Why have ‘austerity’ failed in the PIGS countries and succeed in Iceland?

Recently both the Italian and the Spanish governments have come out and said that they will have to revise their expectations for their budget deficits in negative direction.

Similarly, there has been renewed budget concerns in Portugal and Greece. Hence, last week IMF chief Christine Lagarde expressed strong reservations about Greece’s ability to achievement its fiscal targets.

So far the markets have reacted fairly calmly to rising concerns about the fiscal situation in particularly Southern Europe, but these concerns nonetheless raises the question whether or not we will see renewed euro zone financial turmoil again soon.

Some are eager to claim that the failure to consolidate public finances in Southern Europe is a lack of effort to do so.

However, the fact is that we have seen significant fiscal tightening in countries like Greece and Spain as illustrated by the graph below (the source is IMF and own calculations for all graphs in this post).

Fiscal tightening PIGS Iceland

What the graph is showing is the accumulative tightening of fiscal policy measured as the sum of yearly changes in structural budget deficit in the PIGS countries (Portugal, Italy, Greece and Spain) as well as Iceland. We use Iceland as an example of austerity in a non-euro country.

The graph clearly shows that particularly Greece has tightening fiscal policy dramatically since 2009-10 and now has tightened fiscal policy by nearly 20% of GDP. We have also seen a dramatic tightening of fiscal policy ins Portugal and Spain (and Iceland), but less so in Italy.

But how about the outcome? Lets look at the development in public debt.

Public debt PIGS Iceland

The outcome surely is depressing. Despite tightening fiscal policy by nearly 20% of GDP since 2009/10 public debt in Greece today is nearly 40%-point higher as share of GDP than at the start of the ‘austerity period’. And it is the same sad story for Portugal, Spain and Italy.

However, if we look at Iceland the story is completely different. Here public debt is nearly 40%-point of GDP lower today than when austerity was initiated in 2010.

So why did Iceland succeed with fiscal austerity while the PIGS have failed? Well, my loyale readers already know the answer – nominal GDP growth. Just take a look at the graph below.

NGDP PIGS Iceland

Greece have been a depression style contraction in nominal GDP and NGDP is today nearly 30% lower than at the start of the crisis in 2008 and for the rest of the PIGS-countries we are essentially at the same nominal GDP level as eight years ago!

But then look at Iceland’s nominal GDP. Despite a total collapse of the Icelandic banking sector in 2008 and a sharp contraction in real GDP in 2008-10 nominal GDP grew through the crisis years (2008-10) and has grown robustly since then. Some – including me – would even argue that NGDP growth in Iceland has been growing too strongly.

So why this difference in NGDP growth between the PIGS and Iceland? Well it is simple – it is all about the monetary policy regime. The PIGS countries are of course euro members and have not seen enough monetary easing to get NGDP growth back to decent levels of 4-5%, which would be comparable to ECB’s 2% inflation target. On the other hand Iceland has seen significant monetary stimulus in the form of a sharp depreciation of the Icelandic króna and a drop in interest rates.

As a result monetary policy has more than offset the negative impact on aggregate demand from fiscal policy in Iceland and this is the real reason for the success of fiscal consolidation in Iceland.

This obviously has not been the case in the PIGS countries, where monetary policy has failed to offset the negative impact on demand from the fiscal austerity measures.

Without monetary easing fiscal woes will continue

This also leads me to the clear conclusion that we are very likely to see a continued increase on public debt-to-GDP ratios in the PIGS countries if the ECB fails to fundamentally and permanently lift NGDP growth in the euro zone to at least 4-5%.

Until that happens the PIGS countries have no other option that to continue to the fiscal austerity measures, but it is very unlikely to succeed for long unless we see a pick up in growth.

Therefore, policy makers in the PIGS countries should rather focus on growth enhancing policies such as cuts in corporate taxation and labour market deregulation and maybe also more immigration rather than on focusing on fiscal austerity. But the most important thing will be for the ECB to end the deflationary pressures in the euro zone economy. A 4% NGDP target accompanied by significant open-ended quantitative easing would do the job.

Unfortunately I have little hope for either reforms in the PIGS countries or a fundamental monetary policy regime change so I continue to think that we could very easily see an other of ‘euro turmoil’ in the coming months.

A framework for understanding Tunisia’s economic crisis

The Arab Spring started in 2010-11 in Tunisia and until now Tunisia has been highlighted as basically the only country, where the Arab Spring has not ended in disaster. Unfortunately over the last couple of days social unrest and violent confrontation between demonstrators and police have erupted across Tunisia.

I this blog post I will have a look at the Tunisian economy and try to give my take on what is wrong with the economy. There is of course a lot of ground to cover and I can naturally not cover it all in one blog post, but I will try provide an overall framework for how to understand the economic situation in Tunisia.

The economy has been in crisis since 2011

A look at real GDP growth in Tunisia shows that the economy essentially has been suffering since the outbreak of the Arab Spring in 2010-11.

tunisia-gdp-growth

Prior to 2011 real GDP growth was averaging 4-5% a year – not very impressive given the high growth rate of the labour force and compared to for example Turkey, but nonetheless fairly robust and stable growth.

However, during the 2011 revolution GDP drop in around 2% and after initially recovering in 2011-12 growth have once against slowed significantly and as a consequence the level of real GDP today is more or less unchanged compared to early 2011.

It is hard not to see the latest social unrest and demonstrations in the light of this lackluster economic performance.

AS/AD – a framework for analyzing the crisis

Whenever I want to analyse the economic situation in any country in the world I find it very useful to start out with a simple AS/AD framework. I particularly like the AS/AD framework described in Tyler Cowen and Alex Tabarrok‘s textbook Modern Principles.

This gives us the possibility to think of three kind of shocks to the economy – An Aggregate Demand (AD) shock (essentially a monetary demand shock), a short-run Aggregate Supply (SRAS) shock and a shock to the long-term growth rate of the economy (this is also supply shock). Cowen and Tabarrok terms the long-term growth rate the Solow growth rate after Robert Solow’s famous growth model.

ASAD framework

We can relatively easily apply this model to the Tunisian economy and by looking at the development in inflation and real GDP we can assess whether the development in the economy is driven by supply shocks or demand (monetary) shocks.

Don’t blame monetary policy for the crisis

If the economy is hit by a negative demand shock – either a contraction in the money supply/base or a drop in money-velocity – the AD curve shifts to the left causing both inflation and real GDP to drop and hence therefore also nominal GDP to drop.

The graph below shows the development in real GDP (y), nominal GDP (y+p) and the GDP deflator (p) in Tunisia.

RGDP NGDP P

The graph shows that over the past 15 years nominal GDP growth has been relatively stable about 8% and even though there was a slowdown in nominal GDP growth in the period 2008-11 we have since seen a rebound in NGDP growth back to the old trend about 8%, which indicates that there has not been a major negative demand shock to the Tunisian economy.

This is further confirmed by the fact that inflation – measured by the GDP deflator – has in fact shifted upwards since 2010-11. If there had been a negative shock to aggregate demand (AD) we would have expected inflation to drop rather than to increase.

This all indicate that the we cannot blame the the present crisis on monetary policy failure and in fact the Tunisian central bank deserves some credit for – knowingly or not – to have kept nominal GDP on a pretty “straight line”, which in my view certainly is the preferable monetary policy.

NGDP trend

This obviously does not mean that monetary policy is perfect – far from it – and I certainly think that monetary reform is badly needed to ensure that monetary policy failure is avoided in the future, but at least over the past 15 years the Tunisian central bank very broadly speaking has got it more or less right.

The biggest risk as I see it now is that the central bank will be tempted to focus on inflation rather than nominal GDP growth and that that might cause the Tunisian central bank to tighten monetary conditions unduly in response to rise inflation caused by non-monetary factors (a negative supply shock).

The best away of avoiding this is to communicate and explicitly target nominal GDP growth at 8% as de facto has been the policy for the past 15 years. Alternatively the central bank could target nominal wage growth as a proxy for NGDP growth.

