jamesz

Carney on NGDPLT

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Mark Carney appeared at the Treasury Select Committee today for interrogation before being confirmed as the next Governor of the Bank of England. The big question everybody wanted answered is whether he favoured a move from inflation targeting to NGDP level targeting. The answer is ‘no’, but the reasons are interesting.

Carney is a known proponent of central bank commitment and the use of forward guidance. In recent speeches he has also spoken favourably of NGDPLT and that has prompted a storm of commentary in the UK; little of it was favourable towards the idea. Consequently, all eyes were on Carney’s evidence today. Reading the comments on Twitter suggests that he dismissed NGDPLT and retreated from his previous statements. I don’t think that is true at all.

In both his oral and written evidence he called flexible inflation targeting  “the most effective monetary policy framework implemented thus far.” However, he was at pains to point out that there are problems with it at the ZLB and there are other potential regimes, such as NGDPLT, that might help in those circumstances. In his oral evidence he spoke at length about the benefits of commitment and history dependence when encountering the ZLB. Despite that, he was not in favour of an immediate move away from inflation targeting, as you might expect given the outcome of the Bank of Canada’s review. Some of the reasons he gave are well-known: the problem of revisions and data quality, for instance. Notably, he did not think that NGDPLT would unhook inflation expectations and commented on the additional credibility a central bank could gain by implementing an inflexible rule.

The most interesting argument he made against level targeting was the one he dwelt on in his oral evidence: it relies upon people having rule-consistent expectations. That is to say, the success of a central bank relies on people expecting that it will implement its stated plans, and behaving as if they will come to fruition. Of course, he did not make the naive argument that people’s expectations are irrational. Rather, he pointed out that expectations among the populace have inertia and take time to change. If a large portion of the population have persistently incorrect expectations following a change in target then it would be costly in terms of welfare. He alluded to agent-based modelling done by the Bank of Canada to claim that these transitional costs as expectations gradually adjust could outweigh the gains to the switch.

In summary, he thinks NGDPLT is a great idea but hard to put into practice (data issues) and costly to implement (transitional costs of changing expectations.) Relative to the commentary in the UK press that is a ringing endorsement: one of the top central bankers in world says that the only real barrier is the details of implementation.

jamesz

WSJ suggests abandoning economic models

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Simon Nixon has a provocative article in the WSJ where he argues that the current generation of New Keynesian models are useless because of their poor forecast performance. He proposes looking solely at the rate of debt reduction when forecasting economic performance:

[The] dismal science’s [forecasting] record suggests is that there is something profoundly wrong with the mainstream economics profession’s understanding of how modern economies work. The models on which its forecasts are built are clearly badly flawed.

It is true that forecasting performance is poor, but that is largely because forecasting is very, very difficult. The DSGE models Nixon refers to are important in modern macroeconomics but they were originally designed to estimate the impact of monetary policy, not to forecast the future. In fact, until very recently, most forecasting was not done with structural DSGE models but with statistical models that take their structure from the data. They provided better forecast performance and so were preferred by professional forecasters. These days, the best forecasts tend to be made by estimated DSGE models that outperform the best statistical models because they incorporate some of our understanding about how the economy works. No doubt they will be improved over time but it is incorrect to suggest that forecasters are too constrained by theory to forecast accurately. In fact, economists’ understanding of the economy helps them to provide better predictions about the future than simply using statistical relationships.

Nixon then discusses a paper by Claudio Borio at the BIS, which suggests building models that describe not only business cycles but also ‘financial cycles’. Borio’s paper highlights the monetary nature of the current recession and recommends that the next generation of macro models give serious consideration to the slow buildup of disequilibrium forces in financial booms, which then trigger deep recessions. Whether or not you agree with that diagnosis, the question he tackles is crucial: how do crises endogenously develop? Part of the reason forecasting is so difficult is that turning points are hard to pick because we don’t really understand all of the mechanisms that lead to recessions. Nixon uses that paper to claim that…

…[for] investors, the sensible response is surely to disregard all short-term forecasts based on out-dated models. They should focus instead on identifying those economies most likely to deliver a medium-term recovery by aggressively addressing their stock of debt. In the European context, it is the euro zone where the process of debt reduction and restructuring seems likely to proceed most rapidly, not least because the greater independence of the European Central Bank means there is less prospect of loose monetary policy being used to defer tough decisions.

I don’t think that is what Borio’s paper claims. Can Nixon really be advising you to ignore expert forecasters and instead put your money into EU countries, many of whom are currently facing the possibility of further recession in 2013? He has good company in suggesting that current economic models have problems and could be improved; however, the chances that they can be improved upon by following a simple heuristic like ‘less debt equals more growth’ are exceedingly slim. Indeed, there is considerable public debate among economists over the impact of debt on growth. Reinhart and Rogoff’s work has generated a lot of discussion, and there is a paper entitled ‘Macroeconomic Risk and Debt Overhang’ being presented at the ASSA conference. It’s hardly a matter that has been neglected by the profession!

