On the Political Nature of Monetary Policy

I was intrigued by Munchau’s editorial on central bank independence, that appeared on today’s FT. Munchau argues that central banks’ choices are increasingly political in nature, especially if their mandate is broad, as is the case for example of the Fed. His argument is that a broad mandate implies tradeoffs, and as such it does not go well with central bank independence.

I must say I am unconvinced to say the least, on at least two levels.

First, I do not see how a strict mandate would make central bank choices less political in nature. It makes them more opaque, but by no means less political. I wrote about this in a paper on ECB action during the crisis, and more succinctly in an op-ed for Social Europe co-written with Yan Islam back in 2015.  Let me quote a few excerpts from that piece:

A dual mandate requiring the central bank to pursue two, sometimes conflicting, objectives forces the institution to make inherently political choices. Far from being a shortcoming, this allows for a more flexible and unbiased monetary policy. A central bank following a dual mandate will always be able to take an aggressive stance on inflation, if it deems this necessary. Appropriate choice of the weights given to employment and inflation would allow incorporation of any combination of the two objectives. […]

Inflation-targeting central banks, such as the ECB, de facto also target growth but timidly and without explicitly saying so. This leads to low reactivity and opaque communication, hampering in turn the capacity of central banks to manage expectations and effectively steer the economy. A good case in point is the ECB that – compared to the Fed – did “too little and too late” from 2009, amid a constant debate on whether the inflation-targeting mandate was being violated. […]

ECB opacity is intrinsically linked to the confusion between its mandate and its activities in the real world, and as such it cannot lead to any meaningful discussion but only to legalistic disputes on the definition of price stability, of how medium is the medium term and the like.

The main merit of a dual mandate is in fact that it lets the political nature of monetary policy emerge without ambiguities. It is indeed true that monetary policy with a dual mandate requires hard choices, just like those debated these days, and hence is political by its very nature. The point is, so is monetary policy with a simple inflation-targeting objective. The level of inflation targeted, and the choice of the instruments to attain it, is anything but neutral in terms of its consequences on the economy. Thus, an inflation-targeting central bank is as political in its actions as a bank following a dual mandate, the only difference being that In the former case the political nature of monetary policy is concealed behind a technocratic curtain.

In a sentence, we argued that monetary policy choices are always political, and as such they should be incorporated in the policy mix, without hiding behind what Yan and I called a technocratic illusion.

Munchau’s link between the broadness of the mandate and its political nature, is simplistic and in my opinion strongly misleading. In fact, we concluded back in 2015 that it is linked to a specific intellectual framework

The profound justification of an exclusive focus on price stability can only lie in the acceptance of a neoclassical view in which virtually powerless governments need to make little or no choices. Once we dismiss that platonic view, monetary policy acquires a political role, regardless of the mandate it is given.

The second reason why Munchau’s argument is unconvincing is the conclusion, somewhat implicit in his piece, that a central bank making political choices needs to be a “government agency”. Why is it so, exactly? I fail to see it. What matters is not that the central bank is controlled by the finance ministry, but that it is accountable, like any other actor doing policy, in a system of well functioning checks and balances.

Once we recognize that a central bank has a political role, we need to make sure first, that its mandate is not falsely perceived as technocratic; and second, that its actions are properly embedded in a balanced policy mix, in which there is coordination with, not subordination to, the other branches of government. It seems to me that the US institutional system comes pretty close to this. The same cannot be said for the eurozone.

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John Maynard Trump?

A sentence from Donald Trump’s victory speech retained a good deal of attention:

We are going to fix our inner cities and rebuild our highways, bridges, tunnels, airports, schools, hospitals. We’re going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it.

This was widely quoted in the social media, together with the following from an FT article about the Fed:

In particular, some members of his economic advisory team are convinced that central banks such as the US Federal Reserve have exhausted their use of super-loose monetary policy. Instead, in the coming months they hope to announce a wave of measures such as infrastructure spending, tax reform and deregulation to boost growth — and combat years of economic stagnation.

In spite of its vagueness, the idea of an infrastructure push has sent markets to beyond the roof. In short, a simple (and rather generic) speech on election night has dispelled all the anxiety about the long phase of uncertainty that we face. So long for efficient markets…

But this is not what I care about here. The point I want to make is that Trump’s announcement has triggered a strange reaction. Something going like: “See? Trump managed to break the establishment’s hostility to Keynes and to finally implement the stimulus policies we need. Forget the sexism and the p-word, the attacks on minorities, the incompetence. Enter Trump, exit neo-liberalism”. I see this especially (but not only) among Italian internauts, who tend to project the European situation in other contexts.

