The German social scientist, Jürgen Habermas, has just turned ninety. It is an odd reflection on our times that he is not renowned. In an age of academic specialisation this may reflect on the breadth of his scholarship. No one else in social science commands deep knowledge of thinkers as diverse as Talcott Parsons (sociological theory), Lawrence Kohlberg (cognitive psychology), Keynesian economics, John Searle (philosophy of language), R M Hare (analytical philosophy), Karl Marx, John Rawls (political theory), and continental philosophers, including Michel Foucault, Theodor Adorno, and Hans-Georg Gadamer.
Habermas’s scholarship is vast, but more importantly, the depth of his understanding is peerless, as is his ability to synthesise. In that regard, he is similar to Marx, but ultimately more rewarding. The greatest asset in all thought is to be right.
Summarising Habermas’s entire work is too hard, but one of his most important conclusions can be explained quite clearly. The reason he is the most important social scientist since Keynes is that he resolves one of the central questions facing human society – can ethics be objective, and if so what is the basis of ethical judgement?
Keynes solved macroeconomics. Habermas solved moral philosophy. This is not an abstract or trivial matter. For some bizarre reason, secular society has abandoned ethical education, and as a result most academic and public debate regarding values and ethics confuses matters which Habermas has already clarified and resolved. The same is true of all discussion of values and ideology in the social sciences. In public discourse, ethics is frequently conflated with moralising – which is usually an arbitrary adherence to archaic and confused rules-of-thumb. Education on the universal structural of ethical reasoning would serve society better than simple reliance on an innate capacity for moral reasoning.
Let’s start with some basic observations from Habermas which are profoundly enlightening. It is worth noting that these are simultaneously empirical observations about how humans actually reason, and also philosophical claims about what we assume when we engage in discussions about the right thing to do. Habermas starts by identitifying three independent ‘validity claims’ which we raise in all interaction and are subject to disputes, resolution and contention: truth, rightness, and truthfulness. Empirical claims about the world – including all scientific hypotheses – raise claims of truth. ‘Humans evolved from apes’ is one such example, as is, ‘When unemployment falls below 4% inflation rises’, or ‘paracetemol relieves pain’. Resolving questions of truth requires hypothesis testing against empirical evidence and the application of logic and reason.
‘Truthfulness’ is a claim we raise relating to our sincerity or honesty over inner desires, thoughts, and behaviours. This usually pertains to a specific individual. An example of such a statement would be ‘I do not trust Donald Trump’s sincerity when he discusses his bible readings,’ or ‘Boris Johnson is a dishonest opportunist’, or ‘I don’t think you really believe that.’
The third validity claim we raise, which Habermas has had the most to say about, is the claim to ‘rightness’. Studying Habermas, it becomes clear that what is ‘ethical’, ‘fair’, ‘moral’, and ‘right‘ are in fact equivalents. Statements such as ‘driving a car while under the influence of alcohol, in any circumstance other than a serious emergency, is wrong (or immoral/unethical/unjust)’ raise the claim of ‘rightness’. These claims refer to the ethical appropriateness of actions or rules governing actions. In contrast, claims about how the world works – empirical claims – are questions of ‘truth’, and questions of honesty, authenticity and consistency of thought and action, are claims of ‘truthfulness’.
I will stay with the example of drinking and driving for illustrative purposes. Habermas’s genius is to reveal that the structure of reasoning that humans engage in when confronting a question such as ‘is it acceptable to drive a car under the influence of alcohol?’ is coherent, understandable, and universal. In other words, the standard we implicitly deploy when addressing the rightness of an action, rule, or procedure is assumed by coherent participants in the discussion, whether they are directly affected, operating as independent third parties, or considering the issue in the abstract. We assume a common standard and our reasons imply that we are applying a rule even though we may not be able to articulate explicitly the rule we are employing. This is perfectly analogous to the rules of logic, as assumed in any reasoned discussion or any empirical question, or the rules of grammar assumed in all speech. Of course, ethical reasoning is also subject to the rules of logic and empirical testing. It is the nature of the reasons provided to determine rightness that renders it a unique validity claim.
If correct, this is an extraordinarily powerful conclusion. Implicitly, common ground is a presupposition of any ethical debate. Confusion and disagreement lie elsewhere.
Before outlining the precise structure implicit in all ethical reasoning, which Habermas makes explicit, it is important to clarify the significance of this three-category distinction, because it already clarifies many issues, for example the issue of ‘value-bias’ or ‘ideology’ in science or social science. We can immediately see that there is a categorical distinction between hypotheses pertaining to how the world works and adocacy of policies, actions, rules or laws. ‘Rightness’ and ‘fairness’ pertain to acts. Of course it might be argued that a body of empirical knowledge or the pre-selection of an area of study – itself an act – carries implications for subsequent actions or policies, but already this introduces a greater clarity of thought. To claim that an area of science is ‘value-laden’ is to argue that it somehow affects actions pejoratively, something which Foucault for example attempts in his history of psychiatry.
It is also important to rebut some frequent errors of understanding. Recognising that all modern human societies in fact adopt the same structure in ethical argumentation does not imply that they all agree on what is ethical. In fact, it becomes very clear why they don’t, and it is important and helpful to identify why some ethical questions are in fact irresolvable. Secondly, it is critical to recognise that if an implicit structure of reasoning is raised in an ethical claim: a) there is such a thing as objectivity in ethical reasoning which does not reside in the physical world, but which is a ‘man-made’ semantic or logical standard (there is also compelling evidence that socialised humans have evolved to developing cognitive moral ‘stages’ consistent with these categories); b) all ethical claims are subject to justification.
