Overhyping nothing: The NZ context for the UK FSA speech

Via Bernard Hickey I saw this speech by Adair Turner about monetary policy in the UK.

Let us give it some context – the UK has had their cash rate at virtually zero for some time, and many analysts over there have been screaming hyperinflation and showing that they do not understand the purpose of credibility, independence, and expectations management for a central bank in the slightest.  With these concerns in mind, Turner has come out to try and open up debate a little more, and make it a bit more intelligent.

This is good.  However, I think that Bernard Hickey is misinterpreting these points when he comes back to looking at NZ.  However, as I agree with him that we should discuss these issues I am going to briefly point out here how I can:

  1. Agree with Adair Turner
  2. Disagree with the inferences Bernard Hickey seems to be aiming at.

Let’s go.

1)  So we start with a point that you’d be suprised to hear that no-one in the economics profession would disagree with:

And still only slowly gaining better understanding of the factors which got us there and which constrain our recovery. We must think fundamentally about what went wrong and be adequately radical in the redesign of financial regulation and of macro-prudential policy to ensure that it doesn’t happen again. But we must also think creatively about the combination of macroeconomic (monetary and fiscal) and macro-prudential policies needed to navigate against the deflationary headwinds created by post-crisis deleveraging.

This was an accepted point as soon as the crisis occured.  There was something descriptively missing from our understanding of what was going on – and that appears to have been the large unregulated shadow banking system, which thought it had an implicit backstop, but didn’t.  Given that, central banks didn’t understand the scale of the crisis before it was too late – they didn’t respond sufficiently – and in the ECB’s case they took years to respond appropriately.  There are lessons here for policy makers – but let’s not get too far ahead of ourselves.

2, 3, 4)  Next Hickey comes to the following “2. And then he thinks the unthinkable and says the unsayable.” – where he is talking about helicopter drops (printing money, giving it to people).

Pro-tip, this is far from unthinkable.  It is taught in university.  It is even taught at undergraduate level.  Bernanke, the current Fed govenor, was called “helicopter Ben” for a reason – he was one of the guys that pushed the idea that if we even face a crisis like the Great Depression, where the “natural” interest rate is very negative (so that savings and borrowing are only balanced at a negative rate) we can deal with this by printing dem dollars and dropping them from a helicopter.

Now there was a problem here – this is essentially a form of fiscal policy as well as monetary policy.  As a result, you need a democratic mandate (or permission) to do it.  Central banks didn’t have that – and as a result even if they wanted to do it there were problems.  This is an area where policy needed to be tied down in practical terms prior to the crisis.

Let us bring it back to New Zealand.  Were we ever at a case where the “natural” interest rate was negative?  No.  In that environment, if we have the OCR at the right level and THEN we print a bunch of money and throw it around it IS inflationary.   This is why I was saying QE doesn’t make sense here, let alone direct monetization!

5, 6, 7)  Friedman says abolish fractional reserve banking

Ok ok ok ok ok – Friedman 1948-1960 was very different from later on.  Yes, originally many economists were against fractional reserve banking, as it seems intuitive to be against it. Having the funds on hand to pay back the depositers just seems natural.  Remember, Friedman suggested many things, and as data improved and his experiences widened he updated these views – he was a master economist, his mind was open and sharp.

The thing is that it misses the investment side of things.  Financial institutions are an intermediary, savings and investment are always equal (with any gap captured by the capital/current account), and that demand for investment is in a large part based on an expected rate of return.  By allowing banks to lend out to meet loans, this process gave regulated agents in the economy the ability to screen and provide this intermediary service.  Remember, banks still set assets equal to liabilities – the big thing that differs between assets and liabilities is their time profile!

There are concerns around whether expected returns on investment are adequetely screened, or that there is some systemic risk, or “black swan” events – and that these require a central bank or central government to offer implicit insurance.  However, goes a step further and has the central bank directly set the money supply – given that this supply is set exogenously at a point in time, and shifts in investment demand would lead to swings in the price level and interest rates.

