Suppose you have an intuition, ‘P’*. Should you believe P? Should you believe not-P? For some propositions (e.g. the moral kind) there may not be much to go on other than our intuitions. So for the moral intuitionists in particular, here’s a little puzzle for you.
Suppose intuitions have a probability of being true that is greater than 0.5. Therefore, if you have an intuition that P you should believe it rather than not-P. But if this is true, then the consensus of the masses’ intuition is not only more reliable than yours, but is actually very reliable (Condorcet’s theorem). If intuitions have a probability of greater than 0.5 of being true, you should therefore not trust your intuition, but ask the masses.
Suppose instead intuitions have a probability of being true that is less than 0.5. Therefore, if you intuit P, not-P is more likely. But not only should you should not trust your intuition, you can be pretty certain of the right answer by asking the masses and then believing the opposite!
Obviously I have posed the question in a very simplistic way, and there’s questions of statistical independence, the different reliability of different kinds of intuitions** etc. But it does seem that whatever the probability of your intuitions being true are, in a lot of cases it could still make sense to ask around and then either believe what the masses say, or the opposite (depending on your view of the prior probability of the particular intuition being correct).
*This is philosopher-notation for an arbitrary proposition. P could be anything – ‘Murder is always wrong’, ‘I am the same person I was yesterday’ etc.
**There even may be classes of intuitions that are necessarily reliable on the level of the masses, because they are intuitions about proper conventions… but let’s not go into that here
Maybe we can make this all a lot simpler. Everyone should agree that under the following conditions, the fiscal multiplier is roughly zero
1) The central bank has a mandate that it fulfills through setting the level of Aggregate Demand in the economy
2) The central bank has the operational ability to set AD to be whatever it likes
3) The central bank will always set AD to be at a level it believes will fulfill its mandate.
Arguments over the existence of a ‘liquidity trap’ attack premise 2. I do not find those arguments persuasive, but I won’t list why here (I have no comparative advantage. For a good explanation, I can’t better this). The point that Noah Smith made the other day would be an argument against premise 3. He essentially points out the fact that central banks have, in fact, failed to meet their mandate. The central bank should want more AD, can deliver more AD, but isn’t delivering more AD. Under this condition, there would be a positive fiscal multiplier (up until the point AD reaches the desired level of the central bank).
So the circumstances where central bank ‘incompetence’ results in a fiscal multiplier are actually very limited. The central bank could be incompetent in ways that don’t result in a multiplier (for example, being mistaken as to the level of AD necessary to fulfill its mandate). It is only the bank being seemingly inconsistent (wanting x, being able to produce x and not doing so) that generates a multiplier. There is a non-zero probability that this has happened. But I agree with Scott writing in my comments section that Keynesian models of the multiplier are still useless. This would be a Pyrrhic victory for the Keynesians.
So there you have it. Now if we could all come up with a good model explaining why central banks are being inconsistent, then that would be super. My suspicion is there’s some public choice factors lurking in there somewhere, caused by the astounding incoherence of the implicit economic models used by both the political establishment and the economic elite. But I don’t have any answers… yet.
There are, as I see it, two really big and profound problems with the way we’ve gone about trying to reduce greenhouse gas emissions. The first is that at the level of the individual, it is surprisingly complicated to figure out how you can minimise your own carbon footprint. For electronic products, it has been argued that carbon footprint is actually impossible to measure. I doubt most people understand the massive carbon savings of buying a fuel efficient used car, rather than a new hybrid. It is completely unreasonable to expect people to make these calculations for everything they buy. Furthermore, merely making low-carbon options available to people will not in and of itself do much to reduce emissions from current levels, for essentially the same reason that increasing road capacity or even other forms of transportation doesn’t reduce congestion. It’s all about the price of the thing you are trying to get rid of – hence why congestion charges have worked to reduce traffic in places like London and Stockholm, and merely building new roads hasn’t worked anywhere.
