Never mind the quality of the Green New Deal just feel the width

The Green New Deal has another of their little reports out. Essentially saying the same as all of the previous ones. Print more money to spend on all that Caroline Lucas holds dear. But it really does have to be said that the level of economic knowledge that goes into these reports is not all that high. We've for some years now had the egregious Richard Murphy shouting that we should just collect all hte tax avoided and evaded in order to beat austerity. He not realising that collecting more tax is austerity. For it reduces the fiscal stimulus as it reduces the budget deficit. And of course, there's a similar gross error in this latest report:

No Need to Repay QE Since QE involves a central bank putting new money into circulation by creating e-­‐money and using it to buy assets, this will not increase Europe’s debt levels according to the originator of the term ‘quantitative easing’, Professor Werner, Director of the Centre for Banking, Finance and Sustainable Development at the University of Southampton. He states that since the central bank can simply keep the assets on its balance sheet then there is no need for taxpayers to pay or to expand public debt. The assets should simply stay on the central bank balance sheet. Furthermore, this debt, which would be owed by the government to the central bank would not have to be repaid, as Adair Turner, the former Chairman of the UK Financial Services Authority has made clear. In the European context, the EIB is the European Union's bank, owned by and representing the interests of the EU Member States and so the debt that the EIB would incur through Green Infrastructure QE would also not have to be repaid.

Well, according to that first paragraph I've no need to repay my mortgage as I used the loan to buy an asset. But leaving that aside note the deep appreciation of matters economic on display here.

QE is the central bank creating money to purchase assets. Therefore the EIB can and should do this. But the EIB is not a central bank with money creating powers. It's an EU development bank that borrows on the usual capital markets for funding. The EIB simply cannot do QE because it's not a central bank.

We might not expect any more insight than this from a combination of Caroline Lucas, Richard Murphy and Colin Hines. But Larry Elliott has always been rather more sound than this: is he still with this group or has he left in disgust?

Adam Curtis and the shapeshifting lizards

It is no crime to be ignorant of economics, which is, after all, a specialized discipline and one that most people consider to be a ‘dismal science.’ But it is totally irresponsible to have a loud and vociferous opinion on economic subjects while remaining in this state of ignorance ~ Murray Rothbard

Adam Curtis's segment in Charlie Brooker's look back on 2014 tells us that news is confusing, and hard to paint into black and white. We've withdrawn from Afghanistan, but did we win or lose? Bashar al-Assad is bad, but is ISIS even worse? But nothing, he says, is more confusing than the economy.

The economy is growing, but wages are falling; the deficit is falling, but the national debt is rising. This, he says, keeps the population (whether intentionally or not) in a state of confusion and apathy.

But at the 'dark heart of this shapeshifting world' he says, is quantitative easing (QE), which pumps hundreds of billions of pounds into the economy at the same time as the government is 'taking it out' via its austerity programme.

According to Curtis, the Bank of England has 'admitted' that his has accrued to the richest 5%, a failure of the programme. He calls it 'a ruthless elite, siphoning off billions of pounds of public money'. He even suggests it's roughly analogous to the situation in Russia, comparing British wealthy to oligarchs.

But I wonder if he's looked at any of the research into the programme, asked any economists, or even, perhaps, interviewed some people at the Bank of England?

The reason why some Bank of England research says that the wealth benefited disproportionately in wealth terms is that without the QE programme there would have been a depression, and asset prices would have collapsed. The rich hold assets, the poor don't. But does anyone think the poor would have done better had there been a depression and mass unemployment?

Curtis might find a comparison between what Ambrose Evans-Pritchard calls the 'QE bloc' of the US and UK (and now Japan) and the Eurozone germane. Where have we seen deflation? Where have we seen mass unemployment?

They might look at some of the peer reviewed and robust research telling us whether and how QE has worked.

Much of it is from the Bank of England and Federal Reserve, although I suspect that the credence Brooker & Curtis give to the Bank only extends to stuff that says things they want to hear. Anything else may be dismissed as being exactly what you'd expect the shapeshifting lizards to say.

If QE avoided a Depression it doesn't matter if it increased inequality

I’ve just come from a fascinating event with The Spectator’s Fraser Nelson, on his recent Dispatches show, How the Rich Get Richer. In general the show was very good, and it’s extremely refreshing to see someone as thoughtful as Fraser get half an hour of prime time television to discuss poverty in Britain from a broadly free market perspective.

