Simon Wren-Lewis

Personal Webpage

Email   simon.wren-lewis at economics.ox.ac.uk

Updated October 2011

simon.wren-lewis.jpg

Research Papers

 

Topical Notes

 

Talks

 

Journalism

New – Blog!

 

Teaching

 

CV

 

Fiscal Councils

 

New Since 2008:

 

Research Papers

Topical Notes, Talks, Journalism

Internal consistency, price rigidity and the microfoundations of macroeconomics

10/11 Fiscal Councils: The UK Office for Budget Responsibility

Lessons from failure: Fiscal Policy, indulgence and ideology

10/11 The Case Against Austerity (full) (short summary)

Paper with Leith and Moldovan on Debt Stabilisation in Non-Ricardian Economies

2/11 Demand Denial in macroeconomics

A Comparison of Monetary and Fiscal Policy Delegation

3/11 Ten reasons not to raise interest rates

Paper with Lars Calmfors on What Should Fiscal Councils Do?

2/11 In praise of the Monetary Policy Committee (or at least most of them)

Paper with Leith on Discretionary Policy in a Monetary Union with Sovereign Debt

2/11 Ideological Aspects of the Financial Crisis

Macroeconomic Policy in the light of the Credit Crunch

7/10 Can the Office for Budget Responsibility be Independent

The consensus assignment for monetary and fiscal policy

12/10 Austerity or Stimulus? A question of Commitment

Paper using COMPACT to assess the impact on the UK of a flu pandemic

5/09 Monetary Policy in the Recovery

Paper with Eser and Leith on the sub-optimality of fiscal demand management

 

Paper with Kirsanova and Vines on Phillips curves

 

Paper with Kirsanova and Leith on optimal fiscal policy and a UK Fiscal Council

 

 

Research Papers

 

Stabilisation Policy - General Issues

Policy Objectives in an Open Economy

 

Inflation Bias with dynamic Phillips curves

 

Inflation Persistence

 

Lessons from the 2008/9 Recession

 

 

Monetary Policy in an Open Economy

Stability of simple monetary policy rules

 

Stability in a Fixed Exchange Rate Regime

 

Responding to Exchange Rate Misalignments

 

 

Monetary and Fiscal Policy Interaction

Active and Passive Regimes

 

The Consensus Assignment

 

Interactions in a Monetary Union

 

 

Fiscal Demand Stabilisation Policy

Can Fiscal Stabilisation Policy Improve Welfare?

 

Fiscal Rules, the SGP and the UK

 

Institutions for Fiscal Stabilisation

 

 

Debt Stabilisation Policy

Simple rules for Fiscal Feedback on Debt

 

Optimal Debt Policy

 

Deficit Bias

 

Fiscal Councils: Institutions for Debt Stabilisation

 

 

Equilibrium Exchange Rates

 

 

 

Structural Econometric Models

 

 

 

Methodological Issues

 

 

 

Stabilisation Policy - General Issues

Policy Objectives in an Open Economy

Following from Woodford's derivation of a benevolent monetary policy maker's objective function from agents utility, some papers have suggested that policy in an open economy should have the same objectives as in a closed economy, and in particular that the exchange rate should play no role. The robustness of this isomorphism claim is examined in Kirsanova, Leith and Wren-Lewis (2006). In particular, we look at a model in which there are shocks to International Risk Sharing or Uncovered Interest Parity. Exchange rate volatility generated by such shocks has often been a key element in arguments suggesting that policy should be concerned about exchange rate movements.

Our results suggest that in general the presence of such shocks does introduce a role for the terms of trade gap into the benevolent policy maker's objective function, so isomorphism does not hold. The exception is the special case when agents' utility from consumption is logarithmic, which is the assumption in Gali and Monacelli (2005). We suggest that the terms of trade gap has similarities to deviations from Williamson's Fundamental Equilibrium Exchange Rate or FEER.

An alternative rationalisation for terms related to the exchange rate appearing in the social welfare function is provided in Leith and Wren-Lewis (2006). This looks at a model with traded and non-traded goods. It shows that in general welfare will depend on output and inflation in both sectors, but an objective function involving only aggregate variables can be derived if this function also includes measures related to the exchange rate.

Inflation Bias with dynamic Phillips curves

The possibility that a benevolent policy maker's desire to raise output above the natural rate might cause steady state inflation to be above target when expectations are rational (inflation bias) has been central to debates on macroeconomic policy, and in particular the desirability of independent central banks. While the seminal model (Barro and Gordon, 1983) is static, the analysis has been extended to dynamic Phillips curves (Clarida, Gali and Gertler, 1999, for example). In Kirsanova, Vines and Wren-Lewis (2009), we generalise this literature by looking at NAIRU Phillips curves which contain a combination of forward and backward looking elements, and New Keynesian Phillips curves where policy makers discount at a different rate from the private sector.

We show that negative inflation bias will occur under a commitment or timeless perspective policy, with either a hybrid NAIRU Phillips curve which is mainly forward looking, or with a New Keynesian Phillips curve if policy makers discount at a higher rate than the private sector.

Inflation Persistence

In Kirsanova, Vines and Wren-Lewis (2007), two examples are considered where the extent of inflation persistence (where current inflation depends on past inflation as well as expected future inflation) is crucial for macroeconomic outcomes. 

Lessons from the 2008/9 Recession

The 'Credit Crunch' of 2007-9 showed the limitations of monetary policy, the re-emergence of counter-cyclical fiscal policy, and the importance of policy towards government debt. In Wren-Lewis (2010) I examine these issues, and also the responsibility of macroeconomic policy for the credit crunch itself. This paper summarises a number of themes dealt with in more detail below. It was also written during the initial stages of the recession, when it was still possible to be optimistic about governments’ ability and willingness to close the output gap. However, 2010 saw a shift from (limited) fiscal stimulus to austerity. Wren-Lewis (2011) explores the reasons behind this shift. It argues that although problems with debt can explain this policy change in some (Euro area) countries, the explanation elsewhere owes a great deal to ideological factors.


 

Monetary Policy in an Open Economy

Stability of Simple Monetary Policy Rules

In two papers, we have examined whether monetary policy rules should be specified in terms of consumer or output price inflation. In Leith and Wren-Lewis (2001) we found that this choice was important, particularly in response to exchange rate shocks. In Leith and Wren-Lewis (2009) we look at a two country model where PPP holds for consumer prices. We find that, if both countries target consumer prices, this will probably be destabilising, while targeting output prices will not. Kirsanova, Leith and Wren-Lewis (2006) also looks at a small open economy, and finds that instability can result from monetary policy rules based on consumer price inflation if those rules are aggressive.

Stability in a Fixed Exchange Rate Regime

Under fixed exchange rates when uncovered interest parity holds, nominal interest rates are fixed at overseas levels. If inflation is governed by a backward looking Phillips curve, this raises the possibility that the inflation process may be unstable. It might be thought that this instability is avoided by the impact of competitiveness on aggregate demand. However, in Kirsanova, Vines and Wren-Lewis (2005), we show that this is not the case. Competitiveness effects generate cyclicality, but they do not prevent unstable inflation processes: we observe explosive cycles. However, this instability can be avoided by using fiscal policy in a countercyclical manner. The paper also looks at mixed forward/backward Phillips curves.

Responding to Exchange Rate Misalignments

Periods in which real exchange rates persistently and significantly stray from levels implied by fundamentals seem endemic under floating exchange rates. In standard models these movements are represented as shocks to Uncovered Interest Parity or International Risk Sharing. In Leith and Wren-Lewis (2006) we examine what the optimal monetary response to such shocks would be in a model with traded and non-traded goods.

We show how a social planner would respond to such shocks by maintaining levels of production in both sectors. However, under flexible prices a shock that leads to an exchange rate appreciation will increase the production of non-traded goods relative to traded goods. If we have price rigidity, policy can intervene to moderate this response. We compare an optimal policy (given welfare implied by the representative agent) to one under alternative policy regimes, including output price inflation targeting.

·         Kirsanova, T, Vines, D and Wren-Lewis, S (2005), Fiscal Policy and Macroeconomic Stability within a Monetary Union, mimeo

·         Leith, C. and Wren-Lewis, S. (2001), Interest Rate feedback rules in an open economy with forward looking inflation, Oxford Bulletin of Economics and Statistics, 63,209-232

·         Leith, C. and S. Wren-Lewis (2009), "Taylor Rules in the Open Economy" University of Glasgow, European Economic Review, 53, 971-995.

Monetary and Fiscal Policy Interaction

 

Active and Passive Regimes

Much of the work in this and the following section has been made possible by three ESRC grants held with Campbell Leith at Glasgow University, under the Evolving Macroeconomy programme, the World Economy and Finance programme, and most recently (2008-11) under the Research Grants scheme. The results of the completed projects were rated as 'outstanding' by the ESRC.

In Leith and Wren-Lewis (2000) we look at simple policy rules within the context of a closed economy model where consumers are non-Ricardian (Blanchard/Yaari) and where there is nominal inertia of the Calvo type. The monetary policy rule has real interest rates responding to excess inflation, and the fiscal rule has taxes or government spending responding to excess debt levels. We show that there are two stable policy regimes in this model. In the first, monetary policy is active (see Leeper(1991)) in the sense that real interest rates rise whenever inflation is above target, and the response of fiscal policy to deviations from steady state debt levels is beyond some threshold level. In the second, monetary policy is passive (so real interest rates fall when inflation is above target) and fiscal policy does not respond sufficiently to excess debt.

This second regime has strong similarities to the Non-Ricardian regime in the Fiscal Theory of the Price level (see, for example, Woodford (2000) and Canzoneri, Cumby and Diba (2001)) An important difference, due to the presence of nominal inertia and non-Ricardian consumers in our model, is that this regime can occur even when all government debt is indexed. In addition, both monetary and fiscal policy influence the price level in both regimes, although the impact of fiscal policy is clearly greater in the passive monetary policy regime (see below).

In two more recent papers, we extend our analysis to a two-country setting, under either a monetary union (Leith and Wren-Lewis (2006) or flexible exchange rates (Leith and Wren-Lewis (2008)). In both cases there exist two stable policy regimes of a similar type to those in a closed economy. However, under EMU, a passive monetary policy is only compatible with fiscal inaction in one of the two countries: if both fiscal authorities take little or no action to stabilise their debt stock, the model will be unstable whatever the monetary policy rule. (This echo's the results outlined in the Canzoneri et al (2001) for non-Ricardian regimes.) There is some scope for compensation between the two fiscal authorities, although the paper suggests that this will be small in practice. Under flexible exchange rates we have two monetary authorities as well as two fiscal authorities, and so now both countries can opearte a passive monetary regime with little or no fiscal feedback on debt. One interesting result in the paper is that a passive monetary policy is one country can compensate for fiscal inaction in the other country.

A special case of passive monetary policy is where nominal interest rates are fixed. The result that a fixed interest rate policy need not lead to price level indeterminacy if fiscal policy is inactive (in the sense outlined above) is not peculiar to rational expectations models. In Leith, Warren and Wren-Lewis (2003) we show that stability is possible under this regime in purely backward looking models, and show in a variety of models that in this passive regime nominal rate shocks may have a surprising impact on the price level.

Two particular issues arise from this work:

§  how does an economy under a passive monetary policy regime and insufficient fiscal feedback respond to shocks?

This is addressed to some degree in all of our papers cited above, and explicitly in Wren-Lewis (2003). Not surprisingly, both fiscal shocks and demand shocks have a much larger impact in the passive regime than under an active monetary policy. In this sense, the active monetary policy regime appears to be preferable to the passive regime. This result is formalised in Kirsanova and Wren-Lewis (2007), which finds that welfare in a passive monetary policy regime is always worse than under an active regime.

§  What does fiscal policy have to do to avoid this regime?

The short answer implied by all the papers noted above is 'not much'. Although Leith and Wren-Lewis (2002) explicitly notes how the presence of non-Ricardian consumers increases the amount of fiscal feedback required to ensure a stable active monetary policy regime, using plausible parameter values this critical speed of fiscal feedback is still fairly slow. Whether more rapid debt adjustment is harmful, or alternatively whether debt needs to be corrected at all, is discussed in a later section.

