Archive for January 21st, 2010

Bank of England’s MPC not good enough

January 21, 2010

After his term at Bank of England Monetary Policy Committee (MPC) was over, David Blanchflower is busy criticising MPC and its functioning. WSJ Blog has a review of his recent articles.

In his recent article he says he is worried over stimulus being withdrawn soon leading to a double dip recession. He takes on BoE MPC for missing the recession completely:

And then one of the external members of the Bank of England’s Monetary Policy Committee, Andrew Sentance, gave an interview that sent jitters through the markets, pushing the pound up when he unwisely suggested that growth had arrived and rate hikes were imminent. The first rule, for an MPC member, should be to do no harm. He was the one who throughout 2008 denied there was going to be a recession.

It is now my view that the MPC’s days are numbered, certainly in terms of its remit and probably its membership. After the election we are going to have to reconsider who sets monetary policy. Here is why.

Creating an independent central bank in 1997 was a good idea and much comforted the markets. The idea of inflation targeting had much traction in academic literature and seemedlike it was worth a shot. The claim was that it would help bring macroeconomic stability and it seemed to have worked for a while, because inflation remained low for most of the next decade. But that was driven by cheap imports from China. When Tony Blair was asked recently in an interview at Columbia University what had driven the Great Moderation he replied, “Luck”, and that seems about right.

It turns out that countries without an inflation target did just as well as those with one. And it didn’t protect us from the greatest economic shock of our lifetimes.

It also helped to make it feel like everything was rosy, because all the attention was focused on the consumer price index (CPI) as a measure of inflation, which excluded the major variable that was increasing a lot — house prices. If house prices had been included in the index, interest rates would have been a lot higher in 2006 and 2007, and that would have helped to prevent the bubble that followed. Symmetrically, including house prices now in the measure of inflation would make it clearer that we are in a deflationary period.

The MPC missed the recession entirely. Rates were cut too late and even in early September 2008, just days before the collapse of Lehman Brothers and the secret loans to RBS and HBOS, most of my MPC colleagues were concerned only about inflation and wage-price spirals. The recession was much deeper because of their failure to act. The MPC was asleep at the wheel. Its inability to communicate adequately what quantitative easing is supposed to do suggests it has learned little.

Targeting the CPI alone no longer has credibility and has to go. The US Federal Reserve has a much broader remit — “to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates”. I would advocate that something similar should be the remit for macro policy in the UK, not least because unemployment hurts much more than inflation. The last thing we need is for interest rates to rise any time soon. Inflation is going to jump in the short term because of the VAT increase, but will then fall back sharply.

This MPC is not fit for purpose and should be disbanded. The big question is what it should be replaced with. That is a subject to which I will be returning.

I am surely waiting for his next piece.

We all thought MPCs are great way to do monetary policy. In specific, Bank of England MPC model was seen as one of the ideal ones where one could express his views freely.

And then came this crisis questioning all basics and great ideas of economics we have learnt in recent years. And now this Blanchflower criticism of BoE MPC.

I haven’t heard anyone else criticise the other central banks’ MPC. May be we don’t have Blanchflower type members who are willing to stick their neck out. And this is not when he has moved out of MPC. He spoke for cutting rates very early and did it pretty openly. Or may be there are no such issues with other MPCs.

But I would doubt the second reason as most MPCs missed the recession. All simply looked at inflation and thought all is well. So, there would be issues in other MPCs as well. We need straight talking as Blanchflower to set things right. Otherwise, how will the MPC framework improve?

Equity Premium puzzle solved?

January 21, 2010

Fatih Guvenen of University of Minnesota has written an insightful paper on equity premium. As the paper is too technical, Minneapolis fed has a summary of the same.

First some basics. What is equity premium?

The equity premium—the higher return from stocks than from bonds—is an entrancing puzzle for economists. Standard theory suggests that stockholders should receive perhaps a 1 percent greater return from stocks than from safer bonds, to compensate for the larger risk inherent to equity investing. But the historical reality is dramatically different. Between 1926 and 1999 (to choose a period without recent booms and busts), stocks returned nearly 7 percent more per year than bonds.

Econ reasons:


Euro: It Can’t Happen, It’s a Bad Idea, It Won’t Last

January 21, 2010

This is what major US (and few European) economists believed when the idea of one currency in Europe was floated (HT: Tyler Cowen).

In a paper next on my reading list, Lars Jonung and Eoin Drea track from 1989-2002 the comments and research of US economists on the prospect of European monetary union and the euro. Needless to say, most analysis was like the title of this blog post.

One should also read comments of a few economists who have kinda revised their views on EMU and Euro.

  • C. Fred Bergsten
  • Jeffry Frieden
  • C.A.E. Goodhart
  • Steve Hanke
  • Otmar Issing
  • Peter Kenen
  • Ronald McKinnon
  • George Selgin
  • Roland Vaubel
  • What do you think comes as a key insight from the above economists discussions on Euro? American economists looked at economics and theory of optimal currency areas to say EMU/Euro will not work. However, what was crucial behind EMU/Euro working was not economics but politics. The US economists did not understand politics behind the decision and called it a failure.

    Charles Goodhart even says once economics was taught as political economy. Later politics was just ignored and economics became supreme. To understand EMU/Euro a revisit to political economy is needed.

    I have learnt many lessons from this crisis and two stand put. One, it is so important to know economics history. Two politics is central to decision making. I just learnt how US political cycle prevented this crisis from becoming a depression. I don’t know why economists underestimate the two most of the times.

    95 finance lectures everyone should listen to

    January 21, 2010

    Jesse Young of Online Colleges sends me an email of this very useful compilation – 95 lectures on finance.

    It has lectures on basics, personal finance, business finance, crisis, investing, international issues etc.

    Happy reading. Thanks Jesse.

    %d bloggers like this: