ECB Forum 2015 Panel
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Buiter, Willem
Snower, Dennis
Carney, M.
Summers, Lawrence H.
Praet, Peter
The 2015 ECB Forum on Central Banking is an annual event organised by the European Central Bank in the beautiful surroundings of Sintra in Portugal. It provides a unique opportunity for central bank governors, academics, specialised journalists and high-level financial market representatives to exchange views on current policy issues and to discuss a chosen topic from a longer-term perspective. This year’s Forum will bring together approximately 150 people and will focus on “Inflation and unemployment in Europe”, a key topic of debate in the areas of both economics and policy-making. Snower: Reassessing the Philips Curve
 It really is a pleasure to be here. This is an incredibly beautiful place. I've never been here before and I definitely intend to come here when I have better things to do than talk about economics. Okay, let me start by a point that arose as a result of the first. Presentation this morning. I agreed actually with both the analysis and the recommendations in Mario Dragues' speech on on structural reforms. However, I am very uncomfortable with central bankers making explicit recommendations on things that are way beyond the mandate. That includes both structural reforms and in Europe, fiscal policy. The question of how central banks and central bankers relate to the finance ministry and the economy ministry, the structural reforms, fiscal policy is an important one. The obvious solution that would be first best if there was commitment would be cooperation and coordination. In the euro area, that's not possible because the interpretation of central bank independence that prevails is that it means not answering the telephone when the ministry of finance or the economy calls. That I think leaves really only the central bank acting as Staklberg follower, right? Explain its reaction function, how they would respond to different moral and fiscal policies. It is exhortations, warnings, active attempts to steer fiscal policy into structural reforms. Acting effectively as Staklberg leader is, I think, not desirable because, as I said, it makes the central bank player way beyond its mandate and through that undermines its legitimacy. The scope of central bank actions in this crisis has expanded so much in any case, even without them getting involved in structural reform and fiscal policy. Let's take the Fed, for instance, which is rather more circumspect about these things, that there's a whole slate of legislative proposals in the moment trying to interfere with the operation independence of the Fed, including some rather idiotic proposals for making them follow a Taylor rule, probably with coefficients estimated by Taylor himself. Anyway, you don't want that, right? So basically, very important, I think, that central banks and central bank stick to their knitting. Talk about moral policy, their reaction functions, but don't get involved in structural fiscal policy design or recommendations. Okay. We have, from the earlier two papers, sort of a fascinating. The two observations, the Phillips graph is flatter and appears to be flatter and there appears to be a failure of economies to return to the previous trend growth path following a recession, especially following deep recessions. I'm not totally convinced about the empirical reliability of these estimates. All this work tends to be based on estimates in which the key, one of the key explanatory variables is an unobservable, the natural rate of unemployment. So, and when you see, then the assumptions that are made about this unobservable, which, you know, and even about the observable that is supposed to be related to like the unemployment rate, like being a random walk, you know that you're in trouble. I don't want to talk about the power of random walk tests in worlds when they make a principal sense. The power is low, we know you need enormous sample sizes. But why use random walk tests for variables where you know it cannot apply, right? A random walk for the unemployment rate, for instance. A random walk goes anywhere in finite time, this positive probability. So, and the unemployment rate is bounded by zero and one. A random walk would sort of, if you gave it enough time, be anywhere in an employment space. In fact, you see a lot more clustering near 0% than near 100% unemployment, right? So, whatever it is, it is not a random walk. And so, to base your, they have a maintained hypothesis in your estimation that it is, seems rather self-defeating and of course undermines the reliability of the rest of the estimates. I have a further extreme reverse causality version of the interpretation of the fact that output is not returned to its previous session trends separately. And that is that the reverse causality was simply that the anticipation of a future decline of underlying growth causes demand to slow down, you know, and cause the crisis. But here, it could be also the case that previous session trend growth is systematically overstated. So, previous session trend growth overstates through potential output growth and that leads to a recession which eliminates the excesses created by this growth in excess of potential output. And that, I think, is just as consistent with the findings as any of the things that Blanchard and Geordie came up with. I very much agree with Mr. Reglain pointed out that if you want to compare the U.S. and the Euro area, you better not look at the unemployment rate, the U-3 type unemployment rate. As I said, the participation rate in the U.S. has tanked by about 3.5 percentage points since 2008. It's remained constant roughly in the Euro area. There are many other big differences, but if you look at slack in the labor market, then adjusting for these observables is really important. I think, personally, I think that the U-3 unemployment measure that we tend to use for these regressions bears very little relationship to slack in the labor market and potential wage inflationary pressures. The further point, of course, that there are other unobservables in this wage, in this price-inflation-philip's curve that Blanchard and Geordie estimate, the unemployment rate, of course, is candid for entry into a wage-inflation-philip's curve. And to get to price-inflation, we need both assumptions about underlying productivity, which is, in principle, observable, and about the markup. We know that, of course, there have been systematic variations in the share of labor in GDP. And so not to model these things and basically stick them all in the error term is dangerous. Okay, the argument that the Phillips curve flattening simply reflects low inflation because that's what the original Phillips curve said for wage inflation, and I think it's only true in a non-augmented Phillips curve land. If you just put expected inflation on there, it's the gap between expected and actual inflation or some other measure of inertial inflation that drives the deviation. So there would be no flattening unless the gap between actual and expected inflation has become systematically smaller. And I don't think that we've become that much smarter. Okay, hysteresis in the unemployment rate. I think it's there. There's more hysteresis in capacity, of course, than unemployment. There's hysteresis of a temporary variety through capital formation as well, when there's large excess capacity, CAPEX goes down. But even if we believe, as I do, that hysteresis is an important part of the Eurow area study, are there any particular implications for monetary policy? Clearly, when there's hysteresis, the sacrifice ratio is higher, the cost of achieving a permanent reduction in inflation is higher, the cost of increasing inflation, right? But the good news is, of course, that you can permanently lower in the strict hysteresis case the unemployment rate. There's only a temporary increase in inflation. So that sacrifice ratio is a lot more attractive, depending on which way you look at it. But the question is, if you have hysteresis, but the right policy depends very much on whether you take a human capital view of the hysteresis story or the insider-outsider model. Then you take the human capital, shorten unemployed, becoming long-term unemployed, becoming de-skilled, demotivated, dropping out of the labor force, possible stigmatization effects, which people take the duration of unemployment as a signal of unobservable underlying work equality, and that becomes a self-fulfilling equilibrium. All that's possible. What you do about that is, of course, blast it, stimulate demand as much as you can, not just to monitor policy, anything. If you have supply-side policies that simulate demand, do it as well. If you can use fiscal policy, use that. If you can have fiscal policy with monetary financing, they always do that. Use expansion monitor policy if you can. But it's not a unique monetary money. It simply boosts demand as fast as you can. If it is the galley insider-outsider story, it's a question where it's still be the case that if you manage to shock the economy and get actual employment up, there are more insiders who are outsiders, and you get a larger cohort of insiders negotiating relatives to ignored outsiders, but the obvious solution, structurally, is to eliminate the insider-outside of the distinction, whether that means union-busting. If unionists only negotiate for existing employees, they tend to, and indeed give greater weight to long-term employees. This is really the guarantocracy model, often in practice, the insider-outsider model, with the old either keeping the young unemployed or on short-term contracts of the day laborer variety. More generally, Europe has many countries where collective agreements reach between unions that represent only a very small subset of the workers, and a subset of the firms in the industry are binding, not just on all firms in the industry, but on any new entrants. So you can't undercut an enter. And those so-called generally binding declarations in the Netherlands should be immediately outlawed. I think this is the main insider-outside. So there are supply-side measures that can solve the hysteresis problem in the Galle world, not in the Blanchard world. Now, finally then, central banking, I think, has to become attuned to the fact that unless we raise the inflation target, which in the euro areas is about as likely as we be in the next pope, and I'm both divorced and Protestant, so that is unlikely. We have to find ways, I think, of being able to conduct expansionary monetary policy near or at the zero lower bound without having to engage in a large-scale balance sheet expansion, which I think is deeply problematic, partly because I think that it is, in fact, rather ineffective, except in the disorderly markets, and second, that even if it were effective, the enormous increase in balance sheets, even for central banking systems that don't have the peculiar international redistribution features of possible central bank purchases of private and public debt, the quasi-fiscal role of the central bank increases with the size of its balance sheet, and while a quasi-role for the central bank is inevitable, it should be minimized. It is taxation or subsidization without representation, and so obviously, this introduced eliminated zero lower bound. Get rid of cash, preferably, or have a variable exchange between cash and demand deposits. I'm waiting for it. And finally, also in the euro area, be ready, I think, to lobby for the elimination of Article 123, to have monetary policy and fiscal policy neutered by not being able to engage in direct funding of a fiscal stimulus to the central bank on a permanent basis is, I think, very counterproductive. And for the next recession, we want to be ready with monetary policy that works, rather than monetary policy that relies on prayer. It's great to be at this conference. For the last quarter century, there has been a consensus in favor of macroeconomic models that largely divorce issues of potential and cyclical performance. The consensus affects, and I would argue, in fact, both academic macroeconomics and, more importantly, central banking practice. It is the central premise behind inflation targeting, and central bankers, essentially without exception, assert that they have the capacity to affect or even determine inflation in the long term, but that they do not have the capacity to affect the average level of output, much less its growth rate over time, even though they may have the capacity to affect the amplitude of cyclical fluctuations. It is understandable, given the experience of the 1970s, that this consensus formed. Two percent of Harvard freshmen find themselves alcohol poisoned and in the hospital in the first month each September. In the same way, the world went badly wrong in its first experiment with purely fiat money in the 1970s and produced high inflation to little economic benefit. The subsequent fetish with central bank independence and with rules rather than discretion is entirely understandable and has come with substantial benefits. Nonetheless, my thesis this morning is that the pendulum has swung much too far. While monetary policies are surely not determinative of long run outcomes, they can and in some cases have had major effects on average levels of output over periods of decades. Moreover, the failure to well integrate monetary policymaking with other areas of policy has had substantial pernicious effects. An analogy makes one aspect of my point. I was told recently by someone who was very knowledgeable that the most important question in assessing the health of an aged person is have you had a fall in recent months? If you have, that's very bad. Scholars can and do debate whether people who have fallen were hurt by their fall or whether their fall was a symptom of neurological difficulty. They can and they do debate whether the fall hurts a person or whether the fall sets off a process of ongoing deterioration. But there is no division of opinion on the question of whether or not it is desirable to do everything possible to prevent falls. There is no division of opinion on whether it is desirable to do everything possible to cushion falls when they occur. And there is no division of opinion on the question of whether it is best to get people moving again as rapidly as possible after falls. I would suggest on essentially the same grounds that it is appropriate in macroeconomic policy and in particular monetary policy thinking to focus on two strands of economic theory. That associated with hysteresis and that associated with secular stagnation. Before I develop those two thoughts, let me just remark on how remarkable a time we are living in. In neither the United States, Europe, nor Japan is the market expectation of inflation over the next decade equal to the 2% target. On average in the industrialized world, the market estimate of the real interest rate over the next decade is zero. Keep those forecasts in mind and recognize that those are forecasts by the market that must recognize that if things get sufficiently bad, actions will be taken. And so if one asks what is the forecast of inflation and real interest rates conditional on the currently announced policy path, it would no doubt be of even lower inflation and even lower real interest rates. Keep those realities in mind as you consider the case with respect to both hysteresis and secular stagnation. I thought it would be my purpose here to briefly rehearse the evidence that hysteresis effects are important. Given that close to 90% of you in the poll just taken concluded that hysteresis or super hysteresis was a reality, I am not going to do that. I understand how on grounds of counter causation a variety of other arguments, one can argue that the case for hysteresis effects is unproven. That would not be my reading of the evidence, but I understand as a matter of logic how that case can be made. I do not understand how one can accept the reality of hysteresis effects as important and deny that their presence has very substantial implications for the conduct of monetary policy. I do not understand how one can fail to recognize that if hysteresis is important, it is desirable to move as aggressively as possible even at some inflation risk to contain recessions when they start. And importantly and relevantly for current policy debates almost everywhere. I do not understand how one can fail to recognize that there is a major asymmetry suggested by hysteresis effects in which inflation below target is far more costly than inflation above target. Inflation above target has the distortions associated with excessive inflation mitigated by the fact that the path that got you to inflation above target has some hysteretic benefits going forward for output. Inflation below target on the other hand has the distortions associated with sub-target inflation plus the permanent or semi-permanent output cost that one could avoid by doing what was necessary to push inflation up to target. Now I would just conclude this part of what I have to say by noting that some years ago Brad DeLong and I wrote a paper about fiscal policy and the implications of hysteresis for fiscal policy. We defined in that paper a parameter which we called ADA. ADA essentially was the answer to the question if you have an extra 1% of recession in year T how much lower will potential output subsequently be. We concluded that if you had hysteresis effects on the order of 0.1 that is 1% less output meant a tenth of a percent less potential output those would have profound effects for questions like whether fiscal policy paid for itself. If you take the empirical estimates of Olivier and myself seriously or you take Geordi's empirical estimates seriously they suggest ADA parameters that are ten times that large. I would not be surprised at all if further work refines downwards our estimates of hysteresis effects but I would be very surprised if it was revised downwards far enough that they did not have profound implications. That brings me to the closely related but also clearly distinct issue of secular stagnation. Now secular stagnation and hysteresis obviously have the chance to reinforce each other. If economies are stagnant for one reason that leads to hysteresis effects the prospect of slower growth then leads to further pressures for stagnation. The thesis of secular stagnation is essentially this. Because of a chronic incipient excess of saving over investment there will over time be a tendency for growth to be sluggish and real interest rates to be low perhaps constrained above the levels that would be necessary for full employment equilibrium or at a minimum force to levels that raised questions about financial stability because of the implications of very low interest rates for the duration of assets for risk taking and for various other effects that contribute to financial bubbles. From the perspective of secular stagnation theory much of what people worry about in monetary policy is endogenous rather than exogenous. Zero rates, conditions that give rise to negative long term rates, decisions to expand balance sheets. These are not exogenous acts. These are necessary responses to insufficient employment and deflationary pressure created by the excess of saving over investment. In the presence of these excesses monetary policy has no attractive choices. The determined pursuit of financial stability will put at risk the achievement of full employment. The determined pursuit of full employment and adequate product price inflation will put at risk the objective of financial stability. Central bankers then have a major stake for the achievement of their basic goals in the remainder of economic policy. What that stake is will depend upon circumstances. In Europe it seems to me that the preponderant secular stagnation solution needs to be structural reform quite apart from the traditional virtues of structural reform. It offers the prospect of creating the legendary new frontier of attractive investment opportunity that will raise equilibrium real interest rates and make possible the achievement of full employment at interest rates that are conducive to financial stability. There is also a strong case where there is room for fiscal expansion particularly in those countries that are running large and substantial current accounts surpluses. In the United States there is also substantial scope for structural reform but in my judgment the larger deficiencies are with respect to the lack of public investment. It is indefensible on grounds of microeconomics, macroeconomics or common sense that at a moment of record low capital costs, record high construction non-employment, the share of public investment is at a record low and anyone who flies into Kennedy airport sees what I mean. I have been saying this for a while and what I figured would eventually happen did happen. The guy who was in charge of Kennedy airport called me to get me to stop and he knew he wouldn't get me to stop without giving me a different story and so he did give me one which is that the air traffic control system in the United States of America is based on vacuum tube technology. Nobody under 60 can repair it. It has inadequate capacity and when it gets really crowded over the New York area they move to a different backup technology, yellow stickies on an oak tag bulletin board. That is not as it should be. It makes microeconomic sense and macroeconomic sense and combat secular stagnation to fix it. A final thought. Really a final thought. Some of you will have noticed that there has been what people have described as a blog battle between Ben Bernanke and myself in which I am said to be an advocate of the theory of secular stagnation and Ben is said to be an advocate of the theory of the savings glut. They are the same thing. They are the same idea and excess of saving. The point which Ben very appropriately emphasizes is that unmanaged secular stagnation in one place is contagious. That a higher level of saving over investment leading to low interest rates in one place then leads to currency depreciation, leads to current accounts surplus, leads to a capital outflow, leads to currency appreciation in the other place, leads therefore to spreading low demand and low interest rates everywhere. Secular stagnation is a contagious malady. It is the obligation of those who have it to fix it. It is the right of those who are exposed to the contagion to encourage those who are the source of the contagion to act to respond to it. That is not a call for easier European monetary policy. Easier European monetary policy might or might not be availing in Europe but it would through the mechanism I just described increase the extent of contagion. It is a call as a matter of urgency for other actions in Europe that operate to increase equilibrium real interest rates and to stimulate economic growth. These arguments may or may not be precisely correct and I put them forward in the spirit of provocation and to stimulate discussion. Of this I am nearly certain to understand the problems of this moment. We need to move beyond the idea that monetary policy is only about the second moment, the extent of the variability of output and recognize the profound consequences of monetary and financial policy debates for living standards over time. Thank you very much. Thank you. Thank you, Larry. I am absolutely delighted to be here and what I will have to say will carry on on exactly the same line that Larry ended