Matt Nolan

A different view of an inflation/price level target: No-monetization commitment

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In New Zealand a strange thing is happening.  While other countries are looking at making their inflation targets more explicit following the crisis, and many more countries are debating whether to use a level or growth target (eg the NGDP target is essentially a price level target with some flexibility – while flexible inflation targeting is very close to a NGDP growth targeting type rule), there appears to be calls here that we should throw these things away here.

We have discussed how these rules are useful a number of times in the past, especially important we always say is the ability these targets have for “anchoring expectations”.  After all, if we can anchor expectations of inflation then:

  1. We can largely avoid relative price distortions from unexpected inflation
  2. We increase certainty about the return on investment (by getting rid of purely nominal shifts for contracts without inflation adjustment)
  3. We have the ability to strongly respond in the face of a crisis – as inflation expectations are anchored, firms are monopolistically competitive, and some prices are sticky we can use monetary policy to help boost underlying demand in a demand constrained economy.
  4. As a result, fiscal policy only has to focus on the supply side of the economy and redistribution (unless we run into the zero lower bound, and the central bank isn’t allowed to print or buy assets to meet its targets).

However, for some reason this isn’t enough for people.  So lets look at the idea of expectation in a more public choice sense.

Governments don’t like us to know we are being taxed to pay for the treats we get given, some democratically elected officials are tempted to “monetize debt” in order to pay for it – its a silent tax!  To solve this, we give a central bank independence.  Ok, but the independence only exists in so far as the central bank is following a rule provided by government.  So we want contracts that help solve any possible “time-inconsistency problem”.  This is all fine and good.

So what should this contract be like?  Ultimately, the implicit tax appears whenever inflation is higher than expected – so when the central bank pumps in more juice than is consistent with the price setting behaviour of firms and households.  At first firms and households will be unsure if the extra currency is additional demand for their product/service, or for all products/services, so they will lift output/work … but once they see costs rise and once they see inflation itself is higher, they will respond by lifting inflation expectations.

This tells us that any extra output from breaking an inflation target, is only temporary, but the increase in inflation expectations will be permanent.  Again, this is one of our typical justifications … where does monetization come in?

Well the higher inflation also appears when we think about government bonds.  In money markets people ask for a nominal rate of return, based on expectations of inflation.  By increasing inflation past this level, we lower the real debt burden faced by government – they get a windfall, and the people paying for it are the people who lean’t to them.  However, this windfall is only temporary and ends up with higher nominal interest rates and higher inflation expectations (and realized inflation).

Government could commit to not doing this in two ways:  1)  Only sell inflation adjusted bonds,  2)  Have a central bank with an inflation target.

Here a credible inflation target also amounts to a commitment by government to not tax its citizens by stealth.

Inflation/price level/NGDP targeting (where we are targeting forecasts of the future) offers a clear and consistent way of dealing with the fact that we have a monopoly supplier of currency in a public choice sense, and it allows central bankers to manage the “demand side” of the economy IF we have appropriate information and an understanding of what is going on.  Getting a central bank to target “other things” outside of how they impact upon the forecast of inflation/price level/NGDP doesn’t make any sense.  [Note:  People weirdly seem to think that the Bank completely ignores them – this is completely wrong.  They focus on them as issues with regard to monetary policy, and all that information is captured in their inflation forecast]

If we think the “exchange rate is too high” ask why.  We might say the current account deficit has been high for a long time, but then why.  Well its high because the real exchange rate is high, and real interest rates are high – this tells us that domestic savings are too low … this has nothing to do with the inflation target of a central bank (as they do not control the long-term real interest or exchange rates) and everything to do with competition and fiscal policy in the domestic economy.  It is part of the “cost” of the policies that we have put in place as a society – so we should accept that there is a trade-off there, instead of destroying the RBNZ’s ability to do its job – as we have mentioned before.  Scott Sumner discusses this issue more here – and I think it is a fundamental confusion between the two that is creating so much noise in NZ at present.

 

jamesz

Anomalies and market efficiency

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Tim Harford points to a paper on the EMH showing that:

…after an anomaly has been published, it quickly shrinks – although it does not disappear.

The anomalies are most likely to persist when they apply to small, illiquid markets – as one might expect, because there it is harder to profit from the anomaly.

