Money and the Bernanke Review

After all that, isn't money still missing?

IN EARLY MAY, the former Governor of the Bank of England Mervyn King, now Lord King of Lothbury, lamented a “collective amnesia,” as the Financial Times summarised it, as to the role of money in the economy.

This amnesia contributed to the forecasting failings at the Bank, and elsewhere, according to King—such that central banks missed the coming inflation following the pandemic.

But the Court of the Bank of England had already commissioned a report into forecast failings, led by Ben Bernanke. Does the Bernanke Review agree on the missing role for money?

Back in the Lords

We should start with that debate in the House of Lords.

The full debate where King made his remarks on money is available here. Remarkably, the phrase “three-equation new Keynesianism … is a catastrophic set of ideas” made it onto the floor of the House of Lords!

The relevant part of Lord King’s remarks, abbreviated as “collective amnesia” by the FT, runs as follows:

There continues to be a good deal of disagreement on the causes of the recent rise and subsequent fall in inflation. But many economists, both here and in the United States, pointed to the likely impact of a very substantial monetary and fiscal expansion boosting aggregate demand, at a time when the measures introduced to counteract Covid were lowering aggregate supply. Too much money chasing too few goods is, and always has been, a recipe for inflation. It is troubling that not just on the Monetary Policy Committee, but also on the Federal Reserve Open Market Committee there were no dissenting voices to challenge the view that inflation was transitory.

This lack of challenge is certainly not confined to the Bank of England. The academic economics profession has essentially jettisoned the idea that, from time to time, one should ask what the growth rate of broad money was telling us, especially at a time when, as in the United States, it was rising at the fastest rate at any point since the Second World War. The excessive reliance on models that ignored money altogether was somewhat foolish.

In short, lack of monetary analysis contributed to the inflation shock—and apparently a one off jump in broad and base money, according to Lord King, results in permanent inflation.

Money in the Bernanke Review

In contrast to this narrative, the word “money” features only twice in Bernanke’s lengthy Review; once to name check an internal team within the Monetary Analysis Directorate at the Bank, the second as part of the name of a journal.

That is, there is no emphasis on money in the Bernanke Review. But maybe it is implicit.

Bernanke note the “shortcomings of COMPASS [the Bank’s existing model], [such that] a new central model (or at a minimum a thorough revamping of COMPASS) will likely be needed.”

In this revamp, what should the Bank strive for? Bernanke recommends:

in general, and drawing on the lessons of the recent experience, the developers of the revamped framework should ensure that the component models include (1) rich and institutionally realistic representations of the monetary transmission process; (2) specifications that endogenise public expectations of inflation and of other key variables (without the assumption that longer-term inflation expectations are always well-anchored); (3) empirically accurate descriptions of the setting of wages and prices and their interaction; (4) detailed models of the financial sector, the housing sector, the energy sector, and other key components of the UK economy; and (5) regular incorporation of supply-side developments, such as changes in productivity growth, labour supply, and the efficiency of job-worker matching.

This is what Americans call “motherhood and apple pie.” What’s not to like?

But it is one thing to make such a wish-list and quite another to implement it.

And, of course, it can be argued that either point (1) on the “monetary transmission process” or (4) on “detailed models of the financial sector” encompass monetary balance sheets—as a crucial part of the wider financial system.

So perhaps money is not lost to Bernanke after all?

Missing balance of payments

What Bernanke does not reference here, except (again) implicitly, is the importance of balance of payments analysis for the UK economy.

Given that the Bank does not produce a projection of the UK balance of payments in the conduct of monetary policy during the Monetary Policy Reports, despite the UK’s openness to trade in goods and financial instruments, an opportunity may be lost to restore open economy analysis to a position of prominence.

Moreover, what goes unspoken in Bernanke’s review is the fact that the Bank’s COMPASS model was itself a response to previous inflation forecasting failures.

Losing COMPASS

As noted, in his Review Bernanke singled out the Bank’s COMPASS model for particular criticism. Precisely, from Bernanke’s Executive Summary:

…the baseline economic model, known as COMPASS, has significant shortcomings. These deficiencies in the framework, together with a variety of makeshift fixes over the years, have resulted in a complicated and unwieldy system that limits the capacity of the staff to undertake some useful analyses, including producing alternative forecast scenarios, using information gleaned from forecast errors to improve model specifications and forecasting methods, and considering alternative modeling frameworks.

But what is COMPASS?

Well, it’s the Bank’s “structural central organising model” for forecasting, introduced to the world in a Working Paper in May 2013, shortly before Lord King’s tenure as Bank of England Governor. There we are told:

COMPASS is a “New Keynesian” general equilibrium model and shares many features with similar models in use at other central banks and policy institutions… [it] provides the basic set of relationships that articulate core macroeconomic mechanisms and provides a disciplining framework by ensuring that forecasts are internally consistent. COMPASS itself only provides forecasts for fifteen variables: “key” macroeconomic series such as GDP, inflation, interest rates, trade, wages and consumption.

COMPASS is smaller and simpler than previous central models used at the Bank of England. This makes it easier to estimate and to use, enabling Bank staff to produce timely updates to the MPC’s forecast in the weeks ahead of an Inflation Report. But it also implies some sacrifice of detailed economic structure. To compensate for that, the suite of models is very much an equal partner in the new forecasting platform.

As was explained at the time by Financial News in April 2012, King had overseen the dismantling of the old forecasting model:

The Bank of England governor Sir Mervyn King has ditched the economic forecasting model he brought in when appointed nine years ago…

Financial News can reveal that [the existing forecasting model BEQM] was quietly dropped last November following criticism that the Bank's previous inflation forecasts were wide of the mark. The model also took no account of the role of banks within the economy.

The Bank's new modelling platform is called Compass - Central Organising Model for Projections and Stochastic Simulations.

Sources close to the Bank argue the shock to the system from the credit crisis required a new model. They stressed the human element of their economists' judgment is as important to inflation forecasting as any computer model…

Quoting then-Chief Economist Spencer Dale, the article continues to explain how the “financial crisis exposed many failings with models typically used by economists. Most didn't assign a meaningful role to banks and the ways in which they can affect the real economy.”

In other words, under Lord King, the Bank of England acknowledged inflation forecasting failures during the Great Financial Crisis by revamping their approach, including by adding banks—and therefore presumably money—to their key model.

It is curious to hear Lord King today lament the absence of money when he himself oversaw adding banks to the Bank’s forecasting models before he left his position.

Plus ça Change?

A pattern is emerging, depressing though it is.

Every decade, the UK economy shares in a large, global shock.

Inflation forecasts are off.

The Bank is embarrassed.

Clever people are asked to scratch their heads. Doing so, they conclude the Bank’s models are not up to scratch—that they should be rebuilt to include the financial sector.

New acronyms are assembled to great fanfare.

But in the end, the economics establishment unable to furnish modern central banks with the tools needed to analyse complex, emergent systems like the macroeconomy—and the seeds are sown for the next monetary-fiscal policy fudge at some point in about a decade.

Repeat.

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