Turner goes on to point out the real argument he is making here – there may be a reason why the socially desirable reserve ratio differs from the one banks independently come to.  Full reserve banking sets the RR at 100%, banks will set it at a lower level, what level allows market participants to have an efficient time meeting funding for investment and desire for invest while also dealing with any perceived “collateral damage” in the case of crisis?  This is an old and widely accepted point among economists, and something that there has been a lot of work on especially over the last decade (so prior to the crisis!).

8)  Need to reconsider inflation targetin

This one is easy – he is saying that “strict inflation targeting” doesn’t seem to make sense.  Conveniently the only central bank that tried to follow this is the ECB, not NZ.

Blanchards higher inflation target, current Fed policy, Woodford, and Mark Carney‘s discussion on NGDP are ALL consistent with flexible inflation targeting.  In fact, the last three have made a point of saying flexible inflation targeting is THE BEST framework out there – and that we can use the gains from it to switch to level targeting if we are at the ZERO LOWER BOUND.  Again, NZ isn’t at the zero lower bound, and already does flexible inflation targeting!

9, 10)  Monetary policy isn’t necessarily hyperinflationary

This is targeting squarely at the UK media and analysts – who are talking a lot of nonsence at the moment.  In New Zealand, the central bank knows this, and from what I can tell most analysts do as well.

Finishing remark

As I’ve said before, the policy debate in NZ is going in a strange direction.  Compared to a lot of countries our monetary policy is very good – and the debate we are having needs to be reframed to look at the real issues that are hitting New Zealand.  Why is the real exchange rate and real interest rates persistently so high?  Why is our current account deficit persistently so large?  These are not issues about monetary policy – they involve taking a harder look at government, competition policy, and institutions in New Zealand … as well as more carefully looking at NZ data (after all, our debt profile is a different one!).

  • Bernard Hickey

    Hi Matt. Many thanks. Appreciate the time and response.
    Couple of points. You’re right that economists and some of the ‘grownups’ in central banking have been talking about monetising debt. But it is still a very touchy subject, even there. For the head of the banking regulator to openly talk about it in detail is quite something.

    In the New Zealand context this topic is still verboten in polite circles. The Reserve Bank won’t have a bar of the debate. The new Governor has been dismissive. The government is treating the topic as a joke.
    Academic economists may well be thinking about this, but the public and the polity are not.

    Your point about banks just being intermediaries misses the importance of leverage and the role of credit in asset bubbles. This has been the key mistake of the dominant strand of economic thinking, I reckon.
    You say we have flexible inflation targeting. It is more flexible than the hard 1-3% or else, but it still is a single target and it ignores unemployment and the currency.
    You say monetary policy in New Zealand has been very good. It may well have hit the targets it was designed to, but the overall economic strategy (of which monetary policy is a major part and not operating in isolation) has failed.
    Our debt has broadly doubled, our productivity growth is weak and real per capita GDP has been stagnant since 2003.
    I think it’s strange to believe we can reform our economic policy without reforming the Reserve Bank Act.
    cheers
    Bernard

    • http://tvhe.co.nz/ Matt Nolan

      Hi Bernard,

      In NZ I think authorities don’t see too much of a need to discuss it as it is irrelevant here – if they had to cut rates towards zero I would hope that they come out and discuss policies they are going to use.

      Monetization is an oft abused term as well – if you are at a ZLB and you are aiming to increase your inflation you are “reducing the real value of debt”, but at the same time as long as that is consistent with your inflation mandate you aren’t really monetizing debt in terms of transfering wealth from savers to the government.

      I’ve noted this before:

      http://www.tvhe.co.nz/2012/11/29/a-different-view-of-an-inflationprice-level-target-no-monetization-commitment/

      Everything has to be looked at relative to the target.

      “Your point about banks just being intermediaries misses the importance
      of leverage and the role of credit in asset bubbles. This has been the
      key mistake of the dominant strand of economic thinking, I reckon.”

      I’ve heard this a number of times, but I have to admit it makes no sense to me. How does the fact that banks are descriptively an intermediary make them independent of leverage and asset price bubbles?

      They are factually an intermediary. As a result, the money supply is determined “endogenously” depending largely on investment demand in the economy – with banks facilitating that. Banks attitude to risk given there is a lender of last resort leads them to, as the intermediary, set reserves too low and lend too much – if this is the case, we have a justification for regulatory involvement.

