s derivation of social welfare functions from representative agent’s utility. Although it has now become a standard part of the DSGE toolkit, I remember when I had to really work through the maths for this paper. I recall how exciting it was, first to be able to say something about policy objectives that was more than ad hoc, and secondly to see how terms in second order Taylor expansions nicely cancelled out when first order conditions describing optimal individual behaviour were added.

This kind of exercise can tell us some things that are interesting. But can it provide us with a realistic (as opposed to model consistent) social welfare function that should guide many monetary and fiscal policy decisions? Absolutely not. As I noted in that recent post, these derived social welfare functions typically tell you that deviations of inflation from target are much more important than output gaps - ten or twenty times more important. If this was really the case, and given the uncertainties surrounding measurement of the output gap, it would be tempting to make central banks pure (not flexible) inflation targeters - what Mervyn King calls inflation nutters.

Where does this result come from? The inflation term in Woodford’s derivation of social welfare comes from relative price distortions when prices are sticky due to Calvo contracts. Let’s assume for the sake of argument that these costs are captured correctly. The output gap term comes from sticky prices leading to fluctuations in consumption and fluctuations in labour supply. Lucas famously argued [1] that the former are small. Again, for the sake of argument lets focus on fluctuations in labour supply.

Many DSGE models use sticky prices and not sticky wages, so labour markets clear. They tend, partly as a result, to assume labour supply is elastic. Gaps between the marginal product of labor and the marginal rate of substitution between consumption and leisure become small. Canzoneri and coauthors show here how sticky wages and more inelastic labour supply will increase the cost of output fluctuations: agents are now working more or less as a result of fluctuations in labour demand, and inelasticity means that these fluctuations are more costly in terms of utility. Canzoneri et al argue that labour supply inelasticity is more consistent with micro evidence.

Just as important, I would suggest, is heterogeneity. The labour supply of many agents is largely unaffected by recessions, while others lose their jobs and become unemployed. Now this will matter in ways that models in principle can quantify. Large losses for a few are more costly than the same aggregate loss equally spread. Yet I believe even this would not come near to describing the unhappiness the unemployed actually feel (see Chris Dillow here). For many there is a psychological/social cost to unemployment that our standard models just do not capture. Other evidence tends to corroborate this happiness data.

So there are two general points here. First, simplifications made to ensure DSGE analysis remains tractable tend to diminish the importance of output gap fluctuations. Second, the simple microfoundations we use are not very good at capturing how people feel about being unemployed. What this implies is that conclusions about inflation/output trade-offs, or the cost of business cycles, derived from microfounded social welfare functions in DSGE models will be highly suspect, and almost certainly biased.

Now I do not want to use this as a stick to beat up DSGE models, because often there is a simple and straightforward solution. Just recalculate any results using an alternative social welfare function where the cost of output gaps is equal to the cost of inflation. For many questions addressed by these models results will be robust, which is worth knowing. If they are not, that is worth knowing too. So its a virtually costless thing to do, with clear benefits.

Yet it is rarely done. I suspect the reason why is that a referee would say ‘but that ad hoc (aka more realistic) social welfare function is inconsistent with the rest of your model. Your complete model becomes internally inconsistent, and therefore no longer properly microfounded.’ This is so wrong. It is modelling what we can microfound, rather than modelling what we can see. Let me quote Caballero again

“[This suggests a discipline that] has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one.”

As I have argued before (post here, article here), those using microfoundations should be pragmatic about the need to sometimes depart from those microfoundations when there are clear reasons for doing so. (For an example of this pragmatic approach to social welfare functions in the context of US monetary policy, see this paper by Chen, Kirsanova and Leith.) The microfoundation purist position is a snake charmer, and has to be faced down.

[1] Lucas, R. E., 2003, Macroeconomic Priorities, American Economic Review 93(1): 1-14.

Leading Macroeconomist Leaves Central Bank

Maybe not the most compelling title for a post, but the news that Lars Svensson is not renewing his term as Deputy Governor of Sweden’s central bank (HT Saroj Bhattarai) will be of great interest to academic macroeconomists. What I want to suggest here is that it should also be of wider interest.

Apart from making major contributions to the discipline, Svensson has also been extremely influential among policymakers, and is often associated with the idea of flexible inflation targeting. (Here is just one example.) It is interesting news because of why he is leaving. He says: "I have failed to find support for a monetary policy that I believe would lead to better performance, with both a higher inflation rate closer to the target of two percent and a lower unemployment rate." He has for some time been fighting a losing battle to persuade his colleagues that current Swedish monetary policy is too deflationary (see for example Britmouse), and he has decided to give up the fight.

Interest rates in Sweden are low, at 1%, but according to Svensson they should have got there faster and should now be even lower. Here is a plot of inflation (blue, left hand scale) and unemployment.

Inflation is currently zero, so well below the 2% target. GDP growth was 1.2% last year. Unemployment rose in the recession, came down a bit, but has begun to rise again. The case for lower interest rates over the last two or more years looks pretty clear.

