Supplementary written evidence submitted by Roger Farmer, Distinguished Professor of
Economics, UCLA
This note addresses two questions that were raised by the Committee following my testimony on
April 23rd 2013. First, what is the output gap and can it help to guide monetary policy? The second
explores the feasibility of setting up a sovereign wealth fund as an alternative to fiscal policy. All
references in square brackets refer to the articles listed in the bibliography.
Part 1: The output gap and inflation targeting
1. Existing Bank forecasting models are based on a theory of the relationship between output and
inflation known as the natural rate hypothesis, abbreviated as the NRH. The NRH asserts that
when output is below potential there is downward pressure on wages and prices and we should
expect inflation to fall. When output is above potential, there is upward pressure on wages and
prices and we should expect inflation to rise. This implication is not borne out by real world data
(see [1],[10],[11]).
2. The NRH asserts that markets are self-stabilizing. There is a ‘natural rate of unemployment’ that
reflects job-turnover and a ‘natural rate of output growth’ that reflects innovation and
technological advances at full employment. The natural level of output is called ‘potential
output’. When GDP differs from potential output, the difference is called ‘the output gap’. The
idea that there is a natural unemployment rate and a natural level of output is not in itself a
problem. Where theory has failed us is by assuming that a market economy has a tendency
rapidly to re-establish full employment and maximum growth through adjustments in wages and
prices.
3. According to the NRH, if households and firms do not accurately forecast future inflation, they
may write wage contracts that allow wage inflation to fall below price inflation. In this case,
unemployment will be below its natural rate and the output gap will be negative. Or, they may
predict too much price inflation and write contracts that cause real wages to rise faster than is
warranted by technological improvements. In this case, unemployment will be above its natural
rate and the output gap will be positive. An important implication of this theory is that
unemployment can only differ from its natural rate as long as expectations of inflation are
incorrect.
4. The lynchpin of the Bank’s forecasting model, COMPASS, is an equation called the Phillips curve
that connects inflation and expected inflation to the output gap. For that equation to work well,
the forecaster needs a measure of potential output and its analogue in the labour market, the
natural rate of unemployment. The natural rate of unemployment is difficult to measure
because there is no stable relationship between inflation and unemployment. As a
consequence, central bankers continue to rely on a model that does not tell us in advance if the
measured output gap will put upward or downward pressure on inflation.
5. Defenders of the natural rate hypothesis have responded to this critique by arguing that the
natural rate of unemployment is time varying. But they do not provide us with a way of
establishing in advance, how it varies over time. In the absence of a theory of what determines
the natural rate of unemployment, the theory has no predictive content. When the theory fails it
must be because the natural rate changed. A theory like this, which cannot be falsified by any
set of empirical observations, is religion, not science.
6. I have shown in my research [10], that the NRH can effectively be replaced by modelling
confidence as a separate independent force that determines demand. That research has
significant implications for the current crisis. It implies that holding the interest rate at zero, and
waiting for the economy to recover is not likely to be any more successful in the U.K. than it has
been in Japan, a country that has experienced nearly two decades of stagnation and low interest
rates
7. My work, [6], lends support to a policy of Bank purchases of assets. However, it is important to
differentiate the size of the balance sheet from its composition. The beneficial effects of QE arise
from restoring the value of financial assets and enabling households to concentrate on the
purchase of goods rather than paying down debt that is high only relative to the current
moribund economy. Extending that policy would require that the Bank supports the value of
equity prices. That need not involve the purchase of additional risky assets; it can equally be
accomplished by selling existing gilts and replacing them with riskier securities including shares
in the stock market.
Average inflation by decade
10
BOX 1: The Failure of Natural
Rate Theory
8
6
1970s
1980s
4
1950s
2
2000s
1960s
1990s
0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
Average unemployment by decade
Source [11].
The Phillips Curve, Decade by Decade
This chart plots the average U.S.
inflation rate against the average U.S.
unemployment rate for each decade
from the 1950s through the 2000s. Over
each decade there should be as many
quarters when inflation was above
expected inflation as quarters when it
was below expected inflation. The
natural rate hypothesis predicts that the
points in this graph should line up
around a vertical line at the natural rate
of unemployment. In the real world, the
line is closer to horizontal than vertical.
8. If, as I propose, the Bank were to sell existing gilts and lower the stock of high-powered money,
that policy would put upward pressure on interest rates and depress aggregate demand. For
that reason, the policy is opposed by those whose worldview is based on the NRH. But
opposition based on that argument ignores the ability of the Bank to offset the depressing effect
of an interest rate increase on aggregate demand, by engaging in a policy of investing
government assets in risky securities.
9. The Bank believes that it has effectively controlled inflation in the period since inflation targeting
began in 1992. The record supports that belief. But inflation was conquered by raising the
interest rate when inflation expectations increased and lowering it when inflation expectations
fell. While the interest remains at zero, that mechanism is not operative and there is currently
no effective nominal anchor (see [8]).
10. I believe that it is important to escape from the current policy of very low interest rates sooner
rather than later. Through an aggressive policy of equity purchases, financed by issuing longterm gilts, the Treasury could increase the value of financial assets in the hands of the public and
restore private consumption spending. If the additional gilts are allowed to flow to the private
sector, rather than being purchased by the Bank, this policy will put upward pressure on longterm bond yields and lead to an engineered recovery and a return to a more normal regime of
positive interest rates.
Part 2: Managing Financial Market Volatility with a Sovereign Wealth
Fund
11. In Part 2, I outline a proposal that has the potential to prevent future financial crises and put the
U.K. economy on a path to full employment and sustained growth. It involves the creation of an
actively traded sovereign wealth fund designed to manage stock market volatility. My proposal
is based upon quantitative empirical studies ([6],[7],[14]) that demonstrate the existence of a
stable connection between the stock market and unemployment. My recommendation is also
informed, in part, by the conclusions of academic research, [13], that won this year’s inaugural
Maurice Allais Prize for an outstanding European research paper of the last ten years.
Financial Markets are Too Volatile
12. Economists have known since the early 1980s ([15], [16]), that share prices are too volatile.
Excess volatility shows up in the markets as large swings in the price-earnings (PE) ratio, a
number that has historically been less than 5 and greater than 40. Simple economic models
predict that the PE ratio should be constant. The reality is very different. Real world financial
markets are plagued by asset market bubbles, followed by financial crises that have devastating,
long-lasting consequences.
13. There are a number of important instances where markets fail. Examples include natural
monopolies, public education and health care. My academic work, [6], has shown that the
financial markets are a further example of a market failure that arises, in this instance, from
incomplete participation. Unborn children cannot make financial trades. If they were able to
trade in what I have called prenatal financial markets [6], those trades would smooth out
financial volatility and remove the worst effects of financial crises.
Unemployment and the Stock Market
14. Financial crises are associated with recessions. In published academic work, [7], I have shown
that there is a stable relationship between the stock market and unemployment in the U.S. and
my research team [14], has replicated that study in U.K. data. When household wealth increases,
households spend more. Increased spending leads to increased employment and increased
profits. The existence of a stable connection between stock market wealth and unemployment
implies that unemployment can, potentially, be used as a target to guide financial policy.
15. By preventing financial market volatility, financial policy can remove damaging swings in the
stock market that generate demand driven business cycles. In the current situation, where a
financial crash has already occurred, financial policy can restore the value of financial wealth by
increasing the value of equity prices and giving households and firms the confidence to purchase
goods and services. That policy would create a virtuous cycle of increased spending and
employment that would generate the earnings necessary to justify the initial increase in equity
prices. Bubbles and crashes are self-fulfilling prophecies. But they are not inevitable.
My Proposal for a Sovereign Wealth Fund
16. To manage financial market volatility, I propose the creation of a Sovereign Wealth Fund with
the goal of stabilizing the value of share prices. I recommend that Parliament constitute an
independent commission to study the practical aspects of this proposal. The following
suggestions are aspects that any such commission would want to consider.
17. Is this a fiscal or monetary policy? It has aspects of both. It is fiscal in the sense that active
trade of a Treasury portfolio has the potential to create both gains and losses to the taxpayer. It
is monetary in the sense that it involves the management of an asset portfolio, an activity that
has traditionally been carried out by the Bank of England. A financial policy of this kind would
act as an alternative to fiscal stimulus. Unlike fiscal stimulus, it would not cost the taxpayer a
penny and would instead be likely to raise revenue for the Exchequer.