      IMO, the bit economic thinking forgot was that banks were backed by a lender of last resort – and the disciplines willingness to deal with the issue of “systemic weakness” as an externality represents this!

      “You say we have flexible inflation targeting. It is more flexible than
      the hard 1-3% or else, but it still is a single target and it ignores
      unemployment and the currency.”

      This point also makes no sense to me. How is inflation independent of unemployment and other aspects of monetary policy (asset prices, the dollar). No economist thinks this way. For example:

      http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/02/a-monetary-policy-target-can-only-be-defeated-by-a-better-monetary-policy-target.html

      The inflation target is a way of stating that non-monetization commitment – making it “flexible” is a way of saying that in case case of a shock to demand the central bank will ease monetary conditions. Future inflation outcomes in this sense represent changes in demand – as if the “output gap” is negative inflation will fall below target etc etc.

      A higher currency, all other things equal, signals tighter monetary policy. Lower asset prices, all other things equal, signal tighter monetary policy.

      As I’ve said before “signals” of what is going on are being treated as the problem – the persistently high currency is a signal of an underlying issue, not the cause.

      “You say monetary policy in New Zealand has been very good. It may well
      have hit the targets it was designed to, but the overall economic
      strategy (of which monetary policy is a major part and not operating in
      isolation) has failed.”

      Monetary policy has nothing to do with “broad economic strategy”. It is about easing cyclical fluctuations and guaranteeing the value of a fiat currency.

      The RBNZ is NOT a democratically elected body, there is no way I would accept the central bank doing more than this. As you say, other policy setting cause issues – and these other policy settings are set by other government agencies who are not independent of government, and so have democratic legitimacy to do something.

      “Our debt has broadly doubled, our productivity growth is weak and real per capita GDP has been stagnant since 2003.”

      We haven’t been saving enough, and with a collapse in global demand we have suffered a massive “supply shock”. NZ policy makers have been talking about the first issue for ever – but instead of actually trying to do things, such as making the taxation treatment of different forms of capital equal, we’ve constantly “blamed something else” … such as the Reserve Bank.

      “I think it’s strange to believe we can reform our economic policy without reforming the Reserve Bank Act.”

      I think it’s strange there are so many calls inside NZ to “reform the RBNZ” – when the rest of the world is moving towards our model of flexible inflation targeting, or very similar rule based policies.

      As always though, cheers for the comments – I discussing this all very useful!

      • Apirana

        The BoE is not about to move away from inflation targetting any time soon; and to do so would send out a disasterous message. Those who sit on the MPC naturally recognise this (and as such it was confirmed by Martin Weale this week).

        • http://tvhe.co.nz/ Matt Nolan

          And there is no reason to move away from inflation targeting. However, clearing up what it really is, and actually measuring inflation in the UK, instead of growth in the CPI, would be two ways to improve matters ;)

          • Apirana

            Agreed, The manipulation of inflation reporting under Brown, the ignoring of asset price inflation etc need to be considered.

            • http://tvhe.co.nz/ Matt Nolan

              I’m not sure about the specifics in the UK – but one thing I noticed was that they don’t measure inflation over there (the comovement in prices). CPI growth is a proxy, but communication would benefit with a real measure.

              What asset price changes mean needs to be communicated better. But how this is incorporated to policy is a pretty large issue – there is no silver bullet, and the idea of macroprudential regulation is seen as part of the way forward.

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  • boristhefrog

    Yeah… I’d more inclined to back the trained economist over a ‘journalist’ every day of the week… Matt has to make a living doing this stuff whereas Bernard’s only ‘job’ is to drive page views to turn a buck. Based on the relative incentives… I’m backing the economist on this issue.

    Bernard may be a good journalist (opinions vary) but he is bloody awful at economics and he should realise this.

    • http://tvhe.co.nz/ Matt Nolan

      Tbh, I appreciate people expressing their views publically – although there are points I disagree with Bernard on, the fact he is discussing them gives me an opportunity to talk about why I disagree. This hopefully has some value.

