January 2017 newsletter – Money Macro Finance Annual Conference

The MMF 48th Annual Conference took place in the University of Bath on 7-9th September 2016. This report comes from Paul Mizen.

The Money Macro and Finance Conference was held this year in the beautiful city of Bath. Perhaps best known for its spectacular Georgian architecture, it seemed possible that characters from Jane Austen could be round every corner. And they probably were filming the latest historical drama somewhere, but we had other things to do.

Drawn by the attractions of the city and, I would like to think, the excellent programme of keynote addresses and research papers in parallel sessions, this year's conference was the largest ever. Over 170 delegates presented 150 papers on every topic from monetary policy analysis to applied finance, the conference occupied the superb University of Bath facilities at the top of Bathwick Hill.

The conference was opened with a keynote lecture on ‘Learning and Asset Prices’ by Albert Marcet (Barcelona). His topic was to help us navigate the world where agents are rational but not subject to fully rational expectations. The danger in this world is to get lost in the ‘jungle of irrationaiity’ because so many alternatives to Rational Expectations exist, not all of which have satisfactory properties. Albert steered us towards the models with small deviations from Rational Expectations that go a long way towards explaining the properties of the data such as persistence, volatility and mean reversion but also allow for the possibility of over-optimism and bubbles. Many asset prices — for stocks, houses and other long lived assets — have these characteristics. Albert suggested that agents could be permitted to create their own model reflecting their beliefs about the process for prices (and dividends). They would be able to use all available information optimally, to know their utility function and maximise it. His proposal offers a distinction between internal rationality, where agents that maximise discounted expected utility under uncertainty given consistent beliefs about the future, and external rationality, where agents know exactly the stochastic process for fundamentals-determined variables like dividends and market-determined variables such as asset prices. These internally rational models would offer alternatives that were distinct from Rational Expectations, Bayesian Rational Expectations and Behavioural Finance models. He was able to show that using models of this type it was possible to match key metrics such as the evolution of price dividend ratios in the United States in ways that other models could not do.

One feature that was prominent in the conference this year was the contribution from PhD students, with ten per cent of the papers on the programme delivered by students. These sessions were attended by more senior colleagues who offered comments on each of the presentations. The Bank of England sponsored an evening reception at which the employment possibilities at the Bank of England were enthusiastically presented by Stephen Millard.

Throughout the conference there were special sessions on themes pertinent to current academic debates. Maik Schneider organised a session on Growth, Jean-Sebastian Fontiane and Peter Spencer arranged two sessions devoted to new issues in term structure models, and Chris Martin gathered a group to consider unconventional monetary policy. A special session by Rigas Oikonomou addressed the issue of fiscal policy and sustainability, which was also the topic of the keynote address by Enrique Mendoza (Penn).

Speaking on the subject ‘The Public Debt Crisis of the United States’ Enrique launched into the thorny debate on the sustainability of public debt using data from the United States as an example. We were shown historical data on debt crisis episodes in the United States since 1790, and it was pointed out that the US net public debt to GDP ratio in the Great Recession was the second largest since the Second World War. Enrique noted that many economists believe that the present conditions support arguments for higher debt based on the low cost of issuing debt, the need to satisfy the demand for safe assets and the dangers of secular stagnation. In his view, however, the high level of debt is unsustainable (even at low rates), the demand for safe assets may be transitory and there are substantial default risks that need to be addressed. It was clear that in this debate Enrique believes there is not an argument to issue more debt. The remainder of his lecture was devoted towards showing that the fiscal arithmetic works against expansionary fiscal policy based on the most recent estimates of fiscal multipliers and the adjustment speed of debt. Referring to work by Bohn (2007) in the Journal of Monetary Economics, Enrique illustrated his points using a fiscal reaction function in which the response coefficient of the primary balance to public debt is calculated after controlling for other determinants of the primary balance such as the cyclical positions of GDP and government purchases. He showed that when the reaction function is estimated to 2005 he obtains similar magnitudes for the response coefficient reported in Bohn, but extending the data to 2014 the coefficient drops by three percent, implying a substantially slower adjustment of debt and a higher ratio of net public debt to GDP.