This even applies to any ethical claims which are asserted as being ‘religious beliefs’. As a matter of empirical fact the very existence of theology and religious scholarship suggests that religious tenets are in fact contested and subjected to consistency. From direct personal experience growing up in a religious society, I recognise that statements such as ‘catholics believe X’ are simply false. Religious texts have hierarchal ethical structures and inconsistencies, which provide the basis for theological dispute and argument. Again, there is nothing at odds with this framework in people holding dumb ethical views, in the way that some people also believe that the earth is flat. Those with silly ethical views (for example, that homosexuality is immoral), simply cannot provide coherent or convincing defences of their beliefs, and inconstencies with higher order ethical claims they usually hold are easily identifiable.
Rather bizarrely some recent, naive, criticisms of Habermas, seem to assume that because ethical discourse has a universal structure somehow everyone is ethical and all discourse is positive. As a critique this is risible. That’s as silly as saying that mathematics is false because most people struggle with calculus. Ethical reasoning is hard, and we often have reasons to obfuscate or deny its conclusions. Tribalism, for example, is a deep human instinct which when it takes a violent turn involves the suspension of morals.
Because Habermas shows that moral reasoning raises a claim to ‘rightness’ which is universal in structure, his work is also a synthesis of much of preceding moral philosophy. He proposes that the following rule is in fact implicit in all moral discussions: that the right thing to do is that which weights the interests of all those affected equally.
Anyone schooled in moral philosophy will recognise the principle of weighting the interests of all affected equally as Kantian, but Habermas also argues convincingly that Hare’s Kantian/utilitarian synthesis renders the Kantian/consequentialist distinction pretty much redundant. Rawls’s ‘veil of ignorance’ is a similar attempt to summarise the presupposition of ethical reasoning, by engaging in a thought experiment. Habermas, in contrast to Rawls and Kant, says we argue and provide reasons which reveal that we are attempting to provide equal weight to the interest of all affected. This is what utilitarianism claims to do – the contention is in clarifying ‘interests’ – and Rawls proposes imagining that you should reason as if you don’t know which of those affected you will be. In Christianity, ‘love your neighbour as yourself’ is the same dictum, as is the everyday dictum of putting yourself in the shoes of others. The unique power of Habermas’s formulation is the emphasis on the nature of reasons people actually provide revealing the principle they are deploying. Listen carefully to any ethical debate, discussion of what is fair, and operation of Habermas’s rule becomes apparent. We all deploy it implicitly, as we do logic, or grammar. In this way, Habermas is not proposing his principle and then defending it. He reveals that you have already assumed it when you engage in claims of ‘rightness’. The strength of his case is revealed in the fact that most of the recently published articles criticising him, in fact assume he is right! Interestingly, Chomsky uses the same approach in his famous debate with Foucault. He shows that Foucault needs a concept of justice in order to criticise international law. Communication and critique require presuppositions.
Habermas also identifies an additional aspect of moral reasoning which is often neglected, or simply treated separately – voice and consent. Ideally – and of course this is often practically impossible – we have a moral expectation that all those affected by a rule or action are consulted and consent. It is a feature of ethical interaction that we seek the consent of those affected, so ideally – and this is an implicit ideal – all affected also agree to it. This observation is very relevant, for example, to the ethics of Brexit referendum. In practice, of course, this rarely occurs. So often, pragmatically, we agree to operate with other rules of decision-making.
It is finally worth pre-empting a typical criticism of universalism in ethics, which Habermas brilliantly resolves: how do we square objectivity and reasoned discussion with the apparent diversity of views and beliefs about what is right? And why are certain ethical issues so intractable? Ironically, if we are all operating with a standard of weighting the interests of all those affected there will be consistent controversy. There are conflicts of interest which we will try to disguise. We will exploit the inherent uncertainty in the estimation of consequences and measurement of interests, to suit our self-interest. This is why we need an independent judiciary, and why we need constant critical analysis of the structures of power. At the same time many so-called moral dilemmas are really cases of inherent conflict of interest, for example what should one do if one person’s survival is contingent on another’s death? It’s becomes immediately clear that there is no ‘right’ thing to do. This is simply a terrible situation. That in fact defines most ethical dilemmas, and areas of great controversy. It is an error to assume that despite the profound seriousness of many moral questions, all are resolvable. Some are irresolvable. But this is no reason to abandon hope. Quite the reverse. What Habermas convincingly proves is that reasoned debate between humans on ethical questions is not just always possible but always present. This does not imply some naive victory – self-interest, violence, and amorality often prevail. But there is a universal resilient glimmer of hope.
Contradicting the act of writing this piece, don’t waste time reading others on Habermas. Most of it is less clear than the original and often wrong. The pinnacle of his intellectual achievement is ‘Moral Consciouness and Communicative Action’, available in pdf here. Like Keynes, greatness is not always easy to read. But it’s worth persevering.
The future of monetary policy – Dual interest rates
The significance of dual interest rates remains under-appreciated. The European Central Bank, Bank of Japan, and the Bank of England’s facilities are by far the most significant policy innovations since the financial crisis. Curiously, most of the economics profession and commentariat seems oblivious.
Firstly, what are dual interest rates? Economists love obscuring important policy innovations with (often inaccurate) semantics. So let’s make this clear. As Martin Sandbu points out, central banks have always had more than one interest rate. Typically, they have an interest rate which they pay on bank deposits held at the central bank, and a rate at which banks can borrow electronic cash (‘reserves’) from them – often at ‘punitive’ rates. Typically we pay little attention to these different rates, because policy has a single goal – to influence money market interest rates, which are the benchmark for lending and deposit rates throughout the economy, and influence asset prices. For technical reasons the effective policy rate can vary, but at any point in time, there is typically only one. In the Eurozone it is currently the ‘deposit rate’, in the US it is the ‘fed funds target rate’.
‘Dual interest rates’ refers to a policy where the central bank specifically tries to seprately target an interest rate on bank lending and the interest rate on bank deposits. The traditional constellation of rates does not attempt to do this. Why does this matter? A single interest rate policy – one aimed at targeting money market interest rates or bond yields – has ambiguous economic consequences. This is at the heart of the problem with negative interest rates. In a single rate world, a decline in interest rates leaves the net income of the private sector unchanged – for every borrower who has higher disposable income because interest rates have declined, there is a deposit holder who has lower interest income. In reality, this is complicated by taxes, and financial intermediation, but the essential point holds (Warren Mosler makes a similar point, here, regarding the effects of QE).
