Macroeconomics is to microeconomics as …
This GREAT quote from a commenter on this marginal revolution post:
I’ve always felt that macroeconomics was not economics the way astrology is not astronomy. (*)
That is brilliant. I have to admit, I work doing Macro, but I heart Micro.
Oil shocks
Time is tight so I can’t do a real blog post just now. However, I thought I could mention oil shocks and the difference between their impact in the 1970’s and now.
Oil prices have gone through the roof in recent times as a result of high world prices. In 2006, New Zealand was also suffering from its own oil shock, with world prices high and our dollar falling. However, we haven’t really seen much of an impact on the domestic economy, other than a slight fall off in domestic consumption. Compare this to the 1970’s, when oil shocks caused periods of massive inflation, forcing economists to see that the Phillips curve idea didn’t hold up in a dynamic setting.
Greg Mankiw goes on to discuss three reasons why oil shocks haven’t lead to massive inflation (note that the current oil shock will be severe in the USA, as their dollar has fallen strongly and world prices have risen):
- The economy is more energy-efficient
- Labour markets are more flexible, monetary policy has been designed better
- The inflationary impact of an oil price shock is different when it is the result of greater demand for oil (as it is currently) compared to the 1970’s when their was a cut in the supply of oil.
If I find time, I might try to talk about these issues, and how I think oil price shocks influence the NZ economy, but don’t count on it 🙂 . So, does anyone have anything to say about oil price shocks (preferably not about peak oil, but if you really have to 🙂 )
Update: There was a fourth reason in the Mankiw article. 4) The increase in oil prices was not as sudden, giving economic variables the chance to adjust (this concept comes from his New Keynesian belief in sticky wages and prices).
Update 2: Even NZPA has something to say about Oil prices and inflation, it might be a hot topic.
Update 3: Looks like the topic of Oil prices is making its rounds on the blogsphere. With US economic growth at 3.9% (this is an annualised rate, it is equivalent to have just under 1.0% quarterly growth in terms of how we measure GDP in NZ) with these high oil prices, it looks like this will be an important and interesting issue.
Even economists struggle with inflation
I have to admit that when I read this news story last night I was very angry. BERL seems determined to tell everyone that increasing interest rates increases the money supply, and a higher money supply leads to higher inflation. This would make sense, if money supply wasn’t INFINITE. But it is.
In NZ we have an OCR target, the RBNZ will provide an unlimited supply of money for a given target rate. By doing this the Reserve Bank sets the interest rate, and the quantity of money is determined by money demand not money supply.
Now, the amount of foreign capital available does have an impact on us. If our interest rates rise then additional foreign funds become available for firms and banks to borrow. The foreign funds are available for a rate higher than the previous interest rate (as they required a higher return to become available) but this rate is lower than the domestic rate. If our interest rate is far above the world rate, then a significant amount of capital becomes available at this rate.
The important thing to note here is that this capital will only be spent if there is demand for it. As a result, the fact that foreign capital wants to enter the country will limit the degree with which an increase in the OCR will lift interest rates, it won’t magically make people want to borrow and spend more money.
The problem NZ has faced is that the RBNZ has not been able to drive interest rates up as much or as quickly as they would have liked (I’ve heard a time lag of 18 months mentioned in some circles!). However, the reason inflation has risen strongly is that money demand has increased significantly since from 2003, and the RBNZ was unable (and at times relatively unwilling) to significantly drive up interest rates.
The OCR is still the right tool to use, however if our interest rates are too far above the world interest rates, the marginal effect of an increase in the OCR is very small. In cases like this some type of alternate instrument might be of use. However saying that the OCR increases the money supply is at best ignorant of New Zealand monetary policy, and at worst a desperate plea for attention from a set of economists.
Run on funds drives LDC finance down
So the latest finance firm to collapse was actually in good shape, until good old investor panic lead to a run on funds took it out. The eight company since May 2006, I bet you a lot of people feel scared now.
The main thing to remember is that this company was small, $19m owed to investors is peanuts compared to the size of the ‘finance firm’ market of $16b. This story would not have made news if it wasn’t for the 7 other companies had gone done in recent memory.
Here we have a game of complementary actions. If you believe that other investors are now going to dump the firm, the expected payoff from you dumping the firm rises. If you think other investors are more willing to loan to the firm, the expected payoff from staying with the firm rises. In this case we can have a co-ordination problem. The equilibrium where everyone stays with the firm would have been dominant in the case of LDC, but as peoples beliefs were affected by recent uncertainty, we ended up in a degenerate, sub-optimal equilibrium where LDC folded.
In cases like this, the government can find ways to steady the nerves of investors and prevent things like this from happening, for example by cutting the cash rate. However, as always with economics, there is a trade-off. If the monetary authority cut rates to save the good firms, they would create a moral hazard problem for the market in the future. Finance companies would believe that the government would bail them out, and so would be willing to take on more risk than is socially optimal.
As a result, the best government action would be to tell investors to relax, but do nothing substantial. A correction in the financial market will take out a few genuinely good finance companies. However, this is the price we must face for clearing out all the dead wood in the market, and ensuring that our financial sector functions more cleanly in the future.
Update: Another little finance firm has gone, this one is valued at $16m, Finance and Investments was its name. Its times like these we need someone to come onto TV and tell everyone to calm down, someone like Keynes. I miss Keynes. Note: This firm only went down as it was getting funding from LDC, as a result we can blame the damn run on funds for this as well. Damn you fund runners 😉
Was Greenspan a big softy
Yves Smith think so. His argument is that, even though we didn’t fully appreciate it at the time, Greenspan really really cared about equity markets. He was scared of them, and he didn’t want to go out there and nail them as much as he should have. By being ‘hostage’ to the equity markets, Greenspan surrendered some of the Central Banks integrity. He gave up the hard arse, anti-inflationary image of the Central Bank that Paul Volcker had created.
I’m not sure I agree completely, I mean Greenspan did have the ability to keep inflation in the bag for 19 years. However, his unclear style of speaking and his refusal to target a clear level of inflation did create unnecessary uncertainty in the marketplace, and to some degree, may have damaged the inflation fighting power of the Federal Reserve.
A Reserve Bank governor needs to be a clear speaker, who finds the mere idea of inflation repugnant. That is why Don Brash did such a good job.