with which is that monetary policy is more than about second moments. Monetary policy can have very long-term effects. The current thinking about the Phillips curve has produced a number of puzzles that we have been endlessly engaged in and all I am going to do here is give you two ideas on how to resolve these puzzles. The first puzzle which we talked about in the early morning is the mystery of the missing deflation, why there hasn't been disinflation after the last crisis and the mystery of the missing recovery, why output remains far beneath its long-run trend. Previous puzzles included why in the period 1973 to 82 there was a positive correlation between inflation and unemployment, why in the period between 1982 and 1992 European unemployment rose so much without a significant fall in inflation and why in the period 1996 to 2000 US unemployment was so low and inflation didn't take off. Now, before we entered into this Olivier came to me and said don't you have a feeling of deja vu, Nairu, hysteresis, it's all stuff that we talked about at least two and a half decades ago. If I had more time then I would, which I don't, I would give you these remarks in a politically and socially sensitive way that would avoid anybody from becoming upset. With little time I will just say it as it is to the best of my knowledge and ask you to provide the necessary social filters to enable you to keep an open mind. The dominant explanation of these facts about inflation on employment is the New Keynesian Phillips Curve. All expectations of meant Phillips Curve have a knife edge property which means that when unemployment is above its natural rate inflation falls without limit and when it's below its natural rate it rises without limit. And we know it ain't so. It hasn't been observed that inflation rises or falls and we have desperately tried to get our estimates of the Nairu to conform with our underlying understanding that this is a problem. Hysteresis I think will input it perfectly. We know it can't happen. Over the long run unemployment is definitely not a random walk because it doesn't hit 100% and 0%. If you choose your time period advisedly like between the mid 1970s to 1990 for Europe it will look as if it's a random walk but if you choose an 80 or 100 year time period you're back to common sense which is hysteresis is impossible. And keep in mind that if there are permanent changes in the labor market that would give rise to instability that is an indefinite movement in one direction. So we know that's not possible. With regard to the triangle model there's a lot of common sense there. Obviously the movements of inflation and unemployment depend on demand and supply and lags. Supply is the new factor that keeps dominating the discussion. The mystery of the missing inflation can be explained through higher energy prices declining productivity growth, long lags on unemployment, the financial crisis and so on. What makes one uncomfortable is that one needs to choose the supply side factors exposed advisedly in order to fit what it is that one is trying to explain thereby making the theory non falsifiable but there is sense to it. Now why is it that everyone adheres to the long vertical long run Phillips curve? The reason is very simple. The classical dichotomy seems to be compelling. If you double all wages and prices in the economy then real activity should remain unchanged. Therefore if inflation rises that should have no effect in the long run. Now we know from all our models that reasoning is wrong. For the very simple reason that when inflation rises relative prices become less stable. The dispersion of relative prices rises and that has important real consequences. That means that even in the New Canesian Phillips curve, the long run Phillips curve isn't vertical but with sensible additions to it you get a Phillips curve that looks like this. There is a flat area which looks sort of hysteresis like and there is an area that is a long run tradeoff area. Then there is something that is pretty vertical that looks like a natural rate area and then there is a stagflation like area that explains what we went through in the 70s. Now in order to explain why this is so, it's useful to understand a few underlying mechanisms which I think we all know subliminally. First is the matter that when the inflation rate rises because real wages become more volatile, employment becomes more volatile and that has a negative effect on real activity because of the inefficiencies due to diminishing returns to labor. If there is labor smoothing, people prefer to smooth labor then that will increase their reservation wage and reduce the labor supply and that will also have a negative effect. But there is a small positive effect from temporal discounting which arises before a simple reason that under staggered contracts, a wage contract, the current price level is a weighted average of the past price level and the future price level and if you discount the future, it's given a smaller weight. Prices are like chasing after a moving target where the target is the frictionless price level and the faster the inflation rate, the more the price level falls behind its moving target. Another way to see the same thing is that time discounting reduces the weight put on households future disutility of labor and so more price inflation means that real wages fall over the contract period and there's an associated increase in labor supply. So discounting, it's a small effect but it should alert us to something and what it should alert us to is that this is potentially important because there's lots of evidence that we discount a lot more. Hyperbolic discounting is something that's accepted in behavioral economics and short term discount rates of 60 to 70% are common in the literature and then the discounting effect becomes really strong. Inequality aversion, the greater the inflation rate, the greater is wage dispersion, the greater is our envy and guilt effects that arise out of inequality aversion and envy effects are stronger and the way to overcome envy is to increase your labor supply so the higher the rate of inflation, the more macroeconomic activity you get. If you have job turnover then obviously your time horizon over which you calculate is smaller because the workers will leave with a greater probability and that increases the discount effect again. Obviously if you have increasing returns then employment cycling works to your favor but there are many other effects that have been named in the literature, one of them being nominal wage negotiation rigidities, nominal wages are usually set by mutual consent and the fallback positions are given in nominal terms that implies a certain nominal rigidity that gives rise to a downward sloping Phillips curve. Gift exchange is another possibility that when there's a rise in money growth and that increases inflation then workers are aware that they're purchasing powers in danger of being reduced. When firms shield them from that then workers as part of a gift exchange increase their effort and that gives rise to a downward sloping Phillips curve. There is departures from rational expectations as given by Akhlof Dickens and Perry, zero lower bound and nominal interest rates, nominal tax rigidities, state dependent nominal rigidities all lead you to a long run downward sloping Phillips curve. So the thing to be taken seriously is the possibility of this long downward sloping area that leads into a flat area. That is sort of the first idea that I'd like to leave you with. All our theory tells us that the Phillips curve is backward bending but because we have a methodological, empirical and theoretical predilection for vertical long run Phillips curve we have tried to put everything into this procrastin bed and it simply doesn't work. The knife edge problem, the random walk of unemployment are simply manifestly unrealistic. And so I'd like to then give you come to my second idea which is that this long run Phillips curve may shift because of asymmetric persistence in unemployment. Although I don't believe that history's as possible, lots of theories tell us that adjustment of wages to cycles is asymmetric. When you're going into an upswing then you face very little employment risk. When you go into a downswing you face substantial employment risk and therefore you're more likely to raise your wages in an upswing than you are to reduce your wages in a downswing. There are many other reasons for it that are also given in the literature but the bottom line is given in this figure. If you start at point A where the green line is a downward sloping labor demand curve, the red line is an upward sloping wage setting curve, then when the economy goes into recession from A to B then wages fall and employment falls but when you go into a boom then you go up a different wage setting curve because of this asymmetry in wage adjustment so you don't go back to A but up to C. Now where you arrive at in the long run depends on how big the following boom is. Now if the economy is growing then movements, positive movements in labor demand will be larger than the negative movements in labor demand because otherwise it wouldn't grow and consequently you will have a situation like the red dots show you where you would move if there was no growth so the wage may go slightly upwards although those movements can be counter veiled by other things in the economy, other effects like offshoring automation to keep wages flat whereas if the economy grows then it's the green dots, still asymmetric adjustment but because of the growth the increase in employment dominates the decrease in employment and therefore you move along a different asymmetric path. That means that in employment terms what we have is something like this. Historicis would mean that current employment depends on past employment with a unit root, it's a 45 degree line. With persistence in unemployment it's always less but if there's asymmetric persistence then you have a kink and that kink has important policy implications because you can see that the downward movement takes you much further down than the upward movement on account of the asymmetry and consequently because of these asymmetric possibilities this Phillips curve which is backward bending now in terms of inflation employment space rather than unemployment space can shift due to asymmetric persistence and the rise in European unemployment in the 80s and 70s is due to an inward shift of this curve because of asymmetric persistence whereas the prolonged period of low US unemployment without inflation rising is due to an outward shift. So if you put these two things together that there is a backward bending Phillips curve that it may have a substantial flat portion and that this Phillips curve may shift then you can explain a lot of stylized facts and therefore I would hope that with the help of these ideas which admittedly are very difficult to test empirically because now you need nonlinear multi equation estimation you will help us all to escape from the collective madness that we are under. Thank you. Look I recognize this late I'll try to be quick. First I just want to observe I think the award for analogy of the year has to go to Larry Summers for the Harvard freshman abuse of alcohol fiat money in the 1970s. My abuse of alcohol didn't start freshman week at Harvard it was after shortly after hearing Larry speak for the first time when I was a graduate because I recognized the rather large gap between the dexterity of his mind and the limits of mind and this will become evident as I go on in my remarks which are going to focus on the UK. It's going to focus on the UK because the topic of this conference is inflation and unemployment in Europe and the UK is very much in Europe. So