The world is in turmoil. Trump. Brexit. Marine Le Pen. And as very often when this is so, it’s in turmoil about macro-economic policy although this is often less obvious than you might think. MLP, for example, wants to recreate the franc, redenominate the French national debt, presumably devalue/inflate a great chunk of it away, and then peg to a hard euro. (Remember that?) The point isn’t so much about the content of this plan but more just that, when you get down to the detail, madmen (and women) in authority are still distilling their frenzy from some academic scribbler of a few years back, like the fella said. It’s almost reassuring to think that something as boring as money might be involved. So what’s Ed Balls been up to lately?
Writing a paper on central bank independence, and of course some other stuff. The paper is mostly interesting because it concedes that a major element of the independent central bank model is wrong, but ironically in a way that reinforces the need for its independence. Classically, the justification for making the central bank independent was that it would be able to fight inflation without worrying about how to get re-elected. The core assumption here is that governments like deficit spending and workers like raises, and therefore at some deeply denied level, inflation is a phenomenon of democracy.
As it turns out, central banks these days are spending all their time fighting deflation, which turns out, astonishingly, to be pretty popular. Ask…Ed Balls. Not only that, but their remit has expanded enormously to include things like acting as a financial regulator, generally trying to warn the public off from bubbles, and providing direct business financing. This has resulted, through the search for requisite variety, in a major expansion of their policy toolkit and staffing until they start to look weirdly like a kind of outsourced and unelected economic government, an internal European Commission.
The key driver for this diversification is that, arguably, the politicians have either avoided dealing with these problems, have found dealing with them to be unpopular and given up, or are deadlocked by veto actors on what to do about them. Being operationally independent, this doesn’t apply to the central bank, and therefore its mission tends to expand. Its area of responsibility, however, has not expanded in a similar way because it’s still independent. As a result, people who love deflation can howl “Audit the Fed!” all day but it doesn’t have to listen to them, and people who hate it can picket the ECB all day and the Frankfurt police will crack their heads.
Paul Krugman coined the phrase “a credible promise to be irresponsible” to describe the perceived need for the central bank to do whatever it takes to get away from the zero lower bound on interest rates. The problem, however, is that there is no matching credible promise to be unpopular that binds the fiscal authority. Balls makes some suggestions about this, but the whole issue reminded me of an old idea of mine.
One way of looking at the problem is that while inflation is reasonably close to the target, it makes sense to think in terms of a negative feedback loop between the fiscal and monetary authorities. If the government’s spending plans start to push up inflation, the central bank can respond to keep it down. If prices start falling below target for some reason, the central bank can respond to push them back up without trying to fine-tune the budget. But there is only a restricted domain in which this works well, rather like an aircraft’s flight envelope. Outside this domain, things work differently. The obvious example is the zero lower bound, where the central bank has basically run out of options. Presumably, there is a similar inflection point in the other direction where inflation goes out of kilter, but this is obviously a secondary consideration at the moment.
To get back into the stable domain, we need fiscal and monetary policy operating in the same direction. This, however, is where politics creeps back in. The quasi-automatic setup we just described is in many ways an effort to depoliticise economic policy; but now a fundamentally discretionary, political decision is required and it’s quite possible that we won’t get one whatever the sign, because evidently a lot of people love them some deflation and are determined to get revenge on anyone who denies it to them. Inflation bias, he dead.
So why not apply the same logic that we did to the central bank? Balls argues that the BoE should write one of its famous letters to the Treasury if it looks like it would hit the ZLB. But I think this is weak sauce. Why not commit to fiscal measures in advance, in the same way that operational independence commits us to monetary measures in advance? The Treasury could agree with the BoE that, in the event that the ZLB is reached, it undertakes to reflate until the inflation rate is positive and trending towards the target. It could make a matching commitment to deflate if the inflation rate (or the BoE interest rate) hits some upper bound.
Of course, nobody wants this or anything like it. It strikes me that perhaps the big lesson of 2016 is that we’re sick of depolicitising anything, and we damn well want things politicising.