The real problem is a real problem

As the discussion above slows the main problem in the Tunisian economy right now is not a lack of demand and monetary policy failure cannot be blamed for the marked slowdown in growth particularly since 2011 and the crisis can therefore not be resolved through an easing of monetary conditions.

As a consequence we have to conclude that the problem is one of real factors (the supply side of the economy) rather than nominal factors (monetary conditions).

The question is, however, whether the the slowdown in growth is permanent or temporary. Said in another way has the crisis been caused by a shift to the left of the Short-run Aggregate Supply (SRAS) or is it rather the Solow growth curve, which has shifted to leftwards?

Whether it is the SRAS curve or the Solow growth curve, which has shifted leftwards does matter in terms of the impact on the economy presently, but only a shift in the Solow growth curve should be expected to cause a permanent decline in the long-term growth rate of the Tunisian economy. Below I will argue that it is a bit of both, but that it likely is short-term shocks that has dominated in the last couple of years.

The horrors of terror 

Tunisia has been hard hit by a number of terror attacks in recent years and particularly in 2015 a number of horrible terror attacks hit Tunisia.

One can think of a terror attack both as a demand shock and a supply shock. Hence, it is obvious that a terror attack will tend to scare tourists away and this is certainly also what we have seen.

This obviously is a negative demand shock. However, as we have seen above the Tunisian central bank has more or less kept nominal GDP growth on a 8% growth path. This means that any drop in tourism revenues will be compensated by higher demand growth other places in the economy. This essentially is a version of the so-called Sumner Critique, which says that if a central banks targets nominal GDP or inflation then it will keep aggregate demand growth stable and this will offset other shocks to aggregate demand.

Obviously Tunisian nominal GDP growth has not been completely stable at 8% and we have indeed seen a drop in NGDP growth over the past year, which do indicate some contraction in aggregate demand growth, which could indicate that the Tunisian central bank has not fully offset the shock to aggregate demand from the drop in tourism revenues, however, if the Tunisian central bank – hopefully – continues de facto to target 8% NGDP the effect on aggregate demand from the tourist attacks should prove to be short-lived.

More worryingly is, however, the fact that the threat of new terror attacks and more generally speaking the rise of islamist extremism is causing a more permanent increase in the cost of doing business in Tunisia.

It is hard to quantify just how big these effects are, but it is notable that real GDP slowed from around 2% to 0% during 2015 so the effects have certainly not been small. Whether they are permanent is another question.

The untold story of the ‘Phosphate Crisis’

When I started to think about the slowdown in the Tunisian economy I initially thought that it mostly was about the terror attracts in 2015 and I was unaware of something, which in reality is at least as important – namely what we could term the ‘Phosphate Crisis’.

This is from an article from Al-Monitor from May 2013:

While phosphate is a pillar of the Tunisian economy, it also represents a social time bomb that nearly ousted the regime of former President Zine El Abidine Ben Ali in 2008, when the residents of the mining basin in southwestern Tunisia rose in rebellion, demanding their rights to employment, development and equitable distribution of wealth. Post-2011, protests paralyzing phosphate production became so rampant that the government announced in April the suspension of negotiations with the protesters. It also began a mass media campaign to explain the “phosphate crisis,” stressing these statistics:

The struggles faced by Tunisia’s economy following its 2011 popular uprising have been exacerbated by a decrease in phosphate production, one of the country’s most lucrative resources.
  • Production fell from 8 million metric tons a year to 2.7 million metric tons in 2012.
  • Financial losses reached 3 million dinars ($1.82 million) a day, amounting to a loss of nearly 2 billion dinars ($1.22 billion) in 2011 and 2012.
  • The phosphate company’s workforce tripled from 9,000 to 27,000 workers over the course of three years.

The government even went so far as to threaten to shut down the Gafsa Phosphate Co. The threat baffled [Tunisians], as the company serves as the only operator in mining basin cities and because phosphate is considered a significant source of hard currency in the country. Additionally, the government is currently experiencing several crises of its own, so this sort of escalation would not balance in its favor. Is the threat a political maneuver or an official admission of failure? If the latter is true, does the admission pave the way for the state to give up on “reforms” in the phosphate sector?

Even though the official rhetoric considers the Jan. 14, 2011, Revolution, which toppled Ben Ali, a societal revolution whose flame has been sparked inside the mining sector, all of the post-revolution governments have only shallowly looked into the problem, resulting in the adoption of ineffective administrative solutions.

The government regards the “phosphate crisis” as a mere blip in the flow of production caused by protests that are first and foremost demanding employment. Through the lens of the government, the crisis is temporary, isolated, and related to a lax security and social situation. Some officials even believe that the crisis has “separatist” aspects, and is even a political conspiracy fomented by “extremists who aim to sabotage the economy for political purposes.”

While this is from a 2013 article the crisis continues to this day. Just have a look at this graph of the output in the Tunisian mining sector.

tunisia-gdp-from-mining

Hence, mining output dropped sharply in 2011 and has remained more than 30% lower since then. This obviously is a major negative supply shock to the Tunisian economy and it seems of outmost importance to solve this crisis to get the Tunisian economy out of this crisis.

Corruption is just getting worse and worse

At the core of the protests in 2011 was anger over the widespread corruption in Tunisia and corruption remains a main problem for the Tunisian economy and it is certainly something, which is causing long-term growth to be lower than it could be been (permanently shifting the Solow curve to the left).

The graph below illustrates this.

tunisia-corruption-index@2x

The graph shows Transparency International’s so-called Corruption Perception Index. A lower score in the index indicates more corruption. The development is far from uplifting. In fact of nearly 15 years corruption has been constantly rising in Tunisia as seen by the consistent drop in the Corruption Perception Index.

And the business environment has become less friendly

Another factor that is contributing to shifting the Solow growth curve to the left – permanently lowering real GDP growth – is the fact that despite of the democratic revolution in Tunisia the general business environment has become less friendly.

A way to illustrate this is to look at the World Bank’s Ease of Doing Business survey.

tunisia-ease-of-doing-business@2x

A rise in the index indicates a worsening of the general ‘ease of doing business’ in Tunisia. The picture since 2010 is clear – the business environment has become less friendly in Tunisia. This surely is something, which is lowering Tunisia’s lower term growth potential.

A similarly negative trend is seen in for example Fraser Institute’s Economic Freedom of the World survey, where Tunisia’s overall ranking also have been declining in recent years.

Conclusion – reform is needed to unleash Tunisia’s economic potential

Tunisia is in the midst of a serious political, social and economic crisis. In this blog post I have tried to give an overview of what I believe are the main causes of the economic crisis.

Based on this analysis I would like to offer the following general recommendations for reform and crisis resolution in Tunisia:

  1. Despite the fact that the that Tunisia monetary policy overall has been successful in maintaining nominal stability in the past 15 years monetary reform is needed to ensure that nominal stability is also maintained in the future. A starting point for reform should be to the succes of monetary policy in the past 15 years – that means any new regime should continue to ensure nominal GDP growth around 8%. That would also ensure low and stable inflation in the future.
  2. The threat from terrorism and extremism should to be reduced. That is partly a question of law enforcement, but much more likely it is of outmost importance to empower low-income Tunisians so they to a larger extent are in control of their economic and social destiny and to create economic opportunties for all Tunisians. Other than general economic reform I also think that Tunisians should be given direct ownership of Tunisia’s many government owned companies for example through a Citizen’s account framework.
  3. Bold steps are needed to end the crisis in the Tunisian mining sector. Here privatization of the mining sector should be at the core of these efforts.
  4. Long-term economic growth needs to be increased through massive structural reforms with the purpose to reducing government intervention in the economy and empowering the Tunisian population.

Overall, I think Tunisia has an enormous economic potential – the country has a young and growing population, relatively low public debt, a historical and geographical closeness to (Southern) Europe and by Northern African standards a relatively open economy and access to (some) natural resources.

However, Tunisia cannot unleash this potential without reforms. We have had political revolution – now we need an economic revolution to free up the Tunisian economy.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

Yellen is transforming the US economy into her favourite textbook model

When you read the standard macroeconomic textbook you will be introduced to different macroeconomic models and the characteristics of these models are often described as keynesian and classical/monetarist. In the textbook version it is said that keynesians believe that prices and wages are rigid, while monetarist/classical economist believe wages and prices are fully flexible. This really is nonsense – monetarist economists do NOT argue that prices are fully flexible neither did pre-keynesian classical economists. As a result the textbook dictum between different schools is wrong.