The second problem is that the way we’ve been going about trying to reduce emissions – getting governments to agree on targets by some date – creates an enormous incentive to negotiate down the size of your particular countries emissions, and then to cheat on it. This is because there is an economic cost to doing this, and merely trying to achieve it through blunt regulatory mechanisms means that it is attractive for any individual country to cheat a little, and reduce the cost of doing carbon-emitting business there. You can think of it as a kind of carbon cartel, and is subject to all the problems that bedevil cartels – and more, because limiting production doesn’t give you any tangible monopoly rents. it doesn’t take a genius to realise that if this is the best we can come up with, then we’re completely screwed.
Thankfully, I think there is a solution to this that covers both these problems. My modest proposal would be to eliminate all taxation and replace it with a carbon tax, assessed at the earliest possible point in the production chain (i.e. energy produced within the country, and the carbon footprint of all imports). In order to account for the fact a carbon tax is more regressive than current taxation, I’d establish a citizen’s income. As the amount of carbon used within the country naturally falls and the tax revenue with it, I would replace the lost revenue with a gradual phase-in of the previous tax regime*.
The beauty of this plan is that it will result in individuals re-allocating towards a consumption basket lighter on carbon, merely through the fact carbon has become really expensive. No one has to calculate the carbon footprint of anything (other than imports), because the price of the carbon will be passed down from point where it was assessed into the prices of final goods. Hayek was very wrong about some really important stuff, but his idea that prices reflect information that would otherwise be incalculable to individual agents is one of the most brilliant insights of the last 100 years.
Furthermore, whilst this plan would be terrible for carbon-intensive industries (as it ought to be), if you were the only country to do this then every low-carbon business in the world would want to re-locate to your country. Whilst ‘competitiveness’ on the carbon front would be terrible, for every other kind of economic activity you will have to put the ball in everyone else’s courts in order to make low-carbon industries more attractive in order to prevent them moving. In short, I think my proposal has a healthy rather than perverse ongoing dynamic, by taking what is currently a race to the bottom (countries trying to shirk their obligations) and turning it into a race to the top (through incentivising low-carbon business and industry).
I haven’t thought through all the aspects of this yet. It’s just something that has been stewing in the back of my mind for a while, warmed by my deep dissatisfaction with all the ‘solutions’ people have been talking about. I’m not in a position to comment on how worried we should be about climate change, but if we ought to be as worried as the experts seem to be, then we need to start coming up with ways to drastically reduce our carbon emissions that will actually work. There is something in my plan for everyone… other than industries that heavily rely on carbon emissions. Given that the professional consensus among economists is that consumption taxes are the most efficient, I really struggle to think of any economist who would prefer the current tax regime to this.
I don’t in any way see my ‘plan’ as anything remotely close to a finished product, and I’d really like to hear people’s reactions to it. But it does seem (at least to me) to be a lot better than anything anyone else is talking about.
*I say this just to make it less controversial. In reality, I also hope it would lead to a vigorous debate as to how we should reconstruct the tax code from scratch. Conservatives, you should absolutely love this part
Things no one has asked me to do: adjudicate the dispute on the existence of the fiscal multiplier (in plain English)
(I’ve tried to write this in plain English, because while it is at first glance a somewhat technical dispute in macroeconomics, it is also window into understanding the relationship between government and central bank policy which is so poorly understood by the vast majority of even informed observers. If even a few of the non-economists who I know read this end up getting it, then some good will have been done)
For those of you not in the know, Keynesian macroeconomics has this idea that government spending increases total spending at a multiple of the original amount, because for every (say) $100 spent, 90% (say) of that would then be spent by those who received that money from the government etc. The multiplier is equal to 1-‘Marginal Propensity to Consume’, which in this case is that 90% figure. In this example, the $100 spend would increase total spending by $1000 (multiplier is 10, as MPC is 90% or 0.9).
Of course, this can only work to raise real GDP if there are unemployed resources. Because otherwise, that initial $100 spend represents the using of resources that would have otherwise been employed doing something else. Hence there is no ‘real’ fiscal multiplier in that circumstance, because that spend doesn’t represent an exogenous increase in economic activity, merely a transfer from the private to the public sector. The public sector may or may not be able to make better use of those resources, but the mere fact of spending more cannot make a difference and will either represent foregone private consumption or investment.
