Random economist prediction: A sidenote

Kiwiblog discusses the musings of an economist at a Business Roundtable retreat in this post.

Now of course the economist had a number of good points (it is an economist after all), but there are a few points I would like to discuss in a little bit of detail (although not much 😉 ).

  1. The 90 day rate will fall to 6% in 2009 then rise to average 7% in the future,
  2. Mining in Australia only accounts for 7% of GDP and so cannot account for its strong economic performance,
  3. A decreasing ‘talent pool’ (meaning number of people) will decrease productivity,
  4. The higher cash rate to inflation cycle

Here are my musings:

For point one, this surely assumes that the OCR will be slashed over 2009 by about 250 basis points. This seems a little extreme when he believes that ‘equilibrium inflation’ has risen to 2.5% – surely his forecast should have interest rates higher for longer so that we can beat out the inflation expectations causing this higher level of inflation.

The idea that the 90 day bill rate will average 7% in the future is not contentious – I would prefer it to average 6.5% if it could, but that is just a matter of what number I find prettier 😉 .

The second point is weird. Ok mining in Aussie accounts for 7% of GDP, agriculture in NZ (our big export industry) accounts for a little over 4.6% of GDP – yet he is willing to admit that the performance of agriculture is very important for New Zealand economic growth. The reason these export industries matter so much comes from the fact that we sell these goods on the international market for ‘income’ which goes around the economy. The initial impact from the arrival of some dairy or mining dollars may seem to be constrained to the dairy sector – but through the multiplier effect this transfuses through the economy, stimulating activity (like the 4.8% of the economy that is involved in food manufacturing, or the 8% of the economy involved in wholesale trade).

The third point is interesting. For it to make sense he must believe that mainly highly productive people are leaving while mainly unproductive individuals remain, outside of this assumption the only way this could make sense is if New Zealand was able to take advantage of huge economies of scale, or if there were significant spillover effects between employees. Ultimately, a reduction in the number of people in New Zealand does not necessarily reduce average productivity – this would be an interesting question to explore though.

Finally, the higher cash rate higher inflation cycle. Berl often use this argument as well, stating that a higher OCR increases the money supply. However, as we target a price not a quantity this argument makes no sense.

This random economist had a more sensible argument, one that Rod Oram is a fan of. According to Kiwiblog it took the form:

  • Increasing Inflation –> Increasing Cash Rate
  • Increasing Cash Rate –> Increasing Interest Rates
  • Increasing Interest Rates –> Increased NZ$
  • Increased NZ$ –> Decreasing Exports
  • Decreasing Exports –> Decreasing Economic Growth
  • Decreasing Economic Growth –> Decreasing Investment
  • Decreasing Investment –> Decreasing Productivity Growth
  • Decreasing Productivity Growth –> Decreasing Aggregate Supply (growth)
  • Decreasing Aggregate Supply (growth) –> Increasing Inflation

Alright. This is an important issue – one that I should think about and write something on. However, first I’ll have a crack at mentioning a couple of the issues to think about here.

First I think we can rip out all the stuff about the dollar hurting exporters then hurting growth then hurting investment – a higher dollar also leads to a greater volume of imports for the same total cost, e.g greater consumption. As GDP=C+I+G+X-M, X is falling and C is rising (and M could possibly fall as the $ cost of imports is lower), who knows whats going on. This may shift resources from the exporting sectors to the domestic sectors – potentially a bad thing for productivity in of itself, however I feel that this will depend more on the long-run outlook for the exchange rate than some transitory impact stemming from the OCR.

Now interest rates to investment, interesting stuff, a higher interest rate will lead to a lower level of investment. However, the question then has to be, how does the OCR influence the interest rate that firms face? If the OCR only has a weak impact on firms financing costs then this shouldn’t be a big issue (the big question here is, how mobile is international capital?). Furthermore, if firms borrow based on what they expect their interest charge will be over the long-term, not just what it is now. The OCR rises and falls and as a result tight policy now should not be the issue that kills productive investment – it may just delay it.

I’ll do some reading next month and see if I can say anything intelligent by April. If some can say something intelligent before then, feel free 🙂

  • CPW

    The multiplier effect could account for a small sector having a big cyclical impact, but I don’t think it can change the fact that a small sector is only going have a small impact on productivity growth over the long-run.

    Relevant to point three, haven’t read the paper yet though. Link

    The argument chain seems to be skipping back and forth between short and long-run models, I don’t find it particularly coherent. Aggregate demand is far more responsive to interest rates than aggregate supply (so prices are going to fall, not rise), and anyway a slower growth rate in aggregate supply is only inflationary if money supply growth is held constant.

    The argument could be summarized as short-term slow growth leads to long-run slow growth. A possibility, but inflation and over-investment also harm growth, so there’s a trade-off here (empirically, I thought there was a Milton Friedman paper arguing slowdowns don’t alter the long-run GDP level). To convince me I’d like to here a much better argument for why monetary policy is producing a lower investment rate in equilibrium (not just cyclically). I believe we have high interest rates because we don’t save much, not the other way around.

  • “The multiplier effect could account for a small sector having a big cyclical impact, but I don’t think it can change the fact that a small sector is only going have a small impact on productivity growth over the long-run”

    True, but according to the Kiwiblog post the economist was talking about recent economic growth, not productivity growth.

    “Relevant to point three, haven’t read the paper yet though. ”

    Looks interesting, when you read it tell me what it says 😉

    “The argument could be summarized as short-term slow growth leads to long-run slow growth.”

    I agree, the causal chain seems like rubblish – ultimately that is the assumption that needs to be made (old hysteresis).

    “To convince me I’d like to here a much better argument for why monetary policy is producing a lower investment rate in equilibrium”

    Exactly!

  • CPW

    Sorry Matt, you are correct. Terms of trade growth certainly does explain a lot of recent Australian growth. In my defense, I have often heard the argument that Australia is richer than NZ because of the minerals.

  • dpf

    You need to allow for the fact that my notes are scribbled on a small pad, based on a powerpoint display and his oral comments – not on a handout. Hence I may have stuffed something up.

    I’ve never been convinced there is a better way to run monetary policy. But this presentation was the first time that a reasonably rational explanation of potential problems with it, was presented.