Mark Carney bottles it with baby steps

Mark Carney had the leeway to make radical change here but he’s bottled it with baby steps.

The ‘Carney rule’, promising low interest rates and the possibility of more quantitative easing (QE) until unemployment is low or inflation rises, is definitely an improvement on the current regime. It gives firms clearer guidance on the future stance of policy, removing some of the uncertainty in the world economy today. I expect it to deal with some of today’s demand shortage, and more importantly tomorrow’s expected demand shortage.

But unemployment and inflation come from both aggregate demand (which the bank can control) and aggregate supply (which it has essentially no control over). Since neither of these numbers distinguish between changes in supply or demand, the Bank is still fumbling in the dark with its guesses over whether a change in inflation comes from demand (which means it should react) or supply (which means it shouldn’t). This means firms are still left guessing, and it means that uncertainty still reigns.

What we really need is a truly rule-based system that takes discretion away from nine ‘wise men’ and uses market forecasts to create real stability. That system is nominal income targeting.

Despite its problems, QE might be right

John Butler has a great piece in yesterday’s City A.M. making the case against central bank interest rate interference. He uses the devastating insights of Ludwig von Mises and Friedrich Hayek to show why central planning cannot work rationally for basic epistemic reasons. His example is of the Soviet shoe industry, constantly providing surfeits of boots in summer and sandals during winter.

Absent a pricing mechanism to match supply and demand, there was invariably either a glut or a shortage. And even when there was a glut, there were plenty of summer shoes, but a shortage of winter boots. By contrast, the largely capitalist West, responding to real price signals in real markets, did a pretty good job at producing, in sufficient quantities, a range of shoes that customers wanted, that fit, that they could afford.

Butler argues that in the significantly more important financial markets, which coordinate plans about saving and investment, together determining the future’s capital structure, the same rules apply. We need real prices to convey information and organise society into a rational economic order. He claims the monetary policies of many countries—cutting headline interest rates and buying hundreds of millions of bonds—distort market interest rates (the most important prices in the economy) and thereby drive capital to be used in suboptimal ways.

I think there’s a problem with his approach. Going with the title of this post—isn’t it possible that the free market interest rate is below zero? German bund yields have fallen below zero several times during the Euro crisis, despite no central bank engaging in any major programme to buy them up. In times with few good investment opportunities, lots of funds (saving rates have boomed during the bust), and lots of worrying risky areas, it makes sense that some safe assets would see crashing rates. Bond yields can fall below zero even in a zero inflation or deflationary environment, but that’s not true for many of the myriad interest rates in a modern economy. There is a zero lower bound on most rates, that is, no one would accept a nominal rate less than zero, as they could usually change the money into cash and put it under their mattress. But quantitative easing raises inflation expectations (and inflation), allowing real rates to go below zero, potentially clearing some otherwise stuck markets.

Now this isn’t necessarily telling on Butler’s argument. It might be that sometimes rates need to fall below zero, potentially justifying inflation above zero, but the QE needed to achieve this inflation distorts markets in general more than it benefits in these cases. Other things being equal, the extra demand from bond purchases means higher prices and lower yields on those bonds, and this would be expected to hit all substitute assets. This seems to hold even if the other effects of extra QE (higher inflation and demand growth (NGDP growth) expectations) work in the other direction, or even exactly balance out the demand effect of QE. Compared to the hypothetical situation where the central bank boosts growth expectations without buying up bonds, assets will be more expensive, or yield less.

Funds will look cheaper to firms than they “actually are” in the sense of their social cost as approximated by the information that would have been contained in the relevant market interest rates. Firms will tie up slightly more productive capital in improving capacity when society as a whole would seem to prefer slightly more devoted to consumption. This mispricing of loanable funds seems like it would have distortionary effects, with the size of the efficiency loss depending on the responsiveness of the supply of deposits and the demand for investment to their prices.

Before this starts to sounds one-sided against QE, there is one (big) consideration to take into account—the extra inflation and demand growth expectations that asset purchases create don’t just help some interest rates adjust, but also create the space for a vast number of relative price moves. Labour markets tend not to clear after demand shocks because wages take a long time to adjust downwards. The price of avoiding any interference could be deep, ongoing recessions. So a prudent central banker may need to risk some misallocation of resources into investment if they wish to avoid the probably worse cost of punishing unemployment and slashed living standards.