However, there are those such as economics blogger par excellence Scott Sumner who says that there cannot be a fiscal multiplier in any circumstance, or even a nominal fiscal multiplier, because it depends on the government doing something (increasing ‘Aggregate Demand’, or total spending on final goods and services) which the central bank actually controls. For example, in my native Britain the Bank of England is instructed by the government to manage Aggregate Demand in such a way as to produce a certain level of inflation. In my also-native US, the Federal Reserve has a somewhat less specific mandate to maintain low inflation and low unemployment. If the central bank is doing its job, then it is crystal clear (and I think not disputed on either side) the fiscal multiplier will be at or close to zero (unless the public sector employs resources more productively than the private sector, which is not the Keynesian contention). But if the central bank isn’t doing its job, and has let demand fall below a level consistent with its mandate, then the question gets a lot trickier to answer.
There are two ways you can attack the question – conceptually and empirically. Let’s start with the latter first. Because the impact on government spending isn’t geographically uniform, there is an approach to ‘measuring’ the multiplier by comparing across geographies. These studies (such as this one, which has shown a decent fiscal multiplier of 1.5) suffer from a pretty devastating objection, which is that they could show a fiscal multiplier even if it was actually zero (or, indeed, if it was negative!). This is because government spending really would shift economic activity towards these regions, as the distribution of the central bank’s offsetting mechanism will almost certainly not have the same geographic profile as the government spending. Therefore, the increase in government spending will make it really look like those places where the government is spending are doing better. Indeed, they will be doing better, relative to other parts of the country. But that won’t be because the pie is bigger, but rather because their piece of it is. Score 1 to Sumner on this point.
However, on the conceptual point I think Sumner has a weakness. He is of the view – and it is almost, almost true – that the level of Aggregate Demand in the economy is completely determined by the central bank. If the central bank is letting Aggregate Demand fall too low, it is because they ‘want’ it to. If the government did anything to change it, they would simply offset the change in AD to bring it back to their desired level. In Sumner’s model, the central bank has some implicit objective (inflation of x, unemployment of y, some mix of the two, some mix of GDP growth and inflation etc.) that it then tries to achieve by setting AD at the level consummate with that target. In short, it rules out the possibility that AD is not at the level the central bank wants it to be. It is not possible that the central bank could want higher AD, and be unwilling or unable to take action to achieve it. It can screw up, through either having a bad target or bad beliefs about how to achieve it. But it can’t be inconsistent.
There are thus two angles fiscal policy advocates can take against this – that there are circumstances where the central bank is unable to raise AD to its desired level, or circumstances where it is unwilling to. There is no evidence to believe the former, and every reason to believe that the central bank can increase AD if it wants to. I’m not going to discuss here the arguments for and against the existence of a so-called ‘liquidity trap’, as that would be the subject of a long post in and of itself (not because it’s a complicated case, but because so many bad arguments have been provided for its existence it would take time to refute them all). I believe the arguments for its existence are spurious, and the historical examples used to support it (e.g. Japan in the last 20 years) are spurious also. Let’s assume for the sake of the rest of the post that the central bank is operationally able to produce whatever level of AD it desires.
That then leads us to the final possibility, that the central bank desires more AD, is operationally able to provide more AD, and does not. It would, therefore, be the case that a fiscal expansion would not be offset by the central bank if it increases AD to the level the bank itself desires. It would at least appear at first glance to be irrationality of both the purest and most unforgivable kind. Could this happen? Has this, in fact, happened? I’m inclined to say, pace Sumner, yes it has. As Sumner himself has pointed out, the Fed is currently acting irrationally – quoting him quoting the Fed minutes last week,
[Fed] “Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee’s dual mandate. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.”
We expect to fail, but we’ll keep a close watch on things just to make sure. [Sumner]
Is it then so implausible that the Fed would, for want of a better term, tolerate government action that theoretically should bring inflation and unemployment closer to its mandate? I agree that the Fed could, if it wanted to, achieve this itself. And there is every reason it should want to. But it isn’t doing it. My understanding is that Bernanke has himself said that the government should do fiscal stimulus, despite the fact that it makes nonsense of the rest of his statements strenuously denying that the Fed is ‘out of ammunition’, and nonsense of his academic career prior to becoming Fed chairman.