      • boristhefrog

        Understood… but the problem is that you are debating with an idiot….

        • http://tvhe.co.nz/ Matt Nolan

          No no no, he is a smart guy that is discussing and agreeing on the same issue as a lot of other smart people – in this case I disagree and I feel that there is a sufficiently good economic argument for that, but these discussions have to be had :)

    • Apirana

      “I’d more inclined to back the trained economist over a ‘journalist’ every day of the week..”
      Mmmm Paul Krugman? In is current activities is he engaging in the disinterested pursuit of knowledge? I don’t think so. What makes you think that academic economists are not as open to bias as anyone? They don’t function in a vacuum. Think the lesson is to form you own opinions and place reliance neither on journalists or economists.

      “The whole of economics can be reduced to a single lesson, and that lesson can be reduced to a single sentence. The art of economics consists in looking not merely at the immediate but the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups”
      Henry Hazlitt in Economics in One Lesson

      • http://tvhe.co.nz/ Matt Nolan

        “Think the lesson is to form you own opinions and place reliance neither on journalists or economists.”

        Very true. However, no-one has the capacity to get full information on anything – the question is who are you more willing to rely on in order to update your beliefs. People like Paul Krugman, when they aren’t just pushing for their party, are creating some pretty danged good information for the public.

        • Apirana

          Krugman in terms of opinion forming has made some contribution but his ego and self regard is astounding. I respect his intellect but have little time for his economics and some of the things he has said in last few years have been absolute nonsense.. Jeremy Warner in the Telegraph (who is an excellent journo) wrote an amusing column on his visit to the UK last year.

          • http://tvhe.co.nz/ Matt Nolan

            I think his reliance on ad hominem attacks has made it seem as if his economics isn’t as strong – but it really is. It is such a pity that economics and politics get so intertwined in the US and UK, they are supposed to be different hats!

            • Apirana

              Yes clearly his work on trade theory must have been tops (not that I’ve read any of his work in this field). What is the role of economists? Clearly not to be the guiding hand of the macroeconomy. The IEA issued an interesting paper on this subject some years back. I will try to find a link. Are you related to Patrick Nolan at Reform? Reform do some very good work.

              • http://tvhe.co.nz/ Matt Nolan

                His work on trade theory was great, and also he had some awesome stuff on the Japanese crisis.

                Economists definitely aren’t the guiding hand! They are a bunch of guys and girls who are trying to describe trade-offs, and make sure people realise there is no free lunch. We are sort of like the grinch that stole Christmas.

                Indeed I’m Patrick’s baby brother – I’ll be sure to pass on the comment!

                • Apirana

                  I replied but seems to have been lost in the ether. I think I share common work place in NZ with Patrick although I predate by many by years. I sent you link to monograph on role of economists but will dig outs again. i go to the odd Reform event but as mainly held in work hours little more difficult than many.

                • Apirana

                  A Plea to Economists Who Favour Liberty: Assist the Everyman ed
                  by David Klein on the IEA website.

                  “Should economists remain as detached scholars, pursuing their research to the satisfaction of themselves and fellow academics? Or should they try to educate their fellow men and women in economic ideas, hoping to have an impact on economic policy?”

                • http://tvhe.co.nz/ Matt Nolan

                  Economists, like all people, follow the incentives in front of them. I like the idea of communicating with the public – but the choice of whether to and how to communicate is one for the individual economist.

                • Apirana

                  Have a look at the monograph. It’s an interesting read (although some years since I read it)

                • http://tvhe.co.nz/ Matt Nolan

                  Our site likes to eat things – it is nothing personal, your words must have just tasted good.

  • Blair

    One way of squaring the circle between these two points of view (by which I mean internally generated vs externally imposed imbalances) is laid out in Prof Michael Pettis’ new book, reviewed by Diane Coyle here: http://www.enlightenmenteconomics.com/blog/index.php/2013/02/the-great-rebalancing/

    Using very clear reasoning he shows how what looks like a lack of saving in one country can often be explained by monetary policy in other countries. I don’t think anyone would finish it and say NZ doesn’t have a savings problem but it significantly updates the international economics I was taught at university.

