People should learn from their mistakes, or so we usually all agree. Yet that mostly doesn’t happen. Instead, we get disturbing “serenity” and denial, and we had a prime example of it this week. So it is crucial we develop ways to make learning from mistakes more likely. I’d ban forecasts altogether in central banks if it would make officials pay more attention to what surprises them.
The most powerful institutions in the world economy can’t predict very well. But at least they could learn to adjust to the unexpected.
The Governor of the Bank of England, Mark Carney, testified before Parliament this week to skeptical MPs. The Bank, along with the IMF, Treasury, and other economists, predicted near-disaster if the UK voted for Brexit. So far, however, the UK economy is surprising everyone with its resilience.
So did Carney make a mistake? According to the Telegraph,
If Brexiteers on the Commons Treasury Committee were hoping for some kind of repentance, or at least a show of humility, they were to be sorely disappointed. Mr Carney was having none of it. At no stage had the Bank overstepped the mark or issued unduly alarmist warnings about the consequences of leaving, he insisted. He was “absolutely serene” about it all.
This is manifestly false and it did not go down well, at least with that particular opinion writer.
Arrogant denial is, I suppose, part of the central banker’s stock in trade. If a central bank admits to mistakes, then its authority and mystique is diminished accordingly.
I usually have a lot of regard for Carney, and worked at the Bank of England in the 1990s. But this response makes no sense. Central banking likes to think of itself as a technical trade, with dynamic stochastic general equilibrium models and optimum control theories. Yet the core of it has increasingly come down to judging subjective qualities like credibility, confidence, and expectations.
Economic techniques are really no use at all for this. Credibility is not a technical matter of commitment, time consistency and determination, as economists often think since Kydland & Prescott. It is much more a matter of whether people consider you are aware of the situation and can balance things appropriately, not bind yourself irrevocably to a preexisting strategy or deny mistakes. It is as much a matter of character and honesty as persistence.
The most frequent question hedge funds used to ask me about the Fed or other central banks was “do they see x?” What happens if you are surprised? Will you ignore or deny it and make a huge mistake? Markets want to know that central banks are alert, not stuck in a rut. They want to know if officials are actively testing their views, not pretending to be omniscient. People want to know that officials aren’t too wrapped up in a model or theory or hiding under their desks instead of engaging with the real world.
It might seem as if denial is a good idea, at least in the short term. But it is the single most durable and deadly mistake in policymaking over the centuries. The great historian Barbara Tuchman called it “wooden-headedness,” or persistence in error.
The Bank of England, like other monetary authorities, issues copious Inflation Reports and projections and assessments. But it’s what they don’t know, or where they are most likely to miss something, which is most important. Perhaps the British press is being too harsh on Carney. Yet central banks across the world have hardly distinguished themselves in the last decade.
We need far fewer predictions in public policy, and far more examination of existing policy and how to adjust it in response to feedback. Forget about intentions and forecasts. Tell us what you didn’t expect and didn’t see, and what you’re going to do about it as a result. Instead of feedforward, we need feedback policy, as Herbert Simon suggested about decision-making. We need to adapt, not predict. That means admitting when things don’t turn out the way you expected.
The collapse in European bond yields has been truly historic this year, with German 10-year bunds now hovering around 0.9%. Danger lights are flashing. There are obvious explanations: above all, growing deflation fears, as well as faltering economic data and Draghi’s comments last week about fiscal support and QE. Add to that some safe-haven related flows because of fighting in Ukraine. The ECB is now in full alarm mode because inflation expectations are dropping rapidly.
The terrifying thing about deflation is that expectations of falling prices can feed on themselves and become self-fulfilling, creating a chain reaction of deep problems in a modern economy.. The question is what can policymakers do about it.
The dirty secret about modern central banking is that monetary theorists understand very little about the process of expectation formation. That is why so much policy debate drifts into irrelevance.
Economic policymakers usually turn it into a debate about credibility, stemming from the Kydland-Prescott academic tradition which focuses on time consistency and credible commitments. It is often rational to break previous commitments, so why should anyone believe current promises? It also gets linked to another somewhat stale debate about “adaptive” versus “rational” expectations. For example, much of the difference in opinion on the FOMC come down in practice to disagreement about how forward-looking rather than backward-looking consumers are when it comes to inflation expectations. Do consumers and businesses just observe the recent trend, or anticipate problems before they arrive?
The amount of actual empirical work on the matter in all this is negligible, however. It is mostly prescriptive theory rather than descriptive or experimental work. And thinking generally about credibility in policy debates tends to be sloppy, with dozens of traps. One major lesson is credibility is heavily dependent on the context, not something you can apply to any situation.