The Consensus Assignment

Over the last few decades, the general consensus has been in favour of a particular active monetary policy regime, where the stabilisation of output and inflation is the exclusive preserve of monetary policy, while fiscal policy (and only fiscal policy) is concerned with stabilising government debt. (This consensus applies to a flexible exchange rate regime, where interest rates have not hit a zero lower bound.) Kirsanova, Leith and Wren-Lewis (2009) refer to this as the 'consensus assignment'. The last ten years has also seen the coming together of two previously distinct branches of academic literature: new Keynesian analysis and dynamic optimal taxation. Kirsanova, Leith and Wren-Lewis (2009) ask whether the consensus assignment is supported by this new research. (Non-technical summary)

Interaction in a Monetary Union

 

Suppose a national fiscal authority in a monetary union behave in an optimal manner, but cannot commit. The country suffers a positive debt ‘shock’. The lack of commitment technology means that the debt shock will not be accommodated in the long run. However, unlike the closed economy case examined in Leith and Wren-Lewis (2007), Leith and Wren-Lewis (2010) show that the time consistent solution generates a gradual decline in debt because of the need to maintain competitiveness. If the central bank can commit, it adjusts its policies only slightly in response to higher debt, allowing national fiscal policy to undertake most of the adjustment. However if it cannot commit, then optimal monetary policy involves using interest rates to rapidly reduce debt, with significant welfare costs. We show that in these circumstances the central bank would do better to ignore national fiscal policies in formulating its policy.

 

 

Fiscal Demand Stabilisation Policy

 

Many of the points discussed in this and the following section are summarised in Leith and Wren-Lewis (2006) and Kirsanova, Leith and Wren-Lewis (2007).

Can Fiscal Stabilisation Policy Improve Welfare?

For more than two decades, monetary policy has been seen as the primary or only policy instrument for business cycle stabilisation. However the reasons for this have generally concerned factors outside a standard macroeconomic model, such as implementation lags or political economy concerns. In Eser, Leith and Wren-Lewis (2009) we show that in a New Keynesian model where social welfare is derived from agent's utility, and monetary policy is unconstrained, there is no role for changes in government spending to assist monetary policy in demand management. In other words, there is no social cost in assigning only monetary policy to demand management. The paper shows that this result is robust to a number of model extensions.

There are two important caveats to this result. First, as Eser et al (2009) show analytically, and Leith and Wren-Lewis (2006), also quantify, there is an important supply side role for taxes in a model involving both price and wage rigidity. Second, Leith and Wren-Lewis (2006) show that if monetary policy is constrained because the economy is part of a monetary union, government spending can partially substitute for monetary policy. This updates earlier research using less microfounded models (see Driver and Wren-Lewis (1999)) for example), which also found that fiscal stabilisation could be very useful under EMU.

Fiscal Rules, the SGP and the UK
 
Wren-Lewis 2003 compares the fiscal rules adopted by the Labour Government in the late 1990s with the early versions of the Stability and Growth Pact of the Eurozone. The paper suggests that in important respects the UK rules are superior to those of the SGP. Furthermore, the idea that each Euro member country should be subject to the same rules does not make sense. Wren-Lewis 2003 also argues that Euro governments should be allowed to be exempt from the SGP if they meet two key conditions. First, they have in place rules of their own which ensure sustainability. Second, the European Commission believes that the government is following its own rules. If a government passes the first test, but subsequently fails the second, it then becomes subject to the SGP again. This proposal would allow countries to design fiscal rules and institutions that are appropriate for their own national circumstances, and take ownership of those rules. It adds an additional incentive to keep to its own rules. It preserves the principle of subsiduarity. The alternative currently being explored by the Commission is to modify the rules of the SGP in a number of ways. While each of these modifications may be an improvement, taken together they are likely in practice to involve the Commission in much more detailed inspection and bargaining over individual country's fiscal plans. This leads to an unnecessary reduction in subsiduarity, and adds to poltical tensions.

A more stylised alternative to the SGP is examined in Kirsanova, Satchi, Vines and Wren-Lewis (2006). Here fiscal policy can follow simple rules to help stabilise an economy in the face of asymmetric shocks. The paper examines the consequences for welfare of restricting these rules in various ways.

New institutional arrangements for fiscal stabilisation policy
 
The role, if any, for fiscal policy as a cyclical stabilisation device is discussed above. There it was noted that, even when monetary policy was unconstrained, tax changes could compliment monetary policy in influencing key relative prices. If monetary policy is constrained, fiscal policy had a clear demand management role. The effectiveness of different fiscal instruments is examined in Wren-Lewis (2000). It notes why indirect tax changes like VAT may be much more effective than other tax changes. (The UK government enacted a temporary cut in VAT as part of their efforts to combat the 2008/9 recession.)

Nevertheless, governments may be reluctant to pursue a stabilisation policy alongside a monetary authority, or it may be believed that governments might abuse this role by operating it only when fiscal expansion is required. Wren-Lewis (2003) argues the case for a new institutional structure, where an independent authority is mandated to carry out limited and temporary fiscal changes to selected fiscal instruments to help meet an inflation target. This institution could be the central bank.

In a short piece in the Financial Times: 'Trust the Old Lady' 5/02/2002 I argue for allowing the Bank of England temporary and limited access to selected fiscal instruments. This proposal is politically controversial, as was evident when I gave evidence to the Treasury Select Committee's 10 year review of the Monetary Policy Committee.

These arguments for institutional change relate to short term stabilisation policy, and are in principle quite separate from the arguments for a Fiscal Council to monitor long term government debt discussed below.


 

Debt Stabilisation Policy

 

Much analysis of fiscal policy (including the papers on monetary and fiscal interaction cited above) assumes an explicit or implicit debt target. The implication is that any shock that raises debt will result in policy action that returns debt to its original level. I have looked at two questions that arise: how quickly should debt correction occur, and is this the optimal policy?

Simple rules for Fiscal Feedback on Debt

One issue is how fast any fiscal feedback from debt should be. Results described earlier suggest that only very modest fiscal feedback is required to ensure that monetary policy can be active. In addition, Leith and Wren-Lewis (2000) and Leith and Wren-Lewis (2002) suggest that rapid stabilisation of debt may have negative consequences for inflation and output. This result is formalised in Kirsanova and Wren-Lewis (2007), which computes the optimal speed of fiscal feedback in a closed economy, on the assumption that monetary policy is determined optimally under commitment. Here government spending is adjusted as a proportion lambda of debt disequilibrium (so large lambda implies rapid debt correction), and the optimal lambda is computed. We find that the optimal value of lambda involves very slow debt correction.

Optimal Debt Policy

Two recent papers (Benigno and Woodford (2003) and Schmitt-Grohe and Uribe (2004)) have computed the fully optimal fiscal response (such that fiscal policy is not tied to any simple fiscal feedback rule) assuming that (distortionary) taxes are the fiscal instrument and that policy operates under commitment. They demonstrate a random walk result: following a positive shock to debt, the optimal response is to let debt remain permanently higher. By implication, the costs (in their case of permanently higher distortionary taxes) of leaving debt higher are less than the short term costs of returning debt to its original level. Leith and Wren-Lewis (2007) generalises this result by allowing both taxes and government spending as instruments. We also compute the optimal policy under discretion, and show that this does not imply a random walk in debt, but instead debt returns (slowly) to its steady state level. This result is explained by examining the nature of the time inconsistency involved in the commitment case. The random walk result does not imply complete accomodation of the fiscal shock: there is an attempt in the first period to reduce long run debt. This incentive is time inconsistent, and can only be removed if changes in debt are eliminated in the long run.

The random walk steady state debt result relies on the exact equality of the real rate of interest with the rate of time preference. In OLG models this will not be true in general. Leith, Moldovan and Wren-Lewis (2011) examine the optimal debt target, and optimal rates of adjustment to it, in Blanchard’s (and Yaari’s) Model of Perpetual Youth. This suggests that the optimal long run debt target is negative, but still not negative enough to eliminate the need for distortionary taxation or achieve an optimal capital stock. The optimal speed of adjustment to this target is very slow, but given the size of the total adjustment required compared to current levels, this may still imply significant reductions in debt to GDP ratios over the medium term. 

Deficit Bias

On average, government debt in OECD countries has increased substantially over the last few decades, and there appears to be no good reason why this should have happened. Some potential explanations are surveyed in Wren-Lewis (2010). One is electoral competition. It may be optimal for a party in power to raised debt levels, so that this will restrict the options of an opposition party if they subsequently come to power. This has been examined in models where debt is real, but the mechanism becomes irrelevant if debt is nominal and there are no price rigidities (because any real debt level can be achieved immediately through surprise inflation). Leith and Wren-Lewis (2009) investigate this form of deficit bias in a sticky price environment where debt is nominal. We find that, for reasonable parameters, the size of deficit bias is small, but electoral competition can generate significant political business cycles.

Fiscal Councils: Institutions for Monitoring Debt

Wren-Lewis (1996) was the first occasion I argued that some form of independent fiscal authority might improve macroeconomic outcomes. The case for institutional reform in the context of countercyclical actions was examined above. However, there is at least as strong a case for an institution that is focused on debt stabilisation.

Kirsanova, Leith and Wren-Lewis (2007) argued that the random walk result discussed above means that simple rules for debt stabilisation will never be first best. This strengthens the case for a change in fiscal institutions to help achieve optimal debt stabilisation. Although some have argued for giving new institutions control over fiscal decisions, we make a more modest proposal, for a government financed but independent Fiscal Monitoring Commission to provide annual recommendations for aggregate tax or spending changes designed to move debt towards its optimal path. Although governments would not be required to follow these recommendations, they would be required to explain why they were not doing so. The paper compares this form of national institutional change to existing institutions in various countries, and to monitoring by the European Commission. Between 2007 and 2009 the idea for some form of independent UK fiscal watchdog gained momentum, and after the election of 2010 the Office for Budget Responsibility was established. (For a detailed account, see Wren-Lewis (2011b). An example of my advocacy of a UK Fiscal Council is here.)

For a page devoted exclusively to Fiscal Councils, with links to existing bodies around the world, a list of papers on the subject and some simple questions and answers, go here.)

There are now a large number of Fiscal Councils around the world, many of which have been established in the last decade. Calmfors and Wren-Lewis (2011) surveys these councils, and analyses the structure and activities of each. It asks to what extent the characteristics of these institutions can be related to the potential causes of deficit bias, and what relationship they have to fiscal rules. A more detailed examination is undertaken of the fiscal councils in Sweden and the UK. The paper draws some conclusions on the role of fiscal forecasting, ensuring independence, and the provision of policy advice. (A short summary of the paper appears here.) Wren-Lewis (2011) compares the delegation of monetary and fiscal policy.

·         Benigno, P. and M. Woodford (2003), “Optimal Monetary and Fiscal Policy: A Linear Quadratic Approach”, NBER Macroeconomics Annual.

·         Calmfors, L. And Wren-Lewis, S (2011), What Should Fiscal Councils Do?, Economic Policy, Vol 26, pp 649-695 and Oxford Discussion Paper No. 537

·         Leith, C. and Wren-Lewis, S. (2007) Fiscal Sustainability in a New Keynesian Model

·        Leith, C and Wren-Lewis, S (2009) Electoral Uncertainty, the Deficit Bias and the Electoral Cycle in a New Keynesian Economy, Oxford Discussion Paper No. 460

·        Leith, C, Moldovan, I and Wren-Lewis, S (2011) Debt Stabilisation in a Non-Ricardian Economy, Oxford Discussion Paper No. 542

·         Schmitt-Grohe, S. and M. Uribe (2004), “Optimal Monetary and Fiscal Policy under Sticky Prices”, Journal of Economic Theory,114, February 2004, pp 198-230.

·         Wren-Lewis, S (1996) ‘Avoiding Fiscal Fudge’, New Economy, 3, 128-132, Institute of Public Policy Research.

·         Wren-Lewis, S (2011), Comparing the delegation of monetary and fiscal policy, Oxford Discussion Paper No. 540

·        Wren-Lewis, S (2011b), Fiscal Councils: The UK Office for Budget Responsibility, CESifo DICE Report 3/2011 (Autumn)

 

 

Equilibrium Exchange Rates

Some History

I first began working in this area with Ray Barrell (see Barrell and Wren-Lewis, 1989), as a key input into assessing John Williamson and Marcus Miller's proposal for international policy cooperation (see Currie and Wren-Lewis (1989) and other papers with David Currie in my CV). In 1990, together with colleagues at NIESR, I used this framework to argue that 2.95 DM/£ was too high an exchange rate to enter the ERM, and that entering at this rate could intensify and prolong the emerging recession. (see Wren-Lewis et al (1991)). For an analysis of the benefits of abandoning this parity in 1992, see Hughes Hallett and Wren-Lewis (1997).

An Alternative to PPP

The most widely used method of computing equilibrium exchange rates is Purchasing Power Parity. There are a number of powerful theoretical reasons to doubt the validity of PPP over a medium term time horizon (see Wren-Lewis (2003a) for example). The 'new international macroeconomics' explores a world in which international trade involves differentiated products sold in imperfectly competitive markets, where the terms of trade are influenced by macroeconomic factors such as idosyncratic productivity shocks. In Wren-Lewis (2004) I argue that John Williamson's FEER approach fits naturally into this framework. In Barisone, Driver and Wren-Lewis (2006) we argue that this approach to assessing equilibrium rates is more powerful than PPP in explaining past movement in G7 parities.