thank you for the invitation Mario. Oh no I'm going on. Okay I'll try to link this a bit to what's been said this morning and I think we'll probably run out of time I'm afraid. Three puzzles in the UK missing unemployment missing inflation and missing productivity. Let me go through each quickly. In terms of missing unemployment in the teeth of the crisis based on simple open relationships unemployment in the UK even though it went up substantially went out about one and a half percentage points less than it should have contrast that with the US as everyone here knows went up about a point and a half more than it should have and as was observed it's similar for Europe in terms of the UK this is not a participation rate story the participation rate held up in the UK whereas it fell by three and a half percentage points in the US so the gap in terms of performance the gap in terms of missing unemployment or missing slack is bigger than it first appears. Now to solve that puzzle you obviously look to the flexible labor market it doesn't fully explain the US discrepancy but it explains what happens in the UK real wages are still down 10% on their pre-crisis level whereas they are flat to slightly up in both Europe and the US this is the worst performance since the early 1920s for the UK. It's partly a nominal wage story nominal wage growth about one and a half percent per annum that's about two and a half percent below pre-crisis averages but it there are limits to this flexibility as John Mulevall and others will know it's really clustered around zero in terms of nominal wage performance. The real story is higher inflation which brings me to the second puzzle so where's that missing disinflation inflation given a three and a half percentage point increase in unemployment inflation should and of course this whole morning has been calling into question the use of words like should with respect to Phillips-Kurz relationship but should have been about a percent on average pre-crisis three 2013 it averaged 3.2% over that period and there's two major explanations for that the first very importantly are a series of one-off price increases higher VAT higher tuition fees higher utility costs that Charlie Bean and his colleagues at the time on the MPC quite rightly looked through and secondly higher import prices occasioned by a 25% depreciation in sterling and a key point for the UK is this is not necessarily something you look through and it's relevant for monetary policy because pass-through in the UK for material exchange rate moves is sustained and persistent and stretches over the policy horizon the the scale of that what wasn't the case at least in the UK and I think John Mulebauer was making a point of general application the missing disinflation was not a productivity story productivity performance was terrible but unit wage growth was weak enough that unit labor costs were not strong so that brings me to missing productivity as elsewhere large shortfall relative to trend not a surprise post a financial crisis as Olivier and Larry's paper documents but a 15% shortfall relative to trend as of today we can explain about three percentage points of that in terms of measurement and some sectoral shifts most notably North Sea oil a bit on financial services but then it gets much murkier I would I would argue that impairment of the financial system and a slower process of creative destruction played a central role here I'll just give you one statistic which is that company liquidations ran 40% below past averages during the worst recession since the 1930s which gives you a sense our micro estimates for what it's worth using micro data is that the resource reallocation process contributed only about a third to productivity over the course of the last five years and so it's not just and this is not just a question of the lack of capital for new enterprises but it also arguably is is partly a product of forbearance and forbearance occasioned or allowed by lower interest rates to keep existing enterprises afloat I mean obviously as well there's less capital deepening including very importantly intangible investment one measure of that is measure of product innovation by firms fell by a quarter less human capital investment and I just appeal to the important points made in Olivier's presentation about future expectations of growth and the and the causality that could happen there finally and most recently we have seen important compositional effects in the labor market so there's a lot more low skilled low-wage jobs and because employment has been so strong and much higher job churn there's a lot of people who are new to their jobs 10 years quite low and we detail this in our latest inflation report that actually is pretty much a watch from an inflation perspective but it explains a material part of our shortfall we think in productivity in short term so we think that these drags on productivity are starting to come off but we don't see productivity we see so we see productivity growth picking up but not to historic averages anytime soon a common driver for these effects these three puzzles if you will has been a very large labor supply shock in the UK and I'll just give you a couple of representations of that the participation rate I referenced earlier it's about a percentage point higher than it would have been if we just rolled forward the cohort participation rates from 2007-8 that's about half a million more workers similarly average desired average hours went up as well that's a little more speculative in terms of an estimation of what you know or what people say they want to work is that really what they want to work but that's equivalent again to another half million jobs and the rationale the reasons for this are not just the impact of the financial crisis and worse balance sheets but also changes to the structure of labor market and retirement ages increased in a number of cases benefits reduced in number of cases so a compulsion to work for both financial land and benefit reasons I would I would point out that these changing work patterns of UK nationals dwarf the increase in net migration in the recent past if you look at the increase relative to averages historic averages and net migration the last two years it is 50,000 additional workers in the UK economy versus the million I just totaled up for you okay so what does how does how to map this towards this morning's discussion about Phillips curve Phillips curves and and policy and I do this with some reservation but I'm thrilled that we don't have a Q&A after this now because of the caterers first thing I don't think we can reinforce enough and I think everyone in this room knows it but it took close to say it close regularly to say it you have to look at broader measures of labor market slack than just the unemployment rate which we very much to secondly I wouldn't and we haven't given up on our price Phillips curve relationships we think they are more stable than Olivier's comments suggest nor would we slavishly rely on them obviously but I danced over it quite quickly but there were a series of one-off shocks to the headline price level there's always a series of one-off shocks of course but looking at the measures of core will give you a better sense of the relationships we do have a very stable wage Phillips curve in the UK and Bob Gordon's cautions on this are absolutely right you can't look at it without looking at productivity but it doesn't mean you don't look at it I don't think Bob was suggesting that we have we have seen in the very recent past some weakness in wages relative to that those relationships those compositional effects I mentioned are quite important here but also there is the possibility of a shift in wage expectations a long period and I'll appeal to behavioral science in Dennis's presence here but a long period of very low wage settlements leads to a persistence lower expectations that will just may take longer to come off we're seeing actually in the UK not surprisingly a revert if you will a reversal of the insider-outsider dynamic outsiders in other words people who are shifting jobs are getting new jobs are getting much higher wage settlements than those who are staying in work something we expect to a gap we expect to close as the labor market continues to tighten in the current policy environment we have no inflation in fact the most recent numbers were mild deflation minus point one Olivier and Larry's paper reminds us of the importance of inflation expectations that's one of that's one of the first conclusion points in the second half and we have the advantage in the UK of regime that forces us in this circumstance forces me actually my role to write an open letter to explain why inflation is so low and what we're going to do about it the why is product the prominent reasons for the why pretty easy this is lower global energy and food prices and imported inflation that accounts for about three quarters of the mess if you will relative to target only a quarter of which in other words is accounted for the factors that I've been discussing that doesn't mean they're not important but it does mean in our view that we should look through them we need to be mindful as I said earlier of persistent drag from sterling strength and imported disinflation reference Charlie's comments about the importance of looking not so much you weren't referencing the exchange rate so much but global factors inflation when setting policy in a very open economy such as the United Kingdom we have signaled our intent made clear our intent that to return inflation to target within the next two years and that means setting policy to get domestic cost pressures up and we think we can close the output gap within the next year that's not as heroic as it sounds given that part of the reason is we think that potential has slowed and we've taken a bigger hit to potential both actual and trend and the appropriate path I'm moving to finish the appropriate path for bank rate obviously hinges crucially on on the supply outlook and the equilibrium interest rate our view of the equilibrium interest rate we like others have faced persistent headwinds that weigh on our economy we have been talking about this for a number of years we see weaker global demand we're pleased that some of that is now coming off with the renewed strength in Europe we have sustained fiscal consolidation in the UK it's been relevant for the last several years it will be relevant certainly over the policy horizon and beyond we still have ongoing private deleveraging we think and we think with time we don't have time to get into this but we think that financial intermediation costs are going to go up at a new equilibrium and equilibrium where rates come off the zero lower bound there will be higher prices in financial markets for liquidity and the risk-free rate needs to adjust and then there are the longer fact longer-term factors that Larry is as has highlighted which we think will also persist beyond the policy horizon so all of that merits a pace of rate increases that are would proceed at a gradual pace to a limited extent and let me finish and this is a real finish by quoting my colleague Ben Broadbent who makes the point that whether it's very low interest rates at the effective lower bound whether it's unconventional monetary policy whether it is a limited and gradual pace of tightening perspective pace of tightening of interest rates by central banks that's not the reason why global interest rates are low central banks are actors reading a script written by others that's Ben's way of putting it and it's a and that script at least written for us that theoretically I would I would salute the contribution of Larry and Olivier and others in bringing to the forefront second or stagnation and those factors which will be with us for some time thank you thank you you you