I would instead argue that the key element in understanding the different “scenarios” we talk about in the textbook is differences in monetary regimes. Hence, in my view there are certain monetary policy rules that would make the world look “keynesian”, while other monetary policy rules would make the world look “classical”. As I have stated earlier – No ‘General Theory’ should ignore the monetary policy rule.

The standard example is fixed exchange rates versus floating exchange rates regimes. In a fixed exchange rate regime – with rigid prices and wages – the central bank will use monetary policy to ensure a fixed exchange and hence will not offset any shocks to aggregate demand. As a result a tightening of fiscal policy will cause aggregate demand to drop. This would make the world look “keynesian”.

On the other hand under a floating exchange rate regime with for example inflation targeting (or NGDP targeting) a tightening of fiscal policy will initially cause a drop in aggregate demand, which will cause a drop in inflation expectations, but as the central bank is targeting a fixed rate of inflation it will ease monetary policy to offset the fiscal tightening. This mean that the world becomes “classical”.

We here see that it is not really about price rigidities, but rather about the monetary regime. This also means that when we discuss fiscal multipliers – whether or not fiscal policy has an impact on aggregate demand – it is crucial to understand what monetary policy rule we have.

In this regard it is also very important to understand that the monetary policy rule is not necessarily credible and that markets’ expectations about the monetary policy rule can change over time as a result of the actions and communication of the central and that that will cause the ‘functioning’ the economy to change. Hence, we can imagine that one day the economy is “classical” (and stable) and the next day the economy becomes “keynesian” (and unstable).

Yellen is a keynesian – unfortunately

I fear that what is happening right now in the US economy is that we are moving from a “classical” world – where the Federal Reserve was following a fairly well-defined rule (the Bernanke-Evans rule) and was using a fairly well-defined (though not optimal) monetary policy instrument (money base control) – and to a much less rule based monetary policy regime where first of all the target for monetary policy is changing and equally important that the Fed’s monetary policy instrument is changing.

When I listen to Janet Yellen speak it leaves me with the impression of a 1970s style keynesian who strongly believes that inflation is not a monetary phenomena, but rather is a result of a Phillips curve relationship where lower unemployment will cause wage inflation, which in turn will cause price inflation.

It is also clear that Yellen is extraordinarily uncomfortable about thinking about monetary policy in terms of money creation (money base control) and only think of monetary policy in terms of controlling the interest rate. And finally Yellen is essentially telling us that she (and the Fed) are better at forecasting than the markets as she continues to downplay in the importance of the fact that inflation expectations have dropped markedly recently.

This is very different from the views of Ben Bernanke who at least at the end of his term as Fed chairman left the impression that he was conducting monetary policy within a fairly well-defined framework, which included a clear commitment to offset shocks to aggregate demand. As a result the Bernanke ensured that the US economy – like during the Great Moderation – basically became “classical”. That was best illustrated during the “fiscal cliff”-episode in 2013 where major fiscal tightening did not cause the contraction in the US economy forecasted by keynesians like Paul Krugman.

However, as a result of Yellen’s much less rule based approach to monetary policy I am beginning to think that if we where to have a fiscal cliff style event today (it could for example be a Chinese meltdown) then the outcome would be a lot less benign than in 2011.

How a negative shock would play with Yellen in charge of the Fed

Imagine that the situation in China continues to deteriorate and develop into a significant downturn for the Chinese economy. How should we expect the Yellen-fed to react? First of all a “China shock” would be visible in lower market inflation expectations. However, Yellen would likely ignore that.

She has already told us she doesn’t really trust the market to tell us about future inflation. Instead Yellen would focus on the US labour market and since the labour market is a notoriously lagging indicator the labour market would tell her that everything is fine – even after the shock hit. As a result she would likely not move in terms of monetary policy before the shock would show up in the unemployment data.

Furthermore, Yellen would also be a lot less willing than Bernanke was to use money base control as the monetary policy instrument and rather use the interest rate as the monetary policy instrument. Given the fact that we are presently basically stuck at the Zero Lower Bound Yellen would likely conclude that she really couldn’t do much about the shock and instead argue that fiscal policy should be use to offset the “China shock”.

All this means that we now have introduced a new “rigidity” in the US economy. It is a “rigidity” in the Fed monetary policy rule, which means that monetary policy will not offset negative shocks to US aggregate demand.

If the market realizes this – and I believe that is actually what might be happening right now – then the financial markets might not work as the stabilizing factoring in the US economy that it was in 2013 during the fiscal cliff-event and as a result the US economy is becoming more “keynesian” and therefore also a less stable US economy.

Only a 50% keynesian economy

However, Yellen’s economy is only a 50% keynesian economy. Hence, imagine instead of a negative “China shock” we had a major easing of US fiscal policy, which would cause US aggregate demand to pick up sharply. Once that would cause US unemployment to drop Yellen would move to hike interest rates. Obviously the markets would realize this once the fiscal easing would be announced and as a result the pick up in aggregate demand would be offset by the expected monetary tightening, which would be visible in a stronger dollar, a flattening of the yield curve and a drop in equity prices.

In that sense the fiscal multiplier would be zero when fiscal policy is eased, but it would be positive when fiscal policy is tightened.

What Yellen should do 

I am concerned that Yellen’s old-school keynesian approach to monetary policy – adaptive expectations, the Phillips curve and reliance of interest rates as a policy instrument – is introducing a lot more instability in the US economy and might move us away from the nominal stability that Bernanke (finally) was able to ensure towards the end of his terms as Fed chairman.

But it don’t have to be like that. Here is what I would recommend that Yellen should do:

Introduce a clear target for monetary policy

  • Since Mid-2009 US nominal GDP has grown along a nearly straight 4% path (see here). Yellen should make that official policy as this likely also would ensure inflation close to 2% and overall stable demand growth, which would mean that shocks to aggregate demand “automatically” would be offset. It would so to speak make the US economy “classical” and stable.

Make monetary policy forward-looking

  • Instead of focusing on labour conditions and a backward-looking Phillips curve Yellen should focus on forward-looking indicators. The best thing would obviously be to look at market indicators for nominal GDP growth, but as we do not have those at least the Fed should focus on market expectations for inflation combined with surveys of future nominal GDP growth. The Fed should completely give up making its own forecasts and particularly the idea that FOMC members are making forecasts for the US economy seems to be counter-productive (today FOMC members make up their minds about what they want to do and then make a forecast to fit that decision).

Forget about interest rates – monetary policy is about money base control

  • With interest rates essentially stuck at the Zero Lower Bound it becomes impossible to ease monetary policy by using the interest rate “instrument”. In fact interest rates can never really be an “instrument”. It can be a way of communicating, but the actual monetary policy instrument will alway be the money base, which is under the full control of the Federal Reserve. It is about time that the Fed stop talking about money base control in discretionary terms (as QE1, QE2 etc.) and instead start to talk about setting a target for money base growth to hit the ultimate target of monetary policy (4% NGDP level targeting) and let interest rates be fully market determined.

I am not optimistic that the Fed is likely to move in this direction anytime soon and rather I fear that monetary policy is set to become even more discretionary and that the downside risks to the US economy has increased as Yellen’s communication is making it less likely that the markets will trust her to offset negative shocks to the US economy. The Keynesians got what they asked for – a keynesian economy.

PS I have earlier had a similar discussion regarding the euro zone. See here. That post was very much inspired by Brad Delong and Larry Summers’ paper Fiscal Policy in a Depressed Economy.

PPS I would also blame Stanley Fischer – who I regret to say thought would make a good Fed chairman – for a lot of what is happening right now. While Stanley Fischer was the governor of the Bank of Israel he was essentially a NGDP targeting central banker, but now he seems preoccupied with “macroprudential” analysis, which is causing him to advocate monetary tightening at a time where the US economy does not need it.