Why might this be? How can we have a situation where the Fed wants x, can achieve x by doing y, and decides not to do y? I think it has something to do with the question as to why Prof. Sumner had to launch his seemingly tireless effort to persuade both his profession and the intelligent/informed observer that our beliefs about monetary policy are wrong. It has to do with the fact that basic, intuitive and widely-practiced ways of thinking about macroeconomics are hopelessly inconsistent. That is what is, I think, missing from the so-called ‘Market Monetarist’ model. It’s the question of why doesn’t everyone think this way*.
This matters because a central bank is, at the end of the day, a political institution. Appointees are political, and central banks feel political pressure whether or not there is a direct mechanism of accountability. Earlier in the post, I set up the problem in terms of what the central bank is ‘operationally able’ to do. My phrasing was deliberate. The Fed may be operationally able to do x, but may be unable in some other way. We don’t have a ‘public choice’ model of central banking – and I would be more than willing to supply one if I had any expertise or ability to do so. I believe it really is necessary in order for the Market Monetarist model to provide a satisfactory explanation of why central banks seem to be acting irrationally. The economist’s instinctive reaction to seeming irrationality is to ask ‘what incentive is missing from the picture?’, and it is a very healthy reaction to have. Let’s apply it to the catastrophic failures of central banking in the last three years.
Thinking about this clearly is important, because it is by no means an open and shut case that fiscal expansion would have worked in the US. The Fed has already done politically controversial things like Quantitative Easing, and it is a completely reasonable question to ask whether the Fed would have done that had there been more fiscal stimulus. I don’t know the answer to that question. But I have to agree with Noah that it is at least possible that fiscal stimulus could have helped, given the a plausible interpretation of the revealed preferences of central bankers. However, we simply do not have a sufficiently rich description of the central bank’s ‘reaction function’ to give a remotely satisfying answer.
In summary, I think it is ‘almost’ true that the fiscal multiplier is zero – but within that ‘almost’ lies some intellectual terra incognita that needs to be explored and mapped out. We need a model that takes into account the possibility of being wrong, and the effects on central bank incentives if a large portion of the political class are wrong. I don’t know how to go about doing that, but this humble correspondent is all ears.
*Even being the manager of the world’s largest bond fund clearly doesn’t make you immune to writing an op-ed on monetary policy that makes almost no sense whatsoever
Things have moved on pretty fast since I wrote my first primer on the Euro crisis. I’m not going to repeat the material in there. Rather, I will explain where exactly it is we have gotten to now, because it is pretty impossible to understand if you haven’t been following it closely.
What is the new EU pact all about?
It would require all countries to pass a constitutional amendment severely limiting the government’s ability to run a large budget deficit, and require their budgets to be approved by the European Commission.
Will it help?
The most important thing to grok (new favourite word) is that this whole thing is a complete sideshow to what is actually keeping the Eurozone from falling apart. Indeed, in and of itself it would make the problem worse, because fiscal austerity without monetary expansion will contract the economy. The real action is at the European Central Bank.
What is the ECB doing?
‘Monetary financing’ of government deficits (i.e. direct lending from the central bank to governments) is prohibited by EU law. Now, exactly what technically does or does not count as the monetary financing of government deficits, I have no idea. But safe to say that we won’t get the ECB saying things like ‘We will buy an unlimited number of Italian bonds in order to maintain a yield of under 6%’, even though it is near-universally agreed that if the price of borrowing for the governments of Italy/Spain/Portugal etc. remains at the levels we are currently seeing (which the government does not actually pay until they have to issue new debt or rollover old debt) this will prove unsustainable as and when the governments start actually paying those rates on more and more of their outstanding debt.
However, the ECB is putting in place a mechanism to try and achieve the same thing, but sticking to the letter of the law. What they are doing is saying that they will provide the banks (not the government) with cheap three-year ‘repo’ loans. Now, in ‘wholesale’ bank funding (as opposed to ‘retail’, which is the deposits you, I or the business you work for has) by which means banks finance their lending, one of the key instruments is called a ‘repurchase agreement’ or ‘repo’. Basically, a repo is like a loan against which you offer collateral to the creditor. Kind of conceptually similar to a mortgage, except instead of the loan being secured against a house, it is against a bond or other security you own (and the borrowing terms are considerably shorter, often only a few days or less).