 It really is a pleasure to be here. This is an incredibly beautiful place. I've never  been here before and I definitely intend to come here when I have better things to do  than talk about economics. Okay, let me start by a point that arose as a result of the first.  Presentation this morning. I agreed actually with both the analysis and the recommendations in  Mario Dragues' speech on on structural reforms. However, I am very uncomfortable with central  bankers making explicit recommendations on things that are way beyond the mandate. That includes  both structural reforms and in Europe, fiscal policy. The question of how central banks and  central bankers relate to the finance ministry and the economy ministry, the structural reforms,  fiscal policy is an important one. The obvious solution that would be first best if there was  commitment would be cooperation and coordination. In the euro area, that's not possible because  the interpretation of central bank independence that prevails is that it means not answering the  telephone when the ministry of finance or the economy calls. That I think leaves really only  the central bank acting as Staklberg follower, right? Explain its reaction function, how they  would respond to different moral and fiscal policies. It is exhortations, warnings, active attempts to  steer fiscal policy into structural reforms. Acting effectively as Staklberg leader is, I think,  not desirable because, as I said, it makes the central bank player way beyond its mandate and  through that undermines its legitimacy. The scope of central bank actions in this crisis has  expanded so much in any case, even without them getting involved in structural reform and fiscal  policy. Let's take the Fed, for instance, which is rather more circumspect about these things,  that there's a whole slate of legislative proposals in the moment trying to interfere with the  operation independence of the Fed, including some rather idiotic proposals for making them follow  a Taylor rule, probably with coefficients estimated by Taylor himself. Anyway, you don't want that,  right? So basically, very important, I think, that central banks and central bank stick to their  knitting. Talk about moral policy, their reaction functions, but don't get involved in structural  fiscal policy design or recommendations. Okay. We have, from the earlier two papers,  sort of a fascinating. The two observations, the Phillips graph is flatter and appears to be  flatter and there appears to be a failure of economies to return to the previous trend growth  path following a recession, especially following deep recessions. I'm not totally convinced about  the empirical reliability of these estimates. All this work tends to be based on estimates in  which the key, one of the key explanatory variables is an unobservable, the natural rate of unemployment.  So, and when you see, then the assumptions that are made about this unobservable, which, you know,  and even about the observable that is supposed to be related to like the unemployment rate,  like being a random walk, you know that you're in trouble. I don't want to talk about the power  of random walk tests in worlds when they make a principal sense. The power is low,  we know you need enormous sample sizes. But why use random walk tests for variables where you  know it cannot apply, right? A random walk for the unemployment rate, for instance. A random walk  goes anywhere in finite time, this positive probability. So, and the unemployment rate  is bounded by zero and one. A random walk would sort of, if you gave it enough time, be anywhere  in an employment space. In fact, you see a lot more clustering near 0% than near 100% unemployment,  right? So, whatever it is, it is not a random walk. And so, to base your, they have a maintained  hypothesis in your estimation that it is, seems rather self-defeating and of course undermines  the reliability of the rest of the estimates. I have a further extreme reverse causality version  of the interpretation of the fact that output is not returned to its previous session trends  separately. And that is that the reverse causality was simply that the anticipation of a future  decline of underlying growth causes demand to slow down, you know, and cause the crisis.  But here, it could be also the case that previous session trend growth is systematically overstated.  So, previous session trend growth overstates through potential output growth and that leads  to a recession which eliminates the excesses created by this growth in excess of potential  output. And that, I think, is just as consistent with the findings as any of the things that  Blanchard and Geordie came up with. I very much agree with Mr. Reglain pointed out that  if you want to compare the U.S. and the Euro area, you better not look at the unemployment  rate, the U-3 type unemployment rate. As I said, the participation rate in the U.S.  has tanked by about 3.5 percentage points since 2008. It's remained constant roughly  in the Euro area. There are many other big differences, but if you look at slack in the  labor market, then adjusting for these observables is really important. I think, personally,  I think that the U-3 unemployment measure that we tend to use for these regressions bears  very little relationship to slack in the labor market and potential wage inflationary pressures.  The further point, of course, that there are other unobservables in this wage, in this  price-inflation-philip's curve that Blanchard and Geordie estimate, the unemployment rate,  of course, is candid for entry into a wage-inflation-philip's curve. And to get to price-inflation, we  need both assumptions about underlying productivity, which is, in principle, observable, and about  the markup. We know that, of course, there have been systematic variations in the share  of labor in GDP. And so not to model these things and basically stick them all in the  error term is dangerous. Okay, the argument that the Phillips curve flattening simply  reflects low inflation because that's what the original Phillips curve said for wage  inflation, and I think it's only true in a non-augmented Phillips curve land. If you  just put expected inflation on there, it's the gap between expected and actual inflation  or some other measure of inertial inflation that drives the deviation. So there would  be no flattening unless the gap between actual and expected inflation has become systematically  smaller. And I don't think that we've become that much smarter.  Okay, hysteresis in the unemployment rate. I think it's there. There's more hysteresis  in capacity, of course, than unemployment. There's hysteresis of a temporary variety  through capital formation as well, when there's large excess capacity, CAPEX goes down. But  even if we believe, as I do, that hysteresis is an important part of the Eurow area study,  are there any particular implications for monetary policy? Clearly, when there's hysteresis,  the sacrifice ratio is higher, the cost of achieving a permanent reduction in inflation  is higher, the cost of increasing inflation, right? But the good news is, of course, that  you can permanently lower in the strict hysteresis case the unemployment rate. There's only a  temporary increase in inflation. So that sacrifice ratio is a lot more attractive, depending  on which way you look at it. But the question is, if you have hysteresis, but the right  policy depends very much on whether you take a human capital view of the hysteresis story  or the insider-outsider model. Then you take the human capital, shorten unemployed, becoming  long-term unemployed, becoming de-skilled, demotivated, dropping out of the labor force,  possible stigmatization effects, which people take the duration of unemployment as a signal  of unobservable underlying work equality, and that becomes a self-fulfilling equilibrium.  All that's possible. What you do about that is, of course, blast it, stimulate demand as  much as you can, not just to monitor policy, anything. If you have supply-side policies  that simulate demand, do it as well. If you can use fiscal policy, use that. If you can  have fiscal policy with monetary financing, they always do that. Use expansion monitor  policy if you can. But it's not a unique monetary money. It simply boosts demand as  fast as you can. If it is the galley insider-outsider story, it's a question where it's still  be the case that if you manage to shock the economy and get actual employment up, there  are more insiders who are outsiders, and you get a larger cohort of insiders negotiating  relatives to ignored outsiders, but the obvious solution, structurally, is to eliminate the  insider-outside of the distinction, whether that means union-busting. If unionists only  negotiate for existing employees, they tend to, and indeed give greater weight to long-term  employees. This is really the guarantocracy model, often in practice, the insider-outsider  model, with the old either keeping the young unemployed or on short-term contracts of the  day laborer variety. More generally, Europe has many countries where collective agreements  reach between unions that represent only a very small subset of the workers, and a subset  of the firms in the industry are binding, not just on all firms in the industry, but  on any new entrants. So you can't undercut an enter. And those so-called generally binding  declarations in the Netherlands should be immediately outlawed. I think this is the  main insider-outside. So there are supply-side measures that can solve the hysteresis problem  in the Galle world, not in the Blanchard world.  Now, finally then, central banking, I think, has to become attuned to the fact that unless  we raise the inflation target, which in the euro areas is about as likely as we be in the  next pope, and I'm both divorced and Protestant, so that is unlikely. We have to find ways,  I think, of being able to conduct expansionary monetary policy near or at the zero lower  bound without having to engage in a large-scale balance sheet expansion, which I think is  deeply problematic, partly because I think that it is, in fact, rather ineffective, except  in the disorderly markets, and second, that even if it were effective, the enormous increase  in balance sheets, even for central banking systems that don't have the peculiar international  redistribution features of possible central bank purchases of private and public debt,  the quasi-fiscal role of the central bank increases with the size of its balance sheet,  and while a quasi-role for the central bank is inevitable, it should be minimized. It  is taxation or subsidization without representation, and so obviously, this introduced eliminated  zero lower bound. Get rid of cash, preferably, or have a variable exchange between cash and  demand deposits. I'm waiting for it. And finally, also in the euro area, be ready, I think,  to lobby for the elimination of Article 123, to have monetary policy and fiscal policy  neutered by not being able to engage in direct funding of a fiscal stimulus to the central  bank on a permanent basis is, I think, very counterproductive. And for the next recession,  we want to be ready with monetary policy that works, rather than monetary policy that relies  on prayer.  It's great to be at this conference. For the last quarter century, there has been a consensus  in favor of macroeconomic models that largely divorce issues of potential and cyclical performance.  