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Inside Economics

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This is a space for me to comment on Economics both in terms of the specific bits if economics, how the discipline works and the academic politics. I might also be tempted into talking about the economy!

Back to Financial Repression.

Monetary Policy Posted on Sat, January 14, 2017 16:47:40

The Monetary policy committee (MPC) in the UK seems set to repeat the imposition of financial repression we
saw in the period 2010-12. That is the aggresive reduction in the real
interest rate by failing to keep the nominal rate up with inflation.
Inflation looks set to rise to 3-4% in 2017-18, with nominal interrest
rates left at 0.25 or 0.5% (as seems the plan), that means a negative
real interest rate of -2.5 to -3.5%. Now in 2010 that may have been an
excusable policy: we were in the extraordinary times of the
immediate aftermath of the finacial crisis. However, there is no
justifucation in the current state of the economy for reducing real
rates so rapidly to such a low negative rate. The role of the MPC is to
target inflation, which requires nominal interest rates to rise at
least as much as infation is expected to increase (i.e. the Taylor
principle, that real rates rise when inflation rises above target).

Real interest rates should almost never be negative. Prior to the 2008
crisis, the only time real interest rates had been negative was back in
the 1970s during the “Great Inflation”. Back then there was an excuse:
people did not really understand inflation and how to cope with it.
The failure to keep real interest rates positive is widely seen as
simply bad policy. Since then, real interest rates have nearly always
been positive, with nominal rates being around 1-2% higher than
inflation.

In the last year, we finally had a return to a
positive real rate: the policy rate was 0.5 and inflation was around
zero. However, the MPC and Governor Mark Carney have openly stated that
they intend to keep the policy interest rate at its current level
whilst inflation will be well above target. This will be seen as an
historic failure of judgement by the MPC. Financial repression on this
scale will lead to a massive redistribution of income, with the Bank of
England in effect becoming a major instrument of fiscal policy, taking
from savers and pensioners and giving to borrowers. This sort of
redistribution is not what the MPC is about. Its role is targeting
inflation, something which it seems to have forgotten.

What about Brexit? Well, Andy Haldane (the chief economist at the Bank of England) has admitted that the Bank’s forecasts overstated the effect of the Brexit vote on the real economy. The real effects of brexit have yet to come into play (Brexit has not happened yet). However, the implication is that the post Brexit cut in interest rates needs t be reversed: I have yet to see the MPC indicating that this is what it intends to do.

In the US, interest rates are rising: this is something that the UK would be well advised to do immediately. A policy of financial repression is not what the UK economy needs in 2017.



New Keyensian or neo monetarist

Monetary Policy Posted on Sun, February 02, 2014 22:40:33

There
has been a bit of a flutter of memes recently about new Keynesian
economics. Noah Smith digging out Robert
Barro’s 1989 harangue and Lars Syll’s comment that new Keynesian = new
Freidman.

I just
thought I would add my thoughts into the mix. To understand this you really
need a grasp of what has been going on in macroeconomics for the last 50
years. There is Keynes’s economics (the
stuff in the General Theory and lots of other writings) and “Keynesian”
economics that was developed mostly after Keynes had died. Keynesian economics was the stuff in
textbooks like IS/LM and AS/AD that dominated macroeconomic thinking until the
end of the 1970’s. Don’t forget, some of the key new classical results such as
policy neutrality and the neutrality of systematic monetary policy were derived
in this “Keynesian” framework by simply adding rational expectations (this
happened in the second half of the 1970’s with the “rational expectations
revolution”). Indeed, Milton Freidman said that “we are all Keynesians now”. For nearly all macroeconomists, there was
short-run nominal rigidity (IS/LM), but in the long-run all wages and prices
were flexible and you end up at the natural rate. This was called the neoclassical synthesis,
which I for one always associate with Don Patinkin’s masterpiece “Money,
interest and prices”.

So,
there was an academic consensus about the basic analytic framework for modelling things. There was certainly disagreement: at the time
lots of people did not like rational expectations. Also, there were many who thought that the
IS/LM framework left out a lot that was essential to Keynes’s original thought:
the title of Axel Leijonhufvud’s book “of Keynesian economics and the economics
of Keynes” says it all. I could also reference Robert Clower and Hyman Minsky.
Robert Lucas was putting forward a rather different view that we could
understand everything in terms of competitive equilibrium and Keynesian
concepts such as involuntary unemployment were just hokum. However, I think that it is fair to say that
up until the late 1970s, most macroeconomics, whether monetarist or Keynesian,
adopted the same basic setup.

Things
changed in the 1980s. The idea that you could explain economic fluctuations
using competitive equilibrium developed into the Real Business Cycle
approach. As the name implies, it was a
real model and did not even have money in the model or any concept of
inflation. In this period there was the first group of work that was at the
time designated new Keynesian. The key idea here was the introduction of
imperfect competition into macroeconomics (much as the young Paul Krugman was introducing
imperfect competition into the new international trade models), which made
possible the explanation of nominal rigidity based on an optimizing theory of pricing behavior
based on menu costs or bonded rationality (along with other ideas).

In the mid 1990s the new neoclassical synthesis bought these two strands together: the new Keynesian models of nominal
rigidity were combined with the RBC model of household behaviour (Euler
equations and all that). Now of course, whilst some people stressed the Keynesian
aspects of this (for example David Romer in his J.Econ perspectives paper in
1993), others saw it as a neo-monetarist exercise: for example Miles Kimball in
his 1996 paper “The Quantitative Analytics of the Basic Neomonetarist Model”.

So,
there has always been an underlying idea that the prevailing macroeconomic framework,
whether 60’s Keynesian, 80’s new Keynesian or 90’s first generation
neoclassical synthesis models are really “Keynesian”. Yes, they have nominal rigidity. However, there are lots of elements of the
economics of Keynes that have been left out. It is exactly the same now. The first generation new Keynesian models
became the second generation models (as exemplified by the Smets and Wouters
model, for example).

I
am not a historian of economic thought, but certainly from my recollection, the
criticisms made of the so-called Keynesian/new-Keynesian models have always
been much the same: they include amongst other things the inadequate treatment of uncertainty, money,
the assumption of a unique equilibrium. So no change there then.

Whether
you call the existing crop of models “new Keynesian” or “neo monetarist” is
really a matter of taste. However, one thing
is for sure: whilst the choice of name might have political or ideological
overtones, it sure as hell makes no scientific difference as to how good the
models are!



Repressed inflation and Tapering….

Monetary Policy Posted on Tue, September 17, 2013 14:54:36

Well, the action seems to be hotting up. The story so far: long term bond rates of the UK and US have
become closely related, and guess which one is the tail (UK) and which one the
dog (the US). Both long term rates have
recently been hovering over the German rate which is around 0.5-1% lower. Currently, the UK/US 10 year yields are near
identical at around 2.75%, whilst the German rate is a little under 2%. The trend is upwards: in early May (before
Bernake’s “Tapering” announcement to Congress), the same rates were US/UK 1.6%
and Germany 1.3%. Hence we have a simple
story. Germany can be seen as the
reference point. The US and UK have
higher rates, reflecting “inflation risk”.
With all of the QE going on markets believe that there is clearly much
more of a risk of inflation over the next decade. Also, the Germans seem to be
keeping as hard a grip as possible on the expansionist tendencies of super
Mario at the ECB. France also has higher
long rates than Germany: this could stem from a combination of “Euro break-up”
risk (any post-breakup French currency
would devalue against the new DM) with default risk.

Now, back to Bernanke on the 22nd May announcing
the possibility of tapering commencing soon: well now in fact. QE, which has meant the Fed buying up lots of
the US national debt has kept US government bond prices high, and hence the
long rate low. Stopping buying up
government bonds can have only one effect: bond prices fall, and long term
interest rates rise. But, of course, the
markets are forward looking. If prices are going to fall in a few months,
people will start to change their positions and hold less of the bonds, leading
to rise in interest rates well before any tapering has actually happened. The BBC has been following this, particularly
in relation to the effect on emerging markets. The prospect of rising US
interest rates has led to money flowing out of emerging markets, reversing the
flow caused by QE pushing investors onto emerging markets in search of “higher
yield”.

But of course, the effect will not just be on emerging
markets. If we leave aside the Eurozone for the moment, which has its own
special dynamic, the UK will be affected by this too. Enter Mark Carney, with his forward guidance
in July. No tapering in prospect, with long-term interest rates to be kept low
if necessary with more QE (oh, with a long list of conditions of course, but
let’s stick to the main story). Well,
is it possible for the UK to have substantially lower interest rates than the
US? Well, of course it is possible: however, it will have consequences. Let’s see how the markets reacted. After the Forward Guidance, markets seemed to
give Mr Carney some credibility: UK 10
year rates fell below US rates, about 20 basis points and remained below until
late August. Now they are back
together. Well, markets realised that
the Bank of England will not be able to have lower rates than the US for
long. The consequences would be a
devaluation of sterling, which would almost certainly lead to more
inflation. The recent experience of
Sterling’s devaluation against the Dollar would indicate that a large part of
it would pass through into inflation over 2-3 years. Since inflation is currently well above target,
devaluation would be most unwelcome. And
of course, one of Carney’s caveats referred to interest rates having to respond
if inflation became too high.

So, what is the take home for economists? Well, the most
unnatural state of affairs with low interest rates is a bit of a Prisoner’s dilemma.
Most of the developed world needs to
follow the policy of “repressed inflation” , the key feature being sustained
negative real interest rates to help with public finances and reduce the growth
in debt-GDP ratios. However, as in the Prisoner’s
dilemma, they can only do this if they stick together. If one of the main players (The US, the ECB,
BOJ, maybe even plucky little BoE) decides to break and offer higher interest
rates, funds will flow to it. In order
to keep savers and investors in thrall to negative real returns, they need to
have no safe alternative. Emerging
markets may look attractive but are subject to lots of “other” risk (politics,
potential crises etc.). If the US is
going to offer more attractive interest rates, it will be hard for the Bank of
England to persuade investors to buy British bonds. Of course, a devaluation against the Dollar
might be attractive for some countries: Japan for one might be quite happy as
this will help them generate some of the inflation they want to create. But not the UK. Forget forward guidance? Maybe the markets
already have. Or maybe Mark Carney has something up his sleeve….let’s see how
this continues to evolve over the coming months as tapering (probably) becomes
a reality…Isn’t economics exciting: you never know quite what is going to
happen next…



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