PPPS I realize that my characterization of Janet Yellen partly is a caricature, but relative to Ben Bernanke and in terms of what this means for market expectations I believe the characterization is fair.

If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: roz@specialistspeakers.com. For US readers note that I will be “touring” the US in the end of October.

Rational Partisan Theory, elections, fiscal consolidation and exchange rate determination

When I was in university more than 20 years ago I had one other major interest other than monetary economics and that was public choice theory and I was particularly interested in how to understand macro economic issues through the use of public choice theory.

I particularly remember writing a paper on Political Business Cycle (PBC) theory and at some point I was even considering writing my master thesis on this topic. I instead ended up writing about Austrian Business Cycle theory – partly because I had grown somewhat disillusioned with the theoretical and particularly the empirical aspects of PBC (paradoxically enough writing my Master thesis had a similar impact in terms of leaving me utterly disillusioned with Austrian school macroeconomics).

At the core of my problems with the state of Political Business Cycle theory (at the time) was that even though I essentially was attracted to the traditional PBC model (as originally formulated by William Nordhaus in his is 1975 article “The Political Business Cycle” in Review of Economic Studies) I found that even though I liked to think of policy makers as somebody who try to maximize their power, influence and votes through distorting the macroeconomy I had (huge) problems with the macroeconomic framework – 1970s “Keynesian ” macro models – Nordhaus and other early PBC pioneers used.    

Hence, I might have liked the general political-economic ideas in the early PBC models, but I didn’t think that the macroeconomics of these models made much sense. At the core of this problem is of course that if it is so obvious that governments will ease fiscal (and monetary) policy ahead of elections to spur growth why is it that the agents in the economy (employers, investors, consumers and labour unions) does not realize this in advance? Anybody who had studied rational expectation theory of any kind would find it hard to believe that one systematically would be able to cheat labour unions into accepting lower real wages ahead of elections.

Said in another way if you introduce forward-looking agents in your models the Nordhaus style PBC models simply will not work. This of course in the late 1980s and early 1990s led to the development of models of the political business cycle that took into account the forward-looking behavior of economic agents. Most famously Alberto Alesina wrote a number of very influential articles on what have come to be known as Rational Partisan Theory (RPT).

In RPT models we essentially assume that we have a New Keynesian Phillips Curve and agents form rational expectations about what macroeconomic policy (the level of inflation) we will have after the election. What causes the political business cycle is essentially “election surprises”.

Let me illustrate it. We assume we have two political parties. The first party (“right”) favours a macroeconomic policy that will ensure 2% inflation, while the other party (“left”) favours 4% inflation. Lets then assume that the “left” paty is in power and delivers 4% inflation in period t, but that we will have general elections in period t+1 and that there is a 50/50 chance which party win the election. That means that the rational and risk-neutral economic agent would expect on average 3% inflation in t+1.

That would mean that even though the left government delivers 4% inflation labour unions will negotiate wage contracts on an assumption of 3% inflation (rather than 4%). This will cause a drop in unemployment after the elections if the left party wins as we will get an upside surprise on inflation, which causes real wages to drop. On the other hand if the right party wins it will deliver lower (2%) inflation than expected (3%), which will cause an increase in real wages and cause employment to drop.

I must say that I always found the Rational Partisan Theory extremely interesting and I believe that Alesina’s models (and other similar models) move thinking about Political Business Cycles forward compared to the economically naive models of William Nordhaus. However, other being based o somewhat of a caricature of the “left” and the “right” I early on realized that there was one major problem with Alesina’s models and that was the way they complete lack any proper discussion of monetary policy rules.

Thinking about Rational Partisan Theory without ignoring the Sumner Critique  

A the core of the problem with the early RPT models was that they essentially ignored the so-called Sumner Critique. What Scott Sumner is saying is that if we have a central bank that for example targets 2% inflation then the budget multiplier is zero. Hence, if a “left” government eases fiscal policy to push up inflation to 4% then the central bank – given its mandate to deliver 2% – would simply tighten monetary policy to offset the impact of the fiscal easing on aggregate demand so to ensure 2% inflation.

Hence, if the central bank is fully credible the rational economic agent would always expect 2% inflation in t+1 no matter who would win the elections. This of course means that there might be elections surprises, but there wouldn’t be any inflation surprises.

Furthermore, if the government is not able to set inflation (as the central bank has the final word on aggregate demand and inflation) then there would essentially not be any reason why left and right should difference on this issue. Why would a left party ease fiscal policy when it would know that it would just be overruled by the central bank?

So in my view what we need is essentially a Rational Partisan Theory that takes the monetary policy rule into account and takes into account whether this policy rule is credible or not because if the the policy rule is not credible at all then we are back to the Alesina model. On the other hand under a credible policy rule the dynamics in the model is completely different than in the early Alesina models.

Similarly it is not unimportant what kind of policy rule we have. Take the example of Denmark and Sweden. In Denmark we have a fixed exchange rate policy, which means that the Sumner Critique does not necessarily apply – fiscal easing might increase aggregate demand and inflation – while in Sweden where the Riksbank has an mandate to ensure 2% it is more likely that we will have “monetary offset” of fiscal easing.

This means that if we want to test Rational Partisan Theory we could do it by comparing the development in countries with different monetary policy rules. Similarly – and this I think is highly important – we need to look at financial market developments rather than macroeconomic developments.

Exchange rates and Rational Partisan Theory  

This brings me to what really has caused me to write this blog post. This morning I had a talk with a colleague about how parliament elections could impact exchange rates and as we where talking I realized that the view presented by my colleague essentially was a Rational Partisan Theory model in an economy with a floating exchange rate and an independent and credible inflation targeting central bank.

I want to sketch that model here and what we are interested in is figuring out is how elections influence the exchange rate development ahead of and after elections.

As we assume that the central bank has a credible inflation target – accepted by the two parties (left and right) – it makes little sense to think of different political preferences for inflation. Instead I think we should think of the economic-political differences between “left” and “right” as the “ideological” view of fiscal consolidation.

So we start out in a situation where there is a budget deficit. Both parties acknowledge the problem and see a need for fiscal consolidation. However, the two parties disagree on the speed of consolidation. The “right” party favours “shock therapy” to reduce the public deficit, while the “left” party favours slower consolidation of public finances.

I would here have to make an assumption because one could rightly question why the left would favour slow consolidation even though it should know that fast consolidation would not impact aggregate demand (and employment) negatively as e would have full monetary offset if the central bank is serious about achieving its inflation target.

My way out of this problem would be to assume that differences in policy does not reflect difference in preferences regarding the macroeconomic outcome, but there a need to signal a certain general attitude. Hence, we could argue that by arguing for slower fiscal consolidation the “left” party signals are more “socially balanced” fiscal policy, while by advocating “shock therapy” the “right” party would signal more “economic responsibility”.

So now we have our “model”: Floating exchange rates, a fully credible inflation targeting central bank and two political parties who differs over the desired speed of fiscal consolidation.

Lets now try to “simulate” the “model”.

A Scenario: Right party in power, right party is re-elected 

In this scenario we have a “tight” fiscal stance in period t. To offset the impact of inflation and aggregate demand we have a similar easy monetary stance. However, the valuation of the currency – whether it is “strong” or “weak” would depend on the expectation for the future monetary and fiscal stance.

If we a 50/50 chance of a left or right party win then the rational risk-neutral economic agent would expect a “neutral” fiscal stance (somewhere between “tight” and “ease” and that would mean we would expect a monetary policy that would also be “neutral”.

However, the day after the elections we would know who had won and if the right party win we now (assume) that we will get a more aggressive fiscal consolidation than if the “left” had won. As a consequence on the day the election result shows a “right” party win the currency should drop. The scale of the depreciation will dependent on the electoral surprise. If it is a major surprise then the currency move will be bigger.

Similarly if we have a “left” party wins we should expect to see the currency strengthen.

These results might seem counterintuitive to some thing that “isn’t fiscal consolidation great so shouldn’t it led to a strengthening of the currency?”. Well maybe, if you think of on the impact on the real exchange rate and we can easily think of a situation where swift fiscal consolidation leads to a real appreciation of the currency, but given the central bank is independent and committed to its inflation target the central bank will not allow any real appreciation pressures to led to nominal appreciation as this would undermine the inflation target.