The importance of expectations has, however, led to much more emphasis on policy communication in the last few years, as a matter of practical necessity (and desperation). Monetary policy has become more like theater than math or engineering. How can you sound more credible? How can you make statements believable? How can you get people to understand your approach? Hence Yellen’s endless communication committee work on the FOMC before taking the top job.
But the deeper truth is academic economists just don’t have the skills or tools to understand much about communication, because of course it falls into psychology and organizational science and rhetoric and persuasion instead. Parsimonious mathematical models are not adequate guides in these realms. And people can reasonably doubt whether policymakers have the skill and capability to deliver, whatever their intentions may be.
Instead, it comes down to asking why people change their minds. That is my main focus in policy issues. Everyone knows from their own experience that attitude change is often a drawn-out, fraught, conflicted process. People often see only what they want to see for long periods of time. They can be influenced by networks and relationships and trust, by familiarity and the salience of issues within their larger sphere. They observe facts, but can explain them away or ignore them. (Watch any tv political debate.) There are long time lags and considerable inertia. And many people never change their beliefs at all, regardless of the evidence.
It is also a classic stock-and-flow systems problem. Inflation expectations in particular are usually very sticky, and take a long time to change. Think of a bathtub: it potentially takes a lot of drip-drip information (flow) to change the amount of water in the bathtub (stock), but the system can also suddenly change abruptly (the bathtub overflows.) People frequently forget that many policy issues have major stocks -i.e bathtubs, sinks, buffers – contained within them and so do not react in a linear way to marginal change. There are complex positive and negative feedback loops, and decisive events can change things rapidly. Expectations aren’t simply “adaptive” or “rational” but complex.
Policy tools like fiscal policy and QE most likely do not make much difference to consumer expectations, certainly in the short term. Just ask the Japanese how successful QE and massive fiscal spending has been in putting their economy back on a sustained growth path.
Because there is so much inertia in inflation expectations, it’s more likely that after a few months European expectations will drift back towards 2% again, and the ECB will claim the credit for something they had little to do with. But if inflation expectations really are becoming destabilized, it could take five or ten years and vast pain to fix the problem.
I just want to draw a connection between two recent posts, just to stress a point. I said I was increasingly troubled by the Fed's “forward guidance” communication policy, because it is time inconsistent.
A potential difficulty with commitment-based strategies is that their effectiveness depends on influencing the public’s beliefs about the policy as many as five years or more ahead. Moreover, as we noted above, the optimal commitment strategy involves adhering to low settings of the federal funds rate well after the point at which the unemployment rate has returned to a level consistent with full employment. Thus, the benefits of these strategies are frontloaded while the costs are incurred later, providing an incentive to renege—that is, such policies are dynamically time inconsistent in the absence of a commitment technology or reliable reputation effects. It is understandable that the public may entertain doubts about such long-horizon commitments.
It is verging on irrational to believe the Fed's forward guidance … according to the Fed.
It is legitimate to see forward guidance as an indication of the Fed's current thinking, as a rhetorical device which emphasizes the current perspective. But it is not smart or legitimate to see forward guidance or even talk about thresholds as a hard commitment and guide to what the Fed will do in the future.
What should a central bank do to stop the next recession? Here’s a smart comment by Benn Steil on the debate on whether central banks should target nominal GDP instead of inflation, in order to better stabilize the economy. The approach gets attention when central bankers are looking for every last drop of juice for monetary policy. But the “bad weather” policy would be much less attractive in normal circumstances.
I get impatient with the whole argument, however. The debate is increasingly like the proverbial scholastic arguments about how many angels can dance on the head of a pin. The point of a monetary policy target is ultimately to influence public expectations.
And the dark secret of monetary policy – the great blind spot – is central bankers and economists know very little about how expectations are actually formed by business and the public.
Indeed, much of the difference between “hawks” and “doves” (as one of them put it to me) is largely whether inflation expectations are more backwards or forward-looking.
Expectations are a matter of belief and perception, not simply observation of commitment rules, or the utility of rational-expectations models in economics.
Economics has been searching for “microfoundations” which help model individual economic actors’ behavior, and how it may change in response to policy. But credibility is not simply a matter of what the central bank claims, but whether it can persuade other economic actors about its future actions, in an environment in which even four-year old children know not to believe most political promises. Credibility is much more complicated than simply time consistency in the Kydland-Prescott literature, even if that started as a brilliant step forward. Dynamic optimization models are not enough. You have to be empirical and go look at actual expectations, not get lost in the math.
Once again, you can’t make sense of policy or the economy without looking at how people think and see things. Perception matters.