Well, I have some reservations on this claim. Where to start? Maybe with the “Contract with the American Voter“, that together with the (generic, once more) promise of new investment, promised a massive withdrawal of the State from the economy? Or from the fact that “Establishment Obama” made Congress vote, a month into his presidency, a “Recovery Act (ARRA)” worth 7% of GDP, that successfully stopped the free-fall and helped restore growth? Or from the fact that the “anti-establishment” Tea Party forced austerity since 2011, climaxing in the sequester saga of 2013?

Critics of current austerity policies in Europe should not be delusional. Trump is not the John Maynard Keynes of 2016. His agenda is, broadly speaking, an agenda of deregulation, tax cuts for the rich, and retreat of the State from the economy. Not to mention the strong chance of a more hawkish Fed in the future. To sum up, Trump is, in the best case scenario a new Reagan, substituting military Keynesianism with bridges’ Keynesianism. And we all (should) know that Reaganomics does shine much less than usually claimed.

Those progressives looking for a Trump Keynesian agenda should probably have looked more carefully at the plan proposed by “establishment-Clinton”: A significant infrastructure push (in fact, the emphasis on infrastructures was the only point in common between the two candidates), with the ambition to crowd-in private investment. And what is more important, such an expansionary fiscal policy was framed within a more active role of the government in key sectors like education, health care, and with increased progressivity of the tax system.

Would we have had Hilary Rodham Keynes? Unfortunately we’ll never know…

A Piketty Moment

Update (10/27): Comments rightly pointed to different deflators for the two series. I added a figure to account for this (thanks!)

Via Mark Thoma I read an interesting Atalanta Fed Comment about their wage tracker, asking whether the recent pickup of wages in the US is robust or not.

The first thing that came to my mind is that we’d need a robust and sustained increase, in order to make up for lost ground, so I looked for longer time series in Fred, and here is what I got

This yet another (and hardly original) proof of the regime change that occurred in the 1970s, well documented by Piketty. Before then, US productivity (output per hour) and compensation per hour  roughly grew together. Since the 1970s, the picture is brutally different, and widely discussed by people who are orders of magnitude more competent than me.

[Part added 10/27: Following comments to the original post, I added real compensation defled with the GDP deflator.  While this does not account for purchasing power changes, it is more directly comparable with real output. Here is the result:

The commentators were right, the divergence starts somewhat later, in the early 1980s. This makes it less of a Piketty moment, while leaving the broad picture unchanged.]

Next, I tried to ask whether it is better for wage earners, in this generally gloomy picture, to be in a recession or in a boom. I computed the difference between productivity (output per hour) and wages (compensation per hour), and averaged it for NBER recession and expansion periods (subperiods are totally arbitrary. i wanted the last boom and bust to be in a single row). Here is the table:

Yearly Average Difference Between Changes in Productivity and in Wages
	In Recessions	In Expansions	Overall	% of Quarters in Recession
1947-2016	1.51%	0.40%	0.57%	15%
1947-1970	1.62%	-0.14%	0.19%	19%
1970-2016	1.42%	0.67%	0.76%	13%
1980-1992	0.64%	0.84%	0.81%	17%
1993-2000	N/A	0.68%	0.68%	0%
2001-2008Q1	4.07%	1.10%	1.41%	10%
2008Q2-2016Q2	2.17%	0.12%	0.49%	18%
Source: Fred (my calculations)
Compensation: Nonfarm Business Sector, Real Compensation Per Hour
Productivity: Nonfarm Business Sector, Real Output Per Hour

No surprise, once again, and nothing that was not said before. The economy grows, wage earners gain less than others; the economy slumps, wage earners lose more than others.  As I said a while ago, regardless of the weather stones keep raining. And it rained particularly hard in the 2000s. No surprise that inequality became an issue at the outset of the crisis…

There is nevertheless a difference between recessions and expansions, as the spread with productivity growth seems larger in the former. So in some sense, the tide lifts all boats. It is just that some are lifted more than others.

Ah, of course Real Compensation Per Hour embeds all wages, including bonuses and stuff. Here is a comparison between median wage,compensation per hour, and productivity, going as far back as data allow.

I don’t think this needs any comment.