We can therefore also use this this knowledge to think of the impact on other asset markets – for example the property market or the stock market. Without going into detail this kind of model would tell us that a “right” party win would cause stock prices to rally on the back of increased expectations for monetary easing.

Political Business Cycle theorists should focus on money and markets

This leads me to my conclusion: I believe that a lot of insight about Political Business Cycles (and business cycles in general) can be learned by starting out with an Alesina style model, but we need to incorporate monetary policy rules into the models.

Furthermore, while we probably can learn something of empirical relevance by looking at macroeconomic data I believe it would be much more fruitful to study the impact on asset markets – including currency and equity markets – to understand the Political Business Cycle. The advantage of using financial markets data rather than traditional macroeconomic data is obviously the forward-looking nature of financial markets.

Furthermore, we have well-developed prediction markets (such as Hypermind) for political events such as elections, which provide minute-by-minute or day-by-day odds on different political outcomes. Hence, we could imagine that the prediction market is telling on a daily basis whether the “left” or the “right” candidate will win. We can then test the impact of changes in these odds on the exchange rate (controlling for other factors).

This would be a simple way of test the kind of RPT-based exchange rate model I have sketched above and it would at the same time be a test of Rational Partisan Theory itself.

I am not saying that such literature does not exist, however, I am aware of very few studies that ventures down this road. So I hope this blog post can inspire somebody to do proper theoretical and empirical research based on such thinking.

———

UPDATE: Mike Belongia kindly sent me a new paper by Yoshito Funashima on “The Fed-Induced Political Business Cycle”. I have read the paper yet but it surely looks very interesting – and the abstract reminded me that Nixon was a crook and Arthur Burns was a failed central banker

Here the abstract from Funashima’s paper:

Given that Nordhaus’ political business cycle theory is relevant at election cycle frequency and that its validity can change over time, we consider wavelet analysis especially suited to test the theory. For the postwar U.S. economy, we exploit wavelet methods to demonstrate whether there actually exists an opportunistic political business cycle in monetary policy by allowing for time-varying behavior and by introducing the frequencydomain perspective. Our results indicate an inclination of the Federal Reserve to cut the Funds rate prior to presidential elections except for the 1990s. Moreover, such political manipulation is shown to signifi- cantly affect output in not only the famous Burns–Nixon era but also the Volcker–Reagan era. The outcomes are robust even when the effects of government spending are controlled for.

Belka-gate – the Polish version of the Sumner Critique?

A key Market Monetarist insight (it is New Keynesian insight as well…) is that budget multiplier is zero if the central bank says it is so. Or rather it the central bank targets inflation, the price level or nominal GDP then the central and will offset any shock – positive or negative – to nominal spending (aggregate demand) from changes in fiscal policy.

This means that the central bank – rather than the ministry of finance – has the full control of aggregate demand in the economy. No matter what the government does with fiscal policy the central bank has the instruments to fully offset this. This is the so-called Sumner Critique.

A major scandal involving the Polish central bank governor Marek Belka that has developed over the last couple of days is a powerful illustration of the Sumner Critique.

This is from Reuters:

A Polish magazine said on Saturday it had a recording of a private conversation in which the central bank chief told a minister the bank would be willing to help rescue the government from economic troubles on condition the finance minister was removed.

The weekly Wprost news magazine said it had a recording of a meeting in a Warsaw restaurant last July between central bank governor Marek Belka and Interior Minister Bartlomiej Sienkiewicz. It did not say who recorded their conversation, or how it had obtained the recording.

According to extracts of the audio recording posted on the Internet by the magazine, which have been heard by Reuters reporters, and were also emailed to Reuters by Wprost in transcript form, the minister sets out a possible future scenario in which the government could not meet its financial commitments and faced election defeat.

The man identified in the transcript as Sienkiewicz refers in vague terms to monetary policy action carried out elsewhere in Europe – an apparent reference to central bank stimulus.

“Is that precisely the moment for launching this sort of solution, or not?” Sienkiewicz asks Belka.

Belka replies, according to the transcript: “My condition would be the removal of the finance minister.”

The finance minister at the time, Jacek Rostowski, was removed last November as part of a cabinet reshuffle.

There you go. Central bankers have the power to control nominal spending in the economy. They might even have the power to have finance ministers removed. Never ignore the Sumner Critique.

PS the Polish central bank has said that the recordings are authentic, but that they have been manipulated and that Belka’s comments regarding the removal of the Finance Minister were taken out of context.

PPS It has been – and still is – my view that Polish monetary policy has been far too tight since early 2012. Maybe an explanation to the overly tight stance could be – and I am speculating – dissatisfaction with the Polish government’s fiscal stance.

PPPS for game theoretical based discussion of the Sumner Critique see my earlier posts here and here.

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No ‘General Theory’ should ignore the monetary policy rule

John Maynard Keynes famously titled his magnus opus from 1936 The General Theory of Employment, Interest and Money. However, General Theory, as it is generally known, is nothing of the kind. It is not a General Theory of macroeconomics – rather it is a specific theory of macroeconomics making very specific assumptions about the workings of the economy and I will argue here that Keynes made very specific assumptions particularly about the monetary policy regime or rule under which the economy operates.

Keynes most likely realised that he had made these assumptions, but later generations of Keynesians – particular from the 1950s to the early 1990s “forgot” that General Theory and the general macroeconomic of implications of it was fully dependent on the fundamental assumptions in General Theory about the monetary policy regime/rule.

When I took my first macroeconomic lessons at the University of Copenhagen in the early 1990s the first model we where introduced to was a rudimentary Keynesian model – the so-called 45-degree model or the Keynesian cross. It was basically said that the model was what Keynes was thinking about in General Theory and I would still agree that this simple model basically captures what Keynes was saying in General Theory about aggregate demand.

When I was taught this rudimentary Keynesian economics we were told that Keynes assumed that prices are sticky and this was what really was the difference between Keynes and the so-called Classics (economists before the Keynesian revolution). We today know that Keynes’ claim the “Classics” (Keynes’ term) did in fact not assume that prices and wages are fully flexible, but this is less important for what I want to discuss here. However, the focus on whether prices are sticky or not took away focus from what in my view is a core assumption Keynes makes and, which economists today continue to make and that is that the economy is essentially operating on a monetary standard similar to the gold standard or a fixed exchange rate regime.

When I was taught the Keynesian cross we where told that there was no money in the model – or at least that we ignored it. No big deal was made of it and there was no discussion about whether this was important or not. Now more than two decades later I think that economics students around the world generally are introduced to macroeconomics in the exact same way. We start out with the Keynesian cross, but students are not told that this starting point makes a clear – untold – assumption about the monetary policy regime.

Hence, the case it not that there is no money in the rudimentary Keynesian model, but rather that the supply of money (base money) was determined by a gold standard-like rule. However, this was never discussed when I took my first macroeconomic lessons – and I suspect this still is the norm around the world.

What I here will argue is that if Keynes instead had set out to write a truly General Theory, where he would have discussed the importance of different monetary policy rules then it would indeed have been a General Theory rather than a Theory of a Specific Monetary Regime (the gold standard). Rather what Keynes discusses in General Theory is how the macroeconomic situation looks like in a variation of the gold standard. He was in fact formulating a model for the British economy in 1930 or so. In that regard it is also notable that even though Keynes had called the gold standard a barbaric relic he argued against Britain giving up the gold standard and he seemed to continue to think of the British economy (and any other economy in the world) as operating on a gold standard-like monetary regime long after the gold standard had been given up around the world. He was of course instrumental in setting up the post-War Bretton Wood system, which introduced a global system of fixed – but adjustable – exchange rates. Thereby ensuring that his “model” of the economy still could be said to be “right”.

Yes, he was assuming that prices and wages where sticky, but that was not the crucial assumption. The crucial assumption was his assumption about the monetary policy regime.