Given that a fall in interest rates typically leaves private sector net income income unchanged, textbook economics requires other processes to create a stimulus – for example that the marginal propensity to consume of borrowers is higher than savers (Miles Kimball has written extensively on this). But these effects are entirely contigent – they do not necessarily hold – and there are good reasons to believe that sometimes the effects are the opposite.
That is why dual interest rates are monetary rocket fuel. A system of dual interest rates can necessarily raise the net interest income of the private sector, and can create large, predictable demand for new lending. To make this clear, consider a situation where the ECB raises its deposit rate to zero (it is currently -0.4%). This interest rate is paid on bank deposits held with the central bank (reserves), and will cause money market rates to rise. Typically, this will cause deposit rates across the Eurozone to rise, and also some interest rates on loans. Simultaneously, the ECB offers a new lending facility to banks at -1% fixed for 5 years. To clarify the power, let’s assume the facility is equal to 20% of Eurozone GDP. The conditions for the loans are that they be additional credit and banks must illustrate that borrowers receive a significant share of the reduction in funding rates (say 50 basis points).
There is little doubt that this facility would be taken up in full, because a huge range of investment opportunities are highly profitable at a -1% fixed over five years, and the stimulus is two-fold. The net interest income of the private sector rises, and there is a large increase in lending. Of course, if -1% doesn’t do it, the ECB can cut the rate further and extend the term further. There is no economic model where this type of policy does not generate demand, cause unemployment to fall, and ultimately prices to rise. Dual interest rates, the ECB’s TLTRO being the clearest example, is a huge breakthrough in monetary policy. There is no excuse for any central bank saying they have run out of ammunition and there is no reason why any central bank is failing to hit their inflation target.
It is worth outlining the superiority of dual interest rates to the existing ‘innovations’ since the financial crisis. Forward guidance has all the weaknesses of standard, single rate-based policy. It simply extends the reduction in the single rate out to longer horizons. QE is highly effective when there is a reserve shortage, but once money market rates have collapsed and banks hold huge excess reserves, its effects diminish. The effects of conventional monetary policy suffer from diminishing marginal impact. Dual rates, by contrast, become marginally more powerful: consider a TLTRO at -5% for 20 years, or a perpetual TLTRO at -1% (a combined helicopter drop and a basic income!).
The mystery at this point is the negligence of the global economics community in ignoring the significance of these policy developments. There are a very small number of exceptions, including Megan Greene, Simon Wren-Lewis, Martin Sandbu, and Miles Kimball. Most US policy economists seem to think asset purchases and forward guidance are the only game in town, as the opening speech by Jerome Powell at the Chicago Fed conference on new tools for the Fed illustrates.
The failure of central banks globally to provide overwhelming stimulus to demand and meet their inflation objectives is no longer accepted and should not be tolerated. The first step, as always, is cognitive.
Eurozone growth has stalled and inflation is below the ECB’s definition of price stability. As the recent actions of ECB make clear, further monetary easing is necessary for the ECB to fulfil its mandate.
Unfortunately, the actions taken so far are insufficient, and run the risk of depressing sentiment. There is no point in further debate over negative interest rates. We don’t have enough empirical evidence one way or the other, but the verdict of financial markets is relatively clear. Equities and banking stocks are cyclical risk assets and they are responding poorly to negative interest rates. The logic is straightforward. There is no reason to believe that the economic response to falling interest rates is linear and has a fixed sign. If rates are high and are reduced, it is more likely to be a stimulus, as they approach or pass through zero in economies with high private sector savings, high income per capita, and ageing populations, it is just as likely that the effects are to depress demand.
This by no means renders monetary policy redundant, it just requires are important change in tactics. In fact the ECB – through brilliant innovation – has shown how to do it: dual interest rates. If there are dual interest rates, negative rates will always work. (In this regard, Miles Kimball and I are in agreement).
How? Consider the simplest example. Let’s say everyone banks with the central bank, and there is an equal number of borrowers and depositors. There are two interest rates, a deposit rate and a borrowing rate. Both are variable. Is it an economic stimulus if the central bank raises the deposit rate, say 50bps, and cuts the rate on loans by 100bps? Of course it is, always, and under any economic model: savers and borrowers both experience an increase in disposable income. The only issue is the magnitude of the stimulus.
Ok, so how does the ECB do this? Fortunately, it already has the tools, but is being somewhat sheepish in their application. The ECB’s refi and deposit rates influence Euro money market interest rates rates, which affect deposit rates across the Eurozone, and the lending rate is the interest rate on TLTROs. This is why TLTROs are the most significant monetary innovation since the financial crisis. They can always work, and in contrast to QE, their marginal effectiveness can increase.
What are TLTROs? TLTROs are loans from the ECB to banks which are ‘targeted’, another words the ECB monitors and restricts the use of the funds. The interest rate on the TLTRO is set independently, but with reference to the deposit rate. It would be simplest to free it entirely, or alternately to set it at a negative rate relative to the deposit rate the ECB pays on bank reserves.
So here is what the ECB should do: It should announce a new 10-year TLTRO equivalent to €1trn, at a fixed negative interest rate of 1.5%, and it should simultaneously raise the deposit rate to 0%. In order to offset any potential deterioration in the terms on outstanding TLTROs it can also offer to refinance these on existing collateral and maturity terms, but also reduce the interest rate to a fixed -1.5%. If further stimulus is required, the ECB can completely relax collateral requirements on these TLTROs. These funds should be available for any form of household borrowing (including mortgages which are oddly excluded currently), and any form of new corporate investment spending.
