Matt Nolan

Bailouts, moral hazard, and the money supply

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Over at Anti-Dismal Paul Walker says:

The bailouts were not a good idea, just think of the moral hazard problem this has created, while there may have been more justification for the Fed acting to prevent the money supply from falling.

These are all important issues.  If the “bailout” (I use the term loosely, as buying profitable equity shares and making loans that get paid back are not what we normally view as a bailout) created a moral hazard problem we are just delaying an inevitable contraction – and supporting inefficient firms.  Furthermore, if there is another way for the Fed to control the money supply without a bailout it is likely that would be a preferable action.

However, the fact is that a bank run (which is what we were trying to prevent with the “bailout”) reduces the money supply – even if the Fed leaves the money stock unchanged.  As a result, we can’t really treat the two issues separately.  Remember, the Fed doesn’t control the money supply directly, the money supply is formed through the financial system.  As a result, I don’t think that the Fed could “maintain the money supply” in the face of a massive bank run.

In regards to the 1930’s this point is illustrated by Bruce Bartlett (ht Marginal Revolution):

There’s no way the Fed could have expanded the money supply in the early 1930s without bailing out the banks. How do you think the money supply declined in the first place? It’s because banks failed and their deposits disappeared. To keep those deposits from disappearing in an era before deposit insurance would have required keeping bankrupt banks afloat.

If we had experienced a bank run, we would have suffered a similar decline in the money supply – even with the Fed pumping money out into the money stock.  Now if prices cleared perfectly this wouldn’t matter, the drop in “velocity” would be met by a drop in the price level.  But prices don’t move immediately, implying that the drop in the money supply as a result of the bank run would have had an impact on real output (*).

Now, I completely admit that Moral Hazard is a relevant issue.  But is a the cost of letting large financial institutions know that, in a 1 in 100 year collapse in the global economy, they will be prevented from going bankrupt immediately greater than the benefit of avoiding a sharp and self-propogating decline in economic activity?  For the bailouts to be a good idea we merely need to say:

  1. the costs exceeded the benefits,
  2. this was the best scheme that was able to be approved at the time.

I think both these factors hold – although I completely understand when people feel differently, given that there is a trade-off.

Matt Nolan

The 24% price pick

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There were supposed to be a number of important points made today as I can finally cover the house price pick.  Here is a list of what I was supposed to cover:

  • The first house price increase (to June 2010) merely takes us back to where we were in December 2007 in nominal terms.
  • Real house prices don’t re-reach their peak for another year after the nominal level returns.
  • However, house prices remain 30% overvalued – structural factors imply that this is an “equilibrium”, although not a very nice one.
  • Ultimately, in the long-run, we agree with Bernard Hickey and Gareth Morgan that prices need to go back to “fair value”.  Our argument is only over the transition path.  There is a difference between saying that they economy needs to rebalance (true) and assuming it just magically will – we don’t think it will in the short-term.

Driving growth is:

  • Loosening credit conditions,
  • Low interest rates,
  • Limited supply on the basis of a weak build rate
  • Limited supply on the basis that people don’t really want to sell (unemployment stays moderate, interest rates low, lack of forced sales).
Matt Nolan

GST on rent

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In an excellent article from Brian Fallow, the idea that GST could be applied to rent is brought up.

I agree with this 100%.  By not taxing rent we are distorting incentives regarding the investment in housing – after all, rent is a form of consumption and should be captured by a tax on consumption.  (Note:  I haven’t been clear enough that the “revenue neutrality of the tax” is very important – this only makes sense if we are cutting more distortionary taxes as a result (eg income taxes).)

However, I would go a step further.  We should be taxing the rental equivalent of ALL properties with GST – as the rental equivalent (when you own a house) is consumption.  Now remember this doesn’t just impact on renters, it depends on the incidence of tax.  As a result, it will lead to lower net of tax returns to property investors – net returns that are more closely related to the relevant net returns among other asset classes!!

Part of the reason that New Zealand has overinvested in housing is because of favourable tax treatment.  A clean up of GST in regards to the housing market, combined with a revenue neutral increase in GST rates, would have a big impact on the housing market.

Update:  Kiwiblog comments here.  Not PC comments here.  Rates Blog comment section here.

Matt Nolan

Breakfast tomorrow: Defending the 24% increase in house prices

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I will be on Breakfast tomorrow (at 6.50am) defending Infometrics pick of a 24% increase in house prices over the next three years.

Although the last pick was a little off, house prices still only feel a little bit more than we stated (falling 10% vs our 5% – although if you look at median house prices the decline was only 5.4% :P) and this was really the result of a collapse in credit markets – something that had not fully eventuated at the time.  Once the credit crisis stepped up following Lehman Brothers we moved into the 10% fall camp.

Anyway, feel free to complain about things I say here – until I get a post up discussing what I went over.

The Hand

Bank runs and TARP

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This is a Hand post, but it is actually just the normal authors of the blog.  We all had the same idea at the same time 😀

Over at Anti-Dismal, Paul Walker reaches the conclusion that

The moral of the story, markets can deal with asymmetric information

In the case of bad and good banks.  He states that banks are able to signal whether they are strong or not, and so government intervention is unnecessary.

However, this doesn’t seem to weigh up properly with the vast amount of literature that points out that bank runs are a concern resulting from asymmetric information (and multiple equilibrium – for economists this is because withdrawal decisions are strategic complements) and that a small amount of government intervention can help prevent said negative outcomes (here and here are seminal pieces).

Now there is a way that we can put both points of view together. Lets look at how the market is overcoming the asymmetric information problem:

At least one major US bank is advertising the fact that it refused TARP funds.

So the market was only able deal with asymmetric information in this case because the government created a mechanism that allowed banks to credibly signal (the TARP program).  It is ONLY because the government created this mechanism that the individual banks could signal their “strength” credibly, thereby preventing an inefficient bank run equilibrium.

So I would change the moral of the story slightly to

markets can deal with asymmetric information, when the institutions are in place that allow them to credibly signal quality – an issue government can sometimes help with

Matt Nolan

“Mobility of labour” is not a reason for favouring GST

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There has been a bunch of good stuff written out there about the trade-offs between using GST and a (flat) income tax to raise government revenue.  However, there is one point I think has been slightly exaggerated – the mobility argument for a lift in GST.  An example of this comes from an excellent article by Vernon Small.

Put simply, since people can leave or  go elsewhere – and so can investment  dollars – they should be taxed the least.

On the other hand, local consumption – which attracts GST – can by definition only happen here.

Now the first paragraph has a lot of truth in it.  But in reality the idea that “people can leave” in the face of tax and the idea that “consumption can leave” in the face of tax are equivalent.

Why?  People value their income only insofar as they can buy things with it.  As a result, if someone is forced to either stay at home or move overseas then a GST rate of 25% is equivalent to a tax of 20% on labour – as both taxes drive a wedge between what an employer is paying and what real goods and services a employee is receiving.  This point was also raised by the Tax working group.

So remember, it is not true that switching a “flat” component of income tax to a GST rate will necessarily lead to fewer New Zealanders going overseas.  If it does anything it will change the timing – leading to more New Zealanders staying around to save up income, and then moving overseas to spend it.