Illiberal Ideas Hiding Behind Liberal Names

Bringing up the name of famous economists in order to try and give credibility to otherwise often fairly dubious ideas and theories is pretty common, and in terms of marketing it certainly works. Yet more often than not it seems that these ideas in fact run very much against what the economists that are used to supposedly enhance their credibility actually wrote and thought. Adam Smith’s “Invisible Hand” is probably the most wide-spread, misunderstood and misquoted one of them. From Marx to Keynes to Friedman, every famous economist has fallen victim to these wrongful association in the past, and I find the economics profession has been doing a fairly bad job at setting the record straight or even trying to do so.

The latest occasion that also leads me to write this post is the Free Market Road Show that is currently touring all of Europe and beyond. Some of the planned speakers are actually very interesting and knowleadgeable – Madrid’s event last week, for instance, featured Mark Klugmann who presented some ideas on “charter cities” (he is currently advising Honduras’ government on how to turn these into a reality), a topic that has fascinated me for a long time (and for which I started writing a blog post over a year ago, yet never finished). Another speaker at the event was Barbara Kolm, president of the Friedrich A. v. Hayek Institute – which is also what brings me back to my original topic.

Continue reading

The ECB’s Sterilization Policy And Its Fiscal Effects

First of all, it’s obvious that I have horribly failed at something I always try to do when writing a new post: coming up with a title that hopefully makes people actually want to read it. Yet I still feel this is important, and I’m thankful to Max for insisting on continuing the discussion. In the comments section of my last post, originally meant more as a general monetary policy post, a vivid discussion has emerged on what the ECBs Outright Monetary Transactions Policy (OMT) entails and particularly in what way it would potentially lead to fiscal transfers between Eurozone members, potentially making it illegal under EU treaties. While writing my latest comment, I noticed it was getting way too long, so let me offer a response as a new post.

The way I see it, the main disagreement between Max and me involves the direction any possible fiscal transfers would go if the ECB would, some day, actually buy bonds under the OMT program. We don’t seem to disagree on the fact that any purchases of government bonds by the ECB would potentially prove legally problematic, but rather on what these purchases would entail economically with regards to possible fiscal transfers within the Union. Max argues that, through sterilization, i.e. the ECBs attempts to remove an equal amount of money from the market as it is injecting by buying government bonds of troubles periphery countries, it is substituting low-risk assets on its balance sheet for high-risk assets, making its entire balance sheet more risky and thus representing a real cost to the core, which gets their share of any interest payments accrued from these assets (and thus potentially stands to loose these due to their increased riskiness). However, it would seem that this is based on an inaccurate description of how the ECB conducts (and would conduct) said sterilization. That no OMT purchases have ever actually taken place does not really make the issue harder – for all intents and purposes, OMT is just a replacement for the Securities Markets Program (SMP) instituted by the ECB in 2010 and under which it has already bought around €200 billion worth of bonds of periphery countries (mostly Italy), most of which it still holds on its books. Although there might be some technical differences, conceptually it would seem to me that the main feature of the “change” is that OMT made this program open-ended (thus also reducing the actual need to buy the bonds in the first place). So we know pretty well how OMT as well as sterilization measures would work – so how would they?

Continue reading

The ECB Isn’t Allowed To Directly Finance EU Governments – Who Said It Needs To?

A large part of the debate on whether or not the ECB can do quantitative easing revolves around the issue that the ECB statutes prohibit the central bank from “financing” any of the member governments directly (or, depending on what German courts say, indirectly as well). To a certain extent this policy makes sense – it avoids a lot of explicit moral hazard and essentially prevents the EU from ever getting stuck in a hyperinflationary situation where governments issue bonds to raise their spending and the central banks just acquiesces and goes on buying these bonds. Also, the Bundesbank has a price stability fetish because of something that happened over 80 years ago but for some reason they can’t seem to learn the correct lessons from. Somewhere else on this blog I have also argued that introducing Eurobonds would provide an instrument for the ECB to actually engage in straight-forward QE, even though just buying a reasonably weighted basket of national bonds would do the same trick (however, with potentially different fiscal implications). But why should buying government bonds be one of the go-to policy to try and gain traction in a liquidity trap in the first place?

Continue reading

Could Leaning Against Asset Price Bubbles Exacerbate the Business Cycle?

In my last post I argued that using monetary policy to lean against asset price bubbles would only tend to hurt the real economy in the long-run if for some reason the central banks target is constructed in an asymmetric way, i.e. it reacts to asset price deviations to the upside but ignores them to the downside. If its asset price target, however defined, is correctly chosen and designed in a similar way as its inflation and/or output targets in e.g. a classic Taylor rule, then on average there will be as much leaning against asset prices as there will be propping up asset price. But what effects would such a policy have on the business cycle in general? More precisely, would a central bank that targets asset prices tend to have a stabilizing or destabilizing effect on the overall system?