This is an unambiguous monetary stimulus, the only question is whether or not it is large enough. But its efficacy is easy to test. First, watch the response of cyclical assets. If equity markets rise, which I have no doubt they will, the policy measures have a positive sign – and so too will bank stocks. Second, watch demand. If the response is weak, do more. The ECB now has three axes on on which to ease monetary policy – the interest rate on TLTROs, the term of the loans, and the collateral. It should announce a willingness to use all until its price stability mandate is reached.
There are only two objections to this policy. The most serious is that the ECB is getting involved in directed lending. Well, TLTROs already exist. There has been no significant legal objection to TLTROs, in contrast to the SMP or QE programmes, and they have been designed to serve monetary policy purposes. Other than a restriction that the funds be used for new lending to households and business investment, there should be no restrictions. These requirements can easily be defended as the purpose and function of monetary easing. The ECB could also suggest that the European Parliament vote endorsing its actions – this is not a legal requirement, but would be a suitable response to recent concerns about ‘democratic legitimacy’ – the ECB has complete legal freedom to meet its inflation mandate as long as it does not finance fiscal authorities.
The second objection is spurious, but worth pre-empting, which is that the ECB will ‘lose money’, and see a reduction in accounting equity. The irrelevance of this objection has been covered in detail, but it has a habit of resurfacing. Suffice it to say that the losses are likely lower than under successful QE.
In conclusion, the current fashion for monetary apathy is misguided, and dangerous. There should be widespread calls for the ECB to do its job. It has the tools. Now it should get on with it.
This recent article by Stephanie Kelton is crystal clear and reveals the crux of the ‘MMT debate’. It’s all about central bank independence.
Also listen to this INET interview with Warren Mosler, a well-articulated summary of functional finance. Functional finance explains monetary and fiscal operations like this: the dollar bills in your wallet were created by the state, so the state ran a deficit in order to create money. In that sense, its deficits were self-financed. What happens when the state taxes and issues bonds? It removes the money it has created. It issues bonds to raise interest rates, and taxes to prevent too much money creating inflation. This is a simplification of how things work on many levels. But it is very good pedagogy. It is very clear, and it’s (sort of) correct.
When we map this model onto the real world, its central simplification becomes clear: monetary and fiscal policy are run by separate institutions, and they have been actively separated for very specific reasons. Stephanie, oddly, chooses either to ignore this, pretend it isn’t the case, or doesn’t mention it because she objects to it. She won’t like me saying this, and will probably cite twenty articles where she focuses on institutional structure. But then she says the solution to an unsustainable public sector debt dynamic is to keep interest rates down:
‘Since interest rates are a policy variable, all the Fed has to do is keep the interest rate below the growth rate to prevent the ratio from rising indefinitely. As Galbraith says, “there is no need for radical reductions in future spending plans, or for cuts in Social Security or Medicare benefits to achieve this.”‘
Ok, whether or not this works is debatable. But before one tries it, one has to engage in quite an extreme first move – taking control of the central bank. Central banks across the developed world are, to varying degrees, independent. At one extreme, the second largest economic area in the world has a central bank which is supranational, and legally prohibited from cooperating with national treasuries. But even outside of the Eurozone, central banks have high degrees of institutional independence. Interest rates will not be kept low to accommodate fiscal policy unless the executive takes control of the central bank.
That is in fact policy number one implicit in MMT. It deserves to be explicit, and debated. Stephanie obfuscates on this point:
“Krugman should be wondering why the Fed would ever maintain an interest rate that would put the debt on an unsustainable trajectory. I don’t believe it would.”
There are circumstances where an independent central bank could absolutely be at odds with fiscal policy. The fed tightened in response to Trump’s fiscal stimulus. Central banks across the developed world do not target debt sustainability given fiscal policy. They target what they think inflation might be.
Now you could say, “I don’t agree with this institutional structure. I want to change the law and make the central bank subservient to the Treasury. I want the government to set fiscal policy wherever it wants and the central bank to set interest rates to ensure the debt can be serviced, whatever the implications it thinks there might be for inflation.” But this is a complete reversal of the direction of institutional travel of the past 50 years, and illegal in much of the world economy.
Stephanie then makes an interesting suggestion, ‘if we’re so obsessed with debt sustainability, why are we still borrowing? […] the Fed no longer relies on bonds (open-market operations) to hit its interest rate target. It just pays interest on reserve balances at the target rate. Why not phase out Treasuries altogether? We could pay off the debt “tomorrow.”’
This is intriguing. Anyone obsessed with debt sustainability, has lost the plot for very conventional reasons. But it is worth explaining why we have bond markets! It’s not just that bonds serve a lot of useful functions as financial assets, but also it is precisely because we have separate institutions for fiscal and monetary policy, we have explicitly imposed a constraint on the government. We decided as societies after many decades that we didn’t want politicians to have direct control over the printing press. We want money to be controlled by the central bank. Central government is to finance – yes, finance – itself by issuing bonds. That is why we have government bonds.
It should now be clear why the crux of this debate is in fact about the independence of central banks. Simon Wren-Lewis makes a similar point, here. Let’s be clear about this so we can have a sensible debate. If you want politicians to control the printing press, Stephanie’s MMT is one way to do it. You first take control of the central bank. The second thing to bear in mind is you are not just handing the printing press to your favourite politician, but to all future politicians who take power.
We need a modern monetary policy (MMP). Policy needs redesigning for three fundamental reasons:
Firstly, the mental models for thinking about how the macro-economy in the developed world works have been broken for at least a decade, as some Fed policy makers are now recognising. If there is structural price stability – i.e. never an inflation problem – what should the focus of central banks be?
Secondly, the traditional tools used by central banks are ineffective. I have discussed the relative merits of monetary and fiscal policy before, the challenge is to devise policy tools which can be deployed very quickly – i.e. in a matter of days – and which impact demand directly. A single policy rate and asset purchases do not meet this criteria.
Thirdly, a series of genuinely new, effective, monetary tools have been identified and their significance is under-appreciate – dual interest rates, cash transfers to households, and ‘the Bernanke drop’. Fortunately, we have a policy for all jurisdictions. Unfortunately, divergent legal and institutional frameworks imply different policy tools for different central banks, this makes it harder to build consensus.
