An Empirical Assessment of Optimal Monetary Policy Delegation in the Euro Area

We estimate a New Keynesian DSGE model for the Euro area under alternative descriptions of monetary policy (discretion, commitment or a simple rule) after allowing for Markov switching in policy maker preferences and shock volatilities. This reveals that there have been several changes in Euro area policy making, with a strengthening of the anti-inflation stance in the early years of the ERM, which was then lost around the time of German reunification and only recovered following the turnoil in the ERM in 1992. The ECB does not appear to have been as conservative as aggregate Euro-area policy was under Bundesbank leadership, and its response to the financial crisis has been muted. The estimates also suggest that the most appropriate description of policy is that of discretion, with no evidence of commitment in the Euro-area. As a result although both ‘good luck’ and ‘good policy’ played a role in the moderation of inflation and output volatility in the Euro-area, the welfare gains would have been substantially higher had policy makers been able to commit. We consider a range of delegation schemes as devices to improve upon the discretionary outcome, and conclude that price level targeting would have achieved welfare levels close to those attained under commitment, even after accounting for the existence of the Zero Lower Bound on nominal interest rates.

An Empirical Assessment of Optimal Monetary Policy Delegation in the Euro Area

We estimate a New Keynesian DSGE model for the Euro area under alternative descriptions of monetary policy (discretion, commitment or a simple rule) after allowing for Markov switching in policy maker preferences and shock volatilities. This reveals that there have been several changes in Euro area policy making, with a strengthening of the anti-inflation stance in the early years of the ERM, which was then lost around the time of German reunification and only recovered following the turnoil in the ERM in 1992. The ECB does not appear to have been as conservative as aggregate Euro-area policy was under Bundesbank leadership, and its response to the financial crisis has been muted. The estimates also suggest that the most appropriate description of policy is that of discretion, with no evidence of commitment in the Euro-area. As a result although both ‘good luck’ and ‘good policy’ played a role in the moderation of inflation and output volatility in the Euro-area, the welfare gains would have been substantially higher had policy makers been able to commit. We consider a range of delegation schemes as devices to improve upon the discretionary outcome, and conclude that price level targeting would have achieved welfare levels close to those attained under commitment, even after accounting for the existence of the Zero Lower Bound on nominal interest rates.

Political economics and normative analysis

The approaches and opinions of economists often dominate public policy discussion. Economists have gained this privileged position partly (or perhaps mainly) because of the obvious relevance of their subject matter, but also because of the unified methodology (neo-classical economics) that the vast majority of modern economists bring to their analysis of policy problems and proposed solutions. The idea of Pareto efficiency and its potential trade-off with equity is a central idea that is understood by all economists and this common language provides the economics profession with a powerful voice in public affairs. The purpose of this paper is to review and reflect upon the way in which economists find themselves analysing and providing suggestions for social improvements and how this role has changed over roughly the last 60 years. We focus on the fundamental split in the public economics tradition between those that adhere to public finance and those that adhere to public choice. A pure public finance perspective views failures in society as failures of the market. The solutions are technical, as might be enacted by a benevolent dictator. The pure public choice view accepts (sometimes grudgingly) that markets may fail, but so, it insists, does politics. This signals institutional reforms to constrain the potential for political failure. Certain policy recommendations may be viewed as compatible with both traditions, but other policy proposals will be the opposite of that proposed within the other tradition. In recent years a political economics synthesis emerged. This accepts that institutions are very important and governments require constraints, but that some degree of benevolence on the part of policy makers should not be assumed non-existent. The implications for public policy from this approach are, however, much less clear and perhaps more piecemeal. We also discuss analyses of systematic failure, not so much on the part of markets or politicians, but by voters. Most clearly this could lead to populism and relaxing the idea that voters necessarily choose their interests. The implications for public policy are addressed. Throughout the paper we will relate the discussion to the experience of UK government policy-making.

Fiscal Sustainability in a New Keynesian Model

Recent work on optimal monetary and fiscal policy in New Keynesian models suggests that it is optimal to allow steady-state debt to follow a random walk. Leith and Wren-Lewis (2012) consider the nature of the timeinconsistency involved in such a policy and its implication for discretionary policy-making. We show that governments are tempted, given inflationary expectations, to utilize their monetary and fiscal instruments in the initial period to change the ultimate debt burden they need to service. We demonstrate that this temptation is only eliminated if following shocks, the new steady-state debt is equal to the original (efficient) debt level even though there is no explicit debt target in the government’s objective function. Analytically and in a series of numerical simulations we show which instrument is used to stabilize the debt depends crucially on the degree of nominal inertia and the size of the debt-stock. We also show that the welfare consequences of introducing debt are negligible for precommitment policies, but can be significant for discretionary policy. Finally, we assess the credibility of commitment policy by considering a quasi-commitment policy which allows for different probabilities of reneging on past promises. This on-line Appendix extends the results of this paper.