A rudimentary Keynesian model with NGDP targeting    

We can illustrate this by accepting Keynes’ assumption that prices are not just sticky, but completely fixed (at least in the short-run). We can illustrate that in an AS/AD framework by claiming that that the AS curve is horizontal. This means that no matter what level of aggregate demand (AD) we have in the economy the price level will remain unchanged.

The graph below illustrates this.

Keynesian ASAD

Lets say some “animal spirits” causes investments to collapse (this was essential Keynes’ explanation for the Great Depression). The AD curve shifts to the left causing real GDP to drop to Y’ from Y. As the AS curve is completely flat nothing happens to prices. This is essentially what we have in the rudimentary Keynesian model.

But what have we assumed about monetary policy? Well, we have assumed that the money supply/base is fixed. No matter what happens to the economy the money base is just kept unchanged. This is of course what you (more or less) have under a gold standard.

But what if we had another monetary policy rule – for example a rule to keep nominal GDP (nominal spending) constant. This would mean that the central bank would change the money base to keep P*Y constant. Again lets illustrate this within an AS/AD framework and note that we maintain the assumption of completely fixed prices (a horizontal AS curve).

Keynesian ASAD NGDP rule

Here again the AD initially drops for example because some animal spirits cause aggregate demand to drop (1). However, this would cause nominal GDP (P*Y) to drop and as the central bank operates an NGDP target rule it would automatically increase the money base until the AD curve has been push back to the starting point (2).

So even if we assume completely fixed prices the world looks as if it is “Classic”. We will always be at the “full employment” level of real and nominal GDP.

This also illustrates that it was not enough for Keynes to assume that prices are sticky (not a very heroic assumption for the short-run and most “Classic” economists in fact agreed with that assumption), but he also had to make an assumption that the money base was fixed and all his results breakdown if another assumption about the monetary policy regime is introduced.

This of course also illustrate that Keynes’ famous fiscal multiplier and his argument that fiscal policy can (and should) boost aggregate demand are crucially dependent on assuming a gold standard style monetary policy regime. Hence, the graph above illustrates that even if prices are fixed the fiscal multiplier will be zero under an NGDP targeting regime. This is what we today know as the Sumner Critique.

Obviously it was completely natural to assume that the economy was operating within a gold standard when Keynes wrote the General Theory. However, his insistence on focusing on fiscal policy and ignoring the monetary policy regime for decades caused macroeconomic discourse to be side-tracked. Had he instead argued that his results were crucially dependent on the monetary policy regime then he would truly have written a General Theory and the debate could have been shifted to a discussion about the monetary regime.

Keynes was of course right that the gold standard was barbaric relic, but he failed to understand that the Great Depression was not caused by animal spirits, but was a direct result of this barbaric relic. Instead Keynes argued against Britain giving up the gold standard and instead argued for major public works programs. This is what he tried to justify in his General Theory.

For decades after the publication of General Theory macroeconomists around the world adopted Keynes’ reasoning without realising that Keynes’ core policy recommendations were based on an assumption that we remained on a gold standard. Unfortunately most of today’s macroeconomists continue to ignore the crucial importance of what monetary policy regime we operate under.

The straw men – vertical AS curve and the vertical LM curve   

Going back to my university days again. Following the induction of the rudimentary Keynesian model and the introduction of the famous definition of aggregate demand as Y=G+I+C+X-M we where taught that there of course where other schools of thought.

However, it was never emphasised that we basically all through remained more or less ignorant about the importance of monetary policy rules. Hence, instead the discussion instead focused on two other topics. First, whether prices and wages indeed were fixed/sticky or not. Second what assumptions we should make about the interest rate elasticity of money demand and investments.

This boiled down to two “extreme” assumptions in first the AS/AD model (in a Keynesian variant) and in the IS/LM model. First we where told that if we assumed prices where fully flexible then the AS curve would be vertical and that would mean that fiscal policy (and monetary policy) would never be able to increase real GDP and any fiscal or monetary “stimulus” would just cause inflation to increase. This was called – and still is in most mainstream macroeconomic textbook – the Classical position. This very obviously is a misnomer, which we should blame Keynes for. Hence, most pre-Keynesian “Classical” economists did indeed not assume fully flexible wages and prices. Furthermore, the extreme Keynesian position was exactly unrealistic as everybody can see that real-world prices change all the time. Something which rarely where noted when I took my macroeconomic lessons at the University of Copenhagen in the early 1990s.

It was easy for our professors to dismiss the assumption about fully flexible price. Just look out the window. There are lot of wage contracts and “menu costs” etc., which cause prices to become sticky. Hence, the world was essentially Keynesian. The fiscal multiplier was of course positive – or that is how the argument when. It was enough to show to prices are not fully flexible to argue that we where in a Keynesian world.

When discussing the IS/LM model we again were introduced to an extreme position. The position was that the level of interest rates did have no impact on the demand for money, which would cause the LM-curve to become vertical. This was termed the “monetarist” position. This assumption was harder for our professors to dismiss than the assumption of fully flexible prices, but they could nonetheless come up with graphs for different countries that showed a fairly clear negative relationship between the interest rate level and real money balances (M/P).

So my professors concluded that of neither the AS curve nor LM curve where vertical in the real world because prices are not fully flexible and of course the demand for money depend on the level of interest rates so even though our assumptions in the rudimentary Keynesian model were a bit heroic the fundamental conclusions would still hold. The world was Keynesian and fiscal multiplier was positive.

However, as with the rudimentary Keynesian model in these more “advanced” models we essentially maintained the assumption that the supply of money was fixed. The monetary policy rule essentially was a fixed exchange rate or a gold standard. This was never really stated clearly and I am sure that most of my professors never realized just how important this assumption was for the results that they presented to their students and I suspect that this remains the case for most economic professors around the world today.

A Sketch for a simple (alternative) General Theory

If Keynes really had wanted to formulated a General Theory he in my view should have started out with an AS/AD framework and then discussed the macroeconomic outcome under different assumptions of prices “stickiness” AND the monetary policy rule.

I will now try to sketch an alternative General Theory, which basically encompasses all of the “normal” models, which students are introduced to in their intermediate macroeconomic lessons.

The first model is the rudimentary Keynesian model. As my graph above illustrates we get Keynesian results if we assume that prices are sticky (or completely) fixed only if we also assumes that the money stock is “sticky” or fixed – i.e. if we are in a gold standard/fixed exchange rate world.

This “model” probably is fairly useful in understanding the short-term economic developments in countries like Denmark, which operates a pegged exchange rate regime (a peg to the euro) or for a country like the Netherland, which is a member of a currency union (the euro area). It should, however, be noted that we in this world has made a similar problematic assumption. We have ignored the public budget constraint. Keynes did that as well, but it would probably be quite wrong when analysing the present day Greek economy to ignore the budget constrain (while we probably easily could ignore it in the case of Denmark or the Netherlands). So yes, in the case of Denmark, Netherland or Greece the fiscal multiplier might indeed be positive, but in the case of Greece the Greek government cannot afford utilizing this fact.

However, the rudimentary Keynesian model will provide us with very little inside for countries with explicit inflation targets such as Sweden, Canada or Australia. Here the central banks set the money base – and as a consequence the AD curve – to ensure that a certain inflation target is hit. In this world the fiscal multiplier is zero. This would mean that the world looks as if it is “Classic” or “monetarist” (in the textbook lingo). This would even be the case if we assume that prices are completely fixed. This is more or less similar to the second graph above (the NGDP targeting case).

Note this is course not because Swedish prices are more flexible than Danish prices, but because of differences in the monetary policy regime. Paradoxically enough both Danish and Swedish economics students still to this day are introduced to macroeconomics starting with the rudimentary Keynesian model. Rarely (I think) is there made in reference to the importance of the monetary policy regime in the two countries.

When I was at university in the early 1990s the new hot thing in macroeconomics was the so-called Real Business Cycle model. The RBC models were a real break with Keynesian thinking as RBC theorists like Nobel Prize winner Edward Prescott argued that the business cycle essentially was driven by supply shocks rather than demand shocks.

I remember thinking at the time that the idea that the primary cause of business cycles was supply shocks was crazy. As did most other students and professors, but it was mathematically an impressive set-up, which caused some interesting among students and professors and I was personally equally attracted the RBC theorists insistence on having a proper microeconomic foundation for macroeconomics.