Of course, it’s very difficult to diagnose and fix a problem with a single newspaper article: witness Paul Krugman’s repeated attacks on the current state of macroeconomics and the heated responses that they’ve generated, for instance. When even Nobel prize-winners can’t agree on whether there is a problem it is a sign that we don’t really understand what needs to be done. It’s great that Nixon is bringing interesting papers like Borio’s to public attention and airing the debate that’s going on in the profession. Unfortunately, in this case I don’t think his diagnosis or proposed solution are quite right.

jamesz

University enrolments are down

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The FT reports that university enrolments in the UK have dropped 6% over last year, following a similar fall in the previous year. It speculates that this may be, in part, because “the rise in fees from £3,375 to an average of more than £8,000 appears to be suppressing demand.” No doubt the reduced subsidy has had an effect but we need to be careful with language here. The FT’s reporting suggests that demand has been ‘suppressed’ by the fall in the Government’s fee subsidy. It might be more accurate to say that the subsidy no longer inflates demand to the same extent.

The difference is important because the main justification given for subsidies is that tertiary education generates some wider benefit to society. The important question then is how great the benefit is relative to the subsidy, and so how much we want to subsidise to boost demand. Talking about ‘suppression’ implicitly assumes the optimality of the previous subsidy and ignores the distortionary effect that the subsidy has had on the market for tertiary education. If the externalities from tertiary education are small then it is entirely possible that the fall in student enrolments represents a welfare gain for society.

jamesz

UK debt and default

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There’s been a bit of discussion about the possibility that the UK government’s debt might be downgraded by the ratings agencies.

In response to those suggestions Jonathan Portes claimed that “…unlike countries in the Eurozone, there is no possibility of the UK defaulting, so our fiscal policy is not constrained by markets in the same way; and we should ignore the credit rating agencies, because they’re irrelevant.” He cites the head of the OBR, Robert Chote, as support for that view. Now I don’t deny that there is little chance of the UK defaulting, but I think Portes is only telling half the story. Read more

jamesz

Fiscal rules need an enforcer

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Since the Autumn Statement there has been a lot of discussion about fiscal rules. One of the most substantive comments has come from Simon Wren-Lewis, who is something of an expert on the subject of fiscal rules and fiscal councils. His conclusion is that

…the main problem with the UK government’s fiscal mandate has nothing to do with cyclical adjustment or any of the other things discussed above. It is just inappropriate for the situation we are now in.

There is a lot of good stuff there, so head over and read it, but I’m not convinced by this conclusion. To understand why, let’s go back to the reason for a fiscal rule. The idea is that we need rules to commit the Government to a sustainable debt path because the political incentives don’t necessarily push them in that direction. That means the rules need to constrain the government’s actions in times when it is inconvenient for them to exercise prudence. It is certainly not enough for the rules to be kept only when it is politically convenient.

Wren-Lewis is saying that there will be times when even the best rules must be broken. However, if the Government is given the task of deciding when to break the rules then they may as well be discarded. Rules that bind the Government only when it feels like being bound will never do the job that they were designed for. To be effective, fiscal rules must be resilient to external shocks so that they can force governments to do the prudent thing when it not in their political interests to do so. Anything else compromises the credibility of the rules beyond saving.

That is not to say I disagree with Wren-Lewis that there are circumstances in which you might want to breach the rules, whatever they are. It’s just that you can’t let the Government decide when such circumstances have arisen. This is a strong argument for having an independent body to enforce the fiscal rules, and to decide on circumstances in which they might be legitimately ‘bent’. Rules are usually used in tandem with an independent council who can both enforce the rules and credibly legitimise departures from them. In Sweden, for example, the independent fiscal council recommended that the government run bigger deficits during the financial crisis.

Wren-Lewis may be right that the UK’s current rules are too inflexible to deal with the present situation, but a government can’t expect to break its own rules and retain credibility. Either another mechanism must be found or the fiscal rules become a paper tiger.

jamesz

Carney endorses NGDP level targeting!

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Mark Carney’s speech last night:

For example, adopting a nominal GDP (NGDP)-level target could in many respects be more powerful than employing thresholds under flexible inflation targeting. This is because doing so would add “history dependence” to monetary policy. Under NGDP targeting, bygones are not bygones and the central bank is compelled to make up for past misses on the path of nominal GDP.
…
…when policy rates are stuck at the zero lower bound, there could be a more favourable case for NGDP targeting. The exceptional nature of the situation, and the magnitude of the gaps involved, could make such a policy more credible and easier to understand.

Huge news for the market monetarists! Here is comment from Sumner and Britmouse.