Matt Nolan

Trade-offs run both ways

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I see that discussions with financial market officials has seen the government come out and say that it is going to look at doing something about the interest rate premium in NZ.

Immediately you would expect me to nod and agree.  I’ve been talking about (*,*,*) a “high” real exchange rate, “high” interest rates, and low “competitiveness” stemming from these same and similar issues (although the margin and the level of rates are indicative of different issues … let’s leave that to the side) – and this is true.  But I’m not going to nod in agreement – at first brush this looks like another intermediate target, rather than a clear articulation of they “why” regarding interest rate margins and interest rate levels more generally.

Trade-offs run BOTH ways, we may have instituted policies on the basis that the cost of lower competitiveness etal is worth it for the benefit of greater “equity” in outcomes.  In the same way that I’m begging people who yell at the exchange rate to think of the issues – I beg the people listening to financial analysts who are talking about ways to “lower the cost of capital” to think of it in terms of the full implications for social outcomes.  A while back you would have heard me talking this way on productivity (*,*,*), and my severe mistrust of capital deepening (something that puts me on the fringe of many economists here tbh – and just to make sure that is clear).

Government is the body that society uses to help determine, and implement, the trade-offs that exist due to the inherent trade-off between some perception of equity and strict efficiency.  Let us keep these fundamentals in mind instead of targeting a price, or productivity, or some other “inbetween” function that obfuscates the trade-offs inherent in a decision!  Figure out the trade-offs that exist and getting society to express its desires (both hard tasks) is the way to go, and this sort of sidetracking through “targeting intermediate outputs” in an economy gets in the way of this.

My clearest post on this idea was when I discussed the recent writings by Mai Chen – full respect to her for putting out thoughtful articles on the issue, which is what allowed me to better articulate my problem with ALL those sorts of “aspirational” policy justifications (such as the ones I’ve previously criticised from the Greens – look, I’ve pretty much attacked every point on the political spectrum here 🙂 ).

Note:  This is a point where people will say “this is obvious” and roll their eyes and me – and then wink and say its just Matt ranting again (which is true).  But as well as being obvious it is fundamental – and given it is so fundamental to policy analysis I have to ask why reporting and suggestions of policy continually forgotten about it!

Hmm:  I wrote about remember equity and efficiency issues – in terms of economists recognising the importance of value judgments in 2008.  James was also talking about those issues then.  It is nice to see young “you” agreeing with old “you” on things!

Matt Nolan

The exchange rate as a price

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Over on Rates Blog I’ve knocked up an entry on exchange rates.  In it, I spend a bunch of time just talking about “what an exchange rate is” – all with the aim of turning around and saying that given it is a price, we need to understand what it is telling us and why before we can go off and demand changes.

Effectively, the exchange rate is a symptom of things going on in the real economy – and policy needs to be focused on where these fundamentals may be hit by market and goverment failures, instead of a blanket criticism of the price.  I’d also note that there is a “barrier” to intervention in all this – we do need to actually have a fundamental understand of the issues before we put policy in place.  The persistently high real exchange rate is an issue that has caused some concern (*,*,*) – but “solving” any perceived problem here does not lead us to the conclusion of arbitrarily loosening monetary policy!

Note:  I suspect the comment section over there will look a bit like this – and so will hold off from reading till the weekend.

Update:  Scott Sumner covers similar ground by railing against “imbalances” as a concept – stop concentrating on the price, and start thinking about why the price has shifted.  Lars Christensen reiterates this before both of us.  In some sense, the Lucas Critique stemmed from this very idea.  I genuinely don’t understand why simply saying “let us think of why the price changed, and what the trade-offs are from this fundamental shift (and any policy to change it)” makes people so incredibly angry – but it does!  I have no social skills, and have a passion for discussing trade-offs, so I will never stop making this point – no matter how many nights in bars I have to put up with people yelling at me while I’m drinking my beer 😉

Matt Nolan

Two links that reinforce my priors

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On bubbles (My point:  I keep hearing bubbles matter because “financial stability influences monetary policy” like it is a big idea … but really, no sh*t.  Government spending “influences” monetary policy.  So does competition policy.  They all change the time profile of the natural interest rate.  The fact is that we have monetary policy to manage monetary outcomes given these things – have other sets of government policy for other areas of government concern, and just try to base them in sound economics.)