However, today even though I am rather sceptical about the empirical relevance of RBC models I most say that the RBC model would likely be the best model to descript the economic development under a “perfect” NGDP targeting regime. Again it is about the monetary policy. Something RBC theorist in a similar fashion as Keynesian before completely ignored. Instead early RBC theorist made rather bizarre assumptions about price and wage flexibility that seemed to live up to live up to Keynes’ caricature of the “Classical” economists.

Anyway, if we in an AS/AD framework assume that the central bank has a nominal GDP target then it becomes obvious that all the ups and downs in economic activity will be a result of supply shocks. Hence, all shocks to demand will be “neutralized” or offset by the monetary policy rule to keep aggregate demand fixed (or fixed around a steady growth path). There will be no aggregate demand shocks. We can get shocks to the composition of aggregate demand, but the fiscal multiplier is zero and even if we assume that investments are determined by irrational and crazy animal spirits aggregate demand will grow at a steady fixed rate.

Hence, under “perfect” NGDP targeting the world would look as if the RBC model is right. This is not because demand shock can’t influence the economy, but because monetary policy ensures that that will not be the case.

Conclusion: The crucial assumption is about the monetary regime

I hope to have demonstrated above that the crucial assumption we make in macroeconomic models is not primarily the assumptions about prices flexibility or interest rate elasticities as macroeconomic students still are taught, but the assumption about the monetary policy regime.

Hence, some real world economies look “Keynesian”, while other looks “Classic” and other look like RBC economies – even if we assume the same level of price stickiness.

It is the monetary policy regime stupid!

Related posts:

How I would like to teach Econ 101
The fiscal cliff and the Bernanke-Evans rule in a simple static IS/LM model
Daniel Lin is teaching macro! Lets introduce his students to the IS/LM+ model

The “Weidmann rule” and the asymmetrical budget multiplier (is the euro zone 50% keynesian?)

During Christmas and New Years I have been able to (nearly) not think about monetary policy and economics, but I nonetheless came across some comments from Bundesbank chief Jens Weidmann from last week, which made me think about the connection between monetary policy rules and fiscal austerity in the euro zone. I will try address these issues in this post.  

This is Jens Weidmann:

“The euro zone is recovering only gradually from the harshest economic crisis in the post-war period and there are few price risks. This justifies the low interest rate…Low price pressure however cannot be a licence for arbitrary monetary easing and we must be sure to raise rates at the right time should inflation pressure mount.”

It is the second part of the quote, which is interesting. Here Weidmann basically spells out his preferred reaction function for the ECB and what he is saying is that he bascially wants an asymmetrical monetary policy rule – when inflation drops below the ECB’s 2% inflation target the ECB should not “arbitrary” cut its key policy rate, but when inflation pressures increase he wants the ECB to act imitiately.

It is not given that the ECB actually has such a policy rule, but given the enormous influence of the Bundesbank on ECB policy making it is probably reasonable to assume that that is the case. That in my view would mean that Summer Critique does not apply (fully) to the euro zone and as a result we can think of the euro zone as being at least 50% “keynesian” in the sense that fiscal shocks will not be fully offset by monetary policy. As a result it would be wrong to assume that the budget multiplier is zero in the euro zone – or rather it is not always zero. The budget multiplier is asymmetrical.

Let me try to illustrate this within a simple AS/AD framework.

First we start out with a symmetrical policy rule – an inflation targeting ECB. Our starting point is a situation where inflation is at 2% – the ECB’s official inflation target – and the ECB will move to offset any shock (positive and negative) to aggregate demand to keep inflation (expectations) at 2%. The graph below illustrates this.

ASAD AD shock

If the euro zone economy is hit by a negative demand shock in the form of for example fiscal tightening across the currency union the AD curve inititally shifts to the left (from AD to AD’). This will push inflation below the ECB’s 2% inflation target. As this happens the ECB will automatically move to offset this shock by easing monetary policy. This will shift the AD curve back (from AD’ to AD). With a credible monetary policy rule the markets would probably do most of the lifting.

The Weidmann rule – asymmetry rules

However, the Weidmann rule as formulated above is not symmetrical. In Weidmann’s world a negative shock to aggregate demand – for example fiscal tightening – will not automatically be offset by monetary policy. Hence, in the graph above the negative shock aggregate demand (from AD to AD’) will just lead to a drop in real GDP growth and in inflation to below 2%. Given the ECB’s official 2% would imply the ECB should move to offset the negative AD shock, but that is not the case under the Weidmann rule. Hence, under the Weidmann rule a tightening of fiscal policy will lead to drop in aggregate demand. This means that the fiscal multiplier is positive, but only when the fiscal shock is negative.

This means that the Sumner Critique does not hold under the Weidman rule. Fiscal consolidation will indeed have a negative impact on aggregate demand (nominal spending). In that sense the keynesians are right – fiscal consolidation in the euro zone has likely had an negative impact on euro zone growth if the ECB consistently has followed a Weidmann rule. Whether that is the case or not is ultimately an empirical question, but I must admit that I increasingly think that that is the case. The austerity drive in the euro zone has likely been deflationary. However, it is important to note that this is only so because of the conduct of monetary policy in the euro area. Had the ECB instead had an fed style Evans rule with a symmetrical policy rule then the Sumner Critique would have applied also for the euro area.

The fact that the budget multiplier is positive could be seen as an argument against fiscal austerity in the euro zone. However, interestingly enough it is not an argument for fiscal stimulus.  Hence, according to Jens Weidmann the ECB “must be sure to raise rates at the right time should inflation pressure mount”. Said in another way if the AD curve shifts to the right – increasing inflation and real GDP growth then the ECB should offset this with higher interest rates even when inflation is below the ECB’s 2% inflation target.

This means that there is full monetary offset if fiscal policy is eased. Therefore the Sumner Critique applies under fiscal easing and the budget multiplier is zero.

The Weidmann rule guarantees deflation 

Concluding, with the Weidmann rule fiscal tightening will be deflationary – inflation will drop as will real GDP growth. But fiscal stimulus will not increase aggregate demand. The result of this is that if we assume the shocks to aggregate demand are equally distributed between positive and negative demand shocks the consequence will be that we over time will see the difference between nominal GDP in the US and the euro become larger and larger exactly because the fed has a symmetrical monetary policy rule (the Evans rule), while the ECB has a asymmetrical monetary policy rule (the Weidmann rule).

This is of course exactly what we have seen over the past five years. But don’t blame fiscal austerity – blame the Weidmann rule.

NGDP euro zone USA

PS I should really acknowledge that this is a variation over a theme stressed by Larry Summers and Brad Delong in their paper Fiscal Policy in a Depressed Economy. See my discussion of that paper here.

Ignore the shutdown

Market Monetarists have a tendency not to get all worked up about fiscal issues. I guess the same goes for the discussion about a possible US government shutdown.

But what is history telling us? Well, it would not be the first time we would have a US government shutdown. Last time it happened was in 1995.

I stole this from Wikipedia:

The United States federal government shutdown of 1995 and 1996 was the result of conflicts between Democratic President Bill Clinton and the Republican Congress over funding for Medicare, education, the environment, and public health in the 1996 federal budget.

The government shut down after Clinton vetoed the spending bill the Republican Party-controlled Congress sent him. The federal government of the United States put non-essential government workers on furlough and suspended non-essential services from November 14 through November 19, 1995 and from December 16, 1995 to January 6, 1996, for a total of 28 days. The major players were President Clinton and Speaker of the U.S. House of Representatives Newt Gingrich.

…A 2010 Congressional Research Service report summarized other details of the 1995-1996 government shutdowns, indicating the shutdown impacted all sectors of the economy. Health and welfare services for military veterans were curtailed; the Centers for Disease Control and Prevention stopped disease surveillance; new clinical research patients were not accepted at the National Institutes of Health; and toxic waste clean-up work at 609 sites was halted. Other impacts included: the closure of 368 National Park sites resulted in the loss of some seven million visitors; 200,000 applications for passports and 20,000 to 30,000 applications for visas by foreigners went unprocessed each day; U.S. tourism and airline industries incurred millions of dollars in losses; more than 20% of federal contracts, representing $3.7 billion in spending, were affected adversely.