So why have most of Svensson’s colleagues not been following his advice? Their concern is that low interest rates are encouraging Swedes to borrow too much. Now of course one of the ways monetary stimulus is supposed to work is that it encourages more borrowing, but the worry is that borrowing in Sweden is dangerously high, and could threaten financial stability. There are echoes here of doubts expressed by some members of the Fed (see here and here) and international organisations (Tim Taylor here). However so far these have been just concerns, which do not seem to have had a major impact in preventing expansionary policy. Except in Sweden.

Svensson’s arguments against such concerns are persuasive (pdf), and I find the argument that there are better financial instruments available to deal with these problems particularly strong. However I want to draw a slightly different parallel, with policy at the ECB. At first sight similarities appear slight: although both central banks are resisting a cut in interest rates from low to very low levels, in the Eurozone growth is negative rather than just slow, and inflation is currently only a little below target rather than zero (although the ECB itself expects it to fall to nearly 1%). In addition, the ECB has not focused on financial stability as a reason for not cutting rates. Yet the parallel is this. In both cases we have central banks making decisions that appear to contradict the wisdom of mainstream macroeconomics. So what, you may say, but in both cases the cost is being measured in unnecessary unemployment, and below target inflation. Compute the cost in terms of lost output, and they are the kind of losses that could cost a politician their job. The cost in terms of human misery is greater still. You may be pretty skeptical of the wisdom of macroeconomists, but do you really think that these central bankers know better?   

Why Inflation is not falling

There has been considerable interest in the recent IMF study that found that the responsiveness of inflation to the output gap (or equivalent measure) falls at low levels of inflation. But if the econometrics is right (and Nick Rowe has some cautionary tales here), what is the explanation for this? I start with two standard stories, but then suggest other possibilities that are specific to current financial conditions.

One standard explanation which the paper itself gives is based on the menu cost model of price inertia. The idea is that firms do not change their prices that often because there are costs to making any change (which economists call menu costs, perhaps betraying how often they spend in restaurants rather than buying food in supermarkets), and that often this cost might be higher than any benefit to profits in making a change. If you derive the aggregate relationship between inflation and the output gap from a model of this kind, the coefficient on the output gap will depend on how frequently prices are changed. So if price changes become more infrequent at low levels of inflation, the sensitivity of inflation to the output gap will fall.

Another quite plausible story which has solid empirical backing is that workers particularly resist nominal wage cuts. That actually implies an asymmetry in response rather than a general reduction in sensitivity (if the output gap was positive workers would happily see wages rise), but it will affect the average response in an econometric study that does not allow for asymmetry, and in current circumstances it is an entirely appropriate story.

You might think that enough, but I have a UK-centric reason for wanting more. In the UK, the ‘wages’ Phillips curve does not seem to be showing any reduction in sensitivity - indeed perhaps the opposite (although any additional sensitivity seems to predate the recession). That does not mean workers are not resisting nominal wage cuts, but the overall impact of this has either been small, or has been offset by something else.

The story I want to tell involves firms’ pricing behaviour, and the role of more risk averse banks. Suppose a firm sees demand for its output fall. Its profits are lower, but it calculates that it can reduce that decline in profits by cutting its price, if that price cut increases demand. There are two risks involved in doing this. First, the price cut might raise demand by much less than expected, with the consequence that profits fall further still. Once the firm realises this it can always put prices back up again, but in the short run profits will decline. Second, it may take time for the price cut to feed through into higher demand: those buying competing products may not immediately realise that they should switch. So although profits might rise eventually, they could fall in the short run.

So in both cases, there is a risk that profits in the short run might suffer as a result of the price cut. In normal times firms would be prepared to take those risks, either because the risks are symmetric (maybe demand will increase by more than expected), or because they represent an investment with a positive eventual payoff (as customers switch products). Critically, even if the short run might actually bring losses rather than profits, the firm’s bank will cover the losses because it is taking a long term view.

However, since the financial crisis, the firm may have noticed that the behaviour of its bank has changed. It refused the business down the road any credit, even though by all accounts its difficulties were clearly temporary. Although the firm would like to cut prices in the expectation that this will eventually raise profits, if the price cutting idea does not work out and the bank plays tough that could mean bankruptcy.

The idea is that the aftermath of the financial crisis, by raising the risk of bankruptcy associated with short term losses, has lead to greater price rigidity. In addition, there are two related effects that could actually lead to higher inflation in the short run. First, the firm does not like the fact that it can no longer depend on the bank to cover any short term losses. Who knows what might happen. So although a price increase might reduce profits if sustained (as customers gradually switch), in the short run profits will rise, and that allows the firm to pay off those debts which would otherwise keep its owners awake at night. This is the firm as a precautionary saver. Second, firms might be keeping prices low not because of existing competition, but because of the threat that a new start-up might emerge and steal some of its business. The one silver lining of the financial crisis for existing firms is that new start-ups are much less likely to get any money from the bank, so this diminished threat of new entry allows the firm to safely increase its profit margins.

I have absolutely no evidence that any of this has been happening, or indeed whether these ideas stand up to serious analysis. I don’t know of any papers that have explored the impact of financial frictions of this kind on prices, but that may well be my fault, so please point me to any you know. If there is anything in these ideas, then they caution against interpreting any current rigidity in inflation as evidence against demand deficiency.