But I did take issue with the show’s treatment of Quantitative Easing (QE). Fraser described this as ‘perhaps the biggest wealth transfer from poor to rich in history’. The evidence for this was the rise in asset prices following QE, particularly in stock markets. Since rich people own assets and poor people don’t, the rich got richer and the poor didn’t.

That’s a common view and I understand it, but I think it’s wrong. 

Consider the Great Depression. When the money supply (and hence nominal spending) collapsed in the 1930s, the US economy did too, for reasons outlined in Milton Friedman and Anna Schwartz’s Monetary History of the United States.

Basically, contracts are set in nominal terms, so if nominal spending collapses, you’re left with a musical chairs problem where you have too little money to go round. So people are laid off and firms go bankrupt that would not have done so if money had remained stable across the board. Enormous amounts of wealth were destroyed unnecessarily because the government mismanaged the money supply. (It shouldn't be managing money at all, in my view, but if it is we can at least try to minimise the harm it does.)

Perhaps inequality fell during this period because the rich lost proportionally more than the poor – they had more to lose, basically. But who cares? Everyone became worse off. That’s what matters.

The point of QE since 2008 has been to try and avoid a repeat of the 1930s by boosting the money supply. Its supporters wanted to avoid another massive destruction of wealth that would make everyone much worse off. 

Yes, QE boosted stock markets a lot. But there is nothing about QE that meant that banks or other investors would have to invest there – it’s not an ‘injection of cash into stocks’, as some people seem to believe. Stock markets rose because investors reckoned that QE would help avert a much worse Depression, which meant that firms would be (much) more valuable compared to a QE-less world where many of them may have gone bankrupt, or at least taken severe losses, instead.

Yes, that increased inequality because rich people own stocks and poor people don’t. But if everyone would have been worse off without QE, the extra inequality is beside the point. It's people's absolute wellbeing that should matter, if what you're avoiding is a big Depression. You might as well think economic growth is bad because it makes everyone richer, but rich people a little more so.

Of course, it’s an open question whether QE actually did work as intended. Perhaps it made things worse, or did nothing at all. That is a question worth asking and it's not one I can answer. But focusing on whether it increased inequality or not is beside the point – what matters is whether it prevented a Depression.

QE cannot both boost asset prices and wreck pensions

Quantitative easing is complex and difficult to understand—economists aren't even sure exactly if and how it works. It would be unreasonable to expect non-economists to fully grok its workings even if journalistic explanations were clear and overall true. Since economics journalist's explanations have been largely lacking (including, I expect, my own, when I was an econ journo), it would be very difficult for others, further removed from economics, to 'get it'. Still, this piece on Bank of England staff pensions from Richard Dyson, the Telegraph's personal finance editor, has a number of problems which I can't help but try and correct. Dyson argues that (a) the Bank of England's pension scheme is 'eye-catchingly-generous'; (b) final salary pension schemes have died in the private sector substantially because of the BoE's quantitative easing (QE) programme; (c) QE has harmed pensioners; and (d) the Bank's policy of investing in pension pots in bonds is too low-risk and earns insufficient returns. All are substantially false.

Firstly, the Bank of England's 'generous' pensions are (as Dyson notes at the end) to compensate for lower regular and bonus pay than the jobs that very smart and qualified BoE staff could get elsewhere. Dyson might be right that this, overall, is larger in the public sector, indeed there is a literature suggesting that the total pay + benefits for public sector workers of a given skill and experience level is higher than for private sector workers. But the simple fact of a relatively large fraction of that coming out in pensions doesn't tell us anything on that point—and I would wager that the Bank is run much more like a profit-maximising private organisation than most arms of the state.

Secondly, as we see in Dyson's graph, private sector final salary/defined benefit pension schemes have been declining since a peak in the mid sixties, with about half of the drop coming in the 70s and about half in the 90s. Practically nothing has happened to them since the introduction of QE.

Which brings us onto thirdly: QE boosts asset prices. QE raises the value of stock markets and bonds and pretty much all securities that people hold in their pensions. QE makes pensioners better off, like it makes pretty much everyone better off. Yes, you've heard that QE leads to lower interest rates. I'm not sure that's true. Remember we are at the bottom of a 30-year slide in real risk-free interest rates, and it seems much less clear that QE is a big factor.

