Matt Nolan

Outgrowing Inflation II

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Rod Oram has had another crack at explaining why he thinks higher output will lead to lower inflation. His argument is, that higher output can help us reduce housing, labour, and business capacity constraints which are dogging the economy.

The first point seems to be his main one, that there are too few houses and so building more houses will reduce house prices . He has a point here, but not a strict point about inflation. House prices rising doesn’t mean inflation, it means that there has been an increase in the price of houses relative to other goods. However, house prices increases can drive inflation by making people feel wealthy, and thereby increasing their rate of general consumption. As a result, all that matters is the rate of growth (return) in house prices, which is driven by short-run demand factors (as supply takes time to adjust).

Now, growth won’t help increase house construction enough to drive house prices down, the constraints holding up house prices are structural. Councils refusing infill, the difficulty of getting consents to build property, these are the reasons that house construction activity has been sub-par. As a result, its not a matter of keeping interest rates low, it is more a matter of regulatory constraints.

His second point is that we need to increase labour skill training and capital to increase output. Yes that would increase output, however it is not current growth that drives investment, it is the expectation of future growth. As a result, the current goal of monetary policy of stabilising prices is the best way of driving efficient long-run investment (by reducing uncertainty).

The third point is that businesses need to innovate. Again this is a business decision, government policy is not trying to stifle innovation and so this doesn’t do anything to defend the idea that keeping interest rates down will reduce inflation.

Ultimately, I think in this second article he switched tack slightly, and discussed situations where we could grow, rather than attacking monetary policy as he did in the first article, which we wrote about. However, I don’t believe that he has shown that all things constant higher growth leads to lower unemployment, all he has done is changed some of the parameters (making people more productive etc).

Matt Nolan

Outgrowing the inflation problem

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In this article, Rod Oram discusses the two options he sees for battling inflation:

  1. Raise interest rates to slow growth, thereby reducing the pressure on our limited resources.
  2. Increase the resource base

Both of these ‘strategies’ would reduce inflationary pressure. One would reduce aggregate demand; the other would increase aggregate supply.

The first strategy is what NZ is doing (and most countries try to do when inflation comes out of the bag). The second ‘strategy’ would be preferable, as it would increase the number of goods we can buy as a nation. However, Rod didn’t tell us how we are supposed to increase our resource base. According to him we can ‘grow it’, so as the economy is growing the resource base will magically grow as well.

I don’t agree with this idea, but I’m going to try and rationalize what he is saying, and then say why I think it won’t work. Many people have been saying that if we had lower interest rates, investment would be greater, which is an increase in our resource base. As a result, this may be his solution, lower interest rates increase investment, which increases aggregate supply. The problem is, if we kept interest rates at a lower level, we are implicitly allowing a greater level of money supply growth into the economy, which will in turn cause upward pressure on inflation. Which effect dominates depends on the productivity of new capital investment, as if new capital is very productive then the increase in resources requires an increase in the money supply for prices to remain constant.

New Zealand currently has relatively low capital productivity (capital productivity has only risen 1.2% in the last 10 years), and at the margin, this level of productivity will be even lower. This implies that any increase in the supply of resources from a lower interest rate will be very small, and as a result inflationary pressures will be strong.

Furthermore, when a firm makes a long-run investment decision what matters is the long run (risk adjusted) cost and benefit of that investment. In this case the short-term interest rate is not of importance, it is the long-run rate of interest that matters (as interest rate changes can be insured against). Uncertainty for the firms investment decision comes from issues of price, if the level of inflation is high there will be significant volatility between the price of goods (as prices would change at different discrete time periods) making the return on the investment more volatile than in a low inflation environment. As firms are risk averse, higher inflation will lead to lower long run investment – implying that trying to grow our way out of inflation will not work.

jamesz

Let the healthcare debate continue…

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There are plenty of worthwhile discussions amongst economists and policy-makers about the best way to fund health care. A debate that goes on largely outside the policy-makers’ domain, however, is whether increased health care spending actually improves health care at all. There is a sizable body of research which suggests that increased health care spending doesn’t improve outcomes one iota! If this is true then it makes the whole health care funding debate largely irrelevant.

The real problem with these rather counter-intuitive results is endogeneity bias: often large spending in a particular geographical area indicates that people with serious health problems live in the region. If this is the case then the cross-sectional sample is not randomly selected and the results will be biased. Thankfully, some brainy econometricians came up with a way to instrument for the endogeneity problem and they find that health care spending IS positively correlated with health care outcomes. So now we can all get back to arguing over our entrenched, ideological positions on health funding again. Phew!

Matt Nolan

New Zealand Currency in Free Fall

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So the NZ currency is currently at $0.705US, implying that it has fallen $0.105US in two weeks. What the hell is going on?

As far as I can tell, investors in the US are nervous about some perceived economic contagion from the troubles in the sub-prime mortgage market. As a result of this economic uncertainty in the US, everyone has become significantly more risk averse in their investment behaviour, and in currency markets a ‘flight to quality’ has begun. The quality in this case is US dollars and the Yen.

So the economic situation in the US looks weak, and their dollar has appreciated against ours, messed up aye. Still, for that very reason I don’t think that this is sustainable. The fundamentals that drove our currency to $0.81US still remain in place, robust economic growth, strong world growth, awesome soft commodity prices, and comparatively high interest rates. I’m certain we will hit $0.76US again in the near future, and I wouldn’t be surprised if we hit $0.78US before September. $0.81US was a bit ridiculous, but I think we have fallen a bit past fair value.

Update: Now we are slipping under $0.69US, this reminds me of a famous Keynes quote “The market can stay irrational longer than you can stay solvent”. Damn those animal spirits.

jamesz

Fair pay for the military?

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This blog is all about the times that the market should give way to government intervention; however, I liked Stephen Levitt’s comment on military conscription too much not to post it up. It’s a great example of a case where an area traditionally managed by the government might be improved if we let the market have greater freedom. It’s also a classic Levitt-ism: where he applies economic reasoning to fields not usually studied by economists.

His idea is that, if military service was a job like any other, then soldiers would be paid commensurate to the dangers and hardships they endure. They would also be free to quit at anytime if they felt that they were not being paid a sufficient sum to compensate them for the risks they faced. This, in turn, would force the government to bear the true cost of waging a war: in war-time the troops wages would skyrocket along with the dangers they faced. In economic terms this must be considered far more efficient than the current situation.

The existence of mercenary troops and private security forces in Iraq is testimony to the fact that people are willing to work in that sort of environment if the wage is high enough. Of course, Levitt isn’t suggesting a privatised army, simply an army who can truly be called volunteers in wartime as well as in peacetime. Is that really as traitorous as the comments on his blog suggest?

Matt Nolan

Government intervention and the Right

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The following article by Roger Kerr discusses New Zealand economic growth relative to the OECD. He complains that our economy is growing too slowly, and as a result we are actually falling further behind other developed countries.

As he is from the Business Round Table, he has to criticise government for this lack of economic growth. There are two ways he could do this that would imply government failure. He could:

  1. attack government spending and say that it is crowding out productive investment
  2. attack where government spending is going

In a sense, he chooses to attack where government spending is going in his article, but not directly. What I find interesting is that he complains that productivity growth is too low, and then blames the government for abandoning its goal of economic growth. So he is blaming government for a lack of action, rather than saying that some active government policy was a failure. This implies that he thinks government policy can increase productivity growth.

We also happen to believe that appropriate government policy can improve productivity and economic growth, it is nice to see that people on the right-hand side of the spectrum agree with us.