Fiscal Sustainability in a New Keynesian Model

Recent work on optimal monetary and fiscal policy in New Keynesian models suggests that it is optimal to allow steady-state debt to follow a random walk. Leith and Wren-Lewis (2012) consider the nature of the timeinconsistency involved in such a policy and its implication for discretionary policy-making. We show that governments are tempted, given inflationary expectations, to utilize their monetary and fiscal instruments in the initial period to change the ultimate debt burden they need to service. We demonstrate that this temptation is only eliminated if following shocks, the new steady-state debt is equal to the original (efficient) debt level even though there is no explicit debt target in the government’s objective function. Analytically and in a series of numerical simulations we show which instrument is used to stabilize the debt depends crucially on the degree of nominal inertia and the size of the debt-stock. We also show that the welfare consequences of introducing debt are negligible for precommitment policies, but can be significant for discretionary policy. Finally, we assess the credibility of commitment policy by considering a quasi-commitment policy which allows for different probabilities of reneging on past promises. This on-line Appendix extends the results of this paper.

Picking the Right Budget Constraint for Scotland

This position paper considers the devolution of further fiscal powers to the Scottish Parliament in the context of the objectives and remit of the Smith Commission. The argument builds on our discussion of fiscal decentralization made in our previous published work on this topic. We ask what sort of budget constraint the Scottish Parliament should operate with. A soft budget constraint (SBC) allows the Scottish Parliament to spend without having to consider all of the tax and, therefore, political consequences, of that spending, which is effectively the position at the moment. The incentives to promote economic growth through fiscal policy – on both the tax and spending sides are weak to non-existent. This is what the Scotland Act, 1998, and the continuing use of the Barnett block grant, gave Scotland. Now other budget constraints are being discussed – those of the Calman Commission (2009) and the Scotland Act (2012), as well as the ones offered in 2014 by the various political parties – Scottish Conservatives, Scottish Greens, Scottish Labour, the Scottish Liberal Democrats and the Scottish Government. There is also the budget constraint designed by the Holtham Commission (2010) for Wales that could just as well be used in Scotland. We examine to what extent these offer the hard budget constraint (HBC) that would bring tax policy firmly into the realm of Scottish politics, asking the Scottish electorate and Parliament to consider the costs to them of increasing spending in terms of higher taxes; or the benefits to them of using public spending to grow the tax base and own-sourced taxes? The hardest budget constraint of all is offered by independence but, as is now known, a clear majority of those who voted in the referendum did not vote for this form of budget constraint. Rather they voted for a significant further devolution of fiscal powers while remaining within a political and monetary union with the rest of the UK, with the risk pooling and revenue sharing that this implies. It is not surprising therefore that none of the budget constraints on offer, apart from the SNP’s, come close to the HBC of independence. However, the almost 25% fall in the price of oil since the referendum, a resource stream so central to the SNP’s economic policy making, underscores why there is a need for a trade off between a HBC and risk pooling and revenue sharing. Ranked according to the desirable characteristic of offering something approaching a HBC the least desirable are those of the Calman Commission, the Scotland Act, 2012, and Scottish Labour. In all of these the ‘elasticity’ of the block grant in the face of failure to grow the Scottish tax base is either not defined or is very elastic – meaning that the risk of failure is shuffled off to taxpayers outside of Scotland. The degree of HBC in the Scottish Conservative, Scottish Greens and Scottish Liberal Democrats proposals are much more desirable from an economic growth point of view, the latter even embracing the HBC proposed by the Holtham Commission that combines serious tax policy with welfare support in the long-run. We judge that the budget constraint in the SNP’s proposals is too hard as it does not allow for continuation of the ‘welfare union’ in the UK. We also consider that in the case of a generalized UK economic slow requiring a fiscal stimulus that the Scottish Parliament be allowed increased borrowing to be repaid in the next economic upturn.

Policy Labels and Investment Decision-making

Much attention in recent years has turned to the potential of behavioural insights to improve the performance of government policy. One behavioural concept of interest is the effect of a cash transfer label on how the transfer is spent. The Winter Fuel Payment (WFP) is a labelled cash transfer to offset the costs of keeping older households warm in the winter. Previous research has shown that households spend a higher proportion of the WFP on energy expenditures due to its label (Beatty et al., 2011). If households interpret the WFP as money for their energy bills, it may reduce their willingness to undertake investments which help achieving the same goal, such as the adoption of renewable energy technologies. In this paper we show that the WFP has distortionary effects on the renewable technology market. Using the sharp eligibility criteria of the WFP in a Regression Discontinuity Design, this analysis finds a reduction in the propensity to install renewable energy technologies of around 2.7 percentage points due to the WFP. This is a considerable number. It implies that 62% of households (whose oldest member turns 60) would have invested in renewable energy but refrain to do so after receiving the WFP. This analysis suggests that the labelling effect spreads to products related to the labelled good. In this case, households use too much energy from sources which generate pollution and too little from relatively cleaner technologies.

Effects of stress on economic decision-making: Evidence from laboratory experiments

The ways in which preferences respond to the varying stress of economic environments is a key question for behavioral economics and public policy. We conducted a laboratory experiment to investigate the effects of stress on financial decision making among individuals aged 50 and older. Using the cold pressor task as a physiological stressor, and a series of intelligence tests as cognitive stressors, we find that stress increases subjective discounting rates, has no effect on the degree of risk-aversion, and substantially lowers the effort individuals make to learn about financial decisions.