Finally and fourthly, is the Bank too careful with its money? I don't actually have an answer here but I'd suggest that Dyson (and Ros Altmann, who he quotes on this) are a tad too confident. If the Bank invested in riskier equities or emerging markets or whatever, then sure it would be likely to earn a higher return, but would the Bank's critics really give it any slack if these investments went bad, as they'd be more likely to do? I don't really know how the BoE should invest its pension fund, but it seems to me that they are going to be damned if they do and damned if they don't.

So I think we should leave off the Bank and its pension scheme, whatever issues we might have with its macroeconomic management. It pays high pensions to attract talent. It didn't cause the decline in private sector final salary pensions (I think government is probably to blame for that). It's not to blame for high interest rates and it has helped those with pension investments. And we probably don't have the right info to choose its investment portfolio for it.

What Robert Peston gets wrong about QE

I don't usually read Robert Peston, now the BBC's economics editor, but I came across this piece he wrote for their website on the end of the ongoing US quantitative easing (QE) programme. Here he makes the case, overall, that even though QE did not cause hyperinflation (yet!) it could still prove 'toxic' because it 'inflates the price of assets beyond what could be justified by the underlying strength of the economy'. Basically every line of the piece includes something that I could dispute, but I will try and focus on the most important issues. The first problem is that Peston takes a hardline 'creditist' view that not only is QE mainly supposed to help the economy through raising debt/lending, but by raising it in specific, centrally-planned areas (e.g. housing). When we find that QE barely affected lending, it seems to Peston that it failed. But QE does not raise lending to raise economic activity—QE raises economic activity through other channels, which may lead to more lending depending on the preferences of firms and households.

In his 2013 paper 'Was there ever a bank lending channel?' Nobel prizewinner Eugene Fama puts paid to this view. He points out that financial firms hold portfolios of real assets based on their preferences and their guesses about the future. QE can only change these preferences and guesses indirectly, by changing nominal or real variables in the economy. For example, extra QE might reduce the chance of a financial collapse, making riskier assets less unattractive. But when central banks buy bonds investors find themselves holding portfolios not exactly in line with their preferences and they 'rebalance' towards holding the balance of assets they want: cash, equities, bonds, gilts and so on. This is predicted by our basic expected-profit-maximising model and reliably seen in the empirical data too. It's good because it implies that monetary policy can work towards neutrality.

This doesn't mean Peston is right to be sceptical about the benefits of QE. QE has worked—according to a recent Bank of England paper buying gilts worth 1% of GDP led to .16% extra real GDP and .3% extra inflation in the UK (2009-2013), with even better results for the USA. The point is that it works through other channels—principally by convincing markets that the central bank is serious about trying to achieve its inflation target or even go above its inflation target when times are particularly hard. This is not an isolated result.

The second issue is that Peston claims QE isn't money creation:

Because what has been really striking about QE is that it was popularly dubbed as money creation, but it hasn't really been that. If it had been proper money creation, with cash going into the pockets of people or the coffers of businesses, it might have sparked serious and substantial increases in economic activity, which would have led to much bigger investment in real productive capital. And in those circumstances, the underlying growth rate of the UK and US economies might have increased meaningfully.

But in today's economy, especially in the UK and Europe, money creation is much more about how much commercial banks lend than how many bonds are bought from investors by central banks. The connection between QE and either the supply of bank credit or the demand for bank credit is tenuous.

That is not to say there is no connection. But the evidence of the UK, for example, is that £375bn of quantitative easing did nothing to stop banks shrinking their balance sheets: banks had a too-powerful incentive to shrink and strengthen themselves after the great crash of 2008; businesses and consumers were too fed up to borrow, even with the stimulus of cheap credit.

This is extremely misleading and confused. He suggests that printing cash and handing it out would boost the 'underlying' growth rate, which is nonsense—the 'underlying' growth rate is driven by supply-side factors. He claims that money creation is identical with credit creation, when they are separate things, and he has already pointed out that creating money doesn't always lead to more credit. We have already seen how credit is not the way QE affects growth, despite what economic journalists like Peston seem to unendingly tell us. Indeed, it seems quite clear that the great recession caused the credit crunch, rather than the other way round.

His ending few paragraphs are yet stranger:

But the fundamental problem with QE is that the money created by central banks leaked out all over the place, and ended up having all sorts of unexpected and unwanted effects. When launched it was billed as a big, bold and imaginative way of restarting the global economy after the 2008 crash. It probably helped prevent the Great Recession being deeper and longer. But by inflating the price of assets beyond what could be justified by the underlying strength of the economy, it may sown the seeds of the next great markets disaster.