A Sterling Euro Entry Rate
 
In 2002 I was asked by H.M.Treasury to write a survey of work on equilibrium exchange rates for Sterling and the Euro, and subsequently to calculate a new estimate of my own. The paper (Wren-Lewis (2003a)) was published as part of the Treasury's analysis of its Five Tests for Euro entry. This work was completed in the summer of 2002, when the Euro Sterling rate was above 1.6, and had been for some time. The estimate I made then of an equilibrium rate of around 1.37 Euro/Sterling seems less heroic today! The Euro has also appreciated, and the dollar depreciated, to move past my estimate of an equilibrium $/Euro rate of 1.15. These calculations were produced using a new model (FABEER) involving four main country blocs. Details of the model are contained in the paper.

The paper compares these new estimates with some other recent alternative approaches, and also with my earlier work with Rebecca Driver in Driver and Wren-Lewis (1998) published by the IIE in Washington.

Latest Estimates

Detailed estimates for the US dollar, the Yen, the Euro and Sterling based on the FABEER model are contained in Wren-Lewis, 2004, a paper given in May 2004 to a conference organised by the IIE in Washington DC, and now published as a book. The paper also contains some discussion of China's Renminbi. The paper uses the FABEER model, which was the basis of my analysis for the UK Treasury of the equilibrium Sterling Euro rate. These are updated in Wren-Lewis, 2007, although as the title of this paper suggests, the main focus here is on the implications of alternative paths for US savings behaviour.

One of the drawbacks of the partial equilibrium FEER approach to calculating equilibrium rates is that 'sustainable' current accounts are exogenous inputs. Wren-Lewis, 2004 presents an initial attempt at transforming the partial equilibrium FABEER model into a general equilibrium model. The model is used to examine two particular US shocks: a technology shock and a fiscal shock. (For an earlier discussion using a calibrated small open economy macromodel, see Wren-Lewis, 2003b).

In Wren-Lewis (2004b) I adapt the FABEER model to analyse equilibrium values for the New Zealand and Australian dollars. Both currencies are highly dependent on movements in commodity prices, and both currencies experienced strong appreciations in 2003.

·         Barisone, G., Driver, R.L. and Wren-Lewis, S (2006) Are Our FEERs Justified? Journal of International Money and Finance 25, 741-759

·         Barrell, R and Wren-Lewis, S (1989) Fundamental Equilibrium Exchange Rates for the G7, CEPR Discussion Paper 323

·         Currie, D. and Wren-Lewis, S. (1989), Evaluating blueprints for the conduct of international macropolicy, American Economic Review, 79,264-269

·         Driver, R and Wren-Lewis, S (1998), Exchange Rates for the Year 2000, in , ed(s), International Institute for International Economics, Washington

·         Hughes Hallet, A. and Wren-Lewis, S. (1997), Is There Life Outside the ERM? An Evaluation of the Effects of Sterling's Devaluation on the UK Economy, International Journal of Finance and Economics, 2,199-216

·         Wren-Lewis, S., P. Westaway, S. Soteri and R. Barrell (1991), Evaluating the UK's Choice of Entry Rate into the ERM, Manchester School Money Study Group Conference Volume., 59,1-22

·         Wren-Lewis, S (2003a), Estimates of Equilibrium Exchange Rates for Sterling against the Euro, H.M.Treasury

·         Wren-Lewis, S. (2003b), Medium Term Exchange Rate Dynamics

·         Wren-Lewis, S (2004), The Needed Changes in Bilateral Exchange Rates, in Bergsten, C.F. and Williamson, J (2004), Dollar Adjustment: How Far? Against What? Institute of International Economics, Washington DC.

·         Wren-Lewis, S (2004b), A model of Equilibrium Exchange Rates for the New Zealand and Australian Dollars, Reserve Bank of New Zealand Discussion Paper DP2004/07

·        Wren-Lewis, S (2007), When the Dollar Falls, in Quantitative Economic Policy: Essays in Honour of Andrew Hughes Hallett, eds Neck, R, Richter, C and Mooslechner,P, Springer.


 

Structural Econometric Models

Structural Econometric Macromodels (SEMs) have been largely replaced by VARs and SDGE models in the academic literature, but they remain central to much of the analysis undertaken by policy institutions. (For a discussion of these trends, see Wren-Lewis(2000).) In 1998/9 I provided advice to the Bank of England on the development of their first published model post independence (see Wren-Lewis (1999)), and from 2000 to 2003 I continued to advise them on the development of BEQM, which they now use to forecast the UK economy

In the 1990s I built a new UK SEM, called COMPACT, with in particular Julia Darby and John Ireland. The aim of this model was to incorporate new theoretical advances into a UK econometric model, with a focus on policy analysis rather than forecasting. The emphasis on theoretical system properties is reflected in the technique of theoretical deconstruction, which Wren-Lewis et al (1996) argues should be an essential part of SEM evaluation. The COMPACT model is described in detail in Darby et al (1999). Jacobs and Wallis (2005) present an interesting comparison of COMPACT with the 'structural VAR' model built by Pesaran and his colleagues.

COMPACT has been recently used in Keogh-Brown et al (2009) to examine the macroeconomic impact of a flu pandemic on the UK. Although results clearly depend on the severity of the pandemic, two key results emerge. First, as long as the number of deaths are not significant, the economic costs are short term. Second, these short term effects could be very large if there is large scale avoidance of social contact during its duration.

The latest COMPACT Model Manual is in the form of a help file. The model (along with some of the models in my academic papers cited above) is solved using my own model solution software, MODELPHI, which is a Windows programme developed using Borland's DELPHI. This software is not a commercial product, and was designed for my own use. However it has been used by others, including students. Anyone interested in using MODELPHI should contact me by email.

·         Darby, J, Ireland, J, Leith, C and Wren-Lewis, S (1999), Compact: A Rational Expectations, Intertemporal Model of the United Kingdom Economy, Economic Modelling, 16,1-52

·         Jacobs, J.P.A.M. and Wallis, K.F. (2005), Comparing SVARs and SEMs: Two Models of the UK Economy, Journal of Applied Econometrics, 20, 209-228

·         Keogh-Brown, Marcus, Wren-Lewis, Simon, Edmunds, John, Smith, Richard (2010), The possible macroeconomic impact on the UK of an influenza pandemic, Health Economics 19: 1345–1360

·         Wren-Lewis,S. (1999), Many Models at the Bank of England, London Business School Economic Outlook, 23,17-21

·         Wren-Lewis, S (2000), The decline in macroeconomic modelling, in Public Policy for the 21st Century, ed(s) Neil Fraser and John Hills, The Policy Press

·         Wren-Lewis, S., Darby, J., Ireland, J. and Ricchi, O. (1996), The Macroeconomic Effects of Fiscal Policy:Linking an econometric model with theory, Economic Journal, 106,543-559

 

 

Methodological Issues

Trends in Macroeconomics

Wren-Lewis (2007) is based on a talk to a Treasury/GES conference on the consensus in macroeconomics. I argue that the consensus reflects the success of the microfoundations project, but that this has some important implications for the way macroeconomics progresses.

Microfoundations

Wren-Lewis (2009) is my first attempt to write about the methodology of macroeconomics. I argue that in incorporating nominal inertia, the microfoundations project has had to modify its concept of internal consistency in a way that compromises its methodological position. This had led to some ambiguity among researchers over the extent to which relationships which have empirical support but which lack microfoundations can be examined within otherwise microfounded models. Comments are most welcome.

·         Wren-Lewis, S (2007) ‘Are There Dangers in the Microfoundations Consensus?’ in Is There a New Consensus in Macroeconomics? Ed Arestis, P, Palgrave Macmillan.

·        Wren-Lewis, S (2009) 'Internal Consistency, Nominal Inertia and the Microfoundations of Macroeconomics' Oxford Discussion Paper 450 and Journal of Economic Methodology, forthcoming

 

Topical Notes

A collection of short pieces on topical issues, that are not publically available elsewhere. From December 2012 see my blog.

February 2011:  Demand Denial in Macroeconomics

February 2011, revised March 2011:  Ten reasons not to raise interest rates

February 2011: In praise of the Monetary Policy Committee (or at least most of them)

November 2010/February 2011: Ideological Aspects of the Financial Crisis

July 2010: What the OBR should and should not do

May 2010: Going Beyond the Cuts Debate

Feb 2010: Cut Now or Cut Later: the Clash of Letters

Nov 2009: The UK Outlook 2010-12

Oct 2009, updated Feb 2010: On the Office for Budget Responsibility (the UK Fiscal Council)

See also

·        My webpage on Fiscal Councils.

·        The short talk (June 2010):  Remarks on What the Office for Budget Responsibility Should Do

·        The research paper with a detailed proposal for a UK Fiscal Council: Kirsanova et al (2007).

·        Can the Office for Budget Responsibility be Independent

 

Nov 2008: Two Thoughts on the Pre-Budget Report

 The VAT cut and the prospects for long term debt

June 2008: Have Central Banks Lost the Plot on Inflation

Why the focus on core inflation makes sense.

Jan 2007: Submission to the Treasury Committee

The Treasury Committee to the House of Commons held an enquiry on 'Ten Years of the MPC'. This evidence covers a range of issues, including the nature of the Bank's forecasting model, the inflation target, the composition of the MPC, and the wisdom of publishing projections for interest rates.

Demand Denial in Macroeconomics[1]

February 2011

 “Now the school that believes in self-adjustment is, in fact, assuming that the rate of interest adjusts itself more or less automatically, so as to encourage, just the right amount of production of capital goods to keep our incomes at the maximum level that our energies and our organization and our knowledge of how to produce efficiently are capable of providing. This is, however, pure assumption. There is no theoretical reason for believing it to be true. A very moderate amount of observation of the facts, unclouded by preconceptions, is sufficient to show that they do not bear it out.”  Keynes, 1934.[2]

A producer, facing a fall in the demand for their product, cuts back on output. They may also cut their price, but firms that want to stay in business do not carry on producing the same quantity regardless of demand conditions. Aggregate demand also fluctuates for many reasons. Common sense therefore suggests that movements in aggregate demand would be crucial in understanding movements in aggregate output. An economic theory which suggested otherwise would have some explaining to do.

There is a good reason why, in the medium to long term, we can indeed sideline aggregate demand in theories about output. It is not complicated, and goes by a simple name: monetary policy. Yet macroeconomic text books rarely put it like this. Instead, there is a focus on the flexibility or otherwise of price adjustment. In the standard view Keynesian theory is about a world in which prices are sticky. If prices are flexible, aggregate demand no longer matters. Now this may be correct, if monetary policy takes particular forms. But if monetary policy does other things, it is no longer true. The distinction becomes critical when interest rates hit the zero lower bound.

When nominal interest rates hit the zero lower bound, no amount of price flexibility seems capable of negating the importance of aggregate demand. Yet this proposition appears not to command general acceptance among macroeconomists. Eminent professors make claims that could only be true if aggregate demand was irrelevant. This ‘demand denial’ seems odd. Yet it may only be the more extreme manifestation of a tendency by the profession as a whole to downplay the role of policy in bringing demand back into line with supply. One possible explanation for this tendency is ideological.

Says Law

One very old theory that appeared to justify demand denial was Says Law. The idea here is that agents have to do something with their income. So if the demand for good x falls, that must be because the demand for good y has risen. But what if people wanted to save more? Well that raises the demand for assets. The supply of assets increases, so borrowers get more money, and spend that. Any excess supply has to be matched by an excess demand somewhere else: there can be no overall aggregate excess supply.

This argument breaks down the moment we introduce money. If agents want to save more by holding more money, no one gets more money to spend. This is obvious if the agent holds additional notes and coins. But what if the cash is deposited in a bank – will the bank not use this cash to lend more? Perhaps, but equally if the bank decides to hold more cash itself and lend less, we again have a reduction in the aggregate demand for goods.

Says Law is highly fragile as a result. Suppose agents do save more by holding more money, and so aggregate demand falls. Less output means less income, so aggregate demand falls further. This is of course the multiplier beloved of any first year economics student. It is aggregate demand that determines how much output is supplied, and not the other way around.

All this is standard stuff, that would be familiar to any economics undergraduate. Yet consider the following two recent quotes

Eugene Fama (Professor, Chicago)

The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another.

John Cochrane (Professor, Chicago)

Every dollar of increased government spending must correspond to one less dollar of private spending.

At first sight these look like assertions of Says Law. But perhaps not – maybe there is a more respectable theory that would allow such statements to be made.

Price flexibility

So what could lead to demand denial, once we see past Says Law (as did John Stuart Mill, among others)? Is there some mechanism that returns aggregate demand towards supply? Macroeconomics tends to give two answers to this question, and much confusion arises from trying to relate the two. One answer is that the real rate of interest adjusts to move demand to equal supply. The other is that prices fall.  