18. Who should operate the Fund? I recommend that the Fund be managed by the newly created
Financial Policy Committee, operating in consultation with the monetary policy committee,
(MPC). Parliament would set out operational guidelines, but the day-to-day running of the fund
should be independent of short-term political considerations. Independence is important for the
same reasons that informed the creation of Bank of England independence.
19. What should be traded? The FPC should control a broad market aggregate. It should define the
characteristics of an acceptable exchange-traded fund (ETF) and encourage private financial
institutions to create funds with these characteristics. An acceptable fund should be value
weighted and include all publicly traded companies. Because the goal is financial stabilization
and not industrial policy, it is important that the FPC should not have the power to allocate
capital to individual companies or even to broad asset classes.
20. How large should the fund be? The goal of the fund is to stabilize markets. The size of
intervention needed to maintain any given price would depend, in part, on the confidence of
market participants. The more credible is an announcement, the smaller the intervention
required to achieve it. An initial purchase of £150b would be a good starting point. But: it is
important that no upper bound should be placed on the possible size of an intervention in order
to avoid private investors from gaming the fund.
21. How would the policy operate? Each month, the FPC would make an informed judgement as to
the current state of the economy. Suppose that the ETF is currently trading at 120 but, in the
judgement of the committee, unemployment is too high relative to target. The FPC would
announce a new value at which it would be willing to purchase shares in the fund, for example,
130, and a targeted growth rate for the fund over the next month, for example, 3% annualized.
22. How would the fund be paid for? It would be paid for by issuing gilts. The policy does not
involve an increase in the public sector borrowing requirement. On the asset side, the fund
would receive dividend payments from companies in the ETF. On the liability side of its balance
sheet, it would make interest payments to holders of FPC debt.
23. How would the policy interact with traditional monetary policy? That depends on the maturity
of the debt structure of the fund. A purchase of ETFs, paid for by selling long duration gilts onto
the private market, would put upward pressure on long-term interest rates and facilitate a
return to a more normal functioning of the financial markets. Currently, the MPC has lost access
to its traditional instrument for controlling inflation. There is a significant chance that a situation
may arise where the MPC decides that is prudent to raise short-rates while unemployment is still
unacceptably high. Financial policy, through active trades in the stock market, would give policy
makers the option of targeting the real economy independently of the price level.
24. Isn’t it the case that monetary policy cannot influence the long-term unemployment rate?
Yes. But active control of the stock market is a fiscal policy not a monetary policy. My
recommendation is based on a coherent theory that reconciles Keynesian and classical
economics in a new way and explains why high involuntary unemployment will persist if we do
not act to prevent it (see [2],[3],[4],[5],[9]).
25. Isn’t there a danger of inflating an asset market bubble? Yes. But that is the point. A bubble is
only dangerous to the real economy if it is allowed to burst. Currently, households and firms that
borrowed during the 2000s are paying down debt. That debt was sustainable when the value of
collateral was high. It became unsustainable when the value of collateral assets crashed
following the financial crisis. By restoring the value of equity, those households and firms that
are currently in debt will be able to redirect their purchasing power to the real economy.
26. How do we know when to slow down the economy? A policy of financial control must act to
prevent bubbles as well as crashes. When unemployment falls to a sustainable level, the FPC
should act to slow the growth of equity prices. Theory predicts that lower unemployment will be
accompanied by additional output of goods and services only up to a point. Pushing
unemployment below its optimal rate will lead to lower output growth. Just as monetary policy
makers make judgements based on a range of different indicators; so must financial policy
makers.
27. How would active financial policy affect the future returns to debt and equity? Historically,
the stock market has paid a return that is roughly five percentage points higher than the return
on gilts. That return exists to compensate market participants for the risk involved from
excessive stock market volatility. By stabilizing that volatility, the future return on equity will fall,
and the return on gilts will rise, until returns on the ETF is approximately equal to the return to
long-term government debt. Economic theory suggests that this return should be stabilized at
approximately the growth rate of the real economy.
28. Has anything like this been tried before? A number of central banks have bought equity. The
Hong Kong Monetary Authority bought shares during the Asian financial crisis and came out
ahead. Taiwan has bought shares of individual companies in the past but on a small scale and
without any coherent guiding philosophy. A policy of actively maintaining the price of a stock
market index has never been tried.