Continue reading

Leaning Against Bubbles Hurts the Economy – Except When it Doesn’t

A lot has been written on the so-called lean vs. clean debate in monetary policy that tries to resolve whether central banks should actively try to counter asset price bubbles during their build or just make sure they do everything they can in order to clean up in the aftermath of these bubbles bursting. To recap, there’s decent arguments for both sides of the debate: the clean camp, applying the “Greenspan principle”, generally cites the difficulties in spotting bubbles, often due to efficient market hypothesis concerns, as the main reason for not using the particularly blunt instrument of interest rate policy to deflate potential bubbles – after all, can we ever really know it is one until it bursts? The clean camp, while generally acknowledging the problems involved in bubble-spotting, tend to stress the damage to the real economy that financial asset bubbles can cause, highlight the potential inability of central banks to “clean up” under certain circumstances, such as when the zero lower bound on nominal interest rates is reached, as well as the inconsistency of asymmetrically responding to asset prices – not at all during the build-up of a bubble, yet strongly to its bursting. There are models that supposedly show that both the clean as well as the lean approach is the optimal one (e.g. Bernanke and Gertler on the clean side and Filardo on the lean side, just to name two – both .pdfs).

Continue reading

Goodhart’s Law – in Good Times and in Bad

A large part of the success of central banks all around the world during what became known as the Great Moderation is often attributed to the successful anchoring of inflation expectations to the levels that central banks would like to see – generally defined as 2% in most of the industrialized world. In basic theory this is awesome: if the inflation rate, through some kind of phillips curve or any other structural relationship you prefer, is linked to the aggregate level of economic activity in a stable way, than a stable inflation rate also leads to a stable level of economic activity.

In comes Charles Goodhart, former member of the Bank of England’s Monetary Policy Committee, who stated something as profound as at the same time similar to the famous Lucas Critique: Goodhart’s Law. In it’s most common version it says that “when a measure becomes a target, it ceases to be a good measure”. In other words, once a central bank (or in theory indeed any institution with enough clout to consistently affect the economy) states that it will do whatever it needs to in order to keep a given indicator at a level it so desires, the market structure will be affected by this, expectations of market agents will adapt, and the target will be achieved, even if the central bank does not really even do much – it just has to credibly promise that it would.

First of all, and on a very deep level, this of course could be seen as qualifying the very success of central banks in “anchoring” inflation rates. Has inflation in the past two decades been so tame because central banks have become better, or simply because they somehow managed to credibly make everyone believe that they have become better? In the end, the answer doesn’t matter much – it is outcomes that we want, who cares about how we get there. However, while the upside to this stable inflation anchoring in good times is enormous, it seems to have come back to haunt us at a time when we most need our monetary authorities to act. Even though inflation both in the US as well as in the Eurozone is considerably below target, inflation expectations are awkwardly close to those targets over the near-term (e.g. here for the Eurozone). Given most central banks nowadays target the forecast, they might interpret this as signalling that there is no real big need to act, and thus not act in the first place. I personally find this to be one of the most compelling explanations as to why the ECB continues to fail to do its job. As Draghi stated, “inflation expectations are firmly anchored in line with price stability“. Exactly. That’s the problem.

The Fed is in a somewhat better position since it does not only target inflation but also full employment – even if inflation sticks to 2%, as long as unemployment is above target it will (or should) ease monetary policy. The ECB, on the other hand, focuses essentially solely on inflation, and at the moment there are great doubts as to whether inflation (particularly inflation expectations) are of any use at all as a signal for what it should be doing. This monthly bulletin by the ECB (dating back to 2011, .pdf), for example, states that “well anchored expectations have contributed to enhancing the effectiveness of monetary policy and will assist the ongoing economic recovery”. Sure, stable inflation expectations also prevent us from falling into outright deflation in a scneario were we assume the central bank to be asleep. Further, as Clarida states (.pdf), “inflation inertia is the enemy of reflation once deflation set in”. However, I would state that somewhat differently: inflation inertia (in the context of this post in terms of expectations) is the enemy of reflation – period. At the moment it mostly provides a convenient excuse for central banks to do less than they should. Currently, it would seem that those well-anchored inflation expectations are part of what’s preventing effective monetary policy in the first place.

