Regime change at the Bank of England?

Mark Carney was poached last week to replace Mervyn King as Governor of the Bank of England. As though replacing an incompetent central banker with a competent central banker wasn’t good enough, the news just kept on getting better:

From our perspective, thresholds exhaust the guidance options available to a central bank operating under flexible inflation targeting.

If yet further stimulus were required, the policy framework itself would likely have to be changed. For example, adopting a nominal GDP (NGDP)-level target could in many respects be more powerful than employing thresholds under flexible inflation targeting. This is because doing so would add “history dependence” to monetary policy. Under NGDP targeting, bygones are not bygones and the central bank is compelled to make up for past misses on the path of nominal GDP

I’m behind the curve a little bit on this one, but it is potentially huge news. Remember that under inflation targeting if you crash an economy but get inflation back up to a positive but low value then you’re more or less out of stimulus options. Hello lost decade. With a target for the level nominal GDP you must make up for any shortfall. Hello recovery summer.

Now, Mark Carney isn’t saying he wants to implement NGDP targeting, he isn’t even saying other people might want to implement it. He is merely saying that it is an option and central bankers need more options. The anti-Yes, Minister. “Something must be done. This is something. But there are other somethings too.” Eminently sensible and of course very central bankerese, as you would expect.

The Government is replete with figures who already find this option attractive. Giles Wilkes, much missed blogger, now my favourite coalition apparatchik (low praise indeed!), wrote the book on this from a UK perspective in 2010 in his paper “Credit Where It’s Due.” His Boss, Vince Cable is also sympathetic. Indeed, even George Osborne “said he was pleased Mr Carney was discussing such ideas.”

What makes this exciting is that implementing this policy revolution is really easy given the laws on the books in the UK.

One interesting thing about central bank independence in the UK, is that there are very few checks or balances protecting it. The Bank must aim for “price stability,” but the Chancellor can change the definition of “price stability” whenever he wants. It’s right there in the 1998 Bank Act. I thought I was the first UK blogger to cover this, but actually Britmouse got there a full two months before I picked it up. This isn’t an esoteric or obscure fact, if it’s in the FT it’s more or less in respectable discourse.

Politically, it would cement austerity as a fiscal and social policy measure, but would likely dramatically improve private sector job and productivity performance. As demand picked up underutilised resources and resources (stuff and people, basically) shed from the public sector would find it easier to find work. It is an electoral nightmare for Labour.

However, it would dramatically improve the economy’s performance, so even the anti-Tory in me agrees with Britmouse when he says “Tories Should Embrace Nominal GDP Level Targeting.” In 1931 the UK blazed a trail by abandoning the gold standard and ending the Great Depression, in 2013 maybe we will get a chance to end the Little Depression and one last moment as a great power.


In the main shamelessly cribbed from Britmouse, here are some links to things other people have written.

The BBC lower the tone by getting confused: “Mark Carney suggests targeting economic output

Sky News Editor Ed Conway: “Why we all need to know about NGDP

Jeremy Warner at the Daily Telegraph: “It’s time the Old Lady was given more obvious growth objectives

Larry Elliot at the Guardian: “New Bank of England governor Mark Carney mulls end of inflation targets

Gavyn Davies at the FT: “Carney differs from Bank of England orthodoxy

Chris Giles and George Parker at the FT: “Treasury open to Carney radicalism

FT Editorial: “New broom clears way for Old Lady

Chris Giles again: “Osborne should heed Carney’s message

Faisal Islam, Channel 4: “Carney’s recent musing on UK jobs and housing bubbles


Dropping the Inflation Target? from Duncan Wheldon

Tories Should Embrace Nominal GDP Level Targeting from Britmouse

Monetary Policy Innovations from Simon Wren-Lewis

Mr. Osborne: “There is a lot of innovative stuff happening around the world” from Lars Christiensen

How soon is now, UK NGDP targeting edition from FT Alphaville


How not to hire a central banker OR Are you fucking kidding me Cameron?

Perhaps the fourth most important job in the world is up for grabs. If you (*ahem*) want to be the UK’s chief central banker, the job is available – applications are due by 8th October to 1 Horse Guards Road, London. I say fourth most important because there are only three economies larger than the UK in the same depressed state: the US, Japan and the Eurozone. Unfortunately those doing the hiring have no idea how and why this job is important.

Why is this job so important? It is important because the central bank, to a large degree, determines how quickly we recover. If the bank keeps money tight we will recover very, very slowly, if it gets money right we will recover very, very quickly. I’ve decided to stop demanding loose money because that isn’t what I really want. Monetary policy should be set at the level that is predicted to produce the outcome you want, neither loose nor tight, but right.

