October 2017 newsletter – MMF Annual Conference

The Money, Macro and Finance Research Group held its 49th Anual Conference at King’s College London 5-7 September. This report comes from Paul Mizen.

The MMF conference was hosted this year by what is possibly the newest business school in the country. Kings College London has created a new business school which is located in Bush House, London, the former home of the BBC. Our 49th Annual Conference was privileged to be located nearby in the impressive Strand Building, and was organised by Kings.

The format of the conference followed the pattern of many previous successful conferences, selecting about 120 papers for presentation in parallel sessions that were arranged around the keynote lectures. The topics of the papers covered the full range of money, macro and finance, and were both theoretical and empirical in character, and so did the keynote lectures.

Regulating banks
The first of our keynote addresses was given by Anil Kashyap, speaking in his capacity as Professor at the University of Chicago, rather than as a member of the Bank of England’s Financial Policy Committee. His topic appropriately enough was regulation of banks. His starting point was to ask what do banks do? If they provide liquidity insurance, facilitate credit, and facilitate risk sharing do they supply the correct amounts of those services? He (and co-authors Dimitrios Tsomocos and Alex Vardoulakis) approach the question by modifying a workhorse Diamond-Dybvig model of bank runs by adding several new features. They assume that banks make risky loans funded by deposits and equity, that the loans have uncertain liquidation values and depositors get signals and make decisions about whether to run based on the liquidation values. Runs then depends on fundamentals e.g. the bank’s lending and funding choices. This makes the model more realistic than Diamond-Dybvig, and it also introduces certain frictions that ensure that even though a bank optimises and fully understands the consequences of its actions, it acts differently from a social planner. This is due to limited liability.

A bank will take more credit risk and more leverage than a social planner would do. As a bank exploits limited liability, it will prefer too many loans, too little equity, even though the bank recognises that this affects the probability of a bank run. The planner, by contrast, cares about utility of the agents as well as the utility of the banks and therefore chooses more liquidity, more capital and has more assets on the balance sheet.

How then should we mitigate these incentives facing the banks? They explore the four Basel regulatory ratios currently used to regulate banks comprising the risk-weighted capital ratio (CR), the leverage ratio (LevR), the liquidity coverage ratio (LCR), and the net stable funding ratio (NSFR). In their model all are not needed, we can choose one liquidity ratio and one capital ratio and that will be sufficient. But there are some caveats: used individually the tools must be used more aggressively; and if the right combination is not deployed regulated economy will not match the planner’s.

‘Present bias’
Our second keynote speaker was David Laibson of Harvard University, who took us in a different direction altogether. His research has focused on behavioural economics and in particular present bias — the tendency to value the present rewards above the long term benefits of our actions. He began with a tour of the literature — to show that present bias discounting leads to inconsistent preferences. Self t and self t+1 cannot agree about what should be done today versus tomorrow. Lots of lab evidence supports the present bias view that we are more inclined to choose the better long term options with a delay, and less likely to do so for immediate consumption. We only have to think about how readily we take exercise, diet or revise our lecture notes to verify this statement.

Laibson showed that a sophisticated individual would recognise this and would do today what the future self would want him/her to do. An implication is that agents should be willing to tie their hands. There is increasing evidence that agents are willing to tie their hands, even when the result of doing so is no better, or even worse, than other alternatives offered to them. And increasing the penalty increases the proportion willing to tie their hands.

Laibson looked at consumption choices over a lifetime, and solved for preferences that describe consumer behaviour. He showed his model embedding present bias assumptions is able to explain the use of credit cards and wealth accumulation shown by the data, and his conclusions inform how we should organise savings and pensions schemes if present bias occurs. In a two-period model, representing working life and retirement, where current spending depends on how valuable pre-retirement spending is to the individual he showed that household's consumption is maximised by setting up a liquid account and a second completely illiquid account for saving, with penalties for withdrawal. The option to tie their hands ensures households save more than they otherwise would, and welfare gains are estimated to be up to 3.4 per cent of output versus a system where this option is not available.

Could the private sector take the place of government? Could a private pension scheme replace paternalism? He argued in his lecture that even naïve agents will sign commitment contracts when they offer a means to tie their hands. They would choose this option over complete freedom because these constraints can increase saving, work hours, and productive effort that pays off in the future. Even if agents don’t understand why it works, we find it does work. Potentially, this offers a design framework for financial contracts, employment contracts, mortgage arrangements, pensions with in-built commitment that offsets present bias, and this will be welfare improving.

Low interest rates
In the middle of our conference we hosted two special sessions by the Bank of England on ‘The Causes and Consequences of Low Interest Rates’ and ‘Productivity …’ by ESCoE at the National Institute of Economic and Social Research. In the first session, Greg Thwaites and co-authors, showed that aging can explain a large part of the fall in real interest rates since 1980, the rise in house prices, the slowdown in labour productivity and relative net foreign asset positions between countries, which the model predicts will get more dispersed over time. Phil Bunn and co-authors looked at the consequences of low rates. They modelled the effects of growing pension deficits on firms’ investment, cash holding, dividends and wages. using a new dataset from The Pension Regulator. They showed that firms’ investment spending fell by about 3 per cent and dividend payments were lower than they otherwise would have been. In a third paper Alice Pugh and co-authors asked what were the distributional impacts of monetary policy under low rates. Although this lies outside the Bank of England’s remit, there has been concern about the inequality effects of monetary policy since 2008. It turns out that in aggregate monetary policy has had small effects on income and wealth inequality, but there are greater negative effects on younger households (via employment and wages) and positive effects on older households (via wealth effects).