Let’s start with how the world works. I am going to make a series of statements about the structure of the developed world. I think (most) macro-economists will disagree with these, but I believe the empirical evidence is over-overwhelming, and I shall back up the claims in future posts. I also think
Economists pay insufficient attention to asset prices. Ask most economists what the relevance of the bond equity correlation is for fiscal policy and they will be baffled. You’ll be lucky if they know what you’re talking about. The bond equity correlation is the observable relationship between government bonds and stock prices. Do stock prices rise or fall when bond yields rise? A negative correlation implies that stock prices fall when bond prices rise (and yields fall). Why should economists care? This statistic is nothing less than the indicator of whether or not a country can engage in counter-cyclical fiscal policy. It is far more important, for example, than the fact that the dollar is a reserve currency.
This is worth unpacking because a fresh debate is emerging over the constraints on fiscal policy – particularly as the more enlightened parts of the political world realise that the status quo is untenable, and resisting destructive nationalism, requires more radical and meaningful intervention than we have seen for several decades. The bond equity correlation is in fact at the heart of how we can finance our ambitions.
How so? Let’s start with the stock market side of the equation. Stock markets are a measure of recession risk. They are not predictors of recessions, as such. Paul Samuelson famously quipped that the stock market has predicted seven of the last three recessions – or words to that effect. But the joke is only partly insightful. Yes, there is excess volatility in stock prices for a host of reasons, but the probability of recession fluctuates, so stock prices should fluctuate with these probabilities. In that sense, the stock market should ‘predict’ more recessions than actually occur.
The correlation properties of stock markets reveal more than their predictive powers. Correlation with news and the prices of other assets reveals how the world works, prediction is for astrologers. The critical point is that stock markets fall in recessions, and consequently stock prices are affected by perceptions of recession probability. The precise reasons *why* stock markets fall in recessions are not totally clear, but as an empirical observation it is also very robust. Whenever there has been a significant contraction in US GDP, for example, the major stock market indices have fallen by at least 50%. The obvious explanation is that stock prices are the present value of profits, and aggregate profits are highly cyclical. This is less convincing than at first blush. Why, for example, should a pension fund holding stocks care about a one- or two-year decline in profits, when the capital stock has enduring value? To explain the extent of stock market declines in recession we probably also need to draw on financing constraints, political and behavioural factors. Household and corporate cash flows fall during recessions, probabilities of default rise, political risk rises – often threatening property rights – and behavioural fear and myopia abounds. Every recession propagates the fear of depression.
So stock prices fall in recessions. That is one side of the equation. What do bonds do? And what does all this tell us about the viability of counter-cyclical fiscal policy, and the neutral policy rate?
Government bonds are not as predictable as stocks, or at least their properties are more dependent on the prevailing macroeconomic regime. How bonds behave during recessions depends on what inflation does, and in contrast to profits – which always fall in recessions – there can be recessions which cause falling inflation (the GFC), and recessions which coincide with higher inflation (such as Turkey, currently). Turkish bond yields have risen with recession risk because the central bank has to raise interest rates to stabilise the exchange rate and contain the rising inflation. This is the definition of an ‘emerging market’, or a 1970s developed market.
So if stock prices fall in recessions and bond yields can either rise or fall, the bond equity correlation is the key. It tells us what to expect bond yields to do if recession strikes. If bonds and equities are negatively correlated, expect bond yields to fall in a recession. It is this which signals the viability of counter-cyclical fiscal policy. This should be obvious, because the bond yield is the cost of government finance. A negative bond equity correlation implies that the governments cost of finance falls in recessions which frees it to counteract the opposite force in the private sector reflected in the rising cost of equity.
There has been renewed debate about optimal fiscal rules and the constraints on government borrowing, most recently because Olivier Blanchard has thought through the consequences of government bond yields sitting below nominal growth in most of the developed world (Olivier – this has been the case for more than twenty years in post-crisis Asia!). And some strident literalist functional finance addicts have pointed out that if the state can print money, inflation is the ultimate constraint on the fiscal authorities – whatever ‘ultimate’ means, and assuming the state, the monetary authority, and the fiscal authority are one, which they are not! This is all good intellectual fun, but back in the real world, we collectively decided a long time ago to put checks on the power of elected politicians in macroeconomic policy-making and give central banks varying degrees of autonomy in controlling monetary policy via official interest rates. The practical constraint on fiscal policy is therefore not inflation, but the central bank raising interest rates. Trumpanomics is a controlled experiment: if you aggressively ease fiscal policy when the economy is close to full employment, the central bank will raise interest rates and bond yields will rise.
This leads us to the how the equity market determines the ‘neutral policy rate’. I have argued in the past that we need to get away from the idea of some magic level of the interest rate that somehow brings inflation to 2% and the economy to full employment. It is not just that such an equilibrium interest rate may be hard to determine, it simply may not exist. I have also suggest a view of how the economy works, where the system in fact adapts through time to the prevailing level of rates – keep interest rates at or around a given level for long enough and it will probably become the ‘equilibrium’. I have also engaged in a series of debates and discussions with the effects of rates on the economy more broadly. The standard New Keynesian view of how interest rates affects consumption and investment – which is in part a classical, micro-founded view – has validity and great conceptual value, but also some huge flaws – not least that the corporate sector does not finance itself using the policy rate (which is acknowledged in the models, but rarely in policy discussions), and the consumption Euler equation has lots of problems. Similarly, I have engaged with neo-fisherists, who argue that raising rates raises inflation. In summary, my own view is that the significance of the policy rate is wildly exaggerated and its sign and significance is not linear. It is entirely plausible to me, that moving from zero to -0.5% interest rates might worsen economic conditions, articulacy if the primary effect is to damage the profitability of banks. Similarly, citing real interest rates in Brazil, where they are high, can trigger a boom in durable goods spending.