For several years that is exactly what the Bank of England did. From mid-2004 to mid-2008 they set policy so that they expected 2% inflation in two years time. As this graph cribbed from Britmouse shows.

Since 2008 they have consistently set policy too tight to hit their target, that is, even by they own preferred metric they have been hamstringing the recovery. Money has been tight so growth has been slow. This makes the quality of the successor to Mervyn King very important indeed. Even doing his job properly would be an improvement on the Bank’s current practice.

I would argue that even this is not good enough. Someone who could do Mervyn King’s job well and set policy that is predicted to succeed, not fail as he has, will not get us the recover we need to put a million people back to work. We will remain depressed because inflation is a bad indicator of an economic recovery, much better is something like nominal GDP, which I have been going on about ad nauseum because people still don’t get it. (Click on the two graphs in the right of the blog for more info on this)

Below is a graph that shows the gap that has opened up between where the UK’s nominal GDP should be and where it is.

The economy wants to produce £1.7trn of goods and services a year, but tight money has restricted it to about 1.57trn of goods and services a year. £170 billion is what the UK economy is missing out on each and every year because our central bankers are not good enough at their jobs (nor currently authorised by the treasury) to bring us back to trend. The total loss currently totals around £500,000,000,000 or half a trillion pounds.

So what is a good central banker worth? Well, about £500,000,000,000 would be one answer, but bygones are bygones so lets be more constructive about it. A good central banker is one who closes that gap as quickly as possible. In the US they estimated that thier (bad) central bankers has cost their economy $4trn in lost output and will cost the economy another $4trn by 2018. A good central banker could be worth $4trn to them if they could return the economy to trend twice as quickly, which seems possible.

Lets copy the mechanism they employed here and makes some assumptions. First, a bad central banker closes that gap by 2018 during which the gap steadily closes. Second, a good one does it in half that time and the gap closes correspondingly until then. After a fairly convoluted process involving my half remembered A level maths I’ve decided that a bad central banker costs us a total of £500 billion in lost output, while a good one loses us “only” £250 billion in lost output. So doing this job correctly is worth perhaps a sixth of everything the UK can produce in a single year.

That they’re paying Sir Mervyn’s replacement a measly £307,792 a year suggests to me they aren’t taking things seriously enough. By our metric of good banker versus bad, they are only expecting an economist 0.0001% better than Mervyn King. Which might be setting the bar a little too low, even as a replacement for our worst central banker since the 1930s.

Of course, it being the coaltion, things are even worse than they at first appear. They aren’t even looking for an economist 0.0001% better than Mervyn King, they’re looking for a financial regulator. Read this paragraph and weep:

The successful candidate will have experience of working in, or with, a central bank or similar institution; or will have worked at the most senior level in a major bank or other financial institution. He or she will demonstrate strong leadership, management and policy skills; will have an advanced understanding of financial markets and good economic knowledge.  He or she will be a strong communicator, have good interpersonal skills and will be a person of undisputed integrity and standing.

Advanced knowledge of financial markets, but only “good” economic knowledge? Forgive me a moment, but are you fucking kidding me Cameron?

They don’t want a central banker, they want a financial regulator. A financial regulator needs to prevent fraud and ensure banks adhere to the rules laid out by parliament. A central bank is in charge of nominal demand because they issue currency. The two needn’t have anything to do with each other. Now that the Bank has to take on the FSA’s financial regulation duties they are going to let their other  responsibilities go by the wayside. Ignorance will damn us, not incompetence. As Scott Sumner has said of the 1930s, the last time we got things this wrong:

The elite bankers and financiers of Wall Street were pretty smart people.  So were the central bankers of the US, Britain, and France.  But they weren’t smart enough… So the wealthy conservatives of the interwar period who dominated central banking dug their own graves, and the graves of millions of others.  Not through greed but through ignorance.

This time is perhaps worse. At least in the 1930s people had a rough idea what a central bank was meant to do. Today, those in charge don’t know for which job they are hiring, so those who are hired won’t know what they’re meant to do, and the rest of us will all suffer for it.

This in’t because any of us deserve it or because those doing the hiring or being hired are necessarily bad people, but because life is hard and confusing sometimes. Everyone is finding it hard and confusing and this is why I keep shouting about this, because nobody needs to be evil to inflict suffering, just wrong. So we need to stop being wrong as quickly as possible.

Limits to monetary policy

There is a limit to monetary policy. Once the central bank has bought everything then we will have hit the limits of monetary policy.