The MMF lecture this year was given by Charles Goodhart (LSE), who was able to recollect the first meeting of the MMF (then the Money Study Group) in Hove, 1968. He reminded the audience that Harry Johnson had established the Money Study Group because he disagreed with the findings of the Radcliffe Report that had been published in 1959. The Money Study Group was formed to press for a new investigation of monetary policy, and the Bank of England agreed to participate in the first meeting, sending Kit McMahon (then Executive Director, subsequently Deputy Governor) to deliver a paper. Forty eight years later, Charles took up the topic of ‘The determination of the money supply: flexibility vs control’ to return to the subject of monetary policy.

Drawing on his knowledge of, and immediate involvement in, recent monetary history Charles discussed the relationship between monetary policy and the money supply. He noted that despite a fourfold increase in the size of central bank balance sheets, and vast excess reserves, the money supply has hardly changed at all. His lecture explored four theories of the money supply based on the idea that deposits create loans, base money creates deposit money (money multiplier), credit counterparts drive the money supply and finally that loans create deposits. The flaws in all four approaches were explained with an impressive grasp of institutional detail and historical monetary developments. Lastly, to bring the discussion up to date, Charles challenged the prescription for policy in Mervyn King’s book The End of Alchemy where the Bank of England would become the ‘pawnbroker for all seasons’. The idea would allow any bank to borrow provided it pledged its assets as security in advance, but Charles suggested that much of banks' immediate lending is not in its own control, driven as it is in the short term by overdraft and credit card borrowing, and in the long term by the need for housing finance. In his view it would be wrong to penalise banks for these effects and the development of the Basel Committee net stable funding ratios would be a better idea.

At the end of the second day, the conference dinner was held at the Roman Baths, a location that has been recognised by UNESCO as a world heritage site, and an example of creative human endeavour. While the MMF conference papers are a great example of creative human endeavour we can only hope that they will last a couple of decades rather than a couple of millennia. The dinner was an opportunity to thank the local organisers, Vito Polito and Eleanor Eaton, and the sponsors of the conference, the University of Bath, the Department of Economics, and the South-West Doctoral Training Partnership. Awards were given to Galip Kemal Ozhan (St Andrews) for the best PhD session paper presented at the conference was with a paper entitled ‘Financial Intermediation, Resource Allocation, and Macroeconomic Interdependence’ and the best poster was prepared by Kristina Bluwstein (European University Institute), with a paper entitled ‘Asymmetric Macro-Financial Linkages: How Useful is the Financial Sector for the Economy?’. The sponsor of both prizes was Mr. Assan Din, Chief Executive Officer of Saka Capital.

On the third day we were treated to further papers and a final keynote lecture by Frank Smets (ECB). Frank’s paper was based on recent work for a Handbook of Macroeconomics chapter on macroeconomic modelling. In many ways the Smets-Wouters model is the classic medium sized DSGE model, and the lecture illustrated how the core model could be extended to allow for effective lower bounds on nominal interest rates, financial frictions, and nonlinearities arising from time varying volatilities. These features set the present post-crisis era apart from the Great Moderation that prevailed before 2007. The core Smets-Wouters model did not predict the Great Recession based on data available to 2008 Q3, and in that respect the recession was unexpected, and the prediction once the recessions was observed was for a sharp rebound in output, which turned out not to be the experience.

Frank was able to explore whether the effective lower bound could explain the depth and persistence of the Great Recession that the original Smets-Wouters model could not match. He also explored whether financial frictions reflected in credit spreads could capture the shocks experienced in the financial system. We were reminded that in many respects the Great Recessions is characterised by a high risk premium, negative investment and technology shocks, and positive monetary policy and total factor productivity shock that require a financial system shock to explain them.

The conference papers are available on the MMF website (mmf.ac.uk/conferences) and a selection will be published in The Manchester School later in the year.