On the minimum wage and long-run effects (My point:  Good to see actual work on given so many empirical estimates are for short-run effects – and even those show pain to the young and unskilled even if the aggregate figure isn’t statistically significant – reminds me of McCloskey).

In a time and a place where I have both time and a place to do so – I will post on these.  Hopefully.

Matt Nolan

New Zealand’s sexiest economist for 2013 is …

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As we all know there are few things sexier than economics.  And it seems this applies to New Zealand economists as well with a massive 407 votes cast in the “New Zealand’s sexiest economist poll”.  This was especially impressive as voting was via IP address, meaning that many large organisation could only cast one vote.  This turnout heavily exceeded my initial estimate of 6 votes – implying that not only did my vote model fail to pick the Global Financial Crisis, or the value of the New Zealand, it also failed to actually estimate the number of votes the poll would receive.

After frantic voting the champion was … Darren Gibbs with 97 votes (24%)

Darren Gibbs – Deutsche Bank

Darren Gibbs – Deutsche Bank

This was an impressive performance, and no doubt shows the depth of appreciation for both Darren’s looks and his application of economic ideas and concepts.

In second place was Donna Purdue with 91 votes (21%).  She receive wide ranging support from the economist and non-economist community, and was constantly threatening for first place.

Eric Crampton (3rd place) and Gareth Kiernan (5th place) made an early run during the first day of voting, however both fell off the pace as the voting went on.  Shamubeel Eaqub lived up to his reputation as a dark horse, pulling in a number of votes on the final day to take out 4th spot!

Shamubeel and Jean-Pierre de Raad may feel aggrieved, as by putting down two members of NZIER I was splitting the NZIER vote (BNZ has a similar claim) – however, I would note that the combined NZIER vote still would have had them significantly off the pace set by Darren and Donna.

All in all, congrats to Darren, it was good to see that everyone received some votes, and economics was the winner on the day.

 

Matt Nolan

Ex-ante concerns about moral hazard

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Fascinating post by Stephen Williams, who is a great monetary economist.  In it, he goes through speeches at the Federal Reserve from September 2007 – a few months into the burgeoning credit crisis.  In it he shows that there was a debate between the views of “inherent instability” and “induced fragility” for what was going on – this sort of trade-off was captured in the Sargent paper (at least in part) that we’ve mentioned before.

Now when I’ve described the crisis to people I’ve stuck to the inherent instability line, the trilogy of articles (*,*,*) I did on Rates Blog was supposed to give that impression to people – with the third article pointing out that moral hazard exists as a more long-term point.  According to this, the Fed and then the ECB didn’t do enough to stop a bank run due to “too much” weight on moral hazard – and this drove a deep crisis.

However, the induced fragility hypothesis is also compelling (note they could both have happened – but where you put the weight determines what policy lessons you learn).  According to this, it wasn’t until the policy actions of late 2007 and then the bail out of Bear Sterns then the moral hazard became compelling.  However, once financial institutions saw they would be bailed out, they immediately took on lots of risk – making the system a lot more fragile when the Fed finally decided not to bail out Lehman Brothers.

There is evidence for this, Lehman Brothers took on a lot of debt – highly risky debt – following the collapse of Bear Sterns.  I remember reading the paper that had this, a paper that actually said it was the bailout of Bear Sterns that made the crisis worse, but I have forgotten where it is … I’ll link when I find it.

If the spectre of moral hazard fed into the fragility of the finanical system that quickly, the justification for bailouts becomes a lot weaker – if we accept significant inherent instability in the financial sector, then regulation with a lender of last resort becomes more acceptable.  Evidence helping to determine what weights to put on these explanations will be very useful for designing regulation (or the lack of) in the post-GFC world.

Induced fragility as a medium term concept is a central part of how most economists see this crisis.  However, it is an open question about whether the bailout of Bear Sterns (and the earlier TAF) created “induced fragility” that made the collapse much worse.  More research on this issue will be pretty interesting, and will help to inform what sort of trade-off we are facing with policy.