The productivity puzzle
The second session coordinated by the ESCoE group at NIESR asked whether mismeasurement of the volume of output has been persistently presented as one of the plausible reasons behind the poor productivity performance of the UK economy. Diane Coyle argued that the digital economy has enabled the household sector to make a range of substitutions that have shifted activity across the production boundary that defines GDP. This issue is not just the disintermediation caused by households replacing the ‘traditional’ approach to booking holidays and obtaining insurance and mortgages with their own online searches, it includes sharing economy such as Airbnb, which may not be captured in existing measures of activity. On the UK productivity puzzle itself, Ana Rincon-Aznar, Rebecca Riley and Lea Samek showed that since the crisis a small group of industries was behind the continued poor UK performance. Ignoring the small contribution from the structural decline in the oil sector, finance and insurance account for 30 per cent of the difference from the UK’s pre-crisis trend and the wholesale and retail sector accounts for 7 per cent. The question is whether this is mismeasurement all over again. Lastly, in exploring the mystery of TFP, Nicholas Oulton focused on the question of whether or not structural change had been favourable to TFP growth. Using almost 40 years of industry level data for 18 economies he observed a shift towards industries with low TFP growth from the high growth TFP industries. In addition, TFP in business services were shown to persistently decline while TFP in the market sector overall has had no long run tendency to decline.

Transparency isn’t always optimal
Our third keynote speaker was Jagjit Chadha, Director of the National Institute. His topic was the suspension of convertibility of paper currency into gold in 1797 during the Napoleonic wars. At the beginning of this period the Bank of England controlled payments in London, settlement services to provincial banks, and short term finance to the government. Chadha showed in this lecture that suspension of convertibility gave the Bank greater flexibility, and allowed it to form a contract between the Bank policymakers and public. The promise to go back on the Gold Standard at some point in the future, gave it credibility, prevented a bank run and supported low inflation expectations.

The story of how this was engineered was the intriguing dimension to the story. The Bank did not make the announcement of the suspension to convertibility; rather the Privy Council required the Bank to stop issuing gold in exchange for paper currency and fully indemnified the Bank. This step cleverly avoided a credibility-reducing statement by the Bank itself. Under the counterfactual, if the Bank had not been instructed to suspend convertibility, either gold bullion would have been exhausted, or interest rates would have been too high for trade to continue. Either outcome would have been disastrous, but the Bank effectively managed to maintain the gold reserves through this period, and after the war ended it was able to return to the Gold Standard and the gold reserves increased once again with the Bank’s reputation intact.

In discussion of the paper Charles Goodhart commented that the surprising feature of this period was that the Bank did not exploit this situation, but managed its reserves and loans very prudently. Quoting David Ricardo, he noted: the panic of invasion, rather than the actions of the Bank was responsible for suspension. They exercised their powers with discretion and caution, not exploiting their powers to make a profit in the short run for its owners. The end result was greater powers for the Bank of England and the emergence of the central bank.

The final keynote was given by Ricardo Reis, the AW Philips Professor at LSE, who spoke on anchored inflation expectations. Reis, citing work with several different co-authors, made three points. First, while inflation of the past seven years appears well anchored, he suggested that it is surprising that this is so. Second, he showed that viewed from a macro-finance perspective, inflation does not seem so well anchored. Third, he proposed a new theoretical perspective motivated by the Japanese monetary policy experience.

The evidence of stability can be observed by how strikingly close to their target of 2 per cent inflation has been in all advanced economies (excluding Japan). While Tobin in his 1972 presidential address could say ‘unemployment and inflation still preoccupy and perplex economists, households… and everyone else’ this is hardly the case now. Inflation is not something most people are preoccupied about. However, he argued that the major theories that we have for inflation, from monetarism to the Phillips curve, all suggest that the main drivers of inflation sharply changed after 2010. Without understanding why inflation stayed stable, there is no room for being complacent about it will continuing so.

When he explored with his co-authors the evidence from CPI options data, allowing for computation of the probability distribution of inflation outcomes, he found the evidence for anchoring is weaker. Distributions of inflation outcomes show tails are fatter than expected as the time horizon is extended. Visually, cumulative distributions do not shrink (as law of large numbers suggests they should), they look very similar for 1 – 10 year horizons. Non-parametric estimation of the distributions shows they are not shrinking fast enough (if at all). This implies that shocks persist more than we think, and there is less anchoring. Potentially it could mean a bad shock might persist for a long time.

Lastly, Reis asked ‘what anchors inflation?’. With current theories lacking, as a result of his two first points, he proposed a different theory based on asset purchases with risk and targets for the short and long term rates (à la BOJ). His theory is based on an independent central bank, operating like the BOJ which buys assets and has a remittance rule. The central bank can set targets on the yield curve, equal to the number of sources of uncertainty; and can take on risk in the form of asset purchases. Unconventional policies can then provide effective ways of anchoring expectations. This model offers a new approach to anchoring inflation not previously explored in existing models.

Honouring Charles Goodhart
This conference marked Charles Goodhart’s final appearance as President of the MMF and the MMF, together with NIESR, took the opportunity to thank him for his unstinting support by giving him a bound volume of letters of appreciation from his colleagues and friends. We hope of course that he will be around for many more conferences in the future.