29. Isn’t this like trying to fix the exchange rate? Yes and no. A policy of fixed exchange rates
cannot work if the exchange rate peg is inconsistent with domestic policy goals. It runs into the
problem that, to support an exchange rate above a market determined level; a Central Bank
would eventually run out of foreign exchange. Stock market stabilization is different since there
are no bounds to feasible intervention on either the upside or the downside. A solvent national
treasury has the potential to buy the entire market if necessary. And on the downside, the
central bank has the power to sell the market short if it deems that the market is overheating.
30. Isn’t it inequitable to reward the owners of stocks? Yes and no. It is true that stock ownership
is concentrated predominantly among the wealthy although U.K. pension funds would also be
important beneficiaries of a policy that increases the value of financial assets. More importantly,
unemployment is strongly correlated with stock market wealth over the long-term. For most of
us, our most important asset is the present value of labour income. By initiating a virtuous cycle
of increasing employment and wealth, a sovereign wealth fund will not only benefit the rich. It
will benefit all those who find jobs as the economy recovers.
Conclusion
31. Political and economic institutions evolve in response to historical events. The institution of
central banking is one such institution and a policy of targeting the interest rate was considered
radical at one time. History has taught us that financial market volatility has damaging effects
and economic theory explains why this is so; participation in these markets is necessarily
incomplete. It is time to consider a policy to correct this market failure.
References
[1] Beyer, Andreas and Roger E. A. Farmer (2007): “Natural Rate Doubts,” Journal of Economic
Dynamics and Control, 31, pp. 797—825.
[2] Farmer, Roger E. A. (2010a): Expectations Employment and Prices, Oxford; Oxford University
Press.
[3] Farmer, Roger E. A. (2010b): How the Economy Works: Confidence, Crashes and Self-Fulfilling
Prophecies, Oxford; Oxford University Press.
[4] Farmer, Roger E. A. (2012a): “Confidence, Crashes and Animal Spirits,” Economic Journal,
122(559), pp 155-172.
[5] Farmer, Roger E. A. (2012b): “The Evolution of Endogenous Business Cycles”, CEPR discussion
paper 9080 and NBER working paper 18284.
[6] Farmer, Roger E. A. (2012c): “Qualitative Easing: How it Works and Why it Matters,” NBER
working paper 28421 and CEPR discussion paper 9153.
[7] Farmer, Roger E. A. (2012d): “The Stock Market Crash of 2008 Caused the Great Recession:
Theory and Evidence,” Journal of Economic Dynamics and Control, 36, pp. 696-707. (Plenary
Address to the Society for Computational Economics: Federal Reserve Bank of San Francisco,
summer 2011)
[8] Farmer, Roger E. A. (2012e): “The effect of conventional and unconventional monetary policy
rules on inflation expectations: theory and evidence”, Oxford Review of Economic Policy, Vol. 28,
No. 4, Pages 622-639
[9] Farmer, Roger E. A. (2013a): “Animal Spirits, Financial Crises and Persistent Unemployment”,
Economic Journal 568, May, forthcoming
[10]Farmer, Roger E. A. (2013b): “Animal Spirits, Persistent Unemployment and the Belief Function,”
Chapter 7 in Rethinking Expectations: The Way Forward for Macroeconomics, Princeton New
Jersey; Princeton University Press, Roman Frydman and Edmund Phelps, Eds.
[11] Farmer, Roger E.A. (2013c): “The Natural Rate Hypothesis: An Idea Past its Sell by Date”, Bank of
England Quarterly Bulletin, forthcoming.
[12] Farmer, Roger E. A. and Dmitry Plotnikov (2011): “Does Fiscal Policy Matter? Blinder and Solow
Revisited,” Macroeconomic Dynamics, 16(S1) pp. 149-166
[13] Farmer, Roger E. A., Alain Venditti and Carine Nourry (2012): "The Inefficient Markets
Hypothesis: Why Financial Markets Do Not Work Well in the Real World" CEPR discussion
paper, 9283 and NBER Working Paper 18647
[14] Giuliano, Fernando (2012): “Stock Market Prices and Unemployment in the U.K.”, UCLA working
paper
[15] Leroy, Stephen F. and R. Porter (1981): “Stock Price Volatility: A Test based on Implied Variance
Bounds,” Econometrica, 49, 97—113.
[16] Shiller, Robert J. (1981): “Do stock prices move too much to be justified by subsequent changes
in dividends?,” American Economic Review, 71, 421—436.
June 2013