It's not clear at all why Peston thinks that QE would inflate asset prices beyond what could be justified. I've written at length about this before. The money a trader gets from selling a gilt to the Bank of England is completely fungible with all their other money. There is no reason to expect they will put this money in an envelope and save it for a special occasion. They try and hold the same portfolio of assets as they did before. Through various channels (including equity prices -> investment) QE raises inflation and real GDP and surprise surprise these are exactly the things that asset prices should care about.

Should central banks do emergency lending?

A barnstorming new paper from the Richmond Fed, written by its President Jeffrey Lacker and staff economist Renee Haltom, argues that the Federal Reserve has drifted into doing too much credit policy to the detriment of its traditional goal of overall macroeconomic stabilisation.

In its 100-year history, many of the Federal Reserve’s actions in the nameof financial stability have come through emergency lending once financial crises are underway. It is not obvious that the Fed should be involved in emergency lending, however, since expectations of such lending can increase the likelihood of crises. Arguments in favor of this role often misread history. Instead, history and experience suggest that the Fed’s balance sheet activities should be restricted to the conduct of monetary policy.

The first step in their case is attacking the idea that the Fed was created to be a lender to specific troubled institutions or sectors:

Congress created the Fed to “furnish an elastic currency.”...In other words, the Fed was created to achieve what can be best described as monetary stability. The Fed was designed to smoothly accommodate swings in currency demand, thereby dampening seasonal interest rate movements. The Fed’s design also was intended to eliminate bank panics by assuring the public that solvent banks would be able to satisfy mass requests to convert one monetary instrument (deposits) into another (currency). Preventing bank panics would solve a monetary instability problem.The Fed’s original monetary function is distinct from credit allocation, which is when policymakers choose certain firms or markets to receive credit over others.

They go on to explain further the difference between monetary policy (providing overall nominal stability; making sure that shocks to money demand do not lead to macroeconomic instability & recessions) and credit policy (choosing specific firms to receive support and funds—effectively a form of microeconomic central planning):

Monetary policy consists of the central bank’s actions that expand or contract its monetary liabilities. By contrast, a central bank’s actions constitute credit policy if they alter the composition of its portfolio—by lending, for example—without affecting the outstanding amount of monetary liabilities. To be sure, lending directly to a firm can accomplish both. But in the Fed’s modern monetary policy procedures, the banking system reserves that result from Fed lending are automatically drained through off setting open market operations to avoid driving the federal funds rate below target.

The lending is, thus, effec-tively “sterilized,” and the Fed can be thought of as selling Treasury securities and lending the proceeds to the borrower, an action that is functionally equivalent to fiscal policy.

They go on to explain why Walter Bagehot provides "scant support" for the creditist approach to crisis management, while the facts of the Great Depression do not fit with the creditist story.

Finally, they note that even if there are inherent instabilities in the financial system—something far from proven—many of these are made substantially worse by central bank intervention in credit markets.

Financial institutions don’t have to fund themselves with short-term, demand-able debt. If they choose to, they can include provisions to make contracts more resilient, reducing the incentive for runs. Many of these safeguards already exist: contracts often include limits on risk-taking, liquidity requirements, overcollateralization, and other mechanisms.

Moreover, contractual provisions can explicitly limit investors’ abilities to flee suddenly, for example, by requiring advance notice of withdrawals or allowing borrowers to restrict investor liquidations. Indeed, many financial entities outside the banking sector, such as hedge funds, avoided financial stress by adopting such measures prior to the crisis.Yet, leading up to the crisis, many financial institutions chose funding structures that left them vulnerable to sudden mass withdrawals. Why?

Arguably, precedents established by the government convinced market participants of an implicit government commitment to provide backstop liquidity. Since the 1970s, the government has rescued increasingly large fi nancial institutions and markets in distress. This encourages large, interconnected fi nancial fi rms to take greater risks, including the choice of more fragile and often more profi table funding structures. For example, larger financial firms relied to a greater extent on the short-term credit markets that ended up receiving government support during the crisis. This is the well-known “too big to fail” problem.

I apologise for the length of the quotation, but the paper really is excellent. Do read the whole thing.