The consensus affects, and I would argue, in fact, both academic macroeconomics and,  more importantly, central banking practice. It is the central premise behind inflation  targeting, and central bankers, essentially without exception, assert that they have the  capacity to affect or even determine inflation in the long term, but that they do not have  the capacity to affect the average level of output, much less its growth rate over time,  even though they may have the capacity to affect the amplitude of cyclical fluctuations.  It is understandable, given the experience of the 1970s, that this consensus formed.  Two percent of Harvard freshmen find themselves alcohol poisoned and in the hospital in the  first month each September. In the same way, the world went badly wrong in its first experiment  with purely fiat money in the 1970s and produced high inflation to little economic benefit.  The subsequent fetish with central bank independence and with rules rather than discretion is entirely  understandable and has come with substantial benefits.  Nonetheless, my thesis this morning is that the pendulum has swung much too far. While  monetary policies are surely not determinative of long run outcomes, they can and in some  cases have had major effects on average levels of output over periods of decades.  Moreover, the failure to well integrate monetary policymaking with other areas of policy has  had substantial pernicious effects. An analogy makes one aspect of my point. I was told recently  by someone who was very knowledgeable that the most important question in assessing the  health of an aged person is have you had a fall in recent months? If you have, that's  very bad. Scholars can and do debate whether people who have fallen were hurt by their  fall or whether their fall was a symptom of neurological difficulty. They can and they  do debate whether the fall hurts a person or whether the fall sets off a process of  ongoing deterioration. But there is no division of opinion on the question of whether or not  it is desirable to do everything possible to prevent falls. There is no division of opinion  on whether it is desirable to do everything possible to cushion falls when they occur.  And there is no division of opinion on the question of whether it is best to get people  moving again as rapidly as possible after falls. I would suggest on essentially the  same grounds that it is appropriate in macroeconomic policy and in particular monetary policy thinking  to focus on two strands of economic theory. That associated with hysteresis and that associated  with secular stagnation. Before I develop those two thoughts, let me just remark on  how remarkable a time we are living in. In neither the United States, Europe, nor Japan  is the market expectation of inflation over the next decade equal to the 2% target. On  average in the industrialized world, the market estimate of the real interest rate over the  next decade is zero. Keep those forecasts in mind and recognize that those are forecasts  by the market that must recognize that if things get sufficiently bad, actions will  be taken. And so if one asks what is the forecast of inflation and real interest rates conditional  on the currently announced policy path, it would no doubt be of even lower inflation  and even lower real interest rates. Keep those realities in mind as you consider the case  with respect to both hysteresis and secular stagnation. I thought it would be my purpose  here to briefly rehearse the evidence that hysteresis effects are important. Given that  close to 90% of you in the poll just taken concluded that hysteresis or super hysteresis  was a reality, I am not going to do that. I understand how on grounds of counter causation  a variety of other arguments, one can argue that the case for hysteresis effects is unproven.  That would not be my reading of the evidence, but I understand as a matter of logic how  that case can be made. I do not understand how one can accept the reality of hysteresis  effects as important and deny that their presence has very substantial implications for the  conduct of monetary policy. I do not understand how one can fail to recognize that if hysteresis  is important, it is desirable to move as aggressively as possible even at some inflation risk to  contain recessions when they start. And importantly and relevantly for current policy debates  almost everywhere. I do not understand how one can fail to recognize that there is a  major asymmetry suggested by hysteresis effects in which inflation below target is far more  costly than inflation above target. Inflation above target has the distortions associated  with excessive inflation mitigated by the fact that the path that got you to inflation above  target has some hysteretic benefits going forward for output. Inflation below target  on the other hand has the distortions associated with sub-target inflation plus the permanent  or semi-permanent output cost that one could avoid by doing what was necessary to push  inflation up to target. Now I would just conclude this part of what I have to say by noting  that some years ago Brad DeLong and I wrote a paper about fiscal policy and the implications  of hysteresis for fiscal policy. We defined in that paper a parameter which we called  ADA. ADA essentially was the answer to the question if you have an extra 1% of recession  in year T how much lower will potential output subsequently be. We concluded that if you  had hysteresis effects on the order of 0.1 that is 1% less output meant a tenth of a  percent less potential output those would have profound effects for questions like whether  fiscal policy paid for itself. If you take the empirical estimates of Olivier and myself  seriously or you take Geordi's empirical estimates seriously they suggest ADA parameters that  are ten times that large. I would not be surprised at all if further work refines downwards  our estimates of hysteresis effects but I would be very surprised if it was revised  downwards far enough that they did not have profound implications. That brings me to the  closely related but also clearly distinct issue of secular stagnation. Now secular stagnation  and hysteresis obviously have the chance to reinforce each other. If economies are stagnant  for one reason that leads to hysteresis effects the prospect of slower growth then leads to  further pressures for stagnation. The thesis of secular stagnation is essentially this.  Because of a chronic incipient excess of saving over investment there will over time be a  tendency for growth to be sluggish and real interest rates to be low perhaps constrained  above the levels that would be necessary for full employment equilibrium or at a minimum  force to levels that raised questions about financial stability because of the implications  of very low interest rates for the duration of assets for risk taking and for various  other effects that contribute to financial bubbles. From the perspective of secular stagnation  theory much of what people worry about in monetary policy is endogenous rather than  exogenous. Zero rates, conditions that give rise to negative long term rates, decisions  to expand balance sheets. These are not exogenous acts. These are necessary responses to insufficient  employment and deflationary pressure created by the excess of saving over investment.  In the presence of these excesses monetary policy has no attractive choices. The determined  pursuit of financial stability will put at risk the achievement of full employment. The  determined pursuit of full employment and adequate product price inflation will put  at risk the objective of financial stability. Central bankers then have a major stake for  the achievement of their basic goals in the remainder of economic policy. What that stake  is will depend upon circumstances. In Europe it seems to me that the preponderant secular  stagnation solution needs to be structural reform quite apart from the traditional virtues  of structural reform. It offers the prospect of creating the legendary new frontier of  attractive investment opportunity that will raise equilibrium real interest rates and  make possible the achievement of full employment at interest rates that are conducive to financial  stability. There is also a strong case where there is room for fiscal expansion particularly  in those countries that are running large and substantial current accounts surpluses.  In the United States there is also substantial scope for structural reform but in my judgment  the larger deficiencies are with respect to the lack of public investment. It is indefensible  on grounds of microeconomics, macroeconomics or common sense that at a moment of record  low capital costs, record high construction non-employment, the share of public investment  is at a record low and anyone who flies into Kennedy airport sees what I mean. I have been  saying this for a while and what I figured would eventually happen did happen. The guy  who was in charge of Kennedy airport called me to get me to stop and he knew he wouldn't  get me to stop without giving me a different story and so he did give me one which is that  the air traffic control system in the United States of America is based on vacuum tube  technology. Nobody under 60 can repair it. It has inadequate capacity and when it gets  really crowded over the New York area they move to a different backup technology, yellow  stickies on an oak tag bulletin board. That is not as it should be. It makes microeconomic  sense and macroeconomic sense and combat secular stagnation to fix it. A final thought. Really  a final thought.  Some of you will have noticed that there has been what people have described as a blog  battle between Ben Bernanke and myself in which I am said to be an advocate of the theory  of secular stagnation and Ben is said to be an advocate of the theory of the savings glut.  They are the same thing. They are the same idea and excess of saving. The point which  Ben very appropriately emphasizes is that unmanaged secular stagnation in one place  is contagious. That a higher level of saving over investment leading to low interest rates  in one place then leads to currency depreciation, leads to current accounts surplus, leads to  a capital outflow, leads to currency appreciation in the other place, leads therefore to spreading  low demand and low interest rates everywhere. Secular stagnation is a contagious malady.  It is the obligation of those who have it to fix it. It is the right of those who are  exposed to the contagion to encourage those who are the source of the contagion to act  to respond to it. That is not a call for easier European monetary policy. Easier European  monetary policy might or might not be availing in Europe but it would through the mechanism  I just described increase the extent of contagion. It is a call as a matter of urgency for other  actions in Europe that operate to increase equilibrium real interest rates and to stimulate  economic growth. These arguments may or may not be precisely correct and I put them forward  in the spirit of provocation and to stimulate discussion. Of this I am nearly certain to  understand the problems of this moment. We need to move beyond the idea that monetary  policy is only about the second moment, the extent of the variability of output and recognize  the profound consequences of monetary and financial policy debates for living standards  over time. Thank you very much. Thank you. Thank you, Larry. I am absolutely delighted  to be here and what I will have to say will carry on on exactly the same line that Larry  ended with which is that monetary policy is more than about second moments. Monetary policy  can have very long-term effects. The current thinking about the Phillips curve has produced  a number of puzzles that we have been endlessly engaged in and all I am going to do here is  give you two ideas on how to resolve these puzzles. The first puzzle which we talked  about in the early morning is the mystery of the missing deflation, why there hasn't  been disinflation after the last crisis and the mystery of the missing recovery, why output  remains far beneath its long-run trend. Previous puzzles included why in the period 1973 to  82 there was a positive correlation between inflation and unemployment, why in the period  between 1982 and 1992 European unemployment rose so much without a significant fall in  inflation and why in the period 1996 to 2000 US unemployment was so low and inflation didn't  take off. Now, before we entered into this Olivier came to me and said don't you have  a feeling of deja vu, Nairu, hysteresis, it's all stuff that we talked about at least two  and a half decades ago. If I had more time then I would, which I don't, I would give  you these remarks in a politically and socially sensitive way that would avoid anybody from  becoming upset. With little time I will just say it as it is to the best of my knowledge  and ask you to provide the necessary social filters to enable you to keep an open mind.  