So what bearing do equity prices have on this debate? They provide a very useful short-cut for policy makers. The cliche of the ‘Greenspan put’ had it the wrong way around. The Fed’s job is not to ‘bailout’ equity investors. Nor is it the case that equity prices ‘predict’ recessions with seer-like accuracy, or that falling stock prices cause recessions. No – falling stock prices signal that that a rising policy rate is threatening one. So monetary authorities should take note. Trump stumbles upon a truth.
The recent episode is also instructive in describing the transmission mechanism. As economists we can debate the theoretical and long-sample empirical effects of interest rates, but the facts are quite stark. A rising Fed funds rate and two-year yields appear to have had a very coherent impact on global and US growth. The weakest link is dollar-leveraged emerging markets with large current account deficits. But US stock prices largely ignored the turmoil in Argentina, Brazil and Turkey through the first half of last year. It wasn’t until credit spreads started to widen materially in the third quarter that US stock prices responded. One aspect of the debate on the effects of policy rates on demand, that is often ignored by economists, is default risk. When as economists we consider that the income effects of changes in interest rates should be symmetric and have to rely on different marginal propensities to consume between income earners and payers – an argument Miles Kimball is fond of – we ignore the fact that if rates hit a point where default probabilities rise both borrower and lender are negatively affected. This process completely undermines neo-fisherian pretensions, which seem premised on the assumption that the only entity whose financial growth burden rises with interest rates is the government, which could not be further from the truth, as our bond/equity discussion revealed.
So these observations also have theoretical relevance – equity prices reveal the sign of the impact of the policy rate on demand, and reinforce the view that the sign is not stable. In the early stages of recovery from recession, interest rates and stock prices both rise, because a rising policy rate is a sign of economic strength. Expect this to occur in Europe. It is impossible to know if this is coincidence or causality, or a combination of both. But at a certain juncture policy rates become an independent factor, threaten growth via default risk, the sign changes – and the stock market signals this.
The debate over Brexit has been dominated by propaganda. To date, I have had sympathy with the one ethical argument, which has been made most effectively by Mehreen Khan, for leaving the EU. It is shared by many on the left and the right, which suggests some universal ethical validity. The European Union suffers from a ‘democratic deficit’. The Eurocrisis vindicated this perspective compellingly, as the Trioka and ECB exercised appalling institutional overreach and illegitimately intervened in what were rightly national policy areas by threatening financial panic. This has now been well-documented.
It is a great irony, that the nation-state least affected by the Eurocrisis, because it is not a member of the Euro, is the one most determined to leave the EU. It is an additional irony, that a referendum is a legitimate means to exit the Euro – because it is economically life-threatening – but not to leave the EU. Relatively straightforward moral reasoning reveals why.
Who should legitimately rule on an individual’s rights?
Sadly, the debate over EU membership in the UK has been hijacked by charlatans on both sides. There are some voices of reason, but they are hard to hear above the noise. To my knowledge, no one has made the compelling ethical case for remaining in the EU, or more specifically why the referendum lacks true legitimacy, or ethical status. The ethical argument is straightforward and compelling: decisions about rescinding EU citizenship should be made at an individual level, because individuals are more affected by EU membership than the collective and it is extremely hard to contend that a significant number of British citizens are materially harmed by another citizen’s membership. In fact, for the same reason that the whole of Britain did not decide on Scottish membership of the United Kingdom, the whole of Britain should not decide on an individual’s right to travel freely and work in an EU country. This right does not harm any other individual, and it is far greater in significance than any of the alleged threats to the collective. The ethical case is that simple.
First, we need to clarify the nature of moral reasoning, as frequently our understanding of ethics is left to unreliable intuitions. The most basic ethical question in any legitimate process is who has the right to make decisions. Why, for example, do we all agree that Scotland should hold a referendum on its independence, and not the whole of the UK? Or that individual adults have the right to choose whether or not to smoke? Or that local authorities should adjudicate on local planning issues? The ethical principle at work is in fact very simple: those most affected by a law, rule or action, should have the greatest say. Those unaffected by something should be silent. The reason Scotland decides on its independence is because Scots are most affected. It is not because the rest of the UK is not affected, but because those living in Scotland are significantly more affected than others living elsewhere in the UK. Similarly, smoking is rightly banned in many public places, but not in private areas. If your actions affect me, I have rights, if they only affect you, the decision should be yours. One version of this universal ethical principle was articulated in the classic case for liberty by the great British moral philosopher, political theorist, and economist, John Stuart Mill. Mill argued that the individual should have complete autonomy in all areas of their life unless they materially affect the well-being of others.
Ok, so a fundamental principle of moral reasoning is very clear. If something primarily affects the individual, that individual should decide on the course of action. If something affects us collectively, we should decide through collective democratic means. Obviously, the effects have to be significant and equivalent to warrant that those affected to have a say.
So what does moral reasoning imply for Brexit? Staying in the EU, or leaving, can be framed as a choice about citizenship, about rights and freedoms. In fact it should be framed this way because, on reflection, it becomes clear that the greatest effects bear on individual freedoms – the collective effects are relatively trivial. To deal with that latter issue first, whatever perceptions of the potential of EU membership are to impair our collective well-being, the evidence suggests it is trivial. In contrast to Greek membership of the Euro, for example, it is very hard to claim that any of us suffer materially through EU membership: the transfer of money looks relatively trivial. EU regulations are a relatively small share of total UK regulations and it is almost impossible to argue significant collective harm. The same argument applies to immigration. In order to have the right to a vote on restricting another’s liberties – ethically – one must claim harm. The evidence that a signifcant number of Britons have been harmed by EU immigrants, or British citizens working in the EU, is at best debateable, and more likely flatly untrue, and that includes the effects on public resources. Even if the data is incorrect, and there is net harm, only a very small minority of Britons can claim to have been affected, which does not given them moral legitimacy in determining the freedoms of all. To claim otherwise would be analogous to giving alcoholics the right to ban alcohol consumption. In addition, any ethical argument must also take into account the rights, freedoms and well-being of immigrants. In ethics, no one is a second class citizen.