Voxplainer on Scott Sumner & market monetarism

I have to admit that I usually dislike Vox. The twitter parody account Vaux News gets it kinda right in my opinion—they manage to turn anything into a centre-left talking point—and from the very beginning traded on their supposedly neutral image to write unbelievably loaded "explainer" articles in many areas. They have also written complete nonsense. But they have some really smart and talented authors, and one of those is Timothy B. Lee, who has just written an explainer of all things market monetarism, Prof. Scott Sumner, and nominal GDP targeting. Blog readers may remember that only a few weeks ago Scott gave a barnstorming Adam Smith Lecture (see it on youtube here). Readers may also know that I am rather obsessed with this particular issue myself.*

So I'm extremely happy to say that the article is great. Some excerpts:

Market monetarism builds on monetarism, a school of thought that emerged in the 20th century. Its most famous advocate was Nobel prize winner Milton Friedman. Market monetarists and classic monetarists agree that monetary policy is extremely powerful. Friedman famously argued that excessively tight monetary policy caused the Great Depression. Sumner makes the same argument about the Great Recession. Market monetarists have borrowed many monetarist ideas and see themselves as heirs to the monetarist tradition.

But Sumner placed a much greater emphasis than Friedman on the importance of market expectations — the "market" part of market monetarism. Friedman thought central banks should expand the money supply at a pre-determined rate and do little else. In contrast, Sumner and other market monetarists argue that the Fed should set a target for long-term growth of national output and commit to do whatever it takes to keep the economy on that trajectory. In Sumner's view, what a central bank says about its future actions is just as important as what it does.

And:

In 2011, the concept of nominal GDP targeting attracted a wave of influential endorsements:

Michael Woodford, a widely respected monetary economist who wrote a leading monetary economics textbook, endorsed NGDP targeting at a monetary policy conference in September.

The next month, Christina Romer wrote a New York Times op-ed calling for the Fed to "begin targeting the path of nominal gross domestic product." Romer is widely respected in the economics profession and chaired President Obama's Council of Economic Advisors during the first two years of his administration.

Also in October, Jan Hatzius, the chief economist of Goldman Sachs, endorsed NGDP targeting. He wrote that the effectiveness of the policy "depends critically on the credibility of the Fed's commitment" — a key part of Sumner's argument.

But read the whole thing, as they say.

*[1] [2] [3] [4] [5] [6] [7] [8] [9] [10] [11] [12] [13] [14] [15] [16]

QE boosts equities by boosting fundamentals

Many people suggest that the recovery in equity prices since 2009-2010, seen around round the world but particularly in the American Nasdaq, S&P500 and DJIA, does not represent a general economic improvement. Instead, they believe that these numbers are simply being buoyed by new money pumped into the system. I don't think this argument holds, and I will attempt to explain why. First let's consider why we think people hold equities. Essentially, people hold equities because they expect a given real return for a given risk profile. In our simplest model, people hold portfolios of assets based on their risk tolerance, their subjective judgements over probabilities, and their preferences. Adding in banks, insurers, pension funds and so on makes the overall picture more realistic, but doesn't change our theory much. People pick financial intermediaries that hold the assets according to our preferences—the intermediaries add value through scale, or through providing a payments system and settling accounts.

Why might electronic money printing (which we call "quantitative easing" or QE) affect equity prices?

Well, firstly, we might not expect an effect from quantitative easing under one circumstance. QE increases the amount of narrow money we have—that is the number of notes, coins and bank reserves in the system. Generally we think broad money—which includes bank accounts people can debit or write checks on, and is much, much larger—is what interacts directly with the real economy. The ratio of broad money to narrow money is called the money multiplier, and usually a rise in narrow money leads to an even bigger rise in broad money—but this multiplier is not stable. It's at least possible (although not historically typical) that a rise in narrow money could be completely counteracted by a fall in the money multiplier.

But assuming this doesn't happen, there are three reasons why QE might boost equity prices. First would be because it increases inflation and the future price level. If prices rise, cash is worth less, so relative to a given nominal amount of cash, all things being equal a given equity is worth more. In other terms, the firms' nominal expected returns would rise.

The second reason is that in a depressed economy monetary easing like QE may boost real growth, which we would expect to raise any given company's expected real returns. It might also reduce the risk of very bad economic outcomes. Since equities are riskier than bonds, gilts and cash they pay a risk premium to those who hold them—a higher return (lower price) to compensate for this. If risky outcomes in general become less likely, these risk premia might narrow, making equities more desirable and expensive.

