More immigration?

So, our labour market is looking extremely tight. According to the department of labour all nine of the main occupation classes are currently suffering from labour shortages, and these shortages are likely to continue into the medium term. So the country needs more workers, and it takes time to breed them, so why don’t we get them in from overseas?

The government seems concerned about letting people into the country as it might cause inflation. But if we are actually suffering from a chronic labour shortage, a few extra pairs of hands will surely help suppress inflationary pressures.

As long as the individuals we bring in are more productive than the average New Zealander everyone is better off. Whats the problem?

Outgrowing Inflation II

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).

RBNZ introduces some liquidity

The RBNZ has made it easier for banks to borrow money off them, in order to stave off a squeeze in credit in the banking sector. This sounds fine to me, and the measures they put in place seem reasonable, there was one thing I did not understand though. It says that the bank is selling more short-term bonds, wouldn’t this contract the money supply and reduce liquidity?

Maybe the reporter put it down wrong, but making it easier for banks to borrow money, and then providing them riskless assets to buy with it doesn’t sound like a way of increasing liquidity in the New Zealand credit market. Hopefully the RBNZ does a release soon, and explains to me how I’m an idiot, or if you’re quick maybe you can beat them to it 😉

Outgrowing the inflation problem

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.

New Zealand Currency in Free Fall

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.

Floating GST rates?

So supposedly, the RBNZ has suggested a floating GST rate as a way of controlling inflation. Now this seems silly too me for two reasons:

1) GST is a tax, as a result this would either have to be implemented through fiscal policy (and so would not work, as governments cannot commit to just focusing on inflation), or you would have to give the Bank the right to tax (as the Bank is not elected by the people this is uncomfortable)

2) The level of GST affects the price level, so if the economy is running strongly and you prop it up, you push up the price level.

Now the first criticism is self-evident, however it is a normative problem with the scheme, implying that there might be some theoretical merit. The second criticism is positive. Now, I am not saying that changing the GST tax will cause inflation, as inflation is the rate of change in the price level. Changing the GST tax will change the price level, but not change the rate at which the price level grows, in fact increasing GST will take money out of the economy, slowing growth in the price level and thereby slowing inflation.

So a floating GST tax would slow inflation, however lets think about why we want to slow inflation. We want to reduce volatility in the price level, to give people certainty. Volatility in the price level is bad as the majority of people cannot properly hedge against it. Now by having the GST tax increase and fall we are adding volatility to the price level, causing one of the problems that monetary policy is supposed to solve. It just seems a bit silly.