Sumner on Borio

By Matt Nolan 12/06/2013

A quote via Scott Sumner:

But debt doesn’t make workers want to work less, it makes them want to consume less.  There is a difference.  We need economists to look through these framing effects, and see that the standard model that demand shocks cause high unemployment worked fine; it’s our policymakers who failed us.

There is a huge difference.  Economists say GDP = C + I + G + X – M – but in macro you can’t just take these individual factors and talk about their impact on GDP, they are all massively endogenous.  In other words, this decomposition can be misleading – and gets filled with “fallacy of composition” issues when people try to use it for policy!

“GDP” is produced by factors of production, it is output using labour and other factors.  People are worried about high unemployment, and underutilised resources, this is exactly what Sumner is talking about when discussing active monetary policy of “demand management”.

The obsession with including “finance” into the cycle has to be viewed carefully.  In so far as it improves forecasts, and thereby improves the ability to “target a path” for demand, and improves our understanding of “what could or will happen” it is very very useful.  But it doesn’t actually change the fundamental relationship that monetary authorities should be focused on when setting monetary conditions!

Now this is where I get concerned with Borio’s stuff.  There is a lot of very good work in there (I agree with a lot of the discussion of the financial industry – and using financial indicators to “add information” about the output gap), but he is obsessed with selling his work “output gap that is adjusted for finance” or a “finance neutral output gap”.  This framing doesn’t make any sense to me – and in my reading of his papers he has never provided a full methodological reason why the output gap measure should be sold in this way.  He attempts it post-hoc justifications of why finance impacts on deviations from potential bullet two of this Vox Eu article – but this is still an uncompelling base.  When it comes to monetary policy the actual counterfactual we are interested in is in terms of unemployment and inflation – other factors matter (in terms of monetary policy) only INSOFAR as they influence these!

Macroprudential policy yadda yadda yadda are structural policies about “real economy” issues – monetary policy is set GIVEN these.  But having monetary authorities focus on this instead of actual monetary conditions is missing the wood for the trees.  Financial market information is useful to help inform us of where we are, and where we are going, BUT can we actually focus on the first order issue of the purpose of “active monetary policy” which are medium-long term inflation outcomes and short term unemployment variation (read the short-term as the outlook for 18-24 months out, I realise this term can be vague otherwise!).  If the financial market information helps the central bank set policy to deliver this (which it will) use the hell out of it – but don’t then lose sight of your actual purpose and start trying to value companies and assets for the market at large.  If you want to do that monetary institutions, give up your contract with government and get a job as a financial adviser ;)

When I read this sort of stuff all I see is monetary theorists saying “ahhh, NGDP growth was weaker than authorities were committed to delivering, here are some excuses”.  But as soon as they give up the role they were given by government (deal with inflation and short term fluctuations in the UR) they leave themselves increasingly open to arbitrary demands and politicisation.

After ignoring prudential standards and arbitrarily trying to deal with it with monetary policy, we stumbled into the Great Depression.  Pressure post Great Depression and war, in time led to the hyperinflation and stagflation through the 1970/80s, which led to a recognition that policy needed to narrow.  Which led to completely ignoring macroprudential rules (which is not good either) which then led to the 2008/09 crisis. Which led to …