So the ECB is offering these really cheap three-year repos, and so long the ECB accepts sovereign bonds as collateral, they are therefore essentially offering unlimited financing for anyone with a banking license to purchase as much sovereign debt as they want. Here it is, from the horse’s (a.k.a. Sarko’s) mouth:
Italian banks will be able to borrow [from the ECB] at 1 per cent, while the Italian state is borrowing at 6-7 per cent. It doesn’t take a finance specialist to see that the Italian state will be able to ask Italian banks to finance part of the government debt at a much lower rate.
Will it work?
Here’s some theory. There are all kinds of European banks that will fail in the event of either a Euro-area sovereign default or a break-up of the Eurozone. Therefore, if this is the only plan on offer to prevent that from happening, then it is rational for you to participate in the plan. However, this poses some collective action problems. If yields get driven down through this plan, then all the banks with tons of sovereign debt on their balance sheets essentially profit from an increase in the value of the loans on their books (the yield and the value of a bond have an inverse relationship – if yield increases, the price of the bond has fallen and vice-versa). So this would be good for banks, but I suspect in the real world what they would all really like is for the yield to get driven down without them having to buy any more bonds. So you wait for the other guys to buy the bonds. Everyone does this. No bonds get bought. Disaster. In reality, the banks aren’t so keen on this idea, and it requires their voluntary participation.
Or does it? Sarkozy’s comment hints at another method – when he said the Italian state will be able to “ask” Italian banks to finance the deficit. There is always the possibility that, one way or another, the government (through special tax loopholes or something far more devious) will be able to coerce domestic banks into loading up their balance sheets with their respective government’s debt. The ECB would make such an arrangement economically possible through the provision of cheap financing, and the governments will try and find a way to make it a political actuality.
What’s the potential downside?
This plan is what I like to call ‘stuffing the fat tails’, by which I mean it would make the ramifications of a crisis much, much worse if it does happen. The more exposure the European banking system has to sovereign debt, the more screwed the banking system is in the event of a default. It only takes one country to mess it up for the whole thing to come tumbling down. You start reading things like this out of Portugal, where politicians are openly saying that their debt is an ‘atomic bomb’ they can use to extract concessions from Germany and France, or listening to this NPR podcast on how the Greeks are threatening to throw in prison the EU technocrat who revised their budget deficit upwards, and you start to realize that the politics of this crisis are just as bad as the economics.
Secondly, the ECB essentially has complete ‘control’ of the situation through its collateral requirements. If they were to impose a ‘haircut’ on certain collateral (which essentially means they wouldn’t lend against the full value of the bond), then this would directly translate into higher borrowing costs for the government. As the excellent Steve Waldman points out:
The ECB would have the power to manufacture fiscal crises for a misbehaving state at will, and with marvelous deniability. Laundered through banks and then through capital markets, ECB actions would be attributed to nameless bond vigilantes rather than unelected technocrats.
This plan is terrible for democracy. Central banks necessarily are institutions where significant power resides, and we are going to have in place a monetary policy where it is all but impossible for the layman to observe the massively consequential decisions of these ‘unelected technocrats’. The ECB will have a policy lever that is devilishly difficult to discern from the outside, and that is just going to make the politics of this situation so much more treacherous than it already is.
[Update: in a massive “D’oh” moment, even though it’s pretty unclear to me whether the structural deficit provision of the accord applies only to Eurozone countries or all signatories, obviously the BBC article I quoted completely contradicts my position. Overall the reports I’ve found are conflicting (really surprised how hard it is to get this straight), and I formed the argument in this post on the basis of an impression that the budget provisions would apply to all signatories, as this would explain why it would be controversial in the non-Eurozone countries such as Sweden and Denmark. I then somewhat unthinkingly pasted in the BBC version of events because, well, it was the BBC. If you can enlighten me as to the truth, please do.]
