Matt Nolan

An important warning regarding the monetary policy fine-tuning

/1 Comment/in , /by

A recent opinion piece in the Herald, pitting Don Brash and Brendan Doyle in to debate the issue of monetary policy was good.  They seemed to agree that, ultimately, any issue is one of the real exchange rate – which is due to real economy factors.  A point I’ve heard a number of times before 😉

However, all this debate reminds me of a speech by Bernanke back in the day.  The choice quote:

Although a strict rules-based framework for monetary policy has evident drawbacks, notably its inflexibility in the face of unanticipated developments, supporters of rules in their turn have pointed out–with considerable justification–that the record of monetary policy under unfettered discretion is nothing to crow about. In the United States, the heyday of discretionary monetary policy can be dated as beginning in the early 1960s, a period of what now appears to have been substantial over-optimism about the ability of policymakers to “fine-tune” the economy. Contrary to the expectation of that era’s economists and policymakers, however, the subsequent two decades were characterized not by an efficiently managed, smoothly running economic machine but by high and variable inflation and an unstable real economy, culminating in the deep 1981-82 recession. Although a number of factors contributed to the poor economic performance of this period, I think most economists would agree that the deficiencies of a purely discretionary approach to monetary policy–including over-optimism about the ability of policy to fine-tune the economy, low credibility, vulnerability to political pressures, short policy horizons, and insufficient appreciation of the costs of high inflation–played a central role.

Is there then no middle ground for policymakers between the inflexibility of ironclad rules and the instability of unfettered discretion? My thesis today is that there is such a middle ground–an approach that I will refer to as constrained discretion–and that it is fast becoming the standard approach to monetary policy around the world, including in the United States

“Constrained discretion” is (arguably) very much the flexible inflation targeting framework we use now – the determination to “fine tune” is one that is coming out increasingly, and is based on an illusion of understanding and control regarding the macroeconomy (that and a few fallacious ideas of how things have panned out 😉 ).

No-one is arguing against having a further look at financial regulation, and trying to understand what has happened there.  However, this provides no case for messing around with the way the RBNZ performs monetary policy and the existence of a floating exchange rate – and in their determination to “do something” there are a set of politicians, journalists, and other analysts/economists trying to take us down a dark path.

Matt Nolan

Dealing with debt, financial regulation, and the lender of last resort

/25 Comments/in , /by

Previously we’ve talked a lot here about the lender of last resort function of a central bank.  In discussions a trade-off is often discussed, whereby having a lender of last resort can help to prevent financial crises when financial intermediaries are suffering from issues of “illiquidity”, but are not “insolvent” – however, the existence of a LOLR can in turn lead to moral hazard … where financial intermediaries and lenders are willing to take on “too much risk” and charger borrowers “too little”.

Although the discussion of these issues has a long history in economics, Thomas Sargent’s article (REPEC) on the issue – and the solution mentioned – are worth reading.

Now we live in a history dependent world.  Yes, we have had a global banking system willing to take on too much risk – due in a large part to issues of asymmetric information and an implicit solution subsidy of risk.  Yes, in this environment debt accumulated, and the existence of debt and the following credit constraints on people with “useful projects” that they could invest in is having a big negative impact – likely much bigger than any “social boost” that may have existed from the additional marginal projects that took place with easy credit.

We have an environment where people think there is a real risk of the failure of financial intermediaries.  Now if we understood “why” we could ask if there is a solution.  What are some reasons:

  1. There is too much debt.  If we saw this as an issue, we could convert bondholders into equity holders in banks.  After all, isn’t a government bailout really just a transfer from non-depositors to depositors in the bank?
  2. There is no trust.  There was a “capital stock” of trust that was built up between financial institutions, a stock that was destroyed and will have to be rebuilt.  This can be expected to keep hurting the efficiency of financial markets for a long time.
  3. Central banks/governments have lost credibility as lenders of last resort.  I think this is compelling – everyone talks about “too big to fail”, but exactly what that means, exactly what the “insurance” is, and exactly how the “insurance” is paid for are questions that are still up in the air. One can use Life Cover Quotes to find the best life insurance provider.
For me the key issue is the last one – as the negative impact of the first two is “endogenously determined” by the credibility of the financial system stemming from regulation.  The fact we have a government monopoly for fiat money, and direct management, combined with a LOLR function, ensures this.
A financial advisor life coaching expert will also be able to provide you with feedback and accountability, so you can make sure you’re on track.

Note:  Anyone reading here since the crisis has been in full swing will think I lean strongly on the side of constant bailouts.  However, this is far from the case – I only started writing in favour of them once we already had a crisis where this needed to be the case.  In 2007, once the crisis had begun but a few months before Bear Sterns, I was writing like some sort of “purging our evils” Austrian economist.  After Lehman Brother’s collapse, even a half pint analyst like myself saw the issue of a lack of trust even when it was unclear whether there was a bailout or not 😛 (it was interesting reading these old posts, the lack of clarity around what was going on was even worse than I remember!).   By the time what happened was clear, we had switched our tune in favour of bailouts for that period of time – and even I found the ECB’s call to attack moral hazard in the middle of the crisis strange, even though I saw that as a big issue.

This was seen as a major issue coming into the crisis, it was viewed as a key issue during the crisis (I would argue that the efficiency of NGDP targeting would still depend on a banking system without bank runs), and now during these later stages of the crisis it is an issue receiving a lot of research and taken into account for regulation.  Mainstream economics has the tools to understand what has happened, and hopefully policies can be developed that ensure that the next economic crisis is something completely different.

Matt Nolan

Cartoon: How to find out if someone is an economist

/2 Comments/in /by

The always awesome Saturday Morning Breakfast Cereal (SMBC) popped this comic up.