Matt Nolan

Remember the dollar is a price – work from there

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Via James I see that the Financial Times has given a strange write-up of the RBNZ speech from yesterday (my view here).

The focus of the FT article is solely on the dollar, which in itself is cool as most of the speech was indeed on the dollar.  But they interpreted the comments a bit differently than I did.

First the exchange rate overvaluation relative to the terms of trade and productivity – yes, this has been the Bank’s view for a long long long time.  Of course this begs the question why, which I think is covered relatively briefly … and this is likely why we end up with differing interpretations.

So they go through ways that policy actions of a central bank may influence the exchange rate.  For some reason the FT means that they are planning to use a bunch of exciting tools to reach some sort of right value.  But lets start with this quote from the RBNZ:

Expectations of what central banks can deliver by way of exchange rates and output and unemployment remain excessively high. This is particularly the case in small open economies.

They are spending the speech discussing the tools they have at their disposal, how little they wil able to achieve with them, and how impractical many of the tools would be.  Again, if we actually though about what a real exchange rate is, and the fact that the RBNZ is talking about it being PERSISTENTLY overvalued in their speech, what matters is the fact that the high real exchange rate is a signal of underlying things in the real economy.  It tis a price, and like all prices it is telling us about fundamentals in the market – which are the actual things we are interested in!

This becomes pretty clear if we reiterate the part of the conclusion that the FT didn’t bold:

But further efforts to improve the level and productivity of capital that labour works with, to reinforce ongoing fiscal adjustment, to re-examine the factors that diminish and distort the incentives to save and invest, and to reduce dependence on the savings of others, have to be a major part of the solution.

FT seems to think the RBNZ is saying:

There are no simple solutions, Wheeler said, but it seems the favoured approach is some combination of lowering cash rates and offsetting the domestic effects via some sort of macroprudential policy

Reading earlier in the RBNZ’s speech they are saying that the OCR doesn’t have a clear impact on the dollar, and they adjust that to meet their inflation target (so not to target the exchange rate independently of it’s impact on inflation), and with regards to macroprudential policy they say:

The New Zealand economy currently faces an overvalued exchange rate and overheating house prices in parts of the country, especially Auckland. The Reserve Bank will be consulting with the financial sector next month on macro-prudential instruments. These instruments are designed to make the financial system more resilient and to reduce systemic risk by constraining excesses in the financial cycle. They can help to reduce volatile credit cycles and asset bubbles, including overheating housing markets, and support the stance of monetary policy, which could be helpful in alleviating pressure on the exchange rate at the margin.

So they are saying they will use macroprudential tools for financial stability reasons – and on the margin this might lower the real exchange rate as well.

They are so far from saying that they will use the OCR and macroprudential tools to “target the dollar” that it hurts me to see this inference turn up.

Also it is interesting to see the FT feel that macroprudential tools in NZ are very unclear:

What does he mean by using macroprudential instruments? Capital controls? Raising reserve rates to offset the effect of cutting interest rates? Those are a couple of ideas we’ve heard floated around but no-one seems very confident of how to interpret that.

When Grant Spencer from the RBNZ has actually come out and stated what they are and what their purpose is – maximum LVR’s and risk-weighting adjustments in capital adequacy ratios to deal with issues of systemic risk.  Anyone who has spent anytime looking at the RBNZ would know exactly how to interpret that 😉

Tbf, the RBNZ does explicitly mention the dollar not being a “one-way bet” – and this may be because they are concerned there could be a “bubble” in the value of the NZ dollar.  This comes in here:

The Reserve Bank is prepared to intervene to influence the Kiwi. But given the strength of recent capital flows, we can only attempt to smooth the peaks of the USD/NZD exchange rate; we cannot determine the level. When the NZ dollar is coming under upward pressure, we want investors to know that the Kiwi is not a one way bet.

This jawboning is cool, but I fear the FT is reading too much into these comments.  The speech was as much about educating us New Zealanders about the limited ability of the Reserve Bank to influence economic variables as it was about talking traders out of a perceived “asset price bubble in the NZD”.