I’m not usually one for following the verbal sparring of parliamentary politics, because I value my sanity. I would like to point out that I was not motivated to write this in order to single out a particular side, but rather this is just something I happened to pick up on (and people who know me well will be aware of my near total contempt for almost every political party). Earlier this week, Leader of the Opposition Ed Miliband attacked Cameron for his veto of the proposed revisions to the Lisbon Treaty:
Here’s the truth: last week he [Cameron] made a catastrophic mistake
I would simply like to point out one of the provisions of the agreement
- a commitment to “balanced budgets” for eurozone countries- defined as a structural deficit no greater than 0.5% of gross domestic product – to be written into national constitutions (emphasis mine)
And compare it to something I found on the Labour Party’s website back from a couple of years ago
- we have set out clear plans to reduce the majority of the structural deficit over the course of the next Parliament – falling from 9% of GDP this year to 3.1% in 2014/5 (emphasis mine)
And then compare Ed Miliband just four weeks ago in anticipation of the Autumn budget statement , on the coalition government’s relatively aggressive deficit reduction plans
It will be the moment that we learn that the biggest economic gamble in a generation has catastrophically failed (emphasis mine)
I’m not saying Cameron wielded the veto for the right reasons – I simply don’t know the facts (although what I will say is that the big European countries have consistently shown that they will regulate in such a way as to coddle their larger and more leveraged universal banks). Furthermore, every other European leader has a huge political incentive to shift the blame onto someone else if they can. But if Miliband thinks Cameron should have gone along with the accord, then he’s saying that Britain* should enshrine in constitutional law(!) the very kind of deficit reduction requirements that he simultaneously believes to be so catastrophically dangerous.
Seriously, is there no one in this country who can say anything about Europe that isn’t either daft, xenophobic or in complete contradiction to everything else they ostensibly believe in? Because it sure does seem that way most of the time.
*As I said in the update, I could be quite wrong to think that Britain would have to go along with this part of the agreement. The lukewarm response in the non-Eurozone countries suggests yes, that Cameron didn’t say he vetoed it for this reason suggests no. Either way, the Labour Party’s position ought to be that this is a giant mistake (if they want to be consistent).
So, I finally took up Matt Yglesias’ suggestion and played around with the ECB’s online monetary policy game. And as he said, it’s pretty revealing. The first time I played, I was very aggressive in cutting interest rates in response to demand shocks, and I even cut rates in response to a supply shock. By 2018, unemployment was at under 4%, but inflation over the period had been c.4.5% with medium variability (mostly due to an oil supply shock, which I cut rates in response to). I got no stars.
Then I decided to try and play it how the ECB wants me to play it. After a number of attempts , I eventually managed to get one star. In this scenario, inflation averaged 0.36% with high variability. I got one star (woo!) – even though unemployment was at over 10%.
And then I played again. I got an average inflation rate of 1.24%, with medium variability. This was deemed worthy of two stars (double woo!). Only thing was, the unemployment rate at the end of the period was 9.81%. I then managed to get two stars again, with an inflation rate of 1.65% with medium variability – but on the way I managed to plunge Europe into a second Great Depression, with unemployment running at a whopping 13.13% in 2018.
This is, of course, completely insane. The whole purpose of keeping inflation low and stable is because it is believed by very serious people that this is the most conducive monetary policy for – wait for it – economic growth and full employment!
Oh and by the way, at one point I had inflation running a little out of control at c.5% in 2017. I increased interest rates from 5.25% to 25% (just to see what would happen), and inflation kept on rising and showed no signs of coming down. On another attempt I let inflation get to c.5% in 2013, and even five whole years of 25% interest rates was not enough to bring inflation down. So, for my own peace of mind, I’m going to assume that this is a bug in the game and not indicative of some crazy model inside the minds of the ECB. Because I would really hate to think that the ECB believes they couldn’t control an inflation rate in the mid single digits by increasing the interest rate by two thousand basis points.
Sadly, announcing an 5% NGDP target (or, indeed, making any communication to the market) was not an option. So the game also perpetuates the myth that the only thing that central bank can ‘do’ with regards to monetary policy is increase or decrease the interest rate.
It must be nice to get two gold stars for your monetary stewardship, while being insulated from the impact of continent-wide double-digit unemployment.