The dominant explanation of these facts about inflation on employment is the New Keynesian  Phillips Curve. All expectations of meant Phillips Curve have a knife edge property  which means that when unemployment is above its natural rate inflation falls without limit  and when it's below its natural rate it rises without limit. And we know it ain't so. It  hasn't been observed that inflation rises or falls and we have desperately tried to get  our estimates of the Nairu to conform with our underlying understanding that this is  a problem. Hysteresis I think will input it perfectly. We know it can't happen. Over  the long run unemployment is definitely not a random walk because it doesn't hit 100%  and 0%. If you choose your time period advisedly like between the mid 1970s to 1990 for Europe  it will look as if it's a random walk but if you choose an 80 or 100 year time period  you're back to common sense which is hysteresis is impossible. And keep in mind that if there  are permanent changes in the labor market that would give rise to instability that is  an indefinite movement in one direction. So we know that's not possible. With regard to  the triangle model there's a lot of common sense there. Obviously the movements of inflation  and unemployment depend on demand and supply and lags. Supply is the new factor that keeps  dominating the discussion. The mystery of the missing inflation can be explained through  higher energy prices declining productivity growth, long lags on unemployment, the financial  crisis and so on. What makes one uncomfortable is that one needs to choose the supply side  factors exposed advisedly in order to fit what it is that one is trying to explain thereby  making the theory non falsifiable but there is sense to it. Now why is it that everyone  adheres to the long vertical long run Phillips curve? The reason is very simple. The classical  dichotomy seems to be compelling. If you double all wages and prices in the economy then real  activity should remain unchanged. Therefore if inflation rises that should have no effect  in the long run. Now we know from all our models that reasoning is wrong. For the very simple  reason that when inflation rises relative prices become less stable. The dispersion of  relative prices rises and that has important real consequences. That means that even in  the New Canesian Phillips curve, the long run Phillips curve isn't vertical but with  sensible additions to it you get a Phillips curve that looks like this. There is a flat  area which looks sort of hysteresis like and there is an area that is a long run tradeoff  area. Then there is something that is pretty vertical that looks like a natural rate area  and then there is a stagflation like area that explains what we went through in the  70s. Now in order to explain why this is so, it's useful to understand a few underlying  mechanisms which I think we all know subliminally. First is the matter that when the inflation  rate rises because real wages become more volatile, employment becomes more volatile  and that has a negative effect on real activity because of the inefficiencies due to diminishing  returns to labor. If there is labor smoothing, people prefer to smooth labor then that will  increase their reservation wage and reduce the labor supply and that will also have a  negative effect. But there is a small positive effect from temporal discounting which arises  before a simple reason that under staggered contracts, a wage contract, the current price  level is a weighted average of the past price level and the future price level and if you  discount the future, it's given a smaller weight. Prices are like chasing after a moving  target where the target is the frictionless price level and the faster the inflation rate,  the more the price level falls behind its moving target. Another way to see the same  thing is that time discounting reduces the weight put on households future disutility  of labor and so more price inflation means that real wages fall over the contract period  and there's an associated increase in labor supply. So discounting, it's a small effect  but it should alert us to something and what it should alert us to is that this is potentially  important because there's lots of evidence that we discount a lot more. Hyperbolic discounting  is something that's accepted in behavioral economics and short term discount rates of  60 to 70% are common in the literature and then the discounting effect becomes really  strong. Inequality aversion, the greater the inflation rate, the greater is wage dispersion,  the greater is our envy and guilt effects that arise out of inequality aversion and  envy effects are stronger and the way to overcome envy is to increase your labor supply so the  higher the rate of inflation, the more macroeconomic activity you get. If you have job turnover  then obviously your time horizon over which you calculate is smaller because the workers  will leave with a greater probability and that increases the discount effect again.  Obviously if you have increasing returns then employment cycling works to your favor but  there are many other effects that have been named in the literature, one of them being  nominal wage negotiation rigidities, nominal wages are usually set by mutual consent and  the fallback positions are given in nominal terms that implies a certain nominal rigidity  that gives rise to a downward sloping Phillips curve. Gift exchange is another possibility  that when there's a rise in money growth and that increases inflation then workers are  aware that they're purchasing powers in danger of being reduced. When firms shield them from  that then workers as part of a gift exchange increase their effort and that gives rise  to a downward sloping Phillips curve. There is departures from rational expectations as  given by Akhlof Dickens and Perry, zero lower bound and nominal interest rates, nominal tax  rigidities, state dependent nominal rigidities all lead you to a long run downward sloping  Phillips curve. So the thing to be taken seriously is the possibility of this long downward  sloping area that leads into a flat area. That is sort of the first idea that I'd like  to leave you with. All our theory tells us that the Phillips curve is backward bending  but because we have a methodological, empirical and theoretical predilection for vertical long  run Phillips curve we have tried to put everything into this procrastin bed and it simply doesn't  work. The knife edge problem, the random walk of unemployment are simply manifestly unrealistic.  And so I'd like to then give you come to my second idea which is that this long run Phillips  curve may shift because of asymmetric persistence in unemployment. Although I don't believe  that history's as possible, lots of theories tell us that adjustment of wages to cycles  is asymmetric. When you're going into an upswing then you face very little employment risk.  When you go into a downswing you face substantial employment risk and therefore you're more  likely to raise your wages in an upswing than you are to reduce your wages in a downswing.  There are many other reasons for it that are also given in the literature but the bottom  line is given in this figure. If you start at point A where the green line is a downward  sloping labor demand curve, the red line is an upward sloping wage setting curve, then  when the economy goes into recession from A to B then wages fall and employment falls  but when you go into a boom then you go up a different wage setting curve because of  this asymmetry in wage adjustment so you don't go back to A but up to C. Now where you arrive  at in the long run depends on how big the following boom is. Now if the economy is growing then  movements, positive movements in labor demand will be larger than the negative movements  in labor demand because otherwise it wouldn't grow and consequently you will have a situation  like the red dots show you where you would move if there was no growth so the wage may  go slightly upwards although those movements can be counter veiled by other things in the  economy, other effects like offshoring automation to keep wages flat whereas if the economy grows  then it's the green dots, still asymmetric adjustment but because of the growth the increase  in employment dominates the decrease in employment and therefore you move along a different asymmetric  path. That means that in employment terms what we have is something like this. Historicis  would mean that current employment depends on past employment with a unit root, it's a 45 degree  line. With persistence in unemployment it's always less but if there's asymmetric persistence then  you have a kink and that kink has important policy implications because you can see that the  downward movement takes you much further down than the upward movement on account of the asymmetry  and consequently because of these asymmetric possibilities this Phillips curve which is  backward bending now in terms of inflation employment space rather than unemployment space  can shift due to asymmetric persistence and the rise in European unemployment in the 80s and 70s  is due to an inward shift of this curve because of asymmetric persistence whereas the prolonged  period of low US unemployment without inflation rising is due to an outward shift. So if you  put these two things together that there is a backward bending Phillips curve that it may  have a substantial flat portion and that this Phillips curve may shift then you can explain a  lot of stylized facts and therefore I would hope that with the help of these ideas which  admittedly are very difficult to test empirically because now you need nonlinear multi equation  estimation you will help us all to escape from the collective madness that we are under. Thank you.  Look I recognize this late I'll try to be quick. First I just want to observe I think the award  for analogy of the year has to go to Larry Summers for the Harvard freshman abuse of alcohol  fiat money in the 1970s. My abuse of alcohol didn't start freshman week at Harvard it was  after shortly after hearing Larry speak for the first time when I was a graduate because I  recognized the rather large gap between the dexterity of his mind and the limits of mind  and this will become evident as I go on in my remarks which are going to focus on the UK.  It's going to focus on the UK because the topic of this conference is inflation and unemployment  in Europe and the UK is very much in Europe. So thank you for the invitation Mario.  