Citizenship and liberty
Currently, we are all citizens of both Britain and the EU. Citizenship is a set of individual rights, it is not nationality. EU citizenship is a legally protected set of rights. Prior to any consideration of the merits of EU membership, an ethical, legitimate and legal discussion should have occurred regarding who should decide on removing those rights? Is it legitimate to put this to a majoritarian vote – ie, a referendum – or should the individual be free to chose? Is this a case of Mill’s Harm principle: if my freedom does you no harm, you should have no say in my right to exercise it.
Let’s apply Mill’s universal criteria. We can reframe the choice to leave or remain as a choice between the status quo – we are all both British and European citizens – and an alternative view, where we lose EU citizenship and all become only British. Assume for illustrative purposes that you advocate that we all become British, and I want us to remain British and Europeans. Who is morally entitled to make this decision? To answer this we have to consider the effects. I want to remain a European citizen because I want have the freedom to travel without restriction and to work elsewhere in Europe. I want my children to have the freedom to study in Europe with the same rights as other European citizens. None of this affects you. You are not harmed by me working abroad or my children studying in Europe. So you should not have a say in my decision. Similarly, by choosing to forgo european citrizenship, you are harming yourself and not me, so I should have no say in your decision.
The ethical conclusion is very clear: those who want to rescind EU citizenship should be free to do so, but it is patently immoral for them to impose this on others. The referendum should absolutely be overruled and individuals should be free to choose.
This ethical conclusion holds, without even debating immigration, how much Britain’s pays the EU, the regulation of bananas, taking back control, the ECJ, or trade deals with Singapore. Why? Because they are in fact trivial relative to the impairment of individual liberty an enforced removal of European citizenship implies. Consider immigration, we can debate the effects of immigration on economic growth and the provision of public services, but it is extremely difficult to argue that most British people’s liberty, rights or interests are significantly impaired by immigration. Indeed, EU citizens in the UK and UK citizens living abroad are clearly the groups most affected. Ethically, they should therefore have a greater say than the rest of the population, and yet in the case of non-British, EU citizens living in the UK (other than the Irish), were denied a vote.
What is remarkable is how the British right – a traditional defender of individual liberties – has now become an advocate of a draconian infringement of individual freedom and rights.
The ethical solution at the current juncture is not a second referendum, but to allow individuals in Britain to choose their citizenship. Those who wish to rescind the freedoms and rights available through EU membership should be free to do so. No one should be encourage to impose their preferences on others when their interests are not materially affected.
The obvious counter to this is that it is an impractical proposal. How can those who want to rescind EU citizenship, and the rights and freedoms it comes with, do so while others remain British and EU citizens. This does not require legislative change at all. What does forgoing EU citizenship entail at an individual level? If you stay in the UK, there is virtually no consequence. The share of your taxes going to the EU is trivial. No one is compelling you to travel to EU, educate your children there, or work there. Protecting people from not exercising liberties from which they would benefit is not something societies – for rather obvious reasons – have seen the need to do.
The ethical conclusion in unavoidable: the referendum was, and remains, illegitimate and unethical. Brexit is, and should remain, an individual’s choice.
Acknowledgements: all views and errors are mine entirely! But thanks to the following discussants for their feedback: Paddy Boyle, James Hanham, Nick Lloyd, Corinne Sawers, Gina Lonergan and Marc Beckenstrater.
The fundamental macroeconomic policy challenge faced by the Eurozone is how to have a risk free asset – which is essential to the functioning of a modern financial system – while simultaneously preventing fiscal free-riding. Mario Draghi, somewhat miraculously, may have squared this circle. It is worth being explicit about how he has done it, as most of the macro-policy community still seems unaware, and at some point the relevance of this tension is likely to reappear.
The Euro crisis, a run on the sovereign bond markets of member states which started in late 2009 and did not end until ‘whatever it takes’ in 2012, was preventable. If the ECB had engaged in aggressive QE in 2009, like the rest of the world, sovereign runs would never have occurred. At the time, Eurozone QE was not just legally permitted because all member states were freely issuing bonds in public markets, it was arguably a legal obligation. It was clear that deflation was a significant threat, and there was a global consensus that QE was the answer. It is hard not to conclude that the Eurocrisis was primarily an intellectual failure.
Once the sovereign panic had taken hold, and a number of Eurozone sovereigns had effectively lost market access, the legal position of the ECB became compromised. Consider the following dilemma: Let’s imagine that an Italian debt default threatens price stability in the Eurozone, but simultaneously Italy loses market access. What should the ECB do? Its price stability mandate requires that it buy Italian bonds, the legal constraint on it directly funding a member state’s fiscal needs implies it cannot. For these reasons, the legal status of the SMP programme, or the OMT if it ever materialises, look far more questionable than QE would have been in 2009.
Fortunately, there is no reason for the ECB to ever face this mandate conflict, but it reveals a genuine tension. Whatever ones view of the history, there is a contradiction at the heart of Eurozone macro financial policy. A modern financial system requires a risk free asset. To make this clear, consider deposit insurance. Milton Friedman regarded deposit insurance as the most significant US economic policy innovation of the twentieth century. It ended macroeconomically significant deposit runs in America. This is only possible because the money-printing US state ultimately stands behind FDIC, and in extremis, it can honour limitless deposit withdrawals. Because its potential support is unlimited, its guarantee prevents runs. A variant of this exists within financial markets, where treasury bonds act as insurance policies: whenever there is a deflationary panic and risk assets are falling, interest rates fall and government bonds rally. Faced with the threat of recession, the financial system buys government bonds because they have no default risk. The collapsing yield on government securities also creates fiscal space (yes, austerity was a total fraud).
The ability to issue currency – a risk free asset – is therefore the basis of banking stability, the basis of some degree of financial market stability, and the premise of counter-cyclical fiscal support in a modern economy (for more on this, consider emerging markets for contrast).