Imagine an economy without capital, so output is produced by labour alone. For simplicity, assume that labour supply is fixed. Given an aggregate production function, this gives us one number for total output. We also know that, if consumers make optimal intertemporal decisions subject to no constraints beyond their lifetime budget, then variations in the real rate of interest will alter the current level of consumption. So, there exists a real interest rate that equates consumption (demand) to the output that could be produced by workers (supply). There is a real interest rate that can ensure aggregate demand is sufficient to absorb supply. But how do we know that, after some shock, the real interest rate will move to that level? This is where we have to talk about prices.

 Most undergraduate macro starts with the fiction that the central bank fixes the supply of nominal money. The demand for money depends on nominal interest rates. If prices fall, real money balances increase. For the money market to clear, nominal interest rates must fall to raise demand to meet supply. Lower nominal rates imply lower real interest rates etc. So in this textbook story lower prices induce lower interest rates. If prices adjust slowly, it takes time for real interest rates to fall, and so we may get Keynesian business cycles.

The textbook story tends to gloss over one complication, which involves inflation expectations. Falling nominal interest rates will only reduce real interest rates as long as expected inflation does not fall as much as nominal rates. At first sight this might be a problem, because falling prices mean inflation is falling. However, if the demand shock is temporary, we know that eventually the price level will return to its original point if the money supply is fixed. So if prices are falling now, they must rise again at some point. We discuss expectations in more detail below.

The only problem with this textbook story is that it assumes policy makers do something they do not, and indeed probably never have tried to do except in one or two countries or for one or two short periods. The money supply is not fixed. Instead, short term interest rates are directly controlled by central banks. But the basic story still holds, if central banks respond to falling prices (or a falling inflation rate) by cutting nominal interest rates by enough to reduce real interest rates.

One way of making the story more realistic is to replace the fixed money supply assumption with the proposition that the central bank follows a simplified Taylor rule (simplified, in that the rule does not contain the output gap), where the Taylor rule is such that real interest rates fall when inflation moves below target. If we do this, we retain the link between the speed of price adjustment and the length of the business cycle. If prices fall rapidly enough, this will reduce real interest rates enough to completely eliminate excess aggregate supply. There is one difference from the fixed money story that will be important later on, which is that Taylor rules generally involve inflation targets, while a price level target is implicit with a fixed money supply.

So with both the Taylor rule and a fixed money supply, we can say that price adjustment restores demand to supply, or we could say that monetary policy does this. However the involvement of monetary policy is essential, because nominal rates are one half of real interest rates. Price adjustment is not. To see this, consider two examples. In the first, interest rates adjust directly to excess supply (or the ‘output gap’), and not to inflation at all. (This is a Taylor rule that is simplified by excluding the term in excess inflation.) Suppose further that the authorities can perfectly forecast expected inflation, so they can achieve an exact correspondence between real interest rates and the output gap. In that case, the speed at which real interest rates reacted would have nothing to do with how prices moved, and therefore there would be no link between the speed of price adjustment and the length or severity of the business cycle. In a second example, the monetary authorities can also perfectly forecast expected inflation, but now they do so to keep the real interest rate constant. In this case real interest rates would fail to move demand towards supply, and a non-zero output gap could persist forever, whatever the speed of price adjustment. (A similar situation arises if inflation expectations always follow nominal interest rates: see Brendon, 2010, for an example where such an equilibrium is possible.)

In the textbook stories involving a conventional Taylor rule or a fixed money supply, the flexibility of prices only matters because of an assumption that this determines how quickly and how much policy reacts. There is no automatic mechanism ensuring that aggregate demand adjusts back towards aggregate supply, unless we think one of these policy processes is automatic. This is important, because it is often said of those economists that appear to ignore problems of aggregate demand that they are (implicitly) assuming a world in which prices are highly flexible. From the discussion above we can see that this might make sense, if it is also assumed that policy is following some particular rule. Yet the nature of this rule is hardly mentioned. It would be at least as accurate to say that these economists deny the importance of aggregate demand because they assume policymakers rapidly eliminate excess supply. Yet it is never put like that, which is perhaps odd. It is as if the role of policy is being minimised, and the role of a market correction mechanism is being emphasised.

The Zero Lower Bound

These points become particularly important when we hit a zero lower bound (ZLB) for nominal interest rates. Now we cannot presume that policy can achieve the required level of real interest rates that will stimulate demand sufficiently to bring it back to aggregate supply. Our only hope is that inflation expectations will do that job. How likely is this?

Suppose first that policy involves an inflation target, and inflation is governed by a New Keynesian Phillips curve. The latter ensures that current inflation is influenced by the inflation target (because this determines medium term inflation) and the discounted sum of future expected excess demand. As there is no reason to expect the authorities to engineer a boom after a recession, then current inflation will always be below target. As a result, if expectations are rational the inflation target in effect provides an upper bound for inflation expectations. If the real interest rate required to raise demand to supply is less than minus the inflation target, then inflation expectations can never rise sufficiently to achieve this real rate.

This is critical, because it means that as long as the zero lower bound constraint binds, output will be demand determined. To put it another way, we stay in a Keynesian regime, however flexible prices are. It is simply wrong to use models which presume output is equal to supply when the ZLB constraint bites. As the quotes above were made in the context of using fiscal policy when interest rates had hit the ZLB, they cannot be justified by saying that they are implicitly assuming a flexible price world. Demand denial is illegitimate. The recession will only end when demand recovers for some reason other than real interest rate adjustment alone.

If the central bank operates some form of price level target, then policy is committed to raising inflation above the path originally implied by the target to an extent to match the amount by which prices fall today. On the assumption that at some point demand does recover, then before this point inflation expectations can exceed the inflation target, because it will be dominated by the expected boom. With price level targets the link between price flexibility and the persistence of aggregate excess supply returns. The only problem is that no central bank operates an explicit price level target (unless you believe the money supply still matters to the ECB), and few would argue that any follow one implicitly. Indeed many have deliberately stated that they will not allow inflation to rise above target in the future in an effort to reduce the extent of the current recession. So demand denial that relied on expected inflation would appear to presume a policy that currently does not exist. There may be a good reason why central banks and governments are unwilling to adopt price level targets. Once the recovery is underway, there would be a strong temptation to revise the policy and not engineer a subsequent boom. The policy is highly time inconsistent.

This discussion is very similar to debates following publication of the General Theory. There is one notable difference. Then the Pigou effect was critical in allowing price flexibility to restore demand when the supply of money was fixed. Nowadays with the popularity of intertemporal consumption theory the Pigou effect has withered away. Instead rational expectations ensures expected inflation comes to the rescue instead under price level (e.g. money supply) targeting.

Demand denial and ideology

There are two puzzles that emerge from this discussion. First, why the emphasis on price adjustment rather than monetary policy in ensuring demand moves towards supply. Second, why the failure of some to acknowledge the importance of demand even in situations (the ZLB) when monetary policy cannot eliminate excess supply?

One explanation might be historical. The assumption that the default monetary policy involved a constant supply of nominal money is deeply engrained in macroeconomics. It was used by Keynes, and remains what nearly ever first year economics student is taught. If a constant money supply is treated as the equivalent of a default monetary policy, then it might be understandable that the focus would be on price adjustment. To some extent that replaces one puzzle with another, given the rarity of money supply targeting in actual economies over the last 70+ years.

Demand denial may also be a consequence of the demise of the traditional Phillips curve following rational expectations. As is well known, if inflation at t depends on expected inflation at t and the output gap, then if expectations are rational the output gap must be a random variable. When Keynesian economics adopted the traditional Phillips curve to add a theory of price adjustment to IS/LM, they laid the foundations of the New Classical critique based on rational expectations.  In these circumstances, it is perhaps not surprising that in institutions which led that New Classical critique, the emergence of New Keynesian economics might not have received the attention it had elsewhere. In terms of pedagogy, rational expectations also means that it makes sense to teach the medium run, supply side model first, and then consider the short term. As one former member of a freshwater department told me, they ran out of time before they got to New Keynesian theory.

Yet neither narrative is entirely convincing, particularly when we think about what economists in central banks actually do. They spend much of their time focusing on what will happen to aggregate demand, because this will help determine both the output gap and inflation. Whatever they conclude, they change short term interest rates and they do not fix the money supply. Now while some academic disciplines allegedly live in ivory towers with little regard to the world around them, I have generally found economists both curious about the real world, and eager to find theories about why it is the way it is. The disregard by text books and some freshwater economists about what happens in central banks seems strange as a result.

In the General Theory, Keynes also asked why what we call classical macroeconomic theory ignored aggregate demand.

“That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commended it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority.”

It is a beautiful piece of writing, but it also throws up many ideas that we can dismiss today. New Keynesian theory can be grafted on to a Real Business Cycle framework, which suggests that the ‘vast and logical superstructure’ argument does not apply, unless you take your microfoundations very seriously. (Wren-Lewis, 2011, explains why you might.) However, consider the last sentence from the quote. By emphasising price adjustment as the means by which excess or deficient demand is eliminated, it appears as if the macroeconomy is ultimately self-correcting, without any intervention from the state. The policy debate then becomes whether the state can or should give the system a helping hand. Here fixing the money supply, or some form of price level target, has to be the default policy. The empirically more plausible policy of fixing the nominal interest rate will not work, because that could well be destabilising.

In contrast, to say that monetary policy was the means by which the output gap was eliminated puts the state at the centre of the efficient functioning of the macroeconomy. What is worse, if for some reason monetary policy fails to eliminate the output gap, the state can use other means to influence demand through fiscal policy. That observation does not fit easily with an ideology that argues that state intervention is generally bad, and ideally the market economy is best left to itself.

Ten reasons not to raise interest rates

Revised March 2011

1) Sensible monetary policy has both inflation and the output gap as objectives. The fact that there is an inflation target and not an output gap target says nothing about the relative costs of excess inflation compared to lost output. Instead it reflects more mundane considerations like the difficulty in measuring the output gap. Unfortunately we have very little guidance about how to trade-off output and inflation objectives: the highly elaborate calculations based on Woodford’s analysis neglect key factors like unemployment. But the standard assumption that costs are convex seems reasonable. So we can approximate welfare by summing the output gap squared plus some coefficient (alpha) times inflation minus target squared.

The figures in the appendix, crudely based on the Bank’s February inflation report, suggest that raising rates in line with market expectations compared to keeping rates flat at 0.5% would have virtually no impact on inflation, and very little on output, this year. The calculations are only for 2012 and 2013 (that is all that is published), but they indicate that we would be better off with rising interest rates only if the costs of inflation far exceed those of lost output (alpha>10). If the costs of excess inflation and lost output are more comparable (alpha<10), we would be better off keeping rates flat. In other words, the zero lower bound constraint still bites.

2) Quantitative Easing is a response to the zero lower bound. If the zero lower bound constraint no longer bites, then the rationale for keeping QE unchanged is unclear. If the Bank wants to demonstrate that it still cares about missing the inflation target, winding down QE would seem the most painless way of doing this.

3) The welfare calculation from (1) above just looks at central expectations, but what about low probability/high risk events. The danger of a lost decade of slow growth is clearly a major risk. It happened in Japan, and we also have fiscal austerity. In macroeconomic theory, it is monetary policy that brings demand back in line with supply – there is no other automatic correction mechanism. Another high risk event is inflation rising well above 5% in a sustained way. But there is currently no sign of a wage-price spiral: wage inflation is below price inflation. So giving particular weight to high risks suggests keeping rates unchanged.  

4) What if keeping rates flat now leads to a persistent upward shift in inflation expectations? Actually in the short term this might help raise output. But putting this to one side, suppose that despite a still negative output gap in 2014, inflation sticks to 2.5% if rates are kept flat over the next year, rather than falling to target. The first point to make about this is that the additional social costs are relatively small, because we are quite close to the target. The costs of raising the output gap by 0.5% when it is already at 3% are much larger. But nevertheless the Bank would at some point have to reduce output to stop expected inflation being above the target. It might seem that the sooner it does this the better. However for once this is not necessarily correct, because the cost of reducing output when the output gap is high are much greater than when it is low. Whether it is actually better to wait before ‘breaking’ excess inflation expectations will be a complicated calculation, but while the economy is recovering there is a clear advantage in delay.

5) What about the argument that the Bank will lose ‘credibility’, where we mean something different from just an increase in inflation expectations. In the literature on monetary policy, credibility can mean the ability not to go for periods of ‘surprise inflation’ in order to reduce unemployment below its natural rate (which can cause inflation bias). But unemployment is currently above its natural rate, so this issue just does not arise. It would seem much more consistent with current macroeconomic theory to assume that agents are rational enough to know that the MPC is not putting interest rates up now because the output gap is large and negative, and not because they have secretly abandoned their commitment to the medium term inflation target.