It sounds pretty horrible doesn’t it? But now look at how the US stock market performed ahead of, during and after the 1995 government shutdown.

govt shutdown

Are you scared? I am not. If the stock market is up it is normally a pretty good indication that no permanent damage has been done to the economy.

PS If you do not get why I am not scared about this you should take a look at what I said about the “fiscal cliff” a year ago – See for example here. It is all about a rule based monetary policy and the Sumner Critique.

It is time to stop worrying about austerity – also in the UK

I have a piece in City AM today on the impact of fiscal austerity in the UK:

FIVE years ago, nearly every macroeconomist agreed that central banks determined aggregate demand (total spending in the economy), and that fiscal stimulus was therefore unnecessary to lift depressed economies. Conversely, fiscal austerity was seen as irrelevant at best for overall growth; any impact of austerity on demand can be offset by the right monetary policy – though tax cuts could, of course, boost aggregate supply.

But the age-old discussion about the relation of fiscal policy to growth has resurfaced. Keynesian economists – including Òscar Jordà and Alan M Taylor in a paper just released by the National Bureau of Economic Research – claim that government austerity is to blame for lacklustre UK growth since 2010.

There are technical issues with the paper that make Taylor and Jordà’s precise numbers hard to evaluate. And as the economist David B Smith has noted, the important question of fiscal sustainability is not even addressed. But the more fundamental issue in the whole debate is the idea of “monetary offset”.

Read the rest here.

There is no ’fiscal cliff’ in Japan – a simple AS-AD analysis

It is now very clear that what Milton Friedman advocated the Bank of Japan should do back in the mid-1990s – to expand the money base to get Japan out of deflation – is in fact working. Nominal spending growth is accelerating and with it deflation has come to an end and real GDP growth is fairly robust.

However, some have been arguing the success of Abenomics will be short-lived and that the planned increases in the Japanese sales tax might send Japan back into recession. In other words Japan is facing a fiscal cliff.

In this post I will argue that like in the case of the 2013-US fiscal cliff the fears of the negative impact of fiscal consolidation is overblown and that the risk of recession in Japan is very small if the Bank of Japan keeps doing its job and try to get inflation expectations back to 2%. It is yet another illustration of the Sumner Critique.

All we need is the AS-AD framework

I think it is pretty easy to illustrate the impact of a sales tax increase in a world with a central bank with a credible inflation target within a simple AS-AD framework.

We start out with a Cowen-Tabarrok style AS-AD framework. We use growth rates rather levels and aggregate demand curve is given by the equation of exchange (mv=py).

The graph below is our starting point.

AS AD

We have assumed that inflation in the starting point already is at 2%. This obviously is not correct, but it does not fundamentally change the analysis of the “fiscal shock”.

Japan’s sales tax will be raised to 8 percent from 5 percent in April and to 10 percent in October 2015, but here we just assume it is one fiscal shock. Again that is not important for the conclusions.

A negative fiscal shock in a Cowen-Tabarrok style AS-AD framework is basically a negative shock to money velocity (v), which will push the AD curve to the left as nominal spending drops.

However, as it is clear from the graph this will initially push inflation below the Bank of Japan’s 2% inflation target. We are here ignoring headline inflation will increase, but we are here focusing on core inflation as is the BoJ. Core inflation will drop as illustrated in the graph below.

inflation target BoJ ASAD

If the Bank of Japan is serious about its inflation target it will respond to any demand-driven drop in inflation by counteracting that with an one-to-one increase in the money base to bring back inflation to 2%.

The consequence of BoJ’s 2% inflation is hence that there will be full monetary offset of the negative fiscal shock and as a consequence inflation should broadly speaking remain unchanged at 2% and real GDP growth will be unaffected. Hence, under a credible inflation target the fiscal multiplier is zero. As in the case of the US there will be no fiscal cliff. There will be fiscal consolidation but not a negative impact on growth.

This of course does not mean that the fiscal shock will not have any impact on the Japanese economy or markets. It very likely will. It is for example clear that if the markets expect the BoJ to step up asset purchases (increase money base growth) in response to fiscal tightening then that would likely weaken the yen further. Something Japanese exporters likely will be happy about. As a consequence the sales tax hikes will likely change the composition of growth in Japan.

Finally, it should be noted that everybody in Japan is fully aware of the miserable state of public finances and as a result it is hardly a surprise to Japanese households that the government sooner or later would have to do something to improve public finances. In fact the sales tax hike was announced long ago. Therefore, we should expect some Ricardian equivalence effects to come into play here – an increase net government saving is likely to reduce net private savings. So even with no monetary offset there is likely to be some Ricardian offset. That in my view, however, is significantly less important than the monetary policy offset.

How aggressive will the BoJ have to be to offset the fiscal shock?

A crucial question of course will be how much additional monetary easing is needed to offset the fiscal shock. Here the credibility of the BoJ’s inflation comes into play.

If the BoJ’s inflation target was 100% credible we could actually argue that the BoJ would not have to increase the money base at all. The Chuck Norris effect would take care of everything.

Hence, if everybody knows that the BoJ always will ensure that inflation (and inflation expectations) is at 2% then when a fiscal shock is announced the markets will realize that that means that the BoJ will ease monetary policy. Easier monetary policy will push up stock prices and weaken the yen. That will in itself stimulate aggregate demand. In fact stock prices will continue to rise and the yen will continue to weaken until the markets are “satisfied” that inflation expectations remain at 2%.

In fact this might exactly be what is happening. The yen has generally continued to weaken and the Japanese stock markets have been holding up quite well even through the latest round of turmoil – Fed tapering fears, Syria, Emerging Markets worries etc.

But obviously, the BoJ’s inflation target is not entirely credible and inflation expectations are still well-below 2% so my guess would be that the BoJ might have to step up quantitative easing, but it is certainly not given. In fact the Japanese recovery is showing no signs of slowing down and inflation – both headline and core – continues to inch up.

A golden opportunity for the BoJ to increase credibility

Hence, I am not really worried about the planned sales tax hikes. I don’t like taxes, but I don’t think a sales tax hike will kill the Japanese recovery. In fact I believe that the sales tax hikes are a golden opportunity for the Bank of Japan to once and for all to demonstrate that it is serious about its 2% inflation.

The easiest way to do that is basically to copy a quite interesting note from the Reserve Bank of New Zealand on “Fiscal and Monetary Coordination”. This is from the note:

“…the Reserve Bank, therefore, is required to respond to developments in the economy – including changes in fiscal policy – that have material implications for the achievement of the price stability target;”

And further it says:

“These… features mean that monetary and fiscal policy co-ordination occurs through the Reserve Bank taking fiscal policy into account as an element of the environment in which monetary policy operates. This approach is to be contrasted with approaches to co-ordination that involve joint determination of monetary policy by the monetary and fiscal policy agencies.”

And finally:

“While demand – and thus inflation – pressures may originate from a range of different sources, the task of monetary policy is to respond so as to maintain an overall level of demand consistent with keeping inflation in one to two years’ time within the target range. For example, if the government increases its net spending, all other things being equal, monetary policy needs to be tighter for a time, so as to slow growth of private demand and “make room” for the additional government spending.”

If the BoJ copied this note/statement then it basically would be an open-ended commitment to offset any fiscal shock to aggregate demand – and hence to inflation – whether positive or negative.

By telling the market this the Bank of Japan would do a lot to reduce the worries among some market participants that the BoJ might not be serious about ensuring that its 2% inflation target will be fulfilled even if fiscal policy is tightened.

So far BoJ governor Kuroda has done a good job in managing expectations and so far all indications are that his policies are working – deflation seems to have been defeated and growth is picking up.

If Kuroda keeps his commitment to the 2% inflation target and stick to his rule-based monetary policy and strengthens his communication policies further by stressing the relationship between monetary policy and fiscal policy – RBNZ style – then there is a good chance that the planed sales tax hikes will not be a fiscal cliff.

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