When the company you work for is owned by the central bank and the pub you drink in is owned by the central bank and your pension fund is owned by the central bank, then we may start running into difficulties. How can the central bank inject money into the economy when it has already bought the shoes off your feet? Then we might have a problem. We are nowhere near the point where central banks are out of ammunition. Such a position shows a poverty of imagination.

There are a couple of straightforward ways for monetary policy to boost growth when an economy is depressed, one is to increase the amount of money chasing the  goods that have been produced. When an economy is operating well this simply increases prices, rents and wages without anybody actually getting better off. When an economy is depressed people don’t simply increase prices, rents and wages, they use the spare capacity available to bring more goods, land and people into employment. This is what a recovery is.

The other way of looking at it, would be to see this as a devaluation of the currency vis a vis other countries. This makes imports more expensive and exports more competitive. This shifts production to produce more exports and import competing goods and promotes growth. Is monetary policy impotent to generate either of those effects? Hell no!

If monetary policy is impotent to increase demand and the amount of money chasing goods, then the Bank of England could make the whole stock of national debt vanish without anybody suffering ill effects. If monetary policy is out of ammunition then monetising £1 trillion will have no effect on prices, rents or wages, and will just  reduce future expected taxes. That sounds a little too good to me.

While we at it, we may as well solve the European sovereign debt crisis, if monetary policy is impotent to affect a devaluation we may as well print enough pounds to buy enough euros to retire every continental nation’s stock of debt. If that doesn’t devalue the pound and boost exports I don’t know what will.

Frankly, the idea that somebody with a printing press, capable of producing money which is accepted around the world and for all imaginable goods and serves is unable to increase economy wide spending is laughable.

Of course, nothing is that simple, a central bank that went on a spending spree could always reverse its stance and suck the world dry of currency. The expectation of this reversal would seriously dent the efficiency of easily reversible actions like QE. However, that does not mean we should abandon QE it means we should pair it with a nominal target, a commitment device, like a nominal GDP level target to stabilise expected and current demand.

Is Osborne being squeezed from all sides?

Vincent Cable. Photograph: David Levene

The FT reports that “cabinet ministers”  – it’s Vince Cable, everybody knows it’s Vince! – are looking into completely nationalising RBS and setting it to work directly lending to firms in an effort to boost growth. It would cost £5bn to buy the remainder of RBS and the betting I expect is that this would be paid for several times over if the purchase leads to even a modest increase in growth. Yet, this is the same Vince Cable who asked “What tools does the Government have?” and responded:

The first is continued use of monetary policy, and stronger communication of the policy aim it is meant to achieve – robust recovery in money spending and GDP.

This is what has confused me. Taking over RBS seems to be a losing proposition because were RBS – or the newly formed national investment bank – to boost lending it would eventually lead to firms expanding production and hitting bottle necks. Those bottle necks would cause price increase and those price increases would lead to tightening from the Bank of England. The action would be entirely self defeating.

There seems to be only a couple of ways to explain Vince’s economic policy in view of his previous comments. One is that there is a supply side problem in the banking system. The banking system is currently in a stable equilibrium where no banks are lending much and it doesn’t make commercial sense for any bank to break ranks because unless others join and encourage growth it will fail. The government is there to overcome this and move the banking industry to a high lending equilibrium. Overcoming this problem would actually lend a deflationary pressure to the economy by improving productivity and encourage more stimulus from the Bank of England.

The second justification for Vince’s policy is that no longer doesn’t believe that changing the Bank of England’s mandate to target nominal GDP is enough. Given Vince’s past comments I don’t think either explanation for this policy is really convincing. Vince has always emphasised the Chuck Norris effects of a NGDP target for the Bank: communication is the tool, not the banking channel. I then got reminiscing and thought…where had I heard of combining a nominal GDP target with directed lending to firms…why its good-egg of the liberal blogosphere and coalition apparatchik Giles Wilkes’  Centre Forum paper “Credit Where it’s Due” of course!

It looks like what is being discussed is the second plank of Giles’ prefer policy:

The Bank should start by targeting a high level of nominal growth until the economy is performing at its potential. This will reassure the private sector that liquidity won’t dry up in the near future, and so encourage more investment now. The second step should be for ‘credit easing’ to replace ‘quantitative easing’.

But why start with the second, less potent policy? Politics.

Then it occurred to me. George Osborne is facing as much pressure  to change course from within the Cabinet as from without.

It looks like a rearguard action is being fought within the Government to upset Osborne’s deficit cutting and investment cutting first policy platform. This is unsurprising, the coalition is presided over a lost decade in progress and that does terrible things for your reelection chances, especially for the Lib Dems.

As I’ve pointed, ad nauseum, the Chancellor can change the Bank of England’s mandate to adopt NGDP level targeting at any time, but there are political risks to doing anything unconventional and Osborne seems loathe to deviate from the script. Osborne is very much a part-time Chancellor but he is a full-time political operator.

Perhaps there is a worry in Government that changing the Bank mandate alone will be insufficiently convincing for firms and markets, it may be that this policy is a supporting plank of one that will be much more effective. And perhaps, more importantly, there is a worry in parts of government that they will not be able to convince another part of government change the Bank’s mandate unless the groundwork has been laid to make it politically acceptable.

So although the nationalisation of RBS may prove good policy in the end, it may be that its political power is more important than its economic significance. Although it doesn’t strike me as necessarily the best way run a bank, given that we’re already screwed and convincing expansionary monetary policy is our only hope, I’ll see how this one plays out.

Its a Central Banking Crisis Too

Much like Frances Coppola, I like charts. I think in pictures and words not numbers; I find it significantly easier to translate graphs into reality. But, unlike Frances, I hold the ECB peculiarly responsible for the Eurozone crisis, where she places more blame on the banking sector in general. I hope to present some graphs to convince Frances that the ECB is the real bad guy in Europe.

I have repeatedly called the European Central Bank insane for failing to save the Euro. That might be a little unfair, lots of banks acted insane during the 2000s, but the ECB’s monomaniacal and slavish adherence to inflation targeting led the bank to make two specific policy errors which have had grave consequences.

These policy errors exaggerated the errors of Europe’s banks and turned a balance of payments problem into a triple currency, banking and sovereign debt crisis. It wasn’t debt or deficits that sent the Eurozone periphery into crisis it was consistently importing more than they exported.

Such a lopsided Eurozone demanded flexible demand management, the right amount of demand for Germany had clearly been to inflationary for Ireland et al. However, when the crunch came the ECB was found wanting. Four times the ECB focussed too heavily on short term inflation and raised rates, or failed to cut rates, in error. Below is a graph of Eurozone interest rates as set by the ECB.

In 2008, rapid growth in the developing world pushed up commodity prices and headline inflation around the world. Simultaneous with this the world financial system had begun to blow up. In July 2008 the ECB hiked rates despite it being well aware it was operating in a period of acute financial stress (see chart 2). That is the first error, an over reaction to headline inflation. This error was felt across the world, as described by Lars here.

A few months later, in September, Lehman Brothers collapsed. In September the ECB did not alter its headline interest rate, it waited until October to cut rates. As a consequence of this passive tightening expected inflation in the Eurozone fell well below the ECB’s target rate (see chart 5) and the financial crisis began proper. That was the second error, it was quickly regretted and over the next eight months interest rates were cut to 1%, but no lower.

In April 2011, the ECB once again began to increase interest rates in April 2011 to fight higher inflation. This proved to be a mistake which was reversed between October and December 2011. The consquences of this mistake are plain to see. The below graph was cribbed from Tim Duy and shows the subsequent increase in unemployment.

The cause of this increase in human misery was  decrease in aggregate demand and expected future aggregate demand. Caused by the same demand shock, the borrowing costs of the Eurozone periphery spiked compared with the borrowing costs of Germany. Greece’s ten year borrowing costs spiked from being 9.49% higher than Germany’s to 12.64% higher. Similar movements can also be seen for Ireland, Portugal and Spain by comparing this data from late March 2011, with this data from May 2011.

The ECB’s fourth and enduring mistake is keeping interest rates at 1%, rather than cutting all the way to zero, and in failing to communicate that they will continue to be as accommodative as is necessary to boost growth. The ECB has failed to use the conventional tools and has actively sabotaged itself by failing to convince anyone it is willing to be as accommodative as is necessary to rescue the Eurozone from crisis.

This isn’t entirely the ECB’s fault, they’ve been given a very narrow mandate to maintain price stability. But mandates can be reinterpreted as necessary and blowing up the world financial system and throwing millions out of work to keep a lid on poorly recorded, probably inaccurate, inflation rate is an insane way to interpret a mandate for price stability. So I’ll probably keep calling the ECB insane.

Osborne to the rescue?

Britmouse, otherwise a very informed commenter, makes the mistake of saying Britain would need a new parliamentary act to switch to a nominal GDP level targeting regime. Not so.

Here is the relevant section of the 1998 Bank of England Act:

11 Objectives

In relation to monetary policy, the objectives of the Bank of England shall be –

(a) to maintain price stability, and
(b) subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment.