6) The focus of discussion has been that inflation at 4% or 5% will get ‘locked in’ to higher expectations. However there is also the risk that persistent high unemployment will permanently reduce long run supply. There is a large literature on this hysteresis effect, in part because this was allowed to happen in the 1980s. In addition, unemployment that becomes structural is very costly to reverse. It may well be the case that these costs exceed those of higher inflation expectations.

7) The calculations above used the CPI inflation numbers to calculate welfare. This is natural enough as the inflation target involves CPI inflation. However, just as the inflation target involves flexibility in the short run, it is also legitimate when inflation measures diverge in the short run to ask which inflation measure better corresponds to welfare. There is a large literature that suggests it is not CPI inflation. The basic idea is that inflation is more costly for prices that are sticky than for those that are flexible. A lot of the current inflationary pressure is coming from commodity prices, which are highly flexible. A more ideal inflation target might ignore at least the direct impact of these commodities. For much the same reason, a case can be made for targeting wage inflation alongside price inflation.

8) The case for ignoring the inflation created by higher VAT seems particularly strong. It is likely that the VAT increase will be passed on by most price setters in a co-ordinated fashion. As a result, relative prices will not change much, which is the cost of inflation emphasised by Woodford. 

9) There seems clear empirical evidence that the Phillips curve becomes weaker as inflation approaches zero. There is a straightforward explanation for this, which is that workers try and avoid nominal wage cuts (which again there is clear evidence for). Raising interest rates in the UK will do nothing to stop dollar commodity prices rising. Sterling will appreciate, but that will hit the one sector (traded goods) that we are relying on to generate a recovery. To force non-commodity prices down to compensate for rising commodity prices may be very difficult (i.e. costly) when inflation is so low.

10) Given the lack of growth since output stopped falling, and with little prospect of anything beyond capacity growth in the near future, it seems reasonable to assume that the output gap has not changed much over the last two years. So if interest rates are raised now, then a reasonable implication would be that with hindsight they should have been higher over the last two years to moderate the rise in inflation we are currently seeing. So raising interest rates now comes close to saying that the recession we have just experienced was not deep enough. (OK - this is really the same point as (1), but it does emphasise the low weight that must be being given to the output gap by those suggesting rates should rise this year.)


Appendix

Calculating social welfare

 

2012

2013

Loss

Diff

Inflation - Rising rates

2.4%

2%

0.16

 

Flat rates

2.6%

2.5%*

0.61

0.45

Output growth – rising rates

2.7%

2.6%

 

 

Flat rates

3.0%

3.0%

 

 

Output gap – rising rates

3.3%

2.7%*

18.18

 

Flat rates

3.0%

2.0%

13.00

-5.18

 

 

 

 

 

 

 

 

 

 

* guess based on extrapolating Q1 forecast.

Numbers are estimated using the Bank of England’s February 2011 Inflation report. Output gap numbers assume a 4% gap in 2011 (consistent with the latest OECD Economic Outlook), and that potential grows by 2% p.a.

In praise of the Monetary Policy Committee (or at least most of them)

February 2011

            Those who criticise the MPC for ‘allowing’ inflation to rise well above the inflation target should be made to answer the following question. How much further would they have liked to see output fall in 2009? Would a decline in GDP of 7% done the trick? Would we have had to eliminate the little growth that occurred in 2010? Given the lags between interest rate changes and inflation, the only way the MPC could have avoided the current overshoot of the inflation target is by cutting interest rates more slowly and keeping them higher when the recession hit. This in turn would have inevitably led to a deeper recession, and probably a slower recovery. Neglecting to mention this when criticising the MPC suggests either ignorance of basic macroeconomics or mendacity.

            Of course the MPC did fail to foresee that they would miss their target by so much. Part of this is simply that they did not assume an increase in VAT to 20%, and I guess they would have got into a lot of trouble if they had. But there was also a more general underestimation of inflation (although not output). But macroeconomic forecasts are always wrong, and it is cheap journalism that suggests otherwise. Forecasting error can only be turned into justifiable criticism if there was evidence that the Bank of England had wilfully ignored important evidence. There is no such evidence.

            What the recent outbreak of MPC bashing does reveal, beside the quality of much journalism and analysis by some city economists, is a problem with inflation targets. All academic analysis of monetary policy is based on the policy maker being concerned with two objectives: inflation and the output gap. Inflation targets suggest one objective matters much more than the other. However, we have no reason to believe this. There is some work on how to trade-off these two objectives, but it is rather primitive, ignoring unemployment for example.

            So why have inflation targets, when there are in reality two objectives? The first point is that the two normally go together: that is what the Phillips curve is all about. The second reason for singling out inflation is that in the long run we can choose an inflation rate, but the output gap has to tend to zero. If we had output targets alongside inflation targets, there might be a danger in thinking that we could permanently have a little more output at the cost of a little more inflation, a mistake that policymakers might have made in the 1970s. Third, measuring the output gap is much more difficult than measuring inflation, and so any output target might get frequently revised.

            These are practical reasons for having inflation targets and not output targets, but they do not negate the point that there are ultimately two objectives. However, when inflation increases while the output gap is large and negative, we have a potential communication problem. As long as the divergence is temporary, monetary policy makers can say that (by ignoring current inflation) they are targeting inflation over the medium term, and if they allow a negative output gap to continue inflation will fall below target in the medium term. But when temporary becomes a few years, this line becomes difficult to sell.

            So the MPC is in a difficult position.  They might (I hope) want to say that the costs of reducing output when the output gap is so large (as a result of the biggest recession in 80 years, which we have not begun to recover from) exceeds the benefits of reducing inflation. But their critics can respond that they have an inflation target, and not an output gap target. They might want to be honest, and say that they do have an output gap target, but unfortunately there are not enough people in the media to applaud that honesty, and too many who would make political capital out of it.

Ideological Aspects of the Financial Crisis

December 2010, Updated February 2011

Two aspects of the financial crash of 2007/8 and its aftermath seem very puzzling, at least to an ‘outside’ observer like myself.  The first is that the crisis seems clearly predictable ex post.  The second is that one group of people who seems to have come out of the crisis relatively unscathed are bankers.

Hindsight is of course a wonderful thing, but to say that the financial crisis was eminently predictable is not an artifact of hindsight.  Leverage ratios rose substantially in the decade before the crisis. As Alessandri and Haldane (2010) notes, between 1920 and 1970, the return on UK banks’ equity averaged below 10% per annum, with low volatility of around 2% per year, which was roughly in line with risks and returns in the non-financial economy. Immediately prior to the crisis, returns were close to 30%. Higher returns imply higher risk. The dangers this posed to the ultimate insurer, the state, had also been increasing. Until 1970, the ratio of UK bank assets to GDP had been flat for almost a century, at around 50%. By the start of this century, bank balance sheets were more than five times annual UK GDP. In the space of a generation, the insurable interests of the state had risen tenfold.

One of the arguments used to suggest that we should not have been worried about such trends is that there had been a step change in the ability of banks to handle risk. But this argument only ever applied to idiosyncratic risk. Systematic risk, reflecting similar macroeconomic trends in many economies, was much more dangerous as a result of the additional exposure of banks to risk and their reduced liquidity and capital ratios. Indeed, technological ‘innovation’ in spreading risk increased the interconnectivity of banks, and so meant that general declines in asset prices (like house prices) would have a much more widespread impact.

So why, in the years leading up to the crisis, was the trend in policy to decrease rather than increase the extent of banking regulation? One obvious answer is that this was due to pressure from the financial sector itself. The key card this industry always plays is its geographical mobility. Reduce regulation in your economy, policymakers are told, and banks will move bringing their high profits, which will increase tax revenue. Fail to reduce regulation, and this apparently profitable sector will leave.

That the financial sector itself pushed for less regulation is not too surprising, when we consider bankers pay. What is more interesting is why this pressure succeeded, given the dangers apparent in the data. One factor that must have been important was an ideological view that market intervention is generally undesirable, and that a market system would self regulate. This view is not inherent in economic theory: the potential market imperfections involved in banking are many. Not least, banking losses are limited by being ‘too big to fail’, so there is an inbuilt tendency for bankers to take excessive risks. (This is one of the easier imperfections for economists to think about, and is emphasized in Alessandri and Haldane (2010). Others problems, like an inability of agents to correctly evaluate risk, although perhaps as important, are more problematic for economists to take on board.)The evidence of the data that banking crises are endemic is quite clear (Reinhart and Rogoff (2009)).  

The response to the crisis has been to tighten various aspects of the regulatory regime. Whether this is enough to prevent another crisis is only one part of the question that needs to be asked. The second part is whether this tougher regime will survive. Have the factors that led to the gradual relaxation in banking regulation before the crisis disappeared? Has anything been done to prevent such a gradual relaxation occurring again? Evidence of the extent of banking influence in the political process in the US (see Johnson, 2009) and the UK (Monbiot, 2011) suggest the underlying problem has not gone away.

One area that has largely escaped regulation has been banking sector pay. While most economies remain in deep recession, bank bonuses seem to have largely recovered from the hiccup caused by the crisis. From a political point of view this appears extraordinary. In other areas of public life, those responsible for large social losses are expected to bear both responsibility and significant personal cost. Why is it different in this case?

Once again there is an ideological explanation based on the supposed ideal nature of markets – in this case pay in the labour market. In the bad old days of the 1960s and 1970s, intervention in wage determination was routine in the UK. We had incomes policies and wage commissions, where the latter tried to decide what level of remuneration for particular jobs was ‘fair’. This went much too far, interfering in markets where supply and demand was doing a pretty good job, or to pursue impossible goals like controlling inflation when labour markets were overheating. Today we only have the minimum wage. But I do not think that economists’ aversion to any discussion of whether actual pay levels are warranted can be entirely explained by a concern that we might return to these bad old days.

It is the bread and butter of economics to talk about market failure and how this may ‘distort’ prices away from levels that might bring about efficiency. Yet this discussion has not made its way into the mainstream of public debate, particularly in the area of pay determination. Many of the market failures that apply to the banking sector as a whole also apply to remuneration within that sector (see Thanassoulis, 2009). Yet there is great reluctance by policy makers to broach this issue, even though to do so would clearly be popular amongst most voters. Controlling bank bonuses would also go a long way to helping banks rebuild capital, which in turn would allow them to be less cautious about new lending. There is a clear prisoners dilemma problem here: any individual bank cannot act alone, because they would lose staff, but it would be in the interest of the shareholders of banks collectively to control pay. Yet even forcing banks to disclose what they pay in bonuses seems too much for the current UK government (Robert Peston, BBC Website, 25 November, 2010). When politicians act in ways that appear not to be in their self-interest, something rather interesting is going on. 

 

References

Alessandri, P & A Haldane (2009) ‘Banking on the State’ Speech, Bank of England.

Johnson, Simon (2009) ‘The Quiet Coup’ The Atlantic: see http://www.theatlantic.com/magazine/archive/2009/05/...quiet-coup/7364/

Monbiot, G (2011) See posts 7/2/2011 and 14/2/2011 at http://www.monbiot.com/

Reinhart, C. M and Rogoff, K (2009), This Time is Different: Eight Centuries of Financial Folly, Princeton University Press.

Thanassoulis, J (2009) ‘Now is the right time to regulate bankers’ pay’, Economist Voice, Vol. 6.5

 

What the OBR should, and should not, do

In a very short amount of time, the interim OBR under Sir Alan Budd has had to produce its first pre-budget projection, a post-budget projection, and advise on the structure of the permanent OBR.  Given the technical difficulty involved in this work, under intense time pressure, it is difficult to also keep an eye on the politics of what you are doing.

1) What not to do

Shortly after the budget, the government used OBR figures to claim that the Budget measures would lead to fewer public sector job losses in 2011-12 and 2012-13 than Labour had planned. Given the measures announced in the budget, this result was surprising, as the planned squeeze on public spending appeared to go significantly beyond what the previous government had planned to do. To their credit journalists at the FT decided to enquire further. Their enquiries suggest that this result comes from assumptions about reduced pensions contributions and a slower rate of promotions, which although perhaps plausible consequences of a new government, were not announced as part of the budget. Take out these revised assumptions, and the impact of the budget was indeed to significantly reduce public sector jobs. 

Now it is pretty clear that the OBR did not intend to mislead the public debate in this way. (The document in question is here.) However, it is also clear that it allowed itself to be used to that end. The previous Labour Chancellor is quoted as saying  ”Right from the start the Tories used the OBR not just as part of the government but as part of the Conservative Party. They have succeeded in strangling what could have been a good idea at its birth.” Now this is unfair, but an essential requirement of the OBR is that it is seen as being independent by all the major political parties. It is in danger of failing.