The third reason QE might raise stock prices is because it increases overall social wealth, and thus may lead to greater risk-tolerance overall, if people are willing to bear more risk as they get wealthier, and thus shift towards riskier assets like equities.

In each of these three, the jump in equity prices comes from fundamental factors. One could certainly drive up stocks by creating lots of inflation, but we can easily check if that's what's happening by looking at inflation. Any real/relative growth in equities would refute that explanation. In contrast, real growth, reduced risk and shifted preferences due to extra wealth are all legitimate reasons for higher equity prices.

Accounts of why QE buoys stocks without improving fundamentals (and hence part of the argument that stock indices are not good proxies for economic health) tend to rely on a narrative that QE "flows into equities". But as explained, people try to hold their wealth in the portfolio that fits closest to their preferences. If QE money did "flow into equities" then people would now be holding more of their wealth in stocks than they wanted to—they would rapidly rebalance their portfolio. Typically people needn't even do this themselves, because their pension fund will do so for them. QE has to improve the fundamental factors in order to boost equities.

What's the true free market monetary policy?

Let's imagine we are in a world where central banks are given key roles in the macroeconomy, and have been for decades or even centuries in almost every country. In this imaginary world, studies into the relative efficacy of free banking regimes have been undeservedly overlooked, and the orthodoxy among major economists, even ones otherwise sympathetic to free markets is that they are a bad idea. Major policymakers, let's imagine, are completely unaware of the free banking alternative, and most even use the term to mean something completely different. Proposals to enact free banking have not been mentioned in law making chambers for decades or centuries, if at all. It has not been in any party's policy platform for a similar period of time, in this imaginary world.

What's interesting about this imaginary world is that it is in fact our world. Economists like George Selgin, Larry White, Kevin Dowd (among many others) have done very convincing research about the benefits of free banking. And free banking may one day become a real prospect, perhaps in a new state or a charter city. But free banking has lost the battle for the time being, and abolishing the central bank and government intervention in money is as unlikely as abolishing the welfare state. Now one might say that if free banking is a desirable policy, it is worth continuing to wage the intellectual war for the benefit of future generations, who could benefit from the scholarship. Work done now could end up influencing and improving future monetary policy.

I do not discount the possibility this is true. At the same time, free banking is a meta-policy, not a policy—a way of choosing what monetary regime to enact, rather than a specific monetary regime. After all, it is at least possible that free banks could together target consumer prices, the GDP deflator, the money base, the money supply measured by M2, nominal income/NGDP. And for each of these different measures there are an infinite number of theoretical growth paths, and a large number of realistically plausible growth paths they could aim for. Now, free bankers say that the market will make a good decision, and I can buy that. But let's say we're constrained to choose a policy without the aid of the market mechanism: can we say there are better or worse central plans?

The answer is: of course we can! Old-school monetarism, targeting money supply aggregates, was a failure even according to Milton Friedman, whereas CPI targeting, for all its flaws, delivered 66 quarters of unbroken growth and a period so decent they named it the Great Moderation. The interwar gold standard brought us the stagnation of the 1920s (in the UK) and coming off us brought us our relatively pleasant experience of the Great Depression. Literally the order in which countries came off the gold standard is the order they got out of the Great Depression. And even though the classical gold standard worked pretty well, few of its benefits would obtain if we went back. Some central plans (the interwar gold standard, M2 targeting) don't work, some work a bit (the classical gold standard, CPI) and arguably some work pretty well (NGDP targeting is one in this category, according to Friedman, Hayek and I). If we are stuck with central planning, then why not have a good central plan?

And just because I'm allowing the term "central planning" to describe NGDP targeting, we needn't describe it as "government intervention in money". I don't think they are really the same thing. "Government intervention in money" brings to mind rapid inflation, wild swings in the macroeconomic environment; in short the exact circumstances that NGDP-targeting aims to avoid. Targeting aggregate demand keeps the overall macro environment stable—a truly neutral monetary policy—allowing firms and households to make long-term plans, and preventing recessions like the last one, caused as it almost certainly was by drastic monetary tightening. Indeed, as monetary policy determines the overall path of aggregate demand, we might easily call "sound money" policies aiming for zero inflation or a frozen base as dangerous government meddling—they allow the actually important measures like nominal income to fluctuate drastically.