12 Specifications of matters relevant to objectives

(1) The Treasury may by notice in writing to the Bank specify for the purposes of section 11 –

(a) what price stability is to be taken to consist of, or
(b) what the economic policy of Her Majesty’s Government is to be taken to be

The Treasury can, were George Osborne to be interested in re-election, switch to a nominal GDP targeting regime by only resorting to legislation which is already on the books. Defining the objective of the Bank of England as “to maintain price stability…including its objectives for growth and employment” is almost an exact layman’s description of NGDP level targeting.

If Britmouse means merely  that this decision would not be final, I agree, but no decision made by parliament is ever final. No Parliament may bind its successor. There is no way to forever adopt NGDP targeting, because no parliament can bind its successor. Mervyn King himself has written  (in a paper I will discuss when I get round it) that it doing so is likely impossible:

The core of the monetary policy problem is the uncertainty about future social decisions resulting from the impossibility and the undesirability of committing our successors to any given monetary policy strategy. The impossibility stems from the  observation that collective decisions cannot be enforced so that it is impossible to commit to future collective decisions. The undesirability reflects the fact that we cannot articulate all possible future states of the world.

There would be parliamentary fulminations were Osborne to announce an immediate change of policy, but a steep economic recovery would put pay to those. The British legal system is flexible, and by the time a legal challenge were mounted, if it ever were mounted, it would be easy to pass the Bill to formalise an already successful policy.

I don’t like Tory government, but I dislike this depression even more. The Tory have an almost foolproof re-election tool at their disposal, they should use it.

What would the “failure” of a NGDP targeting central bank look like?

Nominal Gross Domestic Product is depressed, that leads real GDP to be depressed because it is very difficult to accommodate rapid and large deflation so logically it must be lower. It also leads to the quantity of people employed to be depressed because the same is true of aggregate wages.

I don’t fully understand what critics of NGDP targeting mean when they say they suspect the policy would fail. I think the language NGDP targeting is something of a handicap, because once you start thinking in this language you begin to translate people’s statements and in the process they cease to make sense.

Chris Dillow says…

I fear, though, that economists who invoke “expectations” and “credibility” are making the error of mistaking the tidy maps of models for the messy terrain of reality.

Unlearning Economics says…

This is a clear example of confusing correlation and causation. When looking at two correlated variables, a good question to ask is which one moves first – here, the drop in RGDP clearly precedes the drop in NGDP. This suggests that the decline in RGDP is not a result of the decline in NGDP; rather, its the opposite.

So what happened in 2008? Obviously, the conventional story is true: a large drop in asset prices made many households and firms realise they were less wealthy than they thought; this caused firms to lay off workers; real production decreased; nominal income followed; expectations dropped; this created a spiral. The NGDP-driven story doesn’t withstand scrutiny, else we’d expect the NGDP drop to come first.

First of all, I agree with Chris that relying on expectations is a weak lever. But, if you are powerful enough to not have to rely on expectations, the market should anticipate that and you will be able to rely on expectations. To he that hath shall be given, and we hath in abundance. I think a Bank with a fairly doveish reputation with the printing press combined with the supremacy of parliament, the Royal prerogative and a government intent on re-election is more than powerful enough for the above to hold true.

Secondly, I disagree with UE. In 2007/8 asset prices fell because expectations of future NGDP fell which was priced into current asset prices. This lead to a fall in real GDP contemporaneous with a fall in NGDP, but both were caused by fall in expectations of future NGDP as is argued by adherents (cultists?) of NGDP targeting. Asset prices are forward looking and money is an asset, hence you have to look at expectations of future NGDP rather than looking at which moved first by a few months, RGDP or NGDP.

So what I don’t understand is what non-NGDP monomaniacs think will happen were a central bank to adopt a NGDP targeting regime. Say the treasury ask the Bank of England to adopt NGDP targeting and to catch up entirely to trend from 2008. What does failure look like?

  1. NGDP does not reach trend because the bank lacks credibility and the policy is abandoned.
  2. NGDP fails to reach trend for a long time, and so has little effect on anything important.
  3. NGDP reaches trend but nominal growth consists (almost) entirely of price changes.
  4. NGDP over shoots target massively and cannot be contained because  inflation expectations become unmorred and accelerate upwards: the price level spirals out of control.
  5. NGDP targeting is effective and a la Kalecki capitalists stage some sort of investment strike and must be abandoned for political reasons.
  6. NGDP targeting is effective and workers/voters realise it is a way of moderating their wage demands and must be abandoned for political reasons.
  7. NGDP targeting is effective and we realise we’ve seen a series of unsustainable booms rather than real growth because of a slow down in innovation and all economic growth ends up accruing to land and rents and must be abandoned for political reasons.
  8. NGDP targeting is effective and some combination of 5,6 and 7 occur.
  9. Other?

Can anyone fill me in?