    • http://tvhe.co.nz/ Matt Nolan

      Cheers, I will be sure to read the book.

      In the last decade there has been the feeling that many countries are experiencing a “glut of savings” – in which case interest rates get pushed down, and a current account deficit makes sense for a country like NZ. I definitely feel that argument has weight.

      If anything, that shows it is an issue that needs clearer discussion in the public :)

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  • Blair

    It’s great to have blogs where this sort of discussion can happen.

    • http://tvhe.co.nz/ Matt Nolan

      It is great for everyone involved – good fun!

  • Apirana

    “you’d be suprised to hear that no-one in the economics profession would disagree”
    I think you would find that there are plenty who would disagree.

    • http://tvhe.co.nz/ Matt Nolan

      I was taking the passage as saying:

      1) The crisis wasn’t taken as a given – and was given a sufficiently low probability of happening in general

      2) We need to understand why things happened before we talk about doing anything.

      In that context, I think most economists agree! Now, what “should” be done and what descriptively happened – those are things where there is a lot of debate ;)

      • Apirana

        1) Risk modelling might have got it wrong (and the contribution of Basel etc to reliance on those models) but many economists and others saw the crash coming from a long way off. Turner is closely linked to he last Labour administration and he avoids discussing Brown’s contribution, or in fact central govt’s contribution, to the crisis or for that matter the FSA’s.
        2) I think we generally do. However, Turner’s policy prescription (well at least he has suggested in the past) is merely another version of Keynes’s bank notes in bottles (he has run this before). His insistence on creating demand through gifts of fiat money is Weimar economics.
        As for
        “financial regulation and of macro-prudential policy to ensure that it doesn’t happen again”
        I shudder.

        • http://tvhe.co.nz/ Matt Nolan

          I started working as an economist at the start of 2007. At the time everyone was talking about the potential for a crash, and how these things tend to just happen – but the view was much more 1987 rather than 1929. And this was simply because there wasn’t a recognition of the nature of the shadow banking system.

          And there were economists that saw the risk of this, and realised that central banks were missing a beat – very true. But it is hard to separate the wheat from the chaff with many of these, given that some of these people consistently and constantly pick a crisis to happen all the time. In truth, the best economists are the ones who could see a real chance of it happening, where able to use the tools of economics to explain why, and then have contributed to leading our understanding forward post crisis (instead of engaging in pissing contests) – these guys are the real deal.

          “However, Turner’s policy prescription (well at least he has suggested in
          the past) is merely another version of Keynes’s bank notes in bottles
          (he has run this before). His insistence on creating demand through
          gifts of fiat money is Weimar economics.”

          It is basic helicopter economics in the face of massive negative interest rates. I think he is wrong about it being good policy now – but it was justifiable a couple of years back (when organisations were forecasting their own failure). I think he underplays the fact it is a fiscal transfer yes, but that is all.

          “As for “financial regulation and of macro-prudential policy to ensure that it doesn’t happen again” I shudder.”

          I can understand where you are coming from. I get worried that regulation is put in solely to “stop” things without a consideration of the costs and benefits and environment. All we can do here is try to get a better descriptive understanding to help policy makers – rather than directly railing against regulation or the lack of.

          • Apirana

            I agree that at the start of the crisis QE in UK and US was probably the right response. It is interesting that the Irish last week monetised the debt of Anglo Irish Bank without reference to the Euro central bank. The policy responses to the crash in UK have I suspect by and large been unhelpful, particularly regulatory. Financial services are becoming bound up in pointless and corresive regulation that doesn’t solve, or does little to solve, the problems. Banks need a mechanism that enables them to go bust and to be unwound in an orderly fashion. Instead politicians are trying to regulate away risk raising bareers to entry and concentrating power in the hands of the current players. Splitting invetsment banking from retail will do little to reduce risk, will drive up the cost of capital and will not solve issues concerning tax payer underwriting.

            • http://tvhe.co.nz/ Matt Nolan

              Indeed, in NZ the central bank is trying to focus on the orderly winding down of banks for that very reason.

              I do not know enough about the specifics in the UK to offer much I’m sorry, hopefully our UK correspondent can get involved!