The Mystery of the Falling Natural Real Rate of Interest

A couple of weeks ago Larry Summers held a widely praised speech on the difficulties ahead for economic stabilization policy. As far as I can tell, not much of it was really new, as also pointed out by e.g. Krugman, but that does not mean it wasn’t a great speech, and one that seems to have had considerable influence on the policy debate. In essence it boils down to the problems we face due to the zero lower bound on nominal interest rates, and what happens in a world where the real interest rate required to establish full employment, sometimes also called the natural real interest rate, is negative, as it almost certainly is right now.  Yet from the regression’s I have been running, it would seem that the equilibrium real interest rate was already considerably lower than in previous periods even before the crisis started. In other words, even before the crisis struck, monetary policy already had considerably less room to maneuver than in the decades preceding the the 2000s. To recap, let’s again take a look at a fairly simple Taylor rule one might use to describe Fed policy in the 2000s, more precisely from the first quarter of 2000 to the second quarter of 2009, which is roughly around the time when the zero lower bound started binding.

Continue reading

QE is the Fed’s Way to Target Unemployment

During my recent research I thought it would be interesting to look at what different central banks say they target and what they really target. To anyone that does not study economics and reads this, you might think about skipping it. It’s probably going to get somewhat technical. Also, this is as much to find out if what I’m doing makes sense as it is to actually present some of the stuff I’ve stumbled upon.

As many papers have showed, different forms of Taylor rules have worked pretty well in the past in describing particularly the behavior of the Fed in an ex-post fashion. Taylor rules, in term, are essentially nothing else than a formula that describes a central bank’s attempt to minimize deviations from its targets. Tinkering around a bit, the following form of the Taylor rule seems to be able to explain around 95% of Fed behavior (which seems too good to be true, but combing through econometrics books has so far not forced me to assume I did something coming up with my regression results):

TaylorThis isn’t too different from the basic Taylor rule. The only thing it adds is an interest rate lag, essentially the simplest way to take interest smoothing behavior into account, which has been shown many times to be important in describing Fed policy decisions. As a side note, this interest rate smoothing behavior makes it so the Taylor rule no longer obeys the Taylor principle: a rise in inflation of 1% is no longer countered by a rise in the interest rate of more than 1%. The new rule also replaces the output gap with the unemployment gap, in line with the Fed’s official mandate. Let me throw out some graphs for you below the fold. Excuse the somewhat unaesthetic presentation, I’m still coming to grips with R.

Continue reading

Monetary Policy Should not Care About Fiscal Policy

For some reason a fairly extensive part of the literature on monetary economics is dedicated on the “interaction between monetary and fiscal policy”. I am not sure what this means, nor why it matters at all. As a core idea, and again resorting to Friedman’s notion that Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”, the level of inflation is 100% under the control of and thus determined by the central bank. The only additional assumptions required to make this hold is central bank independence, the importance of which has been long established, and at least some degree of central bank competence, without which we can essentially stop talking about monetary policy in general.

Let’s start from a point where a central bank is achieving its target, however defined. Now let’s bring in fiscal policy, and let’s say it tries to increase spending. Clearly this increase in spending would, momentarily, move the economy away from what the central bank is targeting, which would require central bank intervention to bring it back on track. In the end, for the macroeconomic indicators that are generally included in the objective function of central banks, the fiscal policy does not do much after the initial short-lived shock. The whole concept is essentially summarized by the concept of “monetary offset”, basically explained in this paper by Scott Sumner (.pdf).  This inability of fiscal policy to do much on a macroeconomic level in a world where the central bank actually does its job is a feature, not a bug. Fiscal policy should concentrate on achieving democratically determined goals, and as such it can legitimate alter e.g. the income and wealth distribution in an economy in order to bring them in line with this consensus view on what it should be, as well as give the central bank a different target if it so desires. The optimal target a central bank should be given very much depends on what is possible on a fiscal level, particularly in terms of the ability of governments to tax different things. Yet once that is determined, the central banks job is to make sure that whatever the fiscal authorities do does not move the economy away from the target it’s job it is to achieve. Apart from the target setting itself this is essentially a strictly objective task.

In other words the central bank will always dominate the fiscal authorities given the two basic assumptions I made. It should not be the job of fiscal policy to achieve these targets in the first place. If a situation arises where someone has to give in, it is always the fiscal authority that will unless at least one of the two assumption is violated. In terms of final macroeconomic variables targeted by the central bank (once its target is set) like the level of inflation or the level of NGDP, what fiscal policy does, or even its very existence, is irrelevant.

On the Fears of Bubbles

Katharina recently posted some of her thoughts on the developments in asset markets since the start of the FED’s different unconventional monetary policy programs. I honestly do not know how to go about answering the post, as I personally am unable to get much out of the FT report. But let me give it a try. A couple of months back I posted something dubbed “How destructive are asset bubbles really?”, which I find myself still mostly agreeing with. Of course a lot of that argument is based on monetary policy being able to be effective, which might be somewhat limited given we’re up against the ZLB, but right now is not the place to go into that discussion again. When it comes to identifying whether a bubble is indeed forming or not, I shared some of my thoughts in this post on “The Science of Bubble Spotting”, which probably provides a decent starting point to build on. So let’s get into it.

Continue reading