It’s always good to remind ourselves that all anomalies are only fully priced in equilibrium, and we’re probably never in equilibrium. The process of moving towards equilibrium involves market participants seeking out those anomalies and exploiting them. So the continued discovery of new market anomalies isn’t evidence against market efficiency: it’s merely observation of the normal equilibrating process.

Matt Nolan

More on describing the crisis

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Rates blog posted another article by me, this time talking about why the GFC persisted.  So in the first one I laid down Fed actions as the catalyst, and in the second one I’ve primarily laid the blame on institutional confusion in Europe.  I’m not sure anyone will find this article, by itself, particularly enlightening.  These first two are both simply descriptive (although with a background structure guiding what I talk about), and their only purpose is to illustrate that the “crisis” itself was kicked off by a sudden change in the expected actions of policy makers, and uncertainty about that action.  This isn’t to say that even with perfect policy we wouldn’t have had a recession – but it is to say that the depth and length of the slowdown that has occurred is related to such policy inconsistency.

So if we live in a world where we have decided that a lender of last resort is required in the case of such a crisis, what does that mean for the rest of the time.  After all such a commitment leads to moral hazard.  I’ll be covering that next week in the conclusion article.

The reason I’ve tied these three articles together as I have is because I wanted to create a clear narrative, and then work out what that suggests from policy – that requires answering a bunch of stylised facts (the timing in the crisis, the length of the crisis) with a central story.  The world is not that simple, and so every movement and every “bad thing” that occurred cannot be explained by such a clear narrative.  But it does allow us to help identify an issue and then understand what this means.

Matt Nolan

Where the moral hazard comes from

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I have a sneaking suspicion that the term moral hazard is getting a bit abused at the moment.  Let’s use the Wikipedia definition:

A moral hazard is a situation where a party will have a tendency to take risks because the costs that could incur will not be felt by the party taking the risk

Cool, and in the case of the bank bailouts that have occurred around the world, who were the people who knew that the cost of their “risky behaviour” would fall on someone else … bondholders.  This is from Garett Jones:

So by their estimate over 90% of the benefit to banks’ balance sheets went to bondholders …

If most political battles need a villain to succeed, it’s easy to see why bondholders have largely escaped the wrath of voters: Bondholders make poor villains.  The bank promised to repay, and now the bank can’t.  The bondholder wasn’t out there making the loans; the bondholder didn’t vote for the directors who led the company to the brink of destruction; the bondholder just handed some cash to the bank and hoped for the best.

Bondholders have had good luck getting government guarantees, and I suspect their luck will continue.  That means rational investors will dump more cash into the megabanks with minimal scrutiny: The megabanks are the new Fannie and Freddie.
The fact is, if we wanted to “get rid of moral hazard” we’d have to accept the inherent riskiness of our lending – we don’t get paid an interest rate for kicks, it covers inflation and a rate of return stemming from lending that has some inherent risk.
The reason economists have generally shown no sympathy for people when the finance companies collapsed here isn’t because we are heartless, it is because people wanted to act as if their lending was riskless.
Remember, if you are complaining about “moral hazard” you are attacking bondholders – not so much the banks (who are easy to demonise because they wear suits), but the people who leant money without considering risk and those who advised them.
jamesz

The economist and the politician

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There has been a small kerfuffle over the appearance of Jonathan Portes, Director of NIESR, at the Treasury Select Committee. Portes was there to discuss NIESR’s latest economic forecasts and encountered unexpectedly aggressive questioning about his political beliefs from one of the Members. Jesse Norman claimed Portes’ statement that the Government’s austerity plans had ‘failed’ relied upon his personal politics. Portes responded that, while his opinions might be politically relevant, they were purely positive economics.

Norman has now clarified on his blog (HT) that he is specifically saying that reaching a conclusion about a policy’s ‘failure’ requires a normative judgment. Regular readers of TVHE will know that we entirely support Mr Norman’s view that policy judgements require normative statements. Given that a normative statement doesn’t have a right or wrong answer, it must at least be influenced by the same set of personal beliefs as a political view. Hence, it may be that knowing somebody’s personal, political view is helpful for interpreting some of their policy judgements. However, there is a spectrum of normative judgements from those that would be agreed with by only people who share one’s specific political views to those that would be agreeable to experts of all political stripes.