Consider an analogy: school vouchers. Many libertarians may favour a system where parents can spend as little or as much as they want on schooling (considering distributional concerns separately), rather than having central planners decide on the voucher-set minimum. But we usually see a voucher system as an improvement on the status quo—parents may not be able to fully control how much is spent on their children's education but at least they can pick their school. Popular and successful schools grow to accommodate demand, while unpopular and unsuccessful schools can be wound down more quickly. Libertarians may see this as a way from the ideal situation, but none would therefore denounce the policy. The analogy isn't perfect, but I like to see NGDP targeting as similar to school vouchers, versus status quo schooling as the CPI target. Libertarians shouldn't make the perfect the enemy of the good.

Low rates doesn't mean low rates

I got called up last Wednesday to ask if anyone at the Adam Smith Institute would go on the Daily Politics to explain why the Bank of England should raise its base rate (not exactly in those words). The producer was familiar with common free market ideas that argue that artificially low interest rates are blowing up a housing bubble which will later burst. I had to try to explain to the producer why I both agree and disagree with these sentiments: low interest rates do underlie economic limbo, but raising the base rate is not a solution and may produce yet lower real interest rates where it matters—throughout the economy.

The problem comes from the dual use, in the popular economic press, and even by top economists, of the term "interest rates" to mean both the stance of monetary policy and the cost of borrowing. This is understandable because during the Great Moderation of 1992-2008 all the world's most important macroeconomic authorities attempted to control the overall economy through adjusting one or a small number of key interest rates to achieve a consumer price inflation (CPI) target. At the same time, we are familiar with interest rates through our normal life: on loans, mortgages, savings, credit cards and so on. But acting as though the Bank of England directly controls these rates when it adjusts policy seriously obfuscates how the macroeconomy works and contributes to a lot of sloppy thinking.

Whereas the Federal Reserve has always used a form of quantitative easing (QE) to adjust a market interest rate—the Federal Funds Rate—the Bank of England has typically adjusted its base rate, which it calls Bank Rate, instead (updated). Bank Rate is the flat (nominal) interest rate it charges commercial banks for short term funding, and pays on their excess reserves. This sets a lower bound on overnight commercial lending, since it is always an option to lend or borrow money at Bank Rate, and therefore it is included in some market contracts, like tracker variable rate mortgages. The current UK base rate is 0.5%, a nominal number which translates to a negative real rate, but secured loans charge more like 3% in nominal terms, unsecured loans 8%, and credit cards 10%.

So we've established that the Bank of England sets a lower bound on interest rates with its Bank Rate. And we've also established that Bank Rate affects some other rates directly, principally tracker mortgages. We might also expect it to affect other rates in the economy—for example a cut will "ripple out" through the economy, because all other things being equal, it is now cheaper for banks to borrow from the BoE and they will thus be more willing to do so. Economists call this the liquidity effect. They will thus be more willing to lend cheaply and less willing to borrow from savers. So one effect of lowering the Bank Rate is to directly lower some rates, put a lower lower bound on others, and make others cheaper.

However there is an opposed reaction. Lowering Bank Rate doesn't just make loans cheaper, but it increases demand. It does so by injecting extra money into the economy (from the extra loans), but more importantly by signalling to markets that it intends demand to grow faster and that it is willing to take measures (such as further lowering Bank Rate or boosting the money supply through a QE programme) to make sure this happens. This is why stock markets react so strongly to a (policy) interest rate cut—all businesses are worth a bit more because they expect higher total revenues over their future.

But if firms expect higher demand in the future they will in turn demand more investment funds to put into projects to service that demand. This means that cutting the BoE's base rate puts pressure on effective market interest rates in both directions. It is an empirical question which direction the overall effect goes in—but this means that the simple coincidence of low real effective interest rates out in the economy and a low, by historical terms, Bank Rate, shows nothing. It could be that the best way to raise interest rates out there in the economy is to cut the Bank's base rate, or, since it can't go much further now, print money to raise inflation (which would ceteris paribus cut the rate in real terms). Look at the graph above for an illustration of how the Fed's changes in their QE programme (the red line) and their Federal Funds rate (the dark blue line) don't produce big shifts in (real) market interest rates like corporate bond returns and 30-year mortgages.

So my view on low interest rates is complicated. I think the Bank should get out of the business of setting rates altogether, and vary the size of the monetary base to control nominal income in the economy. But if the Bank is going to use rates as its key policy tool, it shouldn't raise them when a recovery hasn't quite taken hold—it's uncertain whether it'll raise market interest rates, but it will certainly choke off the demand we need for solid growth.