The thing is, when I saw the first panel the first question that popped into my mind was “nominal or real dollars” – the amount I ask that, all day long, is ridiculous.  These things are always best when they are relatively true …

Matt Nolan

The outlook for oil: An interview with Hamilton

/3 Comments/in /by

Oilprice.com has a good interview with James Hamilton from Econbrowser up on their site.  I’d suggest taking a look 😉

As will one day become clear, one of the big drivers of the slowdown in the developed world has been the sharp increase in commodity prices – specifically oil.  While the global financial crisis was a major driver, it is also possible to make the case that part of the reason for the run up in debt was an assumption by households and individuals that the lift in oil prices would be temporary – when in fact it looks like it is a relatively persistent shift up.

As stated here:

James Stafford: Whenever oil prices spike politicians are quick to blame speculators and oil companies for manipulating the markets. Are you in agreement with this – are speculators and oil companies to blame? Or are there other factors that are overlooked deliberately or otherwise by the mainstream media?

James Hamilton: The story is pretty simple, and even though politicians may try to distort it, you’d hope that the media would do a better job of reporting the truth than they have.  World oil production was basically stagnant between 2005 and 2008, even though world GDP was up 17%.  With economic growth like that you’d normally expect increased demand, particularly from the rapidly growing emerging economies, and in fact China did increase its consumption by a million barrels a day over these 3 years.  But with no more oil being produced, that meant that the rest of us– the U.S., Europe, Japan– had to reduce our consumption.  It took a pretty big price run-up before that happened.  To those claiming the price is too high, I would ask, how high do you think the price had to go to persuade Americans to reduce oil consumption by a million barrels a day?

We have seen demand rising (on the back of increasing productive capacity in the developing world) while supply has stagnated.  Many times people have told me “there is heap of oil lying around” – and this is true – but the question is, “what is the cost of extracting this oil”.  Even some of the most optimistic people say that we shouldn’t expect oil prices to fall below $70US a barrel in current dollar terms.

The big saviour will hopefully be technology – higher prices drives the incentive to find substitutes.  However, that doesn’t stop the intervening period being painful.

Matt Nolan

What has been driving the real exchange rate?

/1 Comment/in /by

For anyone that has been looking at posts over here, or carefully listening to Reserve Bank speeches, the topic of the real exchange rate is an important one for understanding the New Zealand economy.  Many of the “concerns” or “issues” being raised at present are really just a function of some view of the real exchange rate.

Via the RBNZ we have a graph of the real exchange rate (RER) here:

Now this drives the question, what has caused the change in the real exchange rate – what shocks have we experienced that have pushed it up, and what proportion of the increase was due to these shocks.  Chris McDonald at the Reserve Bank decided to have a go at answering that question.  With so many factors driving the dollar, “causation” is hard to appropriately appropriate between causes – and so his primary focus is on the correlations and their magnitude, albeit within a framework that will help to show what the more important drivers are.  So what is his conclusion:

  • International factors relevant to New Zealand explain more (60 percent) of the exchange rate variance over our sample than idiosyncratic and domestic factors.
  • The most important international factor is likely to be export commodity prices, though our empirical analysis is not conclusive. For instance, high commodity prices can explain why the exchange rate is at current high levels. But, high commodity prices may be partly a result of current low foreign interest rates.
  • The best domestic indicator for the exchange rate is house price inflation. While this indicator also reflects international factors, its movements over and above the impact of these appears to capture some key domestic information for the exchange rate.

Now this doesn’t tell us anything about the key issue of the New Zealand dollar being “persistently overvalued” or not.  But it does indicate the commodity prices have been a major driver of the increases we have seen.  On top of that another interesting point was raised:

The RER response to the other domestic shocks suggests some of them may not be well identified. Notably, an unexplained fall in the 90-day interest rate and an unexplained fall in the output gap both have little impact on the RER. Practically, we expect these shocks to cause quite large movements in the RER. However, once we allow for the correlation of these variables with the international and New Zealand real house price inflation variables, these shocks (despite being not so well identified) have a relatively small impact on the results.

So within this decomposition, the impact of a monetary policy shock (change in 90day bill rate) or exogenous change in AD (fall in output gap) are poorly identified – and seem to have little impact on the RER.  The author believes thsi result doesn’t pass the smell test, which is fair enough – after all the author has the best knowledge of what their empirical model is saying (especially since no empirical results are included).  However, if we were to take it at face value it would suggest that the RBNZ’s ability to actually change the RER with monetary, even in the relatively short term, is limited.

Matt Nolan

Why I shouldn’t read the paper

/2 Comments/in /by

It appears that much of the media (some parts excluded) wants to make the discussion of monetary policy a titianic battle between opposing forces – rather than informing the public of the trade-offs that exist, and the issues that are currently being looked into.

There are two issues currently being debated – only the first one has been influenced by to the financial crisis (although it was an issue that was being looked into well prior to the GFC):

  1. How should financial regulation, and the goal of financial stability, be put in place?
  2. Why is NZ’s real exchange rate persistently so high?

The “orthodoxy” in New Zealand has been discussing these issues and trying to improve policy the entire time, in fact there was nothing wrong with the instituional settings we had in place through the Reserve Bank (hence why the PTA was little changed) – many of the problems that have occurred are to do with other things … and many of the “issues” that are being raised are in fact fallacies that show a fundamental confusion about the issue in the New Zealand context (such as the constant confusion about the nominal and real exchange rates, or the view that QE creates a “prisoner’s dilemma” between central banks).

If we had more articles like Brian Fallow’s, that aim to discuss the issues and ideas involved, instead of the type ideological drivel that often appears, we might be able to have an adult discussion on how to genuinely improve outcomes for New Zealanders.