On the Importance of Fiscal Policy

Last week’s data on EMU growth have triggered quite a bit of comments. I was intrigued by Paul Krugman‘s piece arguing (a) that in per capita terms the EMU performance is not as bad (he uses working age population, I used total population); and (b) that the path of the EMU was similar to that of the US in the first phase of the crisis; and (c) that divergence started only in 2011, due to differences in monetary policy (an impeccable disaster here, much more reactive in the US). Fiscal policy, Krugman argues, was equally contractionary across the ocean.
I pretty much agree that the early policy response to the crisis was similar, and that divergence started only when the global crisis went European, after the Greek elections of October 2009. But I am puzzled (and it does not happen very often) by Krugman’s dismissal of austerity as a factor explaining different performances. True, at first sight, fiscal consolidation kicked in at the same moment in the US and in Europe. I computed the fiscal impulse, using changes in the cyclically adjusted primary deficit. In other words, by taking away the cyclical component, and interest payment, we can obtain the closest possible measure to the discretionary fiscal stance of a government. And here is what it gives:

Krugman is certainly right that austerity was widespread in 2011 and in 2012 (actually more in the US). So what is the problem?
The problem is that fiscal consolidation needs not to be assessed in isolation, but in relation to the environment in which it takes place. First, it started one year earlier in the EMU (look at the bars for 2010). Second, expansion had been more robust in the US in 2008 and in 2009, thus avoiding that the economy slid too much: having been bolder and more effective in 2008-2010, continued fiscal expansion was less necessary in 2011-12.
I remember Krugman arguing at the time that the recovery would have been stronger and faster if the fiscal stance in the US had remained expansionary. I agreed then and I agree now: government support to the economy was withdrawn when the private sector was only partially in condition to take the witness. But to me it is just a question of degree and of timing in reversing a fiscal policy stance that overall had been effective.
I had made the same point back in 2013. Here is, updated from that post, the correlation between public and private expenditure:

Correlation Between Public and Private Expenditure
	2008-2009	2010-2012	2013-2015
EMU	-0.96	0.73	0.99
USA	-0.82	-0.96	-0.04

Remember, a positive correlation means that fiscal policy moves together with private expenditure, and fails to act countercyclically. The table tells us that public expenditure in the US was withdrawn only when private expenditure could take the witness, and never was procylclical (it turned neutral in the past 2 years). Europe is a whole different story. Fiscal contraction began when the private sector was not ready to take the witness; the withdrawal of public demand therefore led to a plunge in economic activity and to the double dip recession that the US did not experience. Here is the figure from the same post, also updated:

To sum up: the fiscal stance in the US was appropriate, even if it changed a bit too hastily in 2011. In Europe, it was harmful since 2010.

And monetary policy in all this? It did not help in Europe. I join Krugman in believing that once the economy was comfortably installed in the liquidity trap Mario Draghi’s activism while necessary was (and is)  far from sufficient. Being more timely, the Fed played an important role with its aggressive monetary policy, that started precisely in 2012. It supported the expansion of private demand, and minimized the risk of a reversal when the withdrawal of fiscal policy begun. But in both cases I am unsure that monetary policy could have made a difference without fiscal policy. Let’s not forget that a first round of aggressive monetary easing in 2007-2008 had been successful in keeping the financial sector afloat, but not in avoiding the recession. This is why in 2009 most economies launched robust fiscal stimulus plans. I see no reason to believe that, in 2010-2012, more appropriate and timely ECB action would have made a big difference. The problem is fiscal, fiscal, fiscal.

Celebrate

Stronger than expected GDP growth in France and Spain (0.5% and 0.8% in 2016Q1, 0.1% more than expected!) has boosted Eurozone GDP to a staggering +0.6% in the first quarter of 2016. The Financial Times notes that GDP is now above its pre-crisis level. I expect, in the next few days, celebrations in some quarters.

So, just a reminder:

The figure speaks for itself. While we had a lost decade (eight-ade), The US and the OECD as a whole were out of the woods in 2011Q2. Our neighbours across the Channel in 2013Q2. Furthermore, we were the only ones to go through a double dip recession, and are the only ones still fighting with deflationary pressures.

Of course, if we look at per capita GDP (warning, I constructed it myself, simply dividing real GDP by population on January 1st), the lost decade may materialize after all:

I added Greece as a second reminder. The country is back at case one, in yet another round of difficult negotiations. And I do believe that remembering what they have endured may help

So, tell me again, what should we be celebrating?

The Quest for Discretionary Fiscal Policy

It is nice to resume blogging after a quite hectic Fall semester. Things do not seem to have gotten better in the meantime…

The EMU policy debate in the past few months kept revolving around monetary policy. Just this morning I read a Financial Times report on the never ending struggle between hawks and doves within the ECB. I am all for continued monetary stimulus. It cannot hurt. But there is only so much monetary policy can do in a liquidity trap. I said it many times in the past (I am in very good company, by the way), and nothing so far proved me wrong.