In this case it is clear that Portes statement about ‘failure’ referred to two things: the results of a NIESR modelling exercise, and a belief that the UK’s current economic predicament is due to a demand shortage. His conclusions about each require value judgements, but not the sort that would usually generate a political division among serious macroeconomists—which isn’t to say they’re not divided! Norman, despite his protestations, was not seeking to engage in a discussion about whether the specific value judgements were likely to be politically motivated. Rather, he sought to discredit Portes view of gilt rates by casting aspersions upon his independence.

It is episodes such as these that discourage experts from contributing to the policy debate, even when they have much to contribute. That is a great shame. As Antonio Fatas says

…some of what we do as academics is not useful enough for policy makers, and in these circumstances is better to be honest and stay out of the debate. But …one can find answers to those questions after careful thinking and a lot of data analysis.
…
policy makers need to choose a number, not a range. [Academics] can be criticized on their assumptions or calculations but not on their willingness to advance the knowledge on an issue of great policy relevance. If any, they should be praised as academics who want to go beyond writing great papers to make those papers useful for policy makers or society at large.

Matt Nolan

Prisoner’s dilemma game justification for state housing

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I’ve been thinking about potential justifications for building a stock of state housing when we have no issues of credit constraints.

Say we have a bunch of people walking around wanting to buy two goods – housing services and non-housing goods and services.  People will, on average, allocate their spending such that the marginal benefit of an extra unit of housing services is equal to the marginal benefit of non-housing services.  This will lead to the appropriate level of housing services being provided, and it is all gravy.

But then say that the benefit of a housing service is actually a function of the quality of the housing service other people are receiving.  So if your neighbour/co-worker builds a big sexy house, you feel you need a bigger house to keep up.  The “marginal benefit” from housing services is higher, so you swap some non-housing goods and services for housing services (building a bigger house) – however, the marginal benefit is only higher because the other persons bigger house imposed a cost on you (making you feel inferior, or reduced the quality of the signal your house was providing regarding how well off you are).  As a result, house sizes are an arms race.

This view of consumption stems from back with people like Veblen, has been written about widely (and are used in modern macro-models), and in recent times has been reiterated by Rogoff and Shiller when discussing issues such as the “housing bubble” in the US.  A common term for this is of course “keeping up with the Joneses”.  An economics term for these sorts of goods is positional goods.

In so far as we see growing house size, and increasing borrowing to fund it, as a type of arms race based on this “positional good” logic we could well end up in a situation where we have “too few” houses that are “too big”.  We cannot rule out that this is in fact a contributor to high house prices and the limited stock of housing in Auckland, in addition to the zoning laws and high cost of subdividing.

Now when looking at this in terms of policy we can say this is really a standard prisoner’s dilemma.  Private value is only being created due to the larger housing being “relative better than” the current  – not because the house itself is bigger.  In that case, each individual sees building a bigger house as a dominant strategy – as if the other people don’t, they feel superior, if the other people involved do they don’t feel inferior.  As a result, everyone builds big houses, even though everyone would be better off with smaller houses and higher non-housing consumption (note this additional point).

Here, state houses may be a mechanism for trying to deal with that – by building a series of similar, smaller, houses at a lower cost.

This is the kicker though – to some people this argument sounds compelling.  To others it sounds horrible, as they genuinely get direct value from a larger house, and the fact that different houses on the street look different.  To buy the PD argument we have to make the case that:

  1. Much of the increase in house size and the variation between houses is due solely to “trying to out do other people”, and not due to actually valuing the additional housing services.
  2. That there are significant enough transaction costs within a community that prevent household near each other “negotiating” about this externality.
  3. That the “externality” itself is large enough to warrant attention.

And even with all that it is not necessarily policy relevant – as if people simply decide to overconsume housing, and lower their own welfare significantly, then we should really be asking why there isn’t more inter-community co-operation rather than arbitrarily throwing money at them.

A more compelling version of this argument would rely on the ideas Robert Frank – where the bidding up of house prices and size is occuring among those who are well off, and is having a negative impact on those with low incomes by also increasing the cost of their housing services!  This is the very issue that everyone is concerned about.  And yet, the data suggests that spending on housing service among the lowest declines relative to income has been declining and relative to incomes those in the lowest declines are spending about the same proportion of their consumer spending on housing …

There are no doubt some things going on in the housing market – but I’m not sure we can use the idea of positional goods to justify building a series of homogenous state houses in of itself.