Welcome Mark Carney, now here’s what you need to do

Today Mark Carney becomes the new governor of the Bank of England, gaining oversight not only of UK monetary policy, but also financial regulation, as part of the Bank’s newly-expanded responsibilites. When George Osborne revealed he had managed to persuade Carney to take on the role there was great fanfare and excitement. This was firstly because the Canadian economy has performed relatively well through the recession and secondly because Carney has shown himself open to innovations in central banking, though he has not implemented any in his time at the helm of the Bank of Canada.

Carney talked up the benefits of targeting the level of demand in the economy—though only for exceptional times—in a recent speech. And one would expect that the chancellor, for the £870,000 he has agreed to pay Carney, is open to significant change, notwithstanding the insignificance of the minuscule changes he himself made to the BoE’s remit in the budget. Put together, these facts give cause for some optimism for someone like me, who supports targeting the level of demand.

So instead of speculating on what the superstar economist actually will do, I will outline the basics of what Mark Carney should—and could do:

I.  Target levels instead of rates—this means bygones are not expected to be treated as bygones, and market actors do not worry about worse-than-expected outcomes because the central bank has committed to sorting them out

II. Target NGDP (demand) instead of inflation—this means supply moves don’t lead to the wrong sorts of tightening or loosening of monetary policy, also means demand is stabilised directly, instead of an arbitrary part of the outcome of demand; stable demand means no recessions caused by nominal factors and no unsustainable booms

III. Target the forecast instead of the outcome—this is what matters for expectations, which are basically all that matters for employment contracts, loan/debt contracts, investment etc. etc. Expectations are the key, so it’s insane to ignore them

IV. Target market, not internal forecasts—set up an NGDP-linked bond, like the RPI-linked bond, and target the spread between the vanilla bond and the linked bond to get an objective idea of where to aim. Guesses where people have skin in the game are systematically better than the relatively costless estimates produced by private consultancies and the Bank’s internal team. But even if they’re wrong it doesn’t matter because expectations are all that count, and the spread between the bonds IS the market expectation. Driving that to a particular point is success, regardless of what happens.

In general the road ahead must be one of rules and discipline, not the translucent discretion of nine unelected barons.They must keep demand steady so we can focus on improving the supply capacity of the economy, and so there is no excuse for fiscal stimulus, with all its flaws. If you still need convincing, read Scott Sumner’s 2011 Adam Smith Institute monograph “The Case for NGDP Targeting”.

The poverty we can relieve

The Joseph Rowntree Foundation (JRF) has a new report out today that takes a look at living costs for the poor and the cost of achieving a ‘socially acceptable standard of living’ in modern Britain. The report continues their excellent approach to poverty measurement, which looks at the cost of a basket of goods that most people would consider necessary to have a decent standard of living.

This approach is very reasonable, and does a good job of contextualising domestic poverty without being led to the sort of absurdities of straightforward relative poverty measures, which, for example, “improve” every time someone wealthy goes bankrupt or leaves the country. The JRF’s method is quite a neat combination of the best elements of relative and absolute measures of poverty.

It’s important to remember that poor people in the UK are still very rich by global standards. But that’s not to say that their problems aren’t still important and worth trying to solve by allowing more wealth to be created. There are some things we can do to help people in poor countries, such as removing barriers to trade and migration, which would also be good for poor people in the UK, but that shouldn’t stop us caring about relatively less poor people in the UK.

The JRF is right to highlight the fact that rises to the cost of living hit the poorest the hardest. I think it’s probably a mistake, however, for anyone to assume that benefits cuts are the main causes of the living standards squeeze for the poor. They might be a factor in declining or stagnating incomes (not as much as the overall economic climate, though), but they don’t explain why the cost of living is rising so rapidly.

Paradoxically, things like ‘affordable housing’ requirements can actually end up hurting people in need of affordable housing. They disincentivise higher-end developments and cause the demand for those homes to be pent-up in the existing housing stock – so, in other words, instead of building new houses for the rich, existing affordable homes are converted to accommodate them, reducing available units for people who need cheaper homes. Liberalizing the planning system so that supply can meet demand would do a lot to reduce the cost of living for the poor.

I also think it’s crazy and inhumane that we tax minimum wage workers so much. A full time worker on NMW earning just under £13,000 a year will have to pay more than £1,300 of that in tax. That’s a scandal.

And of course a lot of the problems facing people on low incomes are due to the overall economic climate. If Mark Carney really does implement a nominal GDP target, the resulting economic recovery and job creation will mitigate some of the worst problems facing people at the bottom of British society.