Europe does not have an equivalent to a treasury bond (it is easily forgotten than German CDS spreads rose dangerously at the peak of the Eurozone crisis: Germany can default in the Eurozone, too). Absent a safety asset, the Eurozone embeds profound economic and financial risk.
One solution to this dilemma would be for the ECB to determine that a default of any member state would threaten price stability. This is certainly plausible for almost any circumstance involving the default of the economies larger than Spain. An Italian sovereign default would result in Euro-wide deflation risk. Implicitly, the ECB – as a matter of law – can never let this happen. The first sign of a significant probability of this occurring and it should intervene to halt the run.
The problem, obviously, is that if the ECB makes this reaction explicit, the market will eliminate credit risk in Italy, and the Italian government will be free to fiscally free-ride. This is the inconsistency at the heart of the Eurozone.
Draghi’s law of conditional safety
Squaring this circle is no easy matter, and committing to doing so may or may not be legal. So how has the maestro of Milan come close to doing so? The ECB, under Draghi’s leadership, has effectively created conditional risk-free assets, which appears not be a contradiction in terms. Simply put, the ECB will stand behind any large sovereign bond market in the Eurozone as long as it is fiscally compliant. This rule has been devised via QE eligibility, which is largely at the discretion of the ECB. The behaviour of sovereign bond markets in the last few years reveal tacit acknowledgement of this rule. Whenever a member state in Europe – be it Portugal, Italy or Spain – announces its plan to take on the Commission and breach fiscal rules, the bond market pounces. QE eligibility is at stake. If you want to issue safe assets in Europe, you have to meet the fiscal rules.
I have broadly described this process before, but it is worth being more explicit. If you support Eurozone fiscal rules, this is huge progress. The bond market is a far more effective law-enforcement agency than the EU, as the recent Italian policy retreat reveals. But is this really a stable or healthy equilibrium?
It may be. Draghi, by virtue of his law of conditional safety, has created the potential for risk free assets in the EZ, although he has not liberated fiscal policy from its dysfunctional straight-jacket. Moreover, logic and incentives now suggest that given member states are bound into the Euro, and the costs are too high for even Greece on the brink of collapse to risk exit, the only way to recover any sort of fiscal sovereignty is to build a fortress around national banks and run with relentlessly tight fiscal policy. The Eurozone savings glut is a permanent feature of this landscape. Will the rest of the world tolerate it?
Accounting objections to cash transfers don’t add up, and if CBs bought equity they could reduce inequality
There is growing recognition – most recently by Janet Yellen – that should another recession strike when global interest rates are this low, central banks will have to embark on either more aggressive forms of what they have already done directly and by stealth, or something new. Regarding the latter, some form of direct support for consumption, looks like the best candidate.
One of the main objections to cash transfers as a means to support household consumption is that it impairs the central bank’s balance sheet. It is important to put this pedantic objection to bed. On reflection, it is clear that the central bank balance sheet consequences of a base money financed cash transfer to households is in fact the same as (successful) quantitative easing (QE) via government bond purchases.
Here’s the background: One objection to central banks making cash transfers to households is that it creates an accounting liability (bank reserves) without a corresponding asset on the central bank’s balance sheet. In conventional accounting this implies a decline in equity. (I have argued that conventional accounting is nonsense when applied to central bank balance sheet, but let’s go along with convention to illustrate the point). So when a central bank makes a cash transfer to households accounting ‘liabilities’ rise, and assets are unchanged. By definition, accounting equity falls. What happens with QE? Despite appearances, the effects are the same – as long as the QE works. Successful QE involves a necessary loss on the government bonds purchased – something frequently overlooked. Why? If QE provides a successful stimulus to the economy, real interest rate structures should end up higher than prior to the stimulus, after an initial decline in term premia. If this is not the case, there was further room for the central bank to reduce real interest rate structures by either cutting rates or committing to keep them lower. It is reasonable to expect government bond yields to decline on the announcement of QE – if it functions either a signal for the future path of rates, or by depressing term premia. But if this stimulus is successful, yields should rise after the bonds are purchased and the economy recovers. The Bank of England’s post Brexit referendum QE is the classic example of what I am describing. Successful QE, if reflected in higher than previously expected growth, should result in higher than expected real interest rate structures at least for the market’s proxy of the risk free rate. The BoE has indeed made capital losses on its post-Brexit gilt purchases.
I am assuming that long duration government bonds are bought under the QE programme, and that the intention is to stimulate the economy through lower long-term real interest rates. This is not QE aimed at bringing down artificially high money market rates caused by a shortage of base money. There are more caveats. The central bank can be ‘lucky’ (or unlucky – depending on your perspective) if there is an unrelated shock to equilibrium real interest rate structures which reduces reduces yields. In this circumstance, they could fortuitously make a capital gain. This has happened in many instances since the financial crisis. These capital gains are accidents, not design.
Some will argue the losses I am describing are ‘only’ mark-to-market losses. This is irrelevant. If QE is successful and needs to be reversed, a mark-to-market loss become a realised loss. So the balance sheet loss of equity is identical to that of a cash transfer, of a similar magnitude.
Those who object to cash transfers on the grounds that they unique impair the central bank’s balance sheet, are barking up the wrong tree. The only significant difference in the balance effects of cash transfers compared to QE, is that the losses in the case of QE are contingent.
QE appears as a somewhat cack-handed and incompetent alternative to cash transfers. Another option, of course, as Roger Farmer points out, is that the central bank buys equities to stimulate demand when recession threat raises its head, rather than bonds. There is much wisdom to this. Not least if the policy works, the state will make a large capital gain, because reduction in the threat of recessions doesn’t just cause real rates to rise it also causes higher stock prices. And as Mark Blyth and I have argued, this capital gain could easily be returned to the lowest deciles in the distribution of wealth – who often bear the brunt of recession.
Having written this short note, I subsequently discovered a very similar argument has already been made by Simon Wren-Lewis. I shouldn’t be surprised. Simon focuses on the distributional differences.