A useful reminder of how important fiscal policy is, and therefore of how criminal it is to willingly decide to give it up, comes from a recent piece from Blinder and Zandi, who tried to assess what the US GDP trajectory would have been, had the discretionary policy measures implemented since 2008 not been in place. I made a figure of their counterfactual:

It is worth just using their own words:

Without the policy responses of late 2008 and early 2009, we estimate that:

• The peak-to-trough decline in real gross domestic product (GDP), which was barely over 4%, would have been close to a stunning 14%;
• The economy would have contracted for more than three years, more than twice as long as it did;
• More than 17 million jobs would have been lost, about twice the actual number.
• Unemployment would have peaked at just under 16%, rather than the actual 10%;
• The budget deficit would have grown to more than 20 percent of GDP, about double its actual peak of 10 percent, topping off at $2.8 trillion in fiscal 2011.
• Today’s economy might be far weaker than it is — with real GDP in the second quarter of 2015 about $800 billion lower than its actual level, 3.6 million fewer jobs, and unemployment at a still-dizzying 7.6%.

We estimate that, due to the fiscal and financial responses of policymakers (the latter of which includes the Federal Reserve), real GDP was 16.3% higher in 2011 than it would have been. Unemployment was almost seven percentage points lower that year than it would have been, with about 10 million more jobs.

The conclusion I draw is unequivocal: Blinder and Zandi give yet another proof that what made the current recession different from the tragedy of the 1930s it the swift and bold policy reaction.

This of course nothing new. But unfortunately, it sounds completely heretic in European policy circles. In my latest post (internet ages ago) I noticed that how little Mario Draghi’s position on fiscal matters differed from Angela Merkel’s, and in general from the European pre-crisis consensus.

The reader will have noticed that in the figure above I also drew EMU12 real GDP. It did not fall as much as the US no-policy counterfactual (among other things because exports kept us afloat thanks to…the US recovery). But we are today stuck in a semi-permanent state of stagnant growth. EMU12 GDP is today at the same level as the level the US would have had, had their policies been completely inertial. Once again, a visual aid:

I already showed this figure in the past. On the x-axis you have the output gap, i.e. a measure of how deep in a recession the economy is. On the y-axis you have he fiscal impulse, i.e. a measure of discretionary fiscal policy (net of interest payment and of cyclical adjustment of government deficit). A well functioning fiscal policy would result in a negative correlation: If the economy goes down (negative output gap), fiscal policy is expansionary (positive fiscal impulse). This is what actually happened in 2008-2009 (red series). But then as we know European policy makers succumbed to the fairy tale of expansionary fiscal consolidations, and fiscal policy turned pro-cyclical (yellow series). A persisting output gap was met with fiscal consolidation (improvement in structural fiscal balance).

Overall, policy was neutral. This is consistent with the Berlin View, that  fears discretionary policies as if they were the plague. And explains much of our dismal performance. The fact that we are close to Blinder and Zandi’s “no-policy” scenario is no coincidence at all. Our policy makers should look at their blue line for the US, and realize that we could be around there too, if only they were less stubbornly ideological.

 

Overheat to Raise Potential Growth?

Update, March 20th: Speaking of ideological biases concerning inflation, Paul Krugman nails it, as usual.

On today’s Financial Times, Phillip Hildebrand gives yet another proof of unwarranted inflation terror. His argument is not new: In spite of the consensus on a weak recovery, the US economy may be close to its potential , so that further monetary stimulus would eventually be inflationary.

He then deflects (?) the objection that decreasing unemployment reflects decreasing labour force participation rather than new employment, by suggesting that it is hard to know how many of the 13 millions jobs missing are structural, i.e.not linked to the crisis. I think it is worth quoting him, because otherwise it would be hard to believe:

However, an increasingly vocal group of observers, including within the Fed, posits that more of the fall in the participation rate appears to have been structural than cyclical, and it was even predictable – the result of factors such as an ageing workforce and the effect of technology on jobs.

(the emphasis is mine). Now look at this figure, quickly produced from FRED data:

The Fiscal Compact puts Europe on the Wrong Track

Today the Irish  people will vote on the Treaty “on the Stability, Coordination and Governance in the EMU”, also known as the “fiscal compact”. This referendum is of paramount importance for the whole European Union.  I recently wrote an editorial on the French daily Le Monde, together with Imola Streho, explaining why we believe it to be poorly designed and economically ill conceived. Here is an English version.