How could this situation have been avoided? Is it even possible for the OBR to be independent of the government, as one respected economic journalist asks? One of the keys to independence is transparency. What should have happened, once the government had used the OBR’s figures in this way, is that the OBR should have immediately (and unprompted) released a statement publicly clarifying how the figures were derived. To be sure, such a statement would certainly have been seen by some as a criticism of the government, but if the government had used the OBR’s numbers in a misleading way, then criticism was due.

In hindsight this situation could have been pre-empted if the OBR, in releasing its post-budget projection, had made it clear what changes were due to measures announced in the budget, and what were due to other policy changes that the government had announced or were expected to announce. But as I noted above, given the interim nature of the OBR and the speed at which it had to act, mistakes like this are not surprising. However, given the damage that has been done, it becomes all the more important that perceived independence is at the centre of the proposals for the permanent OBR.

This issue has already entered the public debate, with the question of who should appoint Sir Alan Budd’s successor. The Treasury intends to make the appointment itself, in the same way it appoints external members of the MPC. Some MPs from the opposition have suggested that parliament, and in particular the Treasury Select Committee, should instead make the appointment. I personally think appointment by a select committee is a bad idea, but I also think that using the MPC model is far from ideal. With the MPC, external members are always in a minority, and so the Treasury cannot aim to fix the committee. In the case of the OBR, they will appoint the director. My own proposal was that the director of the UK Fiscal Council should be appointed by a Board of that Council, who would consist of people like Sir Alan, who had expertise in fiscal policy and long term forecasting, but who did not want the full time job of running the OBR. I certainly think it is essential that such a Board exists, to help safeguard the independence of the OBR.

2) What the OBR should do

Recently the Congressional Budget Office of the United States published its long term budget outlook. This gives projections for the federal budget up to 2080. The US position is somewhat different from the UK, with in the US as yet no coherent plan for dealing with both the existing deficit and longer term pressures caused by health care provision. However, there are features of this document that are exemplary. 

·         In its ‘alternative scenario’, the CBO attempts to make realistic projections of what taxes and spending will be, rather than just project what is strictly current policy. This is much more of a problem for the US, given its constitution, than it would be for the UK, but it is noteworthy that the CBO does not shy away from interpreting what government will actually do.

·         It presents alternative paths for debt depending on when the US deficit problem starts being tackled. It acknowledges that, in a recession, there is a case for delaying corrective action, but presents the implications of that delay in terms of the budget arithmetic.

·         Although they are not part of the central projections, the CBO does attempt to quantify the costs of high debt in terms of lower investment.

·         The preface names the staff members who contributed to the report.

Perhaps the most important feature of the document is the time horizon involved. Debt sustainability, and the lack of it (‘deficit bias’), is a long term issue, which cannot be addressed satisfactorily with a five year forecast. The UK Treasury, to its credit, also used to publish 50 year budget projections.

One unfortunate consequence of the OBR apparently taking over the Treasury’s role in producing post-budget projections is that its focus has shifted away from these critical long term issues towards more short term concerns. The critical questions for the OBR are not what public employment is going to be in two or three years time, but what the long term rate of growth of the economy as a whole will be, and what level of output and unemployment is consistent with constant inflation.

 

Going beyond the cuts debate

 

            The trouble with the debate over how quickly to start cutting the budget deficit is that both sides are right. Cutting public spending now does mean that many people will remain unemployed for longer. But the experience of Greece, Spain and Portugal shows us what can happen if financial markets lose faith in government’s resolve to bring public borrowing down. Now, in the case of the UK, there are good reasons why markets should not lose this faith, and so far they have not. But we have all learnt that hoping that financial markets do the rational thing is a risky strategy.

            Suppose we accept, therefore, that significant spending cuts or tax increases will be made in the short term to convince markets that the government is serious. What kind of measures should be taken? This is usually framed as a political question, but there are two important macroeconomic aspects that tend to get forgotten. First, we want cutting the deficit to have as little impact on aggregate demand in the short term as possible. Second, we want any action to give a clear demonstration about the government’s resolve to maintain fiscal discipline in the future. Luckily, both considerations point in the same direction.

            Consider demand impacts first. Any cut in public spending feeds straight through to lower demand. This is as true for ‘efficiency improvements’ as anything else. Suspending recruitment to the civil service means less jobs and more unemployment in the short term. Equally, reducing benefits for those on low incomes or without a job are likely to lead those individuals to reduce their spending by similar amounts, as they have little or no savings to fall back on and little scope to borrow. However tax increases that are primarily paid by the better off are much more likely to lead to a reduction in savings, and so have less impact on demand. If the tax increase is seen as temporary, most will come out of savings. While reducing saving in the long run is not a good idea, in the short run our problem is that we have too much saving and not enough demand.

            What about convincing the markets that the government will continue to reduce the deficit in later years? By setting up the Office for Budget Responsibility, the government has already taken an important step to achieving this. But experience abroad suggests that the effectiveness of this type of institution can vary a good deal, so until it can establish a reputation it is not enough on its own. What markets may fear is that the relatively painless cuts, in political terms, will be made in the short term, and the government will shy away from more difficult decisions later on. To counteract that impression, the government needs to do things that incur a high political cost now.

            Luckily, for the major partner in this government, these two considerations go nicely together. Most conservative party members would much prefer to cut spending or benefits rather than raise taxes, particularly taxes that hit the better off. But in the short term this is bad for the economy, and politically too easy. So the best thing to do in the forthcoming Budget would be the opposite: to immediately raise taxes, possibly for a temporary period, and leave cuts in public spending until later years. Raising capital gains taxes would meet these criteria, which is why backing away from this idea now would send just the wrong message to the markets. But there are many other measures that would do the trick: a temporary reduction in the estate duty threshold for example. Of course this is just the opposite of what was in the Conservative Party’s election platform, but that is whole point. What could demonstrate better how serious the current government was in reducing the deficit than to raise estate duty? Not only would the financial markets be impressed, but hardly anyone would lose their job as a result. 

Simon Wren-Lewis

28 May 2010

 

Cut Now or Cut Later – what the issues really are

 

            The recent clash of letters between economists over when and how quickly to cut the UK budget deficit has reminded some of the famous letter from 364 economists in 1981 (see, for example, David Smith writing for the ESRC). Whatever the rights and wrongs of the 1981 letter,[3] there is really no comparison. In 1981 economists who supported government policy had a completely different view from those who rejected it, and it was very difficult to find common ground. It involved the validity of monetarism as a macroeconomic school of thought. The dispute today is really small beer in comparison.

            Why. Because no one is claiming that government debt should not come down: the issue is just how soon and how quickly. And the questions involved in this debate are agreed by both sides, although each tends to gloss over difficulties for their own side. Let us take an example from both sides.

1) The problem of a default premium on debt. Here the debate has focused, understandably, on the likelihood of such a premium emerging for the UK. My own view is that there are good rational reasons for thinking that a UK government default is less likely than for most other countries in the world. There is plenty of scope for both lower public spending and higher taxes in the UK. The UK government, even in the case of a hung parliament, has much more executive authority than most, so it can act quickly and radically – once an election is over. We have seen that in the past: we should not forget Gordon Brown’s own first two years as Chancellor, where he took highly unpopular decisions in order to keep borrowing down. If tough action is taken, you are much less likely to see serious civil unrest in the UK than in other countries.

The difficulty here is that financial markets may not always be rational. As we have seen over the last few years, they are very bad at judging risk. However much we might tell ourselves this should not happen, it might. (See for example this letter from Vijay Joshi to the FT.) So those who are against cutting now should really address the following issue. If a significant risk premium on UK government debt did emerge, how should the government react, and would waiting for it to happen make dealing with the problem harder. In his Mais lecture, George Osborn puts the case for why action in a crisis may produce bad results. Those who take a different view need to say what they would do in such a crisis, and why waiting for the crisis to happen (and it may well not happen) need not make matters worse.

2) Most cuts in public spending, or increases in taxes, will reduce demand and therefore, in the current situation, output and employment. In Chicago there are economics professors who appear to deny this, but I doubt if many of those who signed the original ‘cut now’ letter would want to pursue this line. Because it is simply wrong. Brad de Long has tried so hard to find a coherent model that might support such claims, but without success, and Paul Krugman suggests he should stop trying.

Luckily we do not have the same problem as the US. But it would be good if those who do argue for cuts now would acknowledge that this will have a cost. Is their argument conditional on a view that the UK economy will recover, so that such cuts will not be noticed, or not? If not, would an economy that failed to recover in part because of sharp fiscal contraction not be more vulnerable to financial market sentiment?

These are difficult issues, and provided both sides are honest, I think they have to respect the other person’s point of view. We are not talking about clashes between different schools of economic thought here.

There is also a possible ‘third way’. Not all tax increases that bring down debt need be deflationary in the short term, and some are more deflationary than others. If we think that a recovery in two years time is pretty certain, but one this year or next is more problematic, then the announcement of an increase in sales taxes (e.g. VAT), to be enacted in one or two years time, might be a smart move. More generally, tax increases on consumers who are not credit constrained – perhaps because they are likely to be saving – will have much less impact on demand than tax increases on those who are credit constrained, and also have less demand impact than cuts in public spending. So by a careful mix of tax increases and some smaller compensating cuts, debt reduction could be demand neutral in the short term. Unfortunately, although this makes good macroeconomic sense, the reality is that measures of this kind generally involve redistribution from the richer to the poorer, and governments may think as a result that they are not politically feasible.

Returning to the letters, there is a remarkable degree of agreement that government debt should come down. I discuss some of the reasons for this here. As this discussion I hope suggests, there is plenty of uncertainty about the impact and speed at which high debt may be harmful, which in turn is bound to influence views about how quickly debt should come down. But here it is not the case of two sides with their own very different ways of looking at the world – instead it is just that the analysis has not really been done.

SWL Feb 2010

 

The UK Economy - Prospects for 2010-12

In March this year I was asked at a small, private and very select but high powered gathering what I thought would be the eventual size of the fall in UK GDP this year. At the time the consensus was for a decline in GDP of around 3%. I suggested it could approach a fall of 5%. "Impossible!" exclaimed one of the other participants -a highly respected (by me included) UK economist - "arithmetically impossible!".

I mention this as a simple illustration that even the most experience and wise forecasters invariably underestimate cyclical swings, particularly when they are unusually large and part of a global cycle. Indeed, it was this knowledge that partly lay behind my apparently (at the time) extreme prediction. But what is true in downturns is just as true in upturns.

So my instinct is that the UK recovery will be much stronger and more sustained than forecasters are currently predicting. A month or so ago I wrote the following for the ESRC's World Economy and Finance programme. It is hedged, as any macro forecast should be, with the usual uncertainties, but I would not be at all surprised if in a year’s time we witness a strong export led UK recovery. 

SWL Nov 2009

What data we have for UK GDP in the third quarter does not look good. Even if output does not fall, the gap between output and its potential level is likely to increase still further, implying additional increases in unemployment. There may be some boost in demand in the fourth quarter as consumers take advantage of the 15% VAT rate before it returns to 17.5% next year, but this alone is unlikely to be enough to get the economy growing again in 2010.

In 2010, there are likely to be three factors that in themselves could lead to further falls in output. First, the large stimulus that the government has provided to the economy  will be coming to an end, and consumers will instead be focusing on the impact of future cuts required to stabilise the government's finances. Second, with substantial spare capacity around there will be little appetitite for new investment by firms. Third, consumers may continue to increase their savings in an effort to bring their debt to more normal levels, although what exactly is normal is very difficult to say.

To set against this gloomy outlook is one key factor that may be enough to lead to a significant recovery through 2010. Sterling has depreciated substantially over the last two years, and is now highly competitive against the Euro in particular. In normal circumstances a depreciation of this size would provide a large boost to the UK trading sector. We may not have seen this yet for two reasons. First, there are typically quite significant lags before gains in competitiveness feed through to higher exports and lower imports. Second, gains in competitiveness may until now have been swamped by the slowdown in world trade.

So in normal circumstances I would expect to see strong growth in UK net exports of goods and services next year. However there is one important element of doubt - one factor that makes circumstances abnormal. To increase output often requires firms to obtain short term credit: wages need to be paid before the firm gets paid for its output. This credit is normally provided by banks. If UK banks are still recovering from the credit crunch this lending may not be forthcoming, and this could dampen any stimulus from higher world demand for UK output.

Macroeconomic forecasting is a pretty unreliable business at the best of times. The exceptional nature of the credit crunch makes it even more unreliable than usual. While I think we probably will see the economy being pulled in different directions along the lines suggested above, knowing which forces will win out is almost impossible to say with any certainty.

 

A UK Fiscal Council

These thoughts were originally prompted by some excellent discussion around a presentation I gave at a workshop held by the Institute for Government in London in October 2009. They have been updated to note the latest plans for the Office of Budget Responsibility (see section B).        

SWL Feb 2010

A) Frequently Asked Questions

1) Should the FC do short term forecasting?

In my paper[4], I suggest the Fiscal Council (FC) should produce projections of the government's accounts over a 50 year time horizon, mirroring similar projections currently published by the Treasury. A key part of this projection would be an assessment of the medium term trend position of the economy e.g. what the natural rate of unemployment was. But as a 50 year projection includes the next two to five years, then it seems natural that the FC would need a typical short term forecast as part of its 50 year projection.

However, a FC might want to downplay the short term element of its projections. Given the great public interest in the short term, they could become a distraction. There is a danger that, if these short term projections differed from, say, the Bank of England's forecast, an unhealthy competition might develop which would divert FC resources from researching more important longer term issues. It might therefore be more sensible for the FC to use some average of outside forecasters’ views about what dynamic path the economy might follow towards its medium term trend.

Should the FC farm out more of its projections, by, for example, using the Bank's projections for trend output? This I believe would be a mistake. As the position and nature of these medium term trends are central to any projections of the government's accounts, the FC needs to have ownership of the assumptions it uses.

2) Should the FC take account of the impact on demand of its proposals?

The FC I propose would make recommendations about the path of deficits and debt to the government. The impact of these recommendations would be greatly diminished if they were not time specific. Furthermore, it is likely that economic analysis would have something to say about how quickly any adjustment should occur.

Typically, if deficits were thought to be too high, for example, it would be best to start doing something about this straight away. However, a complicating factor might be the level of effective demand in a situation in which monetary policy had lost traction, such as the position we currently are in. In these circumstances, the FC might recommend delaying any adjustment. (Alternatively, if it felt that there was a significant short term danger that a risk premium on government debt might emerge, it could recommend unusually rapid adjustment.) How much further it might want to get into the issue of countercyclical fiscal policy is unclear. The Swedish FC did make specific recommendations on a fiscal stimulus package during the recent recession. However, a UK FC might judge that to do so could involve them in issues of short term forecasting that were a diversion from its main remit (see above).

3) Should the FC or politicians set deficit targets?

It is possible to think of a FC that would only comment on the likelihood of the government achieving targets set by the government itself. The government might have a target for the debt to GDP ratio on some specific date, and the FC through its projections could say whether they thought this target would be met.

To limit the FC to this purely forecasting role would in my view be a mistake, for two major reasons. First, macroeconomics does have quite a lot to say about the costs and benefits of different paths for government debt, and the FC provides an obvious channel for this advice. Second time specific targets for debt or deficits need to be highly conditional on other factors, such as unexpected shocks to taxes or spending.

This second factor makes targets for debt or deficits set by the government problematic. Forecasting deficits is particularly difficult, so almost certainly such targets would be missed. In addition, even if these targets were appropriate given conditions when they were set, unexpected changes to the economy are likely to make them inappropriate. Yet it is very difficult for politicians to argue that targets should be changed, or that targets are unlikely to be hit at all precisely. Opposition parties and the media see such things as weapons to embarrass the government with.

A FC would be better able to communicate the aim of fiscal sustainability, and the dangers of treating debt or deficit levels as targets like an inflation target. However a government may not feel comfortable with saying nothing about desirable debt paths. A relatively harmless, but quite sensible, goal which the government could specify the FC to follow would be a tendency for the debt to GDP ratio to fall over time, at a pace conditional on other macroeconomic criteria.

4) Should a FC examine issues beyond the path of aggregate government debt?

Fiscal Councils in other countries vary widely in the range of issues they cover. Some examine the costs and benefits of specific fiscal measures, going well beyond their impact on the government's accounts. Others look at other macroeconomic issues, like labour market reform.

My own proposal restricts the scope of a FC to the specific role of assessing and commenting on future paths for aggregate government debt. In my view there is some merit in at least starting with a narrow and well defined remit. In fulfilling this remit, the FC may well undertake analysis that has wider implications. For example, labour market reforms like changes in the retirement age will have fiscal consequences which it will need to assess. But the FC that I propose has a very specific goal, which is to counteract the deficit bias that appears to be an endemic (but not uniform) part of democratic government.

B) The Office for Budget Responsibility

Since writing the above, we now have more detail on how (at least initially) the Conservative Party's Office of Budget Responsibility will work. (see the Institute of Fiscal Studies Green Budget Report, February 2010.)  The following list of points is annotated with references to the proposal in Kirsanova et al (2007).

The OBR will be made up of a three person committee, accountable to Parliament, and a small secretariat of economists and public finance experts.

KLWL proposed a Fiscal Council with a single director who was responsible to an appointed Board, rather than directly to Parliament

It will be responsible for publishing independent fiscal forecasts at least twice a year around the time of the Budget and PBR, based on existing government policy at the time.

KLWL suggested publication once a year, before the PBR.

The committee will publish a recommendation for the amount of net fiscal tightening or loosening it judges necessary for the Treasury to have a better than 50% chance of achieving a forward looking mandate set by the Chancellor.

Here is perhaps the most substantive difference from KLWL (see FAQ No.3 above). KLWL's proposal has the Fiscal Council playing a much greater role in assessing what appropriate objectives for government debt are.

If the Chancellor chooses not to abide by that recommendation he or she will have to explain their reasoning to Parliament.

As KLWL. This is very important in establishing the political authority of the Fiscal Council

At least once a year, the OBR will also publish a comprehensive assessment of the true long term sustainability of the public finances, including off balance sheet liabilities such as public sector pensions, PFI and the likely costs of an ageing population.

This was part of the annual report to be published under KLWL's proposals. 

 

 

Some Recent Talks

Papers or presentations not restricted to particular research papers

July 2010: Can the Office for Budget Responsibility be Independent

June 2010: Remarks on What the Office for Budget Responsibility Should Do

Jan 2010: Fiscal Stabilisation and Debt

A presentation given to the final conference of the ESRC's World Economy and Finance Programme.

May 2009: Monetary Policy in the Recovery

A paper given to a conference at the Centre for Central Banking Studies at the Bank of England. It asks what monetary policy should do if inflation rises above target despite a remaining large output gap.

2008/9: Fiscal Councils

The case for a UK Fiscal Council is summarised here. For more background see above.

Can the Office for Budget Responsibility be independent?

Speaking notes for Social Market Foundation event on the OBR

An article based on this talk was published in Public Service

This question was recently posed by Stephanie Flanders of the BBC, and when a serious and respected economic journalist asks a question like this it deserves an answer.

If we look at the international evidence, the answer appears reassuring. The newly formed Fiscal Councils of Hungary, Sweden and Canada quickly found themselves producing reports that were seen as being critical of government policy, and as a result their independence from government is not generally questioned. They are also generally perceived as making important contributions to the public debate over fiscal policy in their countries.

However, the OBR may be in a rather more vulnerable position for two reasons. The first is historical: the creation of the OBR could be seen to serve a very particular political purpose, which was to ‘expose’ the biased and over optimistic forecasts of the previous government. The second is more long lasting. The OBR is more closely integrated in the process of budget making than most other Fiscal Councils. Most fiscal councils play a watchdog role of commenting on the existing activities of government, while in respect of budget forecasting the OBR appears to replace an activity of government.

My own proposal for a UK Fiscal Council assumed that the UK Treasury would continue to produce pre and post budget forecasts. The Fiscal Council would also have the capability of producing fiscal forecasts, although with resources geared to looking at medium to long run macroeconomic  and fiscal trends rather than the short term. This would involve significant replication of resources (the OBR’s capability should go well beyond auditing the government’s forecasts), but it would allow the Treasury to form its own view and it would lay the OBR less open to accusations of being too close to government.

For the moment, however, it looks as if the OBR will be producing the government’s pre and post-budget forecasts, and giving the timing involved, this means that the OBR is very much part of the budget making process. Although most Fiscal Councils do not generally play such a central role, it is not unprecedented: the Central Planning Bureau in the Netherlands, for example, performs a similar role. As the government is obliged to use the OBR’s forecasts, this gives the OBR considerable influence, but it also makes it particularly vulnerable to accusations of lack of independence.

My remaining comments therefore involve five suggestions on how that independence can be ensured.

1) Financial Security. As I noted above, the Canadian PBO published work that appeared critical of the government. Shortly afterwards, its funding was reduced by the government. We could be more confident of the independence of the OBR if its’ funding and personnel were secure for a reasonable length of time (e.g. for at least five years).

2) Active Transparency. The perception of the OBR’s independence has to be actively managed. So when anyone uses OBR figures in a misleading way – and their recent use by the government was misleading – then the OBR needs to quickly and publically say so. It can do this in an objective way by simply setting out the facts – by being as transparent as possible. However, such intervention will be seen as a political act, one that a civil servant would never contemplate, but silence is also a political act that compromises independence.

3) Political Plurality. As I have already noted, the Central Planning Bureau in the Netherlands has some similarities with the OBR in its role as providing official forecasts. However the CPB also offers to cost the budget proposals of opposition parties before an election if they request this, and they usually do. This not only improves the level of the public debate, but it would also open up a dialog between the OBR and the opposition, to set alongside the continuing dialog between the OBR and government.

4) Professional Accountability. At present the OBR has a ‘Budget Responsibility Committee’, but this just consists of the three senior members of the OBR. The independence of the OBR would be enhanced if this committee also had ‘non-executive’ members: people with expertise and experience is forecasting and policy who could advise, on an unpaid basis, the executive. I also think this would greatly help the executive in medium term planning, and ensure its product met the highest international standards. If reporting to the Treasury Select Committee ensures political accountability, non-executive committee members could provide professional accountability.

5) Analytical Authority. One of the dangers of providing the short term forecasts on which the budget is based is that forecasts are always wrong, and half of them will usually be wrong in a direction that could be seen as helpful to the government. In addition, there are plenty of others who provide short term forecasts, and the forecasts produced by the Bank of England at least can claim resources beyond anything the OBR is likely to have. It is therefore important that the OBR also provides information which is both less vulnerable to critique and less in the public domain. The obvious area here is analysis of long term sustainability. While the OBR does have this in its remit, it is important that it has the resources to do it well.

I would hope that in a few years time, the OBR has become the place where people go first on issues like quantifying the medium term level of UK output and growth. A good model here is the Long Term Budget Outlook produced by the Congressional Budget Office in the United States. Not only does this present projections up to 2080, but it also looks at the arithmetic of alternative paths of deficit reduction, and the longer term damage to the capital stock that could result from high government debt. The more the OBR produces analysis which is otherwise absent from the public domain and of the highest standards, the more issues of independence will fade. As it states on the Central Planning Bureau’s website: ‘In the end, our independence is guaranteed best by the scientific quality of the work we accomplish.’

 

Conference on Establishing the Permanent Office for Budget Responsibility, London, June 2010

Introductory Remarks for a session on what should the OBR do?

It is a great pleasure to be at one of the first meetings of a new institution that I first publically suggested some 14 years ago, and more recently actively lobbied for. I’m also very pleased that the interim OBR is consulting widely on the details of what the organisation may do. I guess Alan and Geoff asked me to say a few words because they wanted something provocative to get discussion going. I could do that by comparing the OBR with the blueprint I and others published in 2007, but it would be more informative to compare the OBR with some of the Fiscal Councils that already exist in other countries. There are links to 9 Fiscal Councils in various countries on my Fiscal Councils website, and I’ve probably missed out some, and there number has increased greatly in the last few years. So what do these existing institutions tell us about what the OBR could look like?

The first point to make is that these councils differ widely, in part because the institutional framework in which they operate differs from country to country. Some, such as the two in North America, have responsibility for costing individual policy proposals as well as aggregate budget outcomes. This does not appear to be on the OBRs agenda, but others might want to suggest it should be, or perhaps a separate but linked organisation should do this?

If we restrict ourselves to issues involving aggregate deficits and debts, then one interesting example is provided by one of the longest standing and perhaps most successful Fiscal Council, the Central Planning Bureau in the Netherlands. The CPB not only costs the governments own programme, as the OBR will, but it also costs those of opposition parties before an election, if those parties ask it to. They invariably do. I think this would enhance the level of public debate during elections, and the OBR should have this capability. I also think it would have the useful by-product of encouraging dialog between the OBR and the opposition, which is important if the OBR is to establish itself as politically unbiased and survive a change in government.

The main thing I want to say relates to forecasting and policy. The OBR as it seems to be currently set-up is a purely forecasting body, and indeed one of the bullet points for this session on the programme said ‘how can we keep it that way’. Well if by policy you mean how any deficit reduction should be accomplished in terms of the mix of tax and spending, well I agree entirely – that is a primarily a political and not a technical matter. But if you mean that the OBR should never make any comment on the desirability or otherwise of a particular path for deficits and debt, then I think that would be a serious mistake.

Why would it be a mistake? Because the problem of deficit bias is not solely, or even mainly, a consequence of forecasting errors or over-optimism. It also reflects policy errors. And those policy errors cannot be fixed be laying down rules, because simple rules tend to be bad rules, and complex but better rules are difficult to verify by anyone other than a fiscal council. If in two or three years time, the recovery turns out to be more rapid than currently expected (but trend output is unchanged), and in the (of course unlikely) event that the government takes this as a cue to enact permanent tax cuts, we need the OBR to say hang on, there is a problem here. Or when the opposite happens, the OBR can back the government up when it decides to get on track over a number years rather than in one or two.  The remit of most Fiscal Councils abroad allows them to give advice of this kind – and it is only advice – and in my reading so far their advice has been sensible advice. It may not always have been heeded, but it has improved the overall level of public debate.

There is one notable exception, of a Fiscal Council which is legally obliged not to form a view, and that is the Congressional Budget Office in the US. It published plenty of projections showing the lack of sustainability of fiscal policy during the recent Bush years, but it was never able to say up front that action to deal with this problem should be taken immediately.

Now I’m not suggesting that the new OBR immediately pronounces on whether the new Chancellors fiscal goals are optimal or not. To do so would endanger the new body’s independence. What I do want to argue is that the OBR should not be precluded from giving policy advice of a technical character at some later date, and that from day 1 it quietly builds up its capacity to do so.  


 

Journalism

 

Dec 2010: Austerity or Stimulus? A question of Commitment

Feb 2010: Cutting Now or Later: Making sense of the debate on UK government debt. VoxEU.

When and How Quickly to Cut the UK government deficit. See also above.

2003: Changing the Rules New Economy, New Economy, Vol 10, pp 73-78

Comparing the Stability and Growth Pact with UK Fiscal Rules. For a short summary, see above.

2002: Trust the Old Lady, Financial Times: 5/02/2002

Argues the case for giving the Bank of England temporary, limited control over certain fiscal instruments

2001: The Economics of EMU, New Economy Vol 8, pp 3-8

Austerity or Stimulus? A question of Commitment

Appeared in ‘Britain in 2011’ published by the ESRC

When the Greek government almost defaulted on its debt at the beginning of 2010, the views of leading policy makers around the world changed almost overnight. Before the Greek crisis, governments in the UK and US, as well as the IMF, had suggested that helping the recovery should be the priority. High levels of debt could be tackled later. After Euro area governments and the IMF were forced to rescue Greece, the international consensus became that stabilising the public finances had to come first. In the UK this change in view followed a change in government, but critically the Liberal Democrats changed their mind between campaigning during the election and forming a coalition.

            The immediate trigger for this abrupt change in view was a fear that financial market panic might spread from Greece to any country with high and rising debt levels, which meant nearly everyone. However, a global panic where investors refused to buy any country’s government debt was always extremely unlikely. The recession has not only led to rapid increases in government debt, but also large increases in private saving, and that saving has to go somewhere. As a result, interest rates on US government debt over the last few months have steadily fallen to very low levels as demand outstrips supply, and the UK government has had no funding  problems either.

            The smaller Euro area countries (Portugal, Ireland, Greece, Spain: the so called PIGS) are in a different position because they are part of the Euro and they are uncompetitive relative to Germany in particular. These countries have to lower their costs relative to Germany, and because they share the same currency, this means reducing their wages and prices. To achieve this almost certainly requires a period of stagnation. It is the combination of low expected growth and high debt that worries the market. The UK, in contrast, has seen sterling depreciate by around 20% against the Euro over the last three years. Whatever people may think of Gordon Brown as Prime Minister, his decision not to join the Euro in 2003 has saved us from the fate of the PIGS.

            With this in mind, were policy makers right to switch from stimulus to austerity so abruptly this year? It is almost certainly the case that austerity measures will reduce the speed of the recovery. It is very hard to find a macroeconomic theory that tells a plausible story about the recession and yet also says that cutting government spending or raising taxes will leave output and employment unscathed. The evidence from the US is that Obama’s stimulus package reduced the depth of the US recession, but now as the stimulus runs out the recovery is slowing. In the UK, the newly created Office for Budget Responsibility (OBR) said that the emergency budget in June increased the chances of a double dip recession.

              Does this mean that in the UK stimulus should still take priority over government austerity, and that policy makers have got it wrong? If we take a narrow macroeconomic view, the answer has to be yes. The right time to reduce government debt is when times are good, not in the middle over the deepest recession since the 1930s. But unfortunately, the politics goes the other way. In good times tax receipts are high and government deficits are low, so the debt problem appears less acute. Instead, politicians are keen to raise spending or cut taxes, and believe the electorate will reward them for doing so. This has led to the problem of ‘deficit bias’. Over the 30 year period before the recession, levels of government debt relative to GDP had roughly doubled in the OECD area as a whole, and there was no good economic justification for this.

            Why should we worry about deficit bias? Even if we ignore financial markets and default, there are two good reasons. First, we are burdening future generations with higher taxes compared to the current generation. These higher taxes will tend to reduce output. Second, it is probable that in the long term (but not the short run) high government debt will also divert savings from investment in capital, which once again lowers future growth. To put it simply, deficit bias is a means by which we are exploiting our children.

            This is why almost every macroeconomist agrees that rising government debt is a serious problem that has to be tackled at some point. Those advocating austerity now fear that if we put this problem off until we are out of the recession it will get forgotten about again. Economists describe this as a commitment problem. Today, we would like to commit to reducing the deficit when times are better. But that commitment, judging by the evidence of the past, is not credible.

            How do we get around this commitment problem? One possibility is for governments to set up independent watchdogs, generally called Fiscal Councils, which will put pressure on them to apply fiscal discipline even in good times. The newly formed OBR is the UK’s Fiscal Council. It is ironic that as the new coalition government implements massive public spending cuts that will surely slow the recovery, it has also set up an institution that might allow those cuts to be postponed until more appropriate times.

 

 

Teaching

For my thoughts on how undergraduate macroeconomics should be taught, and the urgency of dropping the LM curve and its derivatives from pride of place in this, see my and other chapters in Macroeconomic Theory and Macroeconomic Pedagogy

·         Information for Merton students

·         Macroeconomics Masters Level

·         Macroeconomics Undergraduate Second Year

·         Macroeconomic Modelling MSc Option

·         Economic Methodology

·         The UK and EMU

Information for Merton students

This can be found on WebLearn (old site). Log in using your code and password (otherwise you cannot view the college site). Go to Colleges, Merton, Subjects, Economics, Undergraduates, and then my name. As well as tutorial reading lists and essay titles, you will also find links to articles or papers on current macro issues with brief introductions.

Masters Level Macroeconomics

For details of my current Oxford MPhil lectures, see the Oxford Economics Department's Intranet. I gave a 10 week MSc Macroeconomics course first at Strathclyde and then Exeter until 2007, which are less detailed and simpler than the Oxford course.

Undergraduate Macroeconomic Lectures

Details of my second year Oxford undergraduate lectures can be found on the Economics Department's Intranet.

Macroeconomic Modelling MSc Option

This is a course I gave until 2005 based on my own model solution software MODELPHI, which is discussed above. The lectures or exercises are designed so that students become familiar with this software at the same time as learning something about both issues in simulating macromodels and the behaviour of the models themselves.

Economic Methodology

Economic Methodology Letters outlines the key ideas in this one semester lecture course.

EMU and the UK

Students and others interested in the issues involved in UK entry into EMU can find a brief summary of my own views in an article I wrote for the journal New Economy. For those who want a much more detailed and up to date analysis, see the excellent set of studies produced by the U.K. Treasury).

 

Macroeconomics MSc

For details of my current Oxford MPhil lectures, see above. I gave this MSc Macroeconomics course first at Strathclyde and then Exeter until 2007. It is based on handouts. These are short, and generally describe a simple model, or explore some aspect of a model. What follows is a complete list, and how they fit together. Not all handouts are currently in use, but old handouts that may still be of some use are also referenced here. These handouts may also contain errors - please let me know if you find one.

Week 1

The course begins with the Solow growth model. A subsidiary handout based on a specific example of this model shows the impact of a savings rate shift over time, and illustrates how slow adjustment can be. A second subsidiary handout shows how to analyse stability using either diagrams or algebra.

This is the first model we explore. A handout describes some generic modeling terms and procedures, mainly using the Solow model as an example.

Weeks 2 and 3

Our analysis of intertemporal consumption is based on a two period example. Two handouts look at the infinite horizon case. The first sets out the 'infinite life' model in continuous time using Hamiltonians. The second uses a simpler discrete time version to examine the importance of expectations.

The infinite life consumption model is then added to the Solow model, replacing the assumption of a fixed saving rate, to give the intertemporal neoclassical growth model. A separate handout presents some simulations of a calibrated version of the model, while another addresses the issue of Ricardian Equivalence.

Week 4

Two variations on the intertemporal neoclassical growth model explore the implications of finite lives and different generations. The first presents the model of pepetual youth, and returns to the issue of Ricardian Equivalence.. The second presents an overlapping generations model, and looks at issues of social welfare. A handout on nominal extensions to the intertemporal model adds money to the infinite life model, and also looks at issues involving nominal debt.

Week 5

Real business cycle models endogenise labour supply, and a brief handout notes some of the issues this raises. A more extensive handout explores the impact of adding imperfect competition into the goods and labour market.

Week 6 and 7

Before examining New Keynesian models of business cycles, we first examine how rational expectations can be used to solve stochastic forward looking equations. We then look at two types of New Keynesian model. The first is based on contracts, while the second looks at menu costs. A handout describing Calvo contracts allows us to examine the relationship between excess demand and inflation.

Week 7 and 8

Rather than present one or two particular open economy models, the two handouts for this part of the course discuss some general issues in open economy macroeconomics. The first outlines Uncovered Interest Parity and compares PPP to an approach to long run exchange rate determination based on imperfect competition. The second looks at the interactions between output and consumption, and the implications for the current account. It also includes a discussion of recent movements in the US dollar. For those who want to take this analysis further, there are two notes that outline aspects of two particular open economy models. One outlines a model due to Giovannini, which shows how it is possible for a permanent increase in output supply to generate a long run appreciation, using a model based on imperfectly competitive goods and consumers with finite lives. Another outlines a model due to Obstfeld and Rogoff, which shows how money neutrality may not hold if consumers are infinitely lived.

Week 9 and 10

The first handout is a pretty technical discussion of how the objective function for a benevolant policy maker can be derived from taking a second order Taylor expansion of individual agent's utility. The second explores the issue of time inconsistency using a very simple inflation model.


 

CV

Short Bio

Simon Wren-Lewis is a professor at Oxford University and a Fellow of Merton College. He began his career as an economist in H.M.Treasury. In 1981 he moved to the National Institute of Economic and Social Research, where as a Senior Research Fellow he constructed the first versions of the world model NIGEM. From 1988-1990, as Head of Macroeconomic Research, he supervised development of this and the Institute's domestic model. In 1990 he became a professor at Strathclyde University, and built the UK econometric model COMPACT. From 1995 to 2006 he was a professor at Exeter University. He has published papers on macroeconomics in a wide range of academic journals including the Economic Journal, European Economic Review, and American Economic Review. His current research focuses on the analysis of monetary and fiscal policy in small calibrated macromodels, and on equilibrium exchange rates.

Academic work has often had a strong policy focus. In 1989 he published, with colleagues at the National Institute, a study suggesting that an entry rate of 1.95 DM/£ into the ERM was too high, which at the time was a minority view. In 2002 he wrote one of the background papers for the Treasury's 2003 assessment of its five economic tests for joining EMU. He was also the principal external advisor to the Bank of England on the development of its current and previous core macroeconomic models. A long time advocate of Fiscal Councils, his 2007 proposal was influential in the formation of the UK‘s Office of Budget Responsibility.

Full CV

 



 

 


[1] Some of the ideas in this note are taken or were provoked by discussions with Charles Brendon, but the responsibility for the opinions expressed here are entirely mine.

[2] From a 1934 BBC radio address, according to the following source: http://ecologicalheadstand.blogspot.com/2011/02/self-adjusting-economic-system.html

If anyone can confirm this is genuine, I would be very grateful.

 

[3] I was working at the Treasury at the time, so could not sign any letter of that kind. My own view has not changed over time: I was highly critical of the 1981 budget (fellow Treasury economists at the time may remember one particular post budget meeting chaired by Terry Burns where I expressed those views). It kept thousands out of work for longer than was necessary, with no compensating gain – inflation would still have fallen rapidly without that budget. But as a piece of economics the letter was dreadful. 

[4] Kirsanova, T, Leith, C and Wren-Lewis, S (2007), Optimal Debt Policy, and an Institutional Proposal to help in its Implementation, European Economy Economic Papers No 275, Apri.