Oh no I'm going on. Okay I'll try to link this a bit to what's been said this morning and I  think we'll probably run out of time I'm afraid. Three puzzles in the UK missing unemployment  missing inflation and missing productivity. Let me go through each quickly. In terms of missing  unemployment in the teeth of the crisis based on simple open relationships unemployment in the  UK even though it went up substantially went out about one and a half percentage points less  than it should have contrast that with the US as everyone here knows went up about a point and a  half more than it should have and as was observed it's similar for Europe in terms of the UK this  is not a participation rate story the participation rate held up in the UK whereas it fell by three  and a half percentage points in the US so the gap in terms of performance the gap in terms of  missing unemployment or missing slack is bigger than it first appears. Now to solve that puzzle  you obviously look to the flexible labor market it doesn't fully explain the US discrepancy but  it explains what happens in the UK real wages are still down 10% on their pre-crisis level whereas  they are flat to slightly up in both Europe and the US this is the worst performance since the  early 1920s for the UK. It's partly a nominal wage story nominal wage growth about one and a  half percent per annum that's about two and a half percent below pre-crisis averages but it  there are limits to this flexibility as John Mulevall and others will know it's really clustered  around zero in terms of nominal wage performance. The real story is higher inflation which brings  me to the second puzzle so where's that missing disinflation inflation given a three and a half  percentage point increase in unemployment inflation should and of course this whole morning has been  calling into question the use of words like should with respect to Phillips-Kurz relationship but  should have been about a percent on average pre-crisis three 2013 it averaged 3.2% over that  period and there's two major explanations for that the first very importantly are a series of one-off  price increases higher VAT higher tuition fees higher utility costs that Charlie Bean and his  colleagues at the time on the MPC quite rightly looked through and secondly higher import prices  occasioned by a 25% depreciation in sterling and a key point for the UK is this is not necessarily  something you look through and it's relevant for monetary policy because pass-through in the UK  for material exchange rate moves is sustained and persistent and stretches over the policy horizon  the the scale of that what wasn't the case at least in the UK and I think John Mulebauer was  making a point of general application the missing disinflation was not a productivity story  productivity performance was terrible but unit wage growth was weak enough that unit labor costs  were not strong so that brings me to missing productivity as elsewhere large shortfall  relative to trend not a surprise post a financial crisis as Olivier and Larry's paper documents  but a 15% shortfall relative to trend as of today we can explain about three percentage  points of that in terms of measurement and some sectoral shifts most notably North Sea oil a bit  on financial services but then it gets much murkier I would I would argue that impairment of the  financial system and a slower process of creative destruction played a central role here I'll just  give you one statistic which is that company liquidations ran 40% below past averages during the  worst recession since the 1930s which gives you a sense our micro estimates for what it's worth  using micro data is that the resource reallocation process contributed only about a third to  productivity over the course of the last five years and so it's not just and this is not just a  question of the lack of capital for new enterprises but it also arguably is is partly a product of  forbearance and forbearance occasioned or allowed by lower interest rates to keep existing enterprises  afloat I mean obviously as well there's less capital deepening including very importantly  intangible investment one measure of that is measure of product innovation by firms fell by  a quarter less human capital investment and I just appeal to the important points made in  Olivier's presentation about future expectations of growth and the and the causality that could  happen there finally and most recently we have seen important compositional effects in the labor  market so there's a lot more low skilled low-wage jobs and because employment has been so strong  and much higher job churn there's a lot of people who are new to their jobs 10 years quite low and  we detail this in our latest inflation report that actually is pretty much a watch from an  inflation perspective but it explains a material part of our shortfall we think in productivity  in short term so we think that these drags on productivity are starting to come off but we  don't see productivity we see so we see productivity growth picking up but not to historic averages  anytime soon a common driver for these effects these three puzzles if you will has been a very  large labor supply shock in the UK and I'll just give you a couple of representations of that the  participation rate I referenced earlier it's about a percentage point higher than it would have  been if we just rolled forward the cohort participation rates from 2007-8 that's about half  a million more workers similarly average desired average hours went up as well that's a little  more speculative in terms of an estimation of what you know or what people say they want to work is  that really what they want to work but that's equivalent again to another half million jobs and  the rationale the reasons for this are not just the impact of the financial crisis and worse balance  sheets but also changes to the structure of labor market and retirement ages increased in a number  of cases benefits reduced in number of cases so a compulsion to work for both financial land and  benefit reasons I would I would point out that these changing work patterns of UK nationals dwarf  the increase in net migration in the recent past if you look at the increase relative to averages  historic averages and net migration the last two years it is 50,000 additional workers in the UK  economy versus the million I just totaled up for you okay so what does how does how to map this  towards this morning's discussion about Phillips curve Phillips curves and and policy and I do  this with some reservation but I'm thrilled that we don't have a Q&A after this now because of the  caterers first thing I don't think we can reinforce enough and I think everyone in this room knows it  but it took close to say it close regularly to say it you have to look at broader measures of labor  market slack than just the unemployment rate which we very much to secondly I wouldn't and we haven't  given up on our price Phillips curve relationships we think they are more stable than Olivier's  comments suggest nor would we slavishly rely on them obviously but I danced over it quite quickly  but there were a series of one-off shocks to the headline price level there's always a series of  one-off shocks of course but looking at the measures of core will give you a better sense of the  relationships we do have a very stable wage Phillips curve in the UK and Bob Gordon's cautions on  this are absolutely right you can't look at it without looking at productivity but it doesn't  mean you don't look at it I don't think Bob was suggesting that we have we have seen in the very  recent past some weakness in wages relative to that those relationships those compositional  effects I mentioned are quite important here but also there is the possibility of a shift in wage  expectations a long period and I'll appeal to behavioral science in Dennis's presence here  but a long period of very low wage settlements leads to a persistence lower expectations that  will just may take longer to come off we're seeing actually in the UK not surprisingly a  revert if you will a reversal of the insider-outsider dynamic outsiders in other words people who are  shifting jobs are getting new jobs are getting much higher wage settlements than those who are  staying in work something we expect to a gap we expect to close as the labor market continues  to tighten in the current policy environment we have no inflation in fact the most recent numbers  were mild deflation minus point one Olivier and Larry's paper reminds us of the importance of  inflation expectations that's one of that's one of the first conclusion points in the second half  and we have the advantage in the UK of regime that forces us in this circumstance forces me  actually my role to write an open letter to explain why inflation is so low and what we're  going to do about it the why is product the prominent reasons for the why pretty easy this is  lower global energy and food prices and imported inflation that accounts for about three quarters  of the mess if you will relative to target only a quarter of which in other words is accounted  for the factors that I've been discussing that doesn't mean they're not important but it does  mean in our view that we should look through them we need to be mindful as I said earlier of  persistent drag from sterling strength and imported disinflation reference Charlie's comments about  the importance of looking not so much you weren't referencing the exchange rate so much but global  factors inflation when setting policy in a very open economy such as the United Kingdom we have  signaled our intent made clear our intent that to return inflation to target within the next two  years and that means setting policy to get domestic cost pressures up and we think we can close the  output gap within the next year that's not as heroic as it sounds given that part of the reason is  we think that potential has slowed and we've taken a bigger hit to potential both actual and trend  and the appropriate path I'm moving to finish the appropriate path for bank rate obviously hinges  crucially on on the supply outlook and the equilibrium interest rate our view of the equilibrium  interest rate we like others have faced persistent headwinds that weigh on our economy we have been  talking about this for a number of years we see weaker global demand we're pleased that some of  that is now coming off with the renewed strength in Europe we have sustained fiscal consolidation  in the UK it's been relevant for the last several years it will be relevant certainly over the policy  horizon and beyond we still have ongoing private deleveraging we think and we think with time we  don't have time to get into this but we think that financial intermediation costs are going to go up  at a new equilibrium and equilibrium where rates come off the zero lower bound there will be higher  prices in financial markets for liquidity and the risk-free rate needs to adjust and then there are  the longer fact longer-term factors that Larry is as has highlighted which we think will also  persist beyond the policy horizon so all of that merits a pace of rate increases that are would  proceed at a gradual pace to a limited extent and let me finish and this is a real finish by quoting  my colleague Ben Broadbent who makes the point that whether it's very low interest rates at the  effective lower bound whether it's unconventional monetary policy whether it is a limited and  gradual pace of tightening perspective pace of tightening of interest rates by central banks  that's not the reason why global interest rates are low central banks are actors reading a script  written by others that's Ben's way of putting it and it's a and that script at least written for  us that theoretically I would I would salute the contribution of Larry and Olivier and others in  bringing to the forefront second or